Category: Economics

We have nothing to fear but fear itself, but
fear itself can be pretty scary.

…Fear is ruling the
financial markets. Billions of dollars have been lost in mortgage-related
investments. The Federal Reserve worked madly over the weekend to
engineer a takeover of Bear Stearns and avert a systemic meltdown. But
the big fear remains. How low will house prices go?

If prices continue to fall, mortgage defaults will move well beyond the
subprime sector. Trillions of dollars in losses for investors are not
impossible. But that doesn’t mean they are inevitable.

That’s me in today’s New York Times.  Believe it or not, my piece is one of the more optimistic pieces you are likely to read on the housing crisis.

I think that housing prices went beyond the fundamentals sometime around 2004 (and I said so in 2005, see here and also note my warning that prices could fall dramatically here).   But 2004 levels are still well above long run trend.  Thus my optimism stems from thinking that unlike Japan, our housing prices need not fall back to long run trend (see my piece for graphs).

But the problem is that we can overshoot the fundamentals going down as well as going up and the United States now faces two potentially
self-fulfilling prophecies.

If the financial markets can predict where and when house prices will
stabilize, then credit conditions can quickly return to normal, the
economy can expand and house prices will indeed stabilize.

But if the financial markets remain uncertain about when the decline in
house prices will end, then fear will tighten credit even further, which
would strangle the housing market and generate even more fear.

Unfortunately, I do not know what will push us into the right prophecy (but read my piece, that will help!)  Thus, I am more optimistic than Paul Krugman, who thinks that we may have slipped into the state where no prophecy can bring us back to a good equilibrium, but I’m not that much more optimistic.

…perhaps the most important reason why the Spanish financial system is
unlikely to suffer a meltdown is the virtual absence of Special
Investment Vehicles (SIV) and conduits. These animals allow banks to
move mortgage-backed securities off their balance sheets, thus
obscuring the exposure of individual institutions and escaping capital
requirements.

There is much more here.  Note also that Spanish originators keep a share of each mortgage they securitize.  In case you didn’t know it, Spain too has had a bursting of its real estate bubble, although so far they have not had comparable troubles with their banks.

It is with Russ Roberts and it covers the roots of our current crisis, why things are far more troublesome than most people expected (and that is the really tough question; real estate bubbles have burst before), why monetary policy matters at all, the tricky balancing act played by the Fed, why a gold standard isn’t the answer, and many other macroeconomic topics.  My core attitude, in case you don’t already know it, is that monetary policy is both an art and a science and there are no secret ways of getting it right, understood by only a few.  The podcast is here. 

Addendum: Arnold Kling summarizes.

Not all investors are expected to be pleased with the deal. A
conference call with investors and analysts on Sunday night was broken
up when a Bear Stearns shareholder sought an explanation of why he
would be better off approving this transaction rather than seeing Bear
Stearns file for a Chapter 11 bankruptcy.

The JPMorgan executives
demurred, instead referring the investor to Bear Stearns executives for
an explanation. The shareholder declared that he would vote against the
deal.

Afterward, Mr. Cavanaugh said JPMorgan felt comfortable in
pulling the trigger despite the short due-diligence process. “We’ve
known Bear Stearns for a long time,” Mr. Cavanaugh said.

Vis-a-vis that last sentence, last year the stock price was $170, late Friday it was $30 a share, yesterday the deal was done at about $2.  Here is the story.  From published accounts, the nature and extent of the Fed and Treasury obligations is not yet clear.

No, not that N word, the other N word.  Nationalize.  As in nationalize a financial institution here and there.

Do you know how Paul Krugman is following the TED spread as an indicator of current financial troubles?  I’ll be following how many times the N word pops up in Google News.  Right now the top mentions all concern other countries, of course including Northern Rock in Great Britain.  So far this is the closest I’ve found to hints of nationalization for the United States; in the blogosphere Nouriel Roubini is saying nationalization is better than bailouts.

