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Anna Schwartz on the Economic Crisis:

Economist Anna Schwartz, Milton Friedman's coauthor on their classic work, A Monetary History of the United States, has some interesting comments on the financial crisis in this recent interview with the Wall Street Journal. She argues that the Federal Reserve's "easy credit" policy during the first half of this decade bears a large portion of the blame. The Fed's policy, of course, was one of several ways in which the current crisis was at least in part brought about by non-free market forces.

lonetown (mail):
I think she is right but it goes back a little further, to the year of irrational exuberance, i.e. 1996. That began the tech bubble and the rest is in part reaction to that (and 911 of course).

The high liquidity seems to have spawned more than a tech bubble. A housing bubble, an oil bubble and a foriegn currency bubble as well.
10.21.2008 7:10am
TA:
Stock market crashes seem to follow the proliferation of easy credit or other financial devices which give the illusion of new wealth, 1929 included.
10.21.2008 8:12am
Robbrl:
So your position is that we shouldn't cut taxes and reduce the size of government because the resulting flood of money into the capitol markets will create a crisis? It is a shame that these benighted capitalists can't be trusted to find worthwhile investments to grow the economy when they have the chance.
10.21.2008 9:07am
Bemused Observer (mail):
Ah yes, Anna Schwartz. I believe the winner of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, Paul Krugman (rolls off the tongue, don'it?) provides a useful evaluation of her work here. Some things never change (pardon the cliche).
10.21.2008 9:08am
TA:
"So your position is that we shouldn't cut taxes and reduce the size of government because the resulting flood of money into the capitol markets will create a crisis?"

Obviously, investment that results in genuine growth is no problem, and this relies on credit. The argument is (in part, at least) that government intervention created a moral hazard. You can disagree, but that's the argument.
10.21.2008 9:46am
paul lukasiak (mail):
re: lonetown -- I don't think that excess liquidity had anything to do with the tech bubble --- that was pure "mania" investing that was based on completely irrational assumptions.

Schwartz is right about Greenspan screwing up, however. The 2001 recession was not based on the actual economy, but was the result of a bursting of a psychological bubble. Right up until election day 2000, no one was talking about a recession, and Bush continued to push his massive tax cuts based on the continued strength of the economy.

Then the Florida election debacle happened -- and uncertainty among markets and consumers crept into play. Both markets and Christmas sales were sluggish -- and sluggish christmas sales were a very bad thing because merchants had stocked up based on expectations of a banner year.

Then (almost immediately after the USSC handed the election to Bush) Bush announced that there was a recession coming that necessitated passage of his big tax cut plan. That doomed any hope for a rebound of Christmas sales -- telling people that there was a recession on the horizon scared people into closing their wallets, and retailers took a bath.

Greenspan's "panic" reduction of interest rates only exacerbated the "psychological" problem, while doing nothing to stimulate the economy because high inventories were the problem, and no one was going to borrow money to make more stuff when their shelves were full already.

The big problem now is that monetary policy no longer has any real influence on economic growth -- the rapid expansion of arbitrage practices have resulted in "risk/reward equalibrium" for all assets and investments, and the minute interest rates are lowered the market absorbs their impact. Existing interest bearing securities and stocks go up in value right away not because of increased confidence in the future, but because they provide better returns relative to Fed rates.

Low short term interest rates accelerated the growth of the derivatives market and arbitrage, and asset inflation was a natural by-product of the resultant commodification of money. The way to make big money stopped having anything to do with the actual value of assets, and became all about exploiting small differences in asset prices by moving vast sums of money into and out of those assets. You made money simply by moving money around as quickly as possible -- no one was getting "hurt", but enormous profits were being made based solely on moving money around -- and those profits were plowed back into the markets inflating the price of assets further.
10.21.2008 10:14am
paul lukasiak (mail):
Obviously, investment that results in genuine growth is no problem, and this relies on credit. The argument is (in part, at least) that government intervention created a moral hazard. You can disagree, but that's the argument.

monetary policy does not create moral hazards -- rather it influences the extent and severity of pre-existing moral hazards.

Deregulation (and lax enforcement of regulations) create moral hazards -- and the combination of deregulation and cheap money is the recipe for the toxic stew we were served over the last month.
10.21.2008 10:25am
Typsy (mail):
Testing
10.21.2008 10:39am
ChrisIowa (mail):
paul lukasiak

Right up until election day 2000, no one was talking about a recession, and Bush continued to push his massive tax cuts based on the continued strength of the economy.

