“neither bank C.E.O.’s nor regulators thought that banks were taking excessive risks.” So if the risks were viewed as small, he adds, “compensation incentives would not induce them to avoid those risks.”
He points out that in 2006, a collateralized-debt obligation with a triple-A rating didn’t look like a huge risk. “On the contrary, it looked like an extremely low-risk asset,” he says. “Yet, banks incurred extremely large losses on such C.D.O.’s.”
Regulations that would have encouraged executives to take on less risk, he adds, might have made matters worse because executives “might well have chosen to invest even more in AAA-rated C.D.O.’s and other asset-backed securities.”
Sunday, September 27, 2009
Friday, September 25, 2009
Meanwhile, Daniel Gross at Slate makes some important similar points, especially that many of the bailed out banks have actually paid income back to the government, and that the expenditures actually made are very small compared with the commitments. For example,
After the failure of Lehman Bros., the Treasury Department agreed to guarantee the $3.8 trillion industry for money-market funds. In so doing, taxpayers assumed a massive liability. Managers of money-market funds were charged a tiny fee for this insurance. On Sept. 18, the government lifted the guarantee, reporting that it had collected $1.2 billion in fees without having made any payments.This seems to be the experience with most of the bailouts. Large commitments, much smaller expenditures, programs being wound down. Emergency actions paid off, at least so far.
Thursday, September 24, 2009
Wednesday, September 23, 2009
I need to write more about the contribution of Keynes to understanding this crisis.
Tuesday, September 22, 2009
Monday, September 21, 2009
...the word timing is misleading. Let's accept that a crisis cannot be predicted to the day or even to the year. Nevertheless, it is perfectly reasonably and fully consistent with rational expectations to predict an increased probability of a crisis.It seems to me, however, that once you define the problem as one of predicting increased risk of a crisis then the charge against macroeconomics is lessened. Many economists argued that the risk of a crisis had increased after 2006.
If you play Russian Roulette with 1 bullet and 100 chambers in your pistol, I can't predict when the crisis will occur. If you play with 10 bullets, I still can't predict when the crisis will occur but I can say with certainty that the risk has increased by a factor of ten. Analogously, nothing in modern economics makes it theoretically impossible to forecast that greater leverage and higher than normal price to rental rates, to name just two possibilities, increase the probability of crisis. Nor does modern theory make it theoretically impossible to forecast that conditions are such that if a crisis does occur it will be a big one.
All of this is true even in the context of stock markets. Efficient markets theory implies that any two stocks will have similar risk-adjusted returns it does not imply that the risk of bankruptcy is the same for any two firms. It is perfectly reasonable to say that Google revenues are going to have to increase at a historically unprecedented rate or the stock will plummet. It is even consistent with efficient markets theory to predict that the probability of Google stock falling is much greater than the probability of it rising (but if it rises it will rise very far, very fast).
Thus the "we could not have predicted the crisis even in theory" argument is a weak defense--even with rational-actor, rational-expectations models there are plenty of senses in which economists could have better predicted the crisis and, although this is yet to be seen, perhaps they could and will do even better with other sorts of models.
The notion that economists should be able to isolate periods of increased risk is a good one. The IMF has tried to do that with early warning indicators. The BIS was warning of increased risks from at least 2006.
Meanwhile, Mankiw reviews Skidelsky's new book on Keynes in the Wall Street Journal (subscription required). He notes:
In his preface, Mr. Skidelsky says that he is a historian, not an economist. The book bears out the claim, in both its strengths and weaknesses. Mr. Skidelsky is most engaging when he draws on his biographical work. Keynes, we are reminded, had a fascinating life. He was a widely read intellectual who wrote accessibly for the general public. He advised world leaders on the crucial issues of the day and socialized with the artists and writers of the Bloomsbury group. But most of "Keynes" is devoted to ideas, not history, and here Mr. Skidelsky is not playing his strong suit. To economists his discussion of macroeconomic theory will seem pedestrian and imprecise. To laymen it will seem abstract and hard to follow.I also liked this line:
I enjoyed Skidelsky's 3 volumes on Keynes, and I will probably enjoy this book too. But I know the Mankiw is right about Skidelsky's weaknesses, and that is all the more important for the claim that Keynes is what is needed now.
This brings us to the biggest problem with "Keynes." Mr. Skidelsky admits to being poorly trained in the tools that economists use: "I find mathematics and statistics 'challenging,' as they say, and it is too late to improve. This has, I believe, saved me from important errors of thinking."