The Swedes, of course, nationalized Nordbanken, their #2 bank at the time, in the early 1990s, during their financial crisis.  They also nationalized Gotabanken and supplied funds to several other institutions.  The belief at the time was that loan liquidation would have been even worse.  And since Nordbanken was on life support anyway, and the government had to limit systematic risk by paying off creditors anyway, why not just control the bank directly?  The bank was subsequently re-privatized.  You’ll find more background on the Swedish experience here.  Of course in these situations none of the options are pretty.  But keep in mind that the Fed (and ultimately, the taxpayer) is already residual claimant on the Bear Stearns deal and then read Mises on the dynamics of interventionism.

There are many things we do not do as well as the Swedes.  In any case, if use of the N word remains spotty or non-existent in the U.S., you’ll know that things are going OK, at least relative to what might have happened.

Addendum: Brad DeLong has much to add, including some policy recommendations.  Arnold Kling doesn’t agree.

By Dean Foster and H. Peyton Young.  They fear that hedge fund managers can write a series of naked puts with high probabilities of above-average returns and low probabilities of extreme disaster.  Most of the managers will establish track records and attract more funds.  They gain on the upside but don’t lose that much on the downside.  The key problem is that investors judge investors on the basis of observed past performance, not the entire probability distribution they have created.  Yet the latter is what we all end up having to live with.

The Philosopher’s Hotel features a series of rooms that are perhaps less overtly amazing but equally compelling for the right clientele: each room revolves around the life, work and philosophy of a particular philosopher. The above rooms, for example, respectively play off Georges Bataille’s concepts of sexuality and eroticism, Ludwig Wittgenstein’s philosophies of language, ethics and mysticism and Henry David Thoreau’s obsession with time, age and nature. Other rooms revolve around famous thinkers such as Nihilist Friedrich Nietzsche…

I hear that in the Parmenides room the mini-bar does not open and the Heraclitus room has a water bed.  The hotel is in the Netherlands, so where is the Bernard Mandeville room ("Private Vices, Publick Benefits")?  Here are many more unusual hotel rooms, both the texts and photos are interesting.  And here are (supposedly) the smallest hotels and hotel rooms in the world.

The house where Adam Smith lived for many years with his mother and which more recently was used as a home for troubled youth has been put up for sale by the Edinburgh Council for £700,000.  Sir Alan Peacock says "It’s a disgrace that the council has
agreed to dispose of a building as significant as this. It should be
saved for the nation."

I think it would be a disgrace if the house went to anyone but the highest bidder.

Take a simple model of liquidity.  I can sell at a good price only if I think you — you in the broad aggregate and collective sense — won’t.  (Remember: "Liquidity is only there when you don’t need it")  In other words, my motive in selling has to be idiosyncratic.

Now say some common knowledge comes to this market.  No one can sell in response to this common knowledge.  Everyone has it, by definition, so it’s not idiosyncratic.  Transparency, by the way, is simply more common knowledge and that is, with respect to liquidity, the problem in the first place.

Let’s say the new common knowledge is "this asset class isn’t as liquid as we used to think."  Ideally price should fall but how much?  If selling is only scattered the market never learns the shape or exact location of the new demand curve.  Furthermore the selling you observe only tells you "how good is the market at responding to this knowledge shock" and not "what was the initial liquidity downgrading in the first place."  Convergence, today, appears to be problematic.

Does herd behavior, combined with agency problems, make things worse?

Is it the standard story that everyone is afraid of the other trader’s knowledge?  Or can liquidity crises become more acute in a hyper-informed world?  We like to think: "market — trade — liquidity — good, etc.", forgetting the Glosten-Milgrom point that liquidity often rests upon the presence of fools.  Informing the fools eliminates one business cycle problem but creates another.

Addendum: Felix Salmon adds excellent commentary.

