Financial meltdown cause and effect
I was in Europe during the (now not so) recent events and got a different perspective. But I didn't have the time or access to read up on it at that time, so my initial thoughts were this:
1) It's only a matter of time until ... yep, in the very first article I finally sat down to read, the words "laissez faire" were used to assign blame for the problem. It was from a writer in the US. It held little resonance there since EU institutions were having a problem at the same time, and they are certainly not afflicted with the LF disease. Here in the US, I cannot get any of the people arguing the "laissez faire" angle to explain the simultaneous meltdown in enlightened, regulated, social-democratic Europe.
2) As I recall, we had a series of up and down market "events" over the last 10 years. Some of these included a tech stock bubble, the collapse of LTCM, the Asian crisis, some concern over the potential Y2K problem, and a downturn in 2001. Alan Greenspan admitted to pumping cheap money into the economy in reaction to these events, creating or at least exacerbating a bubble or two.
3) In an up market, people can afford to make mistakes because there are so many other factors erasing the effect of those mistakes. Another way to look at it is that bubbles are like a Ponzi scheme in which the early participants are bailed out by subsequent participants. Yet another way to view it is that the entrance of new buyers is a public good since their actions prop up the price of everyone else's investment (in some circles, public goods are always a good thing and must be subsidized). A sufficiently advanced bubble is easily popped if new entrants fail to materialize or participants start backing out. I have yet to see much written on the triggering mechanism.
4) An obvious but unmentioned triggering mechanism, which is surprising because it was all the rage a year or so ago, was the effect of soaring energy and food costs. Fewer people were willing to buy homes and some probably had to back out of loans because they could not also afford to keep their Suburban fueled up or their refrigerator filled with HFCS. I suspect this has gone unmentioned because those costs have been going down just at the moment the financial "crisis" came into full swing.
My take on this fiasco, before spending much time looking into it, was that the energy and food costs pricked a real estate bubble. The real estate bubble was caused (or at least aided and abetted) by the Fed's policies by Greenspan's own admission. Fuel prices were high because of both a lack of additional fuel coming onto the market and a greater demand in the emerging Asian markets. Food prices were rising in part because of the fuel prices, and in part because of distorting farm policies (including ethanol subsidies, which is another fuel-related angle). While the fuel problem is arguably related to real market forces [1], energy production, distribution, and pricing is about as far from "laissez faire" as one can get. The other factors -- food, real estate, and Fed policies -- are not even arguably laissez faire.
Once I got to looking into it, though, I can't help but note the bizarre mix of policy and blunder on the part of both state and state-capitalists at the heart of the so-called crisis.
First, I got a link to a video clip that blamed everything on Democrats who lobbied for increases in lending to the poor via the Community Reinvestment Act. While interesting, it failed on several levels. At one point, it implies that Democrats made a major change in 1995. I'm pretty sure Republicans were running Congress at that time. Also, it doesn't explain convincingly why the crisis didn't show up then instead of now.
Then, I came across a chart that showed a rapid expansion of subprime lending in the 2003 period. Why then?
Then, I started looking into the Credit Default Swaps, the key and/or only factor in the opinion of the "laissez faire caused this" crowd. Interesting, but hardly an example of laissez faire. More like, unregulated side market in a broadly regulated, subsidized, and entry-controlled industry.
Over and over, though, I kept coming across references to Fannie Mae and Freddie Mac. First, Paul Krugman's assertion that they didn't really have a problem and were in fact an example of a well-regulated system. But then there were the rebuttals that argued several things that seem important, but have not been well-covered. The first was that, in the era of Sarbanes-Oxley [2], Fannie Mae and Freddie Mac were exempted from such reporting. In fact, in spite of the fact that several hundred government overseers have nothing to do but look after these two Government Sponsored Enterprises, they made some huge accounting mistakes. The second was a paper, cited as a counterargument to Palin's claim that these two GSE's had gotten to be a huge risk to taxpayers, that noted that the GSE managers played a double game of telling Congress that they weren't claiming to be government-backed while telling investors that they were. The third was another paper that argues that because of their accounting errors and their desire to curry favor with Congress and an Administration that placed home ownership as a policy cornerstone, the GSEs basically went overboard in participating in the subprime market.
That last point specifically contradicts Krugman's claims of the triumph of regulation. The authors of the paper (Wallison and Calomiris) argue that Fannie Mae and Freddie Mac fooled lots of people besides Dr. Krugman, in part because they adjusted their definition of subprime. As Krugman argues it, subprime is by definition the class of people to whom the GSEs will not lend. That would be correct if they were honest, but in fact they had shifted the goal posts without being explicit about it. So they actually were helping to fuel the subprime market.