Has it, really? Mr. Skidelsky would like to think that his math-aversion allows him to focus on the big ideas rather than being distracted by mere analytic details. But mathematics is, fundamentally, the language of logic. Modern research into Keynes's theories—I have conducted such research myself—tries to put his ideas into mathematical form precisely to figure out whether they logically cohere. It turns out that the task is not easy.
Sunday, September 20, 2009
The whole story is worth reading for sure, and the lesson is very important. Especially in societies where informal arrangements are crucial.
For more than half a century, those collectors were the zabaleen, a community of Egyptian Christians who live on the cliffs on the eastern edge of the city. They collected the trash, sold the recyclables and fed the organic waste to their pigs — which they then slaughtered and ate.Killing all the pigs, all at once, “was the stupidest thing they ever did,” Ms. Kamel said, adding, “This is just one more example of poorly informed decision makers.”
Saturday, September 19, 2009
our models don't just fail to predict the timing of financial crises - they say that we cannot. Do you believe that it could be widely believed that the stock market will drop by 10% next week? If I believed that I'd sell like mad, and I expect that you would as well. Of course as we all sold and the price dropped, everyone else would ask around and when they started to believe the stock market will drop by 10% next week - why it would drop by 10% right now. This common sense is the heart of rational expectations models. So the correct conclusion is that our - and your - inability to predict the crisis confirms our theories. I feel a little like a physicist at the cocktail party being assured that everything is relative. That isn't what the theory of relativity says: it says that velocity is relative. Acceleration is most definitely not. So were you to come forward with the puzzling discovery that acceleration is not relative...Levine is being coy here. Without mentioning it, he is trying to outline Krugman's own model of first-generation exchange rate collapses. But not exactly. For in Krugman's model there is a fundamental that is driving the currency collapse. Excessive money growth is driving down reserves, so in Krugman's rational expectations model, investors do not wait for all reserves to be evaporated before selling the currency, they do so at the first moment that an attack is feasible. Krugman's model ties down the timing of the attack exactly, even though it is based on rational expectations (indeed that is the novel point). Thus, I suppose one could argue that with better models of fundamentals we would know more about the timing of crashes.
I should have linked earlier to John Cochrane's response to Krugman. It is long, but well worth reading.
Meanwhile, Gilles Saint-Paul provides a modest defense of the economics profession.
International finance has always been one of the more elusive areas of economics, in part because the channels through which capital moves around the world are so tortuous that the system looks as if it had been thought up by Rube Goldberg. It’s not surprising, therefore, that among all the various forces and factors to be blamed for the current global economic crisis — deregulation, Alan Greenspan, credit-default swaps, the power of the financial lobby, excessive leverage, securitization, Wall Street greed — the most difficult to get one’s head around is the international monetary system.
Thursday, September 17, 2009
Two weeks prior, on Sept. 7, the government took over Fannie Mae and Freddie Mac, wiping out much of their shareholder equity. On Sept. 16, the government bailed out AIG, lending it $85 billion. On Sept. 25, Washington Mutual, the nation's sixth-largest bank, was seized by the FDIC. On Sept. 29, Wachovia, the nation's seventh-largest bank, was sold to avoid a similar fate. All this would have happened without Lehman. Meanwhile, the Federal Reserve and the Treasury Department went to Congress to ask for $700 billion for the Troubled Asset Relief Program (TARP).Which, they ask was pivotal?
Their argument is that these speeches were announcements that we had a real financial crisis, we are in desperate shape and we need emergency help. So investors believed banks were in even worse shape than they turned out to be. As I noted in a previous post, Lehman was Pearl Harbor. We wanted to fight the Germans, but we needed the Japanese to bomb Pearl Harbor before we could attack. Cochrane and Zingales are arguing that the speeches of Bernanke and Paulson were like FDR announcing the attack and calling for a declaration of war.
The nearby chart shows that the main risk indicators only took off after Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke's TARP speeches to Congress on Sept. 23 and 24—not after the Lehman failure.
The risk of Citibank failure (the Citi-CDS spread) and the cost of interbank lending (the Libor-OIS spread) rose dramatically after Ben Bernanke and Hank Paulson spoke to Congress. (In basis points.)