Here is another innovative way to help the poor:

Sangini Women’s Co-operative Bank
aims to help these women break that cycle by providing savings accounts
to the sex workers that can then be passed down to their children. As
one sex worker laments:

“But earlier there was no way to save money. Even if you
gave it for safekeeping to a shopkeeper or brothel manager, they would
never return it.”

One of the interesting outgrowths of this newfound ability to save
is that it provides the women a means to say no to clients that are
unwilling to use or do not have condoms. Accordingly, these savings accounts give the opportunity to the women to protect themselves from HIV.

Here is the link and more.  Note that when it comes to insuring against consumption risk, even zero interest savings can be more efficient than paying a high interest rate on micro-credit.

By Paul Krugman, circa 1978.  He considers the arbitrage conditions for interstellar trade, given that not all traders will inhabit the same frame of temporal reference.  There is much humor in this piece. 

My own puzzling focuses on the determinants of real interest rates, given how time dilation changes the meaning of time preference.  As you approach the speed of light you move into the future relative to more stationary observers.  So can you not leave a penny in a savings account, take a very rapid spaceflight, and come back to earth "many years later" as a billionaire?  Hardly any time has passed for you.  In essence we are abolishing time preference, or at least allowing people to lower their time preference by spending money on fuel.  I believe that in such worlds the real interest rate cannot exceed the costs at which more fuel can "propel you into the future through time dilation."   

Whether the individual arbitrage conditions translate into economy-wide arbitrage conditions is a difficult puzzle.  What if everyone gets into a fast spaceship?  Do the savings accounts still bear positive interest?  How does the price of robots enter into this equation?

Is monetary policy neutral in such a world, with time travelers arbitraging against any attempt by the Fed to shift real interest rates?  Does the Fed have to subsidize the price of fuel to stimulate the economy?  Does everyone just end up in the future?

But wait, surely these people do know history.  Marco, a loyal MR reader, writes to me:

Over here in the Netherlands, court proceedings are starting this week on the "biggest speculation fraud ever in the Netherlands", according to a national newspaper that ran a big story about it today. Investors have lost tens of millions of euros in what turned out to be a big pyramid scheme.

Now for the ultimate irony. Any idea what these people were investing in? Tulip bulbs. Really.

Here is one link in Dutch, here is another.  I can’t find anything in English but these articles do seem to reflect Marco’s summary.  I can understand sentences like: "Ook volgens De Greve was er sprake van een piramidefonds," and "November 2006 ging Novacap falliet," if not: "De Greve: „Er is geen spatje bewijs voor dat de groep die Novacap heeft gedaagd, de boel heeft opgelicht. Dat is flauwekul.”

It’s not so hard to explain:

The conditions under which transactors can use the market (repeat-purchase) mechanism of contract enforcement are examined.  Increased price is shown to be a means of assuring contractual performance.  A necessary and sufficient condition for performance is the existence of price sufficiently above salvageable production costs so that the nonperforming firm loses a discounted stream of rents on future sales which is greater than the wealth increase from nonperformance.  This will generally imply a market price greater than the perfectly competitive price and rationalize investments in firm-specific assets.  Advertising investments therefore becomes a positive indicator of likely performance.

That’s Klein and Leffler, JPE, 1981, who shy away from making the prurient explicit.  This is one easy way to get a demand curve sloping upwards, namely you only trust the person if she is receiving lots of money.  But what’s the point of preventing shirking if you’re going to be self-incriminating?

Investors collectively spend around $100 billion a year trying to beat the stock market. That’s the finding of a rigorous effort to measure the total costs of Americans’ efforts to surpass the returns they would have received by simply holding a stock index fund. The huge price tag helps explain why beating a buy-and-hold strategy is so difficult.

Here is much more, and from Felix Salmon.  You can think of this sum as the amount it costs to keep markets relatively efficient, a source of societal fraud and rent-seeking, a Nash equilibrium mixed strategy (no one tries to beat the market on every margin), a donation to the broader social good, or most properly all of the above.  Interfluidity adds comment.