It has to be recognized that anyone buying up any mortgages is helping to lower the costs of even the most expensive (risky, subprime) mortgage. Let's say that a bank lends 90% of its money to consumers with good credit and 10% to those with bad. Then someone comes along and buys up some of those good mortgages. Now the bank has money to loan more to both the good risks and the bad. To the extent that they think they can still make money with that 90/10 ratio, they will lend the money to both good and bad risks. It's a damn subsidy intended to promote lending, and it works. All that is accomplished by CRA and shifts in subprime lending is to move that ratio; that's the point. Why are people now arguing that those effects are not real, or that they are not important? If they are not real or not important, then what is the point of the legislation that promotes those policies?
In the end, the finger-pointing going on between left and right wing is pure hypocrisy on both sides. Yes, changes were made in the laws in the 1990s. Some or most of these were passed by a Republican Congress and a Democratic president. Yes, some changes were made in the laws in the 2000s, all Republican. However, it has been noted that the Bush Administration drastically increased funding for regulation. They also sought increases in regulatory scope, but were not successful in getting it past a Republican Congress. At the same time, Democrats have been serving on the boards of Fannie Mae and Freddie Mac, have been benefiting from lobbying and campaign contributions, and have not done anything meaningful in the 18 months in which they have controlled Congress.
Finally, the bailout should be seen as a fleecing of taxpayers to prop up the assets and income of large bankers, fund managers, lobbyists, GSEs, and so on. It is the essence of state capitalism, embraced enthusiastically by both Democrats and Republicans. European wags are hailing this as the end of American capitalism -- ha! It is a null change in course, a culmination of all they have worked toward, the grandchild of the Federal Reserve Act, business as usual, another day at the office. While people fear the socialism that Obama might bring, they ignore the socialism that Bush confirmed.
The most vexing thing to me is the use of free market rhetoric by Republicans and the right wing. They use it while enthusiastically undermining it. They call a realignment of regulations, "deregulation". [3] Then, when the new regulations have "unexpected" consequences, the left, which frequently supports these "deregulation" schemes (natural gas, trucking, railroads, and S&Ls were all "deregulated" by a Democratic Congress and Jimmy Carter while the electricity industry in California was "deregulated" by their heavily Democratic state legislature) uses the event to decry "free markets", "deregulation", "laissez faire" policies, and "market fundamentalism". Shame on both of them.
--------------------------------
[1] And also to policy-driven emergence of Asian economies and export-driven state capitalism. China didn't get into the Wal-mart supplier business by accident.
[2] S-O should be judged a complete failure at this point since it did not prevent the single thing that it was designed to prevent -- surprise abnormalities in corporate reports and balance sheets ala Enron.
[3] I have always thought it interesting that Left wing polemicists are quick to point out all of the government supports, but they quickly forget those supports when discussing deregulation.
1) It's only a matter of time until ... yep, in the very first article I finally sat down to read, the words "laissez faire" were used to assign blame for the problem. It was from a writer in the US. It held little resonance there since EU institutions were having a problem at the same time, and they are certainly not afflicted with the LF disease. Here in the US, I cannot get any of the people arguing the "laissez faire" angle to explain the simultaneous meltdown in enlightened, regulated, social-democratic Europe.
2) As I recall, we had a series of up and down market "events" over the last 10 years. Some of these included a tech stock bubble, the collapse of LTCM, the Asian crisis, some concern over the potential Y2K problem, and a downturn in 2001. Alan Greenspan admitted to pumping cheap money into the economy in reaction to these events, creating or at least exacerbating a bubble or two.
3) In an up market, people can afford to make mistakes because there are so many other factors erasing the effect of those mistakes. Another way to look at it is that bubbles are like a Ponzi scheme in which the early participants are bailed out by subsequent participants. Yet another way to view it is that the entrance of new buyers is a public good since their actions prop up the price of everyone else's investment (in some circles, public goods are always a good thing and must be subsidized). A sufficiently advanced bubble is easily popped if new entrants fail to materialize or participants start backing out. I have yet to see much written on the triggering mechanism.
4) An obvious but unmentioned triggering mechanism, which is surprising because it was all the rage a year or so ago, was the effect of soaring energy and food costs. Fewer people were willing to buy homes and some probably had to back out of loans because they could not also afford to keep their Suburban fueled up or their refrigerator filled with HFCS. I suspect this has gone unmentioned because those costs have been going down just at the moment the financial "crisis" came into full swing.
My take on this fiasco, before spending much time looking into it, was that the energy and food costs pricked a real estate bubble. The real estate bubble was caused (or at least aided and abetted) by the Fed's policies by Greenspan's own admission. Fuel prices were high because of both a lack of additional fuel coming onto the market and a greater demand in the emerging Asian markets. Food prices were rising in part because of the fuel prices, and in part because of distorting farm policies (including ethanol subsidies, which is another fuel-related angle). While the fuel problem is arguably related to real market forces [1], energy production, distribution, and pricing is about as far from "laissez faire" as one can get. The other factors -- food, real estate, and Fed policies -- are not even arguably laissez faire.
Once I got to looking into it, though, I can't help but note the bizarre mix of policy and blunder on the part of both state and state-capitalists at the heart of the so-called crisis.