On Sept. 22, bank credit-default swap (CDS) spreads were at the same level as on Sept. 12. (CDS spreads are the cost of buying insurance against default.) On Sept. 19, the S&P 500 closed above its Sept. 12 level. The Libor-OIS spread—which captures the perceived riskiness of short-term interbank lending—rose only 18 points the day of Lehman's collapse, while it shot up more than 60 points from Sept. 23 to Sept. 25, after the TARP testimony. (Libor—the London Interbank Offer Rate—is the rate at which banks can borrow unsecured for three months.)
Tuesday, September 15, 2009
"THIS sucker could go down.” George Bush’s verdict during the worst of the financial crisis a year ago was crude but penetrating. Barack Obama, delivering a speech in New York on September 14th to mark the anniversary of Lehman Brothers’ failure, managed the opposite trick. He produced plenty of elegant phrases but little that was new, and quite a bit that was confusing.How can one argue for both extending financial services to those unserved and for regulations to prevent this sort of thing? How can one argue that future bailouts will not cost taxpayers? The tone is serious but the arguments are not.
The intricacies of bank reform were never likely to get a thorough airing in a set-piece political speech. But the casual listener to Mr Obama’s oratory might conclude that the crisis occurred because there were no regulations, that big banks would be allowed to fail in the future and that the proposed constraints of finance will create a new age of prosperity. (They would also think that the incomprehensible decision on Friday to impose tariffs on Chinese tyre imports was designed to save free trade.) The truth is far messier. Reform is badly needed, but people will still be greedy, banks will still need saving and a more stable system will entail less credit flowing through it. Mr Obama is eloquent but too often he does not tell it like it is.That last part just about says it.
Yes, the United States had been in recession since the beginning of 2008. But world trade had held up quite well. But after the Lehman shock, all world trade began to shrink rapidly. Starting in September 2008, the volume of world trade began to plummet sharply. As the World Trade Organization reported in March, "the months since last September have seen precipitous drops in global production and trade, first in the developed economies, then in developing ones as well." In late 2008, world trade was contracting at a 40 percent annual rate. In Japan, exports, which had held up well in 2008, fell 57 percent between August 2008 and January 2009. (Go here and click on "exports.") Through the first half of 2009, they were down nearly 40 percent from the first half of 2008. In Germany, exports in July 2009 were 25 percent below the level of July 2008. China's exports have fallen, too, although less dramatically.Also, interesting is this report that bankruptcy courts in England are still working on the Lehman collapse.
Lehman Brothers' European clients and creditors could have to wait another two years before they get back billions of dollars of assets tied up in the bank when it collapsed a year ago.
Tony Lomas, partner at PwC and administrator for the bank's European operations, said he had hoped to have "broken the back" of the case by this time next year, substantially reconciling claims, returning assets to clients and putting in place a process for paying dividends to unsecured creditors.As Tyler Cowen notes, one should think about this delay when arguing that a bankruptcy of a large interconnected bank would be superior to the bailout.
The Economist has an interesting article on how the post-Lehman world of finance may shape up.
Saturday, September 12, 2009
In the months between Bear Stearns and Lehman Brothers, Mr. Paulson and Mr. Bernanke had approached Congressional leaders about the need to pass legislation that would give them a handful of additional tools to help them deal with a larger crisis, should one ensue. But they quickly realized there was simply no political will to get anything done. After Lehman, however, Mr. Paulson and Mr. Bernanke were able to persuade Congress to pass a bill that gave the Treasury Department $700 billion in potential bailout money — which Mr. Paulson then used to shore up the system, and help ease the crisis. Even then, it wasn’t easy; it took two tries in the House to pass the legislation. Without the crisis prompted by the Lehman default, it would have been impossible to pass a bill like that.
Friday, September 11, 2009
Why is it the American way that I in New Jersey should feel obliged to give financial help to a family whose beach house in Mississippi was blown down by a hurricane, but it is socialist and un-American to help a Mississippi woman struck by breast cancer?When financial institutions got in trouble -- think Bear Stearn, Bank of America, Citigroup -- they ran to the government for a bailout.
Why are some forms of social insurance more acceptable than others? Is it just politics?
The financial markets had prided themselves on their expertise in pricing and managing financial risk prudently. But left on their own, they proved that they could not even manage properly as simple a transaction as a mom-and-pop mortgage loan, let alone fancy derivatives such as the collateralized debt obligations (C.D.O.’s) that were based on sloppily-written mortgage loans and the credit-default swaps (C.D.S.’s) meant to insure the value of these C.D.O.’s, but without adequate reserves to back up that credit insurance.
In the end, like teenagers who hate Mother’s strictures when all is well, but run to Mommy whenever they get in trouble, the swashbuckling oligarchs of the financial sector ran to government for cover, owning up once again to the time-honored mantra of this country’s legendary rugged individualists:
When the going gets tough, the tough run to the government.Another term for “government risk management,” of course, is “social insurance.”
Thursday, September 10, 2009
Our models show that even an economy that is massively overleveraged can, in theory, plod along for years, even many decades, before crashing and burning.The large debts we are incurring are reducing the negative consequences of the financial crisis, but these were emergency measures. Will be able to unwind them successfully?
It all boils down to confidence and coordination of expectations, which depend, in turn, on the vagaries of human nature. Thus, we can tell which countries are most vulnerable, but specifying exactly where and when crises will erupt is next to impossible.
A good analogy is the prediction of heart attacks. A person who is obese, with high blood pressure and high levels of cholesterol, is statistically far more likely to have a serious heart attack or stroke than a person who exhibits none of these vulnerabilities.
Yet high-risk individuals can often go decades without having a problem. At the same time, individuals who appear to be ``low risk" are also vulnerable to heart attacks.
Of course, careful monitoring yields potentially very useful information for preventing heart attacks. Ultimately, however, it is helpful only if the individual is treated, and perhaps undertakes a significant change in lifestyle.
Wednesday, September 9, 2009
...once American households rebuild their retirement accounts, they may return to their profligate ways. Indeed, the Obama administration and the Federal Reserve are doing all they can to pump up US spending. The only reason the US trade deficit is falling is that the country remains in a severe recession, causing US imports and exports to collapse in parallel.The answer depends a lot on decisions outside the US. For example, will China continue to lend to the US. A disaster could arise if China turns away from holding US assets. He concludes:
With recovery, both may recover to previous levels, and the 6%-of-GDP US external deficit will be back. In fact, there has been no change in relative prices or depreciation of the US dollar of a magnitude that would augur a permanent shift in trade and spending patterns.
There are two hopes for avoiding this disastrous outcome. One is relying on Chinese goodwill to stabilize the US and world economies. The other is for the Obama administration and the Fed to provide details about how they will eliminate the budget deficit and avoid inflation once the recession ends. The second option is clearly preferable. After all, it is always better to control one’s own fate.
The nature of the crisis, and of the government's response, now threaten to undermine the public's sense of the fairness, justice, and legitimacy of democratic capitalism. By allowing the conditions that made the crisis possible (particularly the concentration of power in a few large institutions), and by responding to the crisis as we have (especially with massive government bailouts of banks and large corporations), the United States today risks moving in the direction of European corporatism and the crony capitalism of more statist regimes. This, in turn, endangers America's unique brand of capitalism, which has thus far avoided becoming associated in the public mind with entrenched corruption, and has therefore kept this country relatively free of populist anti-capitalist sentiment.This is, indeed, an issue of long run concern.
Experts predict a steady drumbeat of defaults over much of the next decade as these interest-only loans mature. Auctioned off at low prices, those foreclosed houses could help brake any revival in home prices.
Interest-only loans are not the only type of exotic mortgage hanging over the housing market. Another big problem is homeowners with “pay option” loans; in many of these loans, principal balances are actually increasing over time.
Still, interest-only loans represent an especially large problem. An analysis for The New York Times by the real estate information company First American CoreLogic shows there are 2.8 million active interest-only home loans worth a combined total of $908 billion.
The interest-only periods, which put off the principal payments for five, seven or 10 years, are now beginning to expire. In the next 12 months, $71 billion of interest-only loans will reset. The year after, another $100 billion will reset. After mid-2011, another $400 billion will reset.
Tuesday, September 8, 2009
You can see here that the initial rally happened after Bear Stearns collapsed, and that it accelerated after Lehman's collapse, really after the TARP legislation was first rejected by Congress.
If the world economic crisis is receding then the value of the dollar as a safe haven is less important, and long-term fundamental factors begin to drive investor behavior.
Friday, September 4, 2009
Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, thatstocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.
As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations.
For example, it is just not fair to argue that economists accepted the efficient markets hypothesis or the belief in market efficiency for personal gain:
The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.What about the evidence from financial markets that demonstrates the difficulty of beating the market? Most empirical studies, especially the early ones, were quite clear on this (see, for example, here). This is especially true for the weak form of the hypothesis that says that asset prices incorporate all publicly available information.