First, I got a link to a video clip that blamed everything on Democrats who lobbied for increases in lending to the poor via the Community Reinvestment Act. While interesting, it failed on several levels. At one point, it implies that Democrats made a major change in 1995. I'm pretty sure Republicans were running Congress at that time. Also, it doesn't explain convincingly why the crisis didn't show up then instead of now.
Then, I came across a chart that showed a rapid expansion of subprime lending in the 2003 period. Why then?
Then, I started looking into the Credit Default Swaps, the key and/or only factor in the opinion of the "laissez faire caused this" crowd. Interesting, but hardly an example of laissez faire. More like, unregulated side market in a broadly regulated, subsidized, and entry-controlled industry.
Over and over, though, I kept coming across references to Fannie Mae and Freddie Mac. First, Paul Krugman's assertion that they didn't really have a problem and were in fact an example of a well-regulated system. But then there were the rebuttals that argued several things that seem important, but have not been well-covered. The first was that, in the era of Sarbanes-Oxley [2], Fannie Mae and Freddie Mac were exempted from such reporting. In fact, in spite of the fact that several hundred government overseers have nothing to do but look after these two Government Sponsored Enterprises, they made some huge accounting mistakes. The second was a paper, cited as a counterargument to Palin's claim that these two GSE's had gotten to be a huge risk to taxpayers, that noted that the GSE managers played a double game of telling Congress that they weren't claiming to be government-backed while telling investors that they were. The third was another paper that argues that because of their accounting errors and their desire to curry favor with Congress and an Administration that placed home ownership as a policy cornerstone, the GSEs basically went overboard in participating in the subprime market.
That last point specifically contradicts Krugman's claims of the triumph of regulation. The authors of the paper (Wallison and Calomiris) argue that Fannie Mae and Freddie Mac fooled lots of people besides Dr. Krugman, in part because they adjusted their definition of subprime. As Krugman argues it, subprime is by definition the class of people to whom the GSEs will not lend. That would be correct if they were honest, but in fact they had shifted the goal posts without being explicit about it. So they actually were helping to fuel the subprime market.
It has to be recognized that anyone buying up any mortgages is helping to lower the costs of even the most expensive (risky, subprime) mortgage. Let's say that a bank lends 90% of its money to consumers with good credit and 10% to those with bad. Then someone comes along and buys up some of those good mortgages. Now the bank has money to loan more to both the good risks and the bad. To the extent that they think they can still make money with that 90/10 ratio, they will lend the money to both good and bad risks. It's a damn subsidy intended to promote lending, and it works. All that is accomplished by CRA and shifts in subprime lending is to move that ratio; that's the point. Why are people now arguing that those effects are not real, or that they are not important? If they are not real or not important, then what is the point of the legislation that promotes those policies?
In the end, the finger-pointing going on between left and right wing is pure hypocrisy on both sides. Yes, changes were made in the laws in the 1990s. Some or most of these were passed by a Republican Congress and a Democratic president. Yes, some changes were made in the laws in the 2000s, all Republican. However, it has been noted that the Bush Administration drastically increased funding for regulation. They also sought increases in regulatory scope, but were not successful in getting it past a Republican Congress. At the same time, Democrats have been serving on the boards of Fannie Mae and Freddie Mac, have been benefiting from lobbying and campaign contributions, and have not done anything meaningful in the 18 months in which they have controlled Congress.
Finally, the bailout should be seen as a fleecing of taxpayers to prop up the assets and income of large bankers, fund managers, lobbyists, GSEs, and so on. It is the essence of state capitalism, embraced enthusiastically by both Democrats and Republicans. European wags are hailing this as the end of American capitalism -- ha! It is a null change in course, a culmination of all they have worked toward, the grandchild of the Federal Reserve Act, business as usual, another day at the office. While people fear the socialism that Obama might bring, they ignore the socialism that Bush confirmed.
The most vexing thing to me is the use of free market rhetoric by Republicans and the right wing. They use it while enthusiastically undermining it. They call a realignment of regulations, "deregulation". [3] Then, when the new regulations have "unexpected" consequences, the left, which frequently supports these "deregulation" schemes (natural gas, trucking, railroads, and S&Ls were all "deregulated" by a Democratic Congress and Jimmy Carter while the electricity industry in California was "deregulated" by their heavily Democratic state legislature) uses the event to decry "free markets", "deregulation", "laissez faire" policies, and "market fundamentalism". Shame on both of them.
--------------------------------
[1] And also to policy-driven emergence of Asian economies and export-driven state capitalism. China didn't get into the Wal-mart supplier business by accident.
[2] S-O should be judged a complete failure at this point since it did not prevent the single thing that it was designed to prevent -- surprise abnormalities in corporate reports and balance sheets ala Enron.
[3] I have always thought it interesting that Left wing polemicists are quick to point out all of the government supports, but they quickly forget those supports when discussing deregulation.
Labels: failure, politics, regulation, state-capitalism, subsidization
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