Somewhat surprisingly, however, between around 1985 and 2007 the disputes between freshwater and saltwater economists were mainly about theory, not action. The reason, I believe, is that New Keynesians, unlike the original Keynesians, didn’t think fiscal policy — changes in government spending or taxes — was needed to fight recessions. They believed that monetary policy, administered by the technocrats at the Fed, could provide whatever remedies the economy needed.
In recent, rueful economics discussions, an all-purpose punch line has become “nobody could have predicted. . . .” It’s what you say with regard to disasters that could have been predicted, should have been predicted and actually were predicted by a few economists who were scoffed at for their pains.
Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst.
The person who gets the most credit for predicting the crisis is Nouriel Roubini. He did predict crisis, the one that many economists did expect. But that was a currency crisis due to our excessive current account deficits. This was quite a rational fear. As for the excessive risk in the banking system, it seems that Raghuram Rajan was the only major economist who talked about this (there was some very good work at the BIS that was also ignored). And as Krugman notes in his article, when Rajan made these warnings even Larry Summers belittled him. Why was this the case? I suspect that most economists understood the basics of securitization, but could not believe how much of the CDO's banks were keeping on their books or in special investment vehicles they were responsible for. Since the latter are off-balance sheet, they are precisely organized to fool analysts.
This leads to another interesting point about economics. Normally economics works through negative feedback loops. When demand for a good falls so does its price. The fall in the price reduces the extent of the fall in sales and signals producers to produce other things. Negative feedback is what makes the equilibrium hypothesis useful. But what happens when the economy is so far out of kilter that we have positive feedback loops? This is what happened when the housing bubble burst. The fall in asset prices led to a deterioration of bank balance sheets and less lending. This hurt investment and production and incomes declined. So people could not purchase homes that were much cheaper. This is positive feedback, and it is what turned the asset bubble into the great recession.
Notice that after many asset bubbles burst negative feedback loops operated. Think of the 1987 crash or the end of the tech bubble. These had little economy-wide effects because of negative feedback. But in rare cases we do get positive feedback. Yet if these cases are so rare most of the data we operate with will not display it. So most of our experience, and most of our analysis will be conducted using data generated by negative feedback behavior. It is not surprising that we are not well-prepared for positive feedback loops. If we were it would mean we had experienced many more crises.
One could then blame economists for focusing so much on normal times and ignoring how the economy works outside the corridor (see my previous post on the Corridor hypothesis). But given how rare depressions have been was this such an unwise strategy?
Tuesday, September 1, 2009
Decades from now, the crisis of 2008 mightn't be remembered as the last days of Bear Stearns and Lehman Brothers, but as the moment the dollar lost its undisputed No. 1 ranking among world currencies.French President Nicolas Sarkozy continues a French tradition when he writes:
"What was true in 1945 can no longer be true today," Mr. Sarkozy said last week. "The dollar cannot claim to be the only currency in the world."and we have a Malaysian human rights activist
In Malaysia, peace activist Dr. Chandra Muzaffar has talked repeatedly about phasing out the dollar as the world's sole reserve currency. "It's one of the pillars of U.S. hegemony," he said in an interview. "The signs indicate that we are on the cusp of major change."These last comments make no economic sense, but what of the issue that the dollar will cease to be the world's reserve currency. Nothing lasts forever. The pound was the reserve currency till the dollar took over during the interwar period. What of the dollar's future.
There is a network effect involved with a reserve currency (as with domestic as well). The fact that many people hold makes others willing to hold it. So a rapid decline is unlikely. But given large US current account deficits the dollar is bound to continue to depreciate. This means that countries that hold dollars must expect capital losses. Will they be willing to do this for a long time? Unlikely, but even talk of replacing the dollar hurts the value of their stocks today. To an extent they are stuck with the dollar because of past decisions.
Another factor that supports the dollar is the size of the US market. Many countries hold dollars to prevent their currencies from appreciating so that they can export to the US. But it is unclear that this is a sustainable force.
One factor that has supported the dollar is the lack of an alternative. The euro is, however, a more plausible alternative to the dollar than any single country's currency. The yuan or ruble are unlikely candidates -- a reserve currency must be issued by a country with open capital markets. But the euro represents a large economy with stable politics. Over time its share of world reserves is bound to grow, and the role of the dollar will shrink. How far and how fast is the question.