Except that the stack market started falling like a rock in March 2000, well before the election, and the growth rates for GDP in Q2 and Q3 were anemic, something under 1 percent. when Bush43 said in December 2000 that the economy was heading into a recession, he was only stating the obvious.
10.21.2008 10:40am
TA:
"monetary policy does not create moral hazards -- rather it influences the extent and severity of pre-existing moral hazards."

Sure (or subsequent moral hazards). I think that's what's being argued.

"Deregulation (and lax enforcement of regulations) create moral hazards -"

Deregulation is a change from something. Whether deregulation is a good thing or not has to do with that something that's being changed.

I believe the government encouraged sub-prime mortgages, then failed to enforce suitable standards. In this case it was the government itself that needed regulation. The old fashioned word for this is corruption.
10.21.2008 10:45am
Houston Lawyer:
Deregulation doesn't create moral hazard. Government subsidies create moral hazard. People bought Fannie Mae and Freddie Mac paper because of the implicit government guarantee. Those who are now calling loudest for more regulation, were previously actively involved in preventing prudent oversight of those institutions. We had the same problem with the S&L crisis. Without the government's involvement, the market would have been more prudent.

We may still have had this crash, but it would not likely have been so severe.

So glad that we put Sarbanes Oxley in place to avoid future market meltdowns. Can't wait to see what extra stupid regulation is loaded onto companies following this fiasco.
10.21.2008 10:46am
SenatorX (mail):
I think she is right but it goes back a little further, to the year of irrational exuberance, i.e. 1996.

I tend to agree with this. I think it might be the retail sweep program that allowed banks to avoid reserve requirements and also leverage all that new money into loans for assets. This kicked off in 1995.

When you look at a bunch of charts something new clearly started happening in 1996 in regards to money flows.
10.21.2008 11:11am
MarkField (mail):

The Fed's policy, of course, was one of several ways in which the current crisis was at least in part brought about by non-free market forces.


Is it your position that the government should not regulate the money supply?
10.21.2008 11:47am
paul lukasiak (mail):
Except that the stack market started falling like a rock in March 2000, well before the election, and the growth rates for GDP in Q2 and Q3 were anemic, something under 1 percent. when Bush43 said in December 2000 that the economy was heading into a recession, he was only stating the obvious.

nice try... the dow reached a closing high of 11723 on January 14 of 2000. Thanks to the (mostly indirect) impact of the collapse of the tech bubble, there was considerable volatility in the Dow for the first 10 months of 2000, but its lowest close was at 9796 on March 7 (a 16 percent drop from the January high), and within two week it was back to 11,120 (only 5% off its january high). On October 30, the dow closed at 10,812 -- that is not a sign of a recessionary market-- rather its a sign of the impact of the loss of wealth in tech stocks.

As for anemic growth in the 2nd and 3rd quarters of 2000, again, you're looking at the impact of the tech bubble -- which had lead to higher reported growth rates when it was inflating -- and its bursting led to a major recession in the tech sector, which drove down overall growth numbers.

In other words, the economy was healthy -- it was merely adjusting to the impact of the collapse of tech bubble, but it was "fundamentally sound". While the collapse of tech stocks early in 2000 had a lot of people "doomsaying", by September it was obvious that there would be a "soft landing", rather than a recession.

Again, its nearly impossible to find anyone predicting a recession in the days and weeks prior to the election -- confidence was pretty high.
10.21.2008 11:48am
paul lukasiak (mail):
Deregulation doesn't create moral hazard. Government subsidies create moral hazard.

deregulation is what creates the conditions under which government rescue packages have to be put together to "save the economy". Absent deregulation (and lax enforcement of regulations) there is no need for government subsidies.

IMHO, the minute an institution becomes "too big to fail", it should be considered "too big to exist" and broken up through regulations.
10.21.2008 11:52am
paul lukasiak (mail):
I believe the government encouraged sub-prime mortgages, then failed to enforce suitable standards.

the government did not encourage the "sub-subprime" mortgages, and the derivatives market, that lead to this crisis. That was private enterprise all the way. (HUD and the VA loan programs didn't issue these "no documentation", "no money down", loans -- that was private enterprise.

It should be noted that Fannie and Freddie were PRIVATE corporations -- who got into bundling sub-prime loans because of pressure from its stockholders. The low risk mortgages that Fannie and Freddie traditionally bundled had a lower rate of return, and other companies had gotten into the bundling business including sub-primes in their bundles.

The decision of Fannie and Freddie to accept sub-prime mortgages probably had a big psychological impact on investers, because of the (false) impression that their securities were backed by the government, and/or the sense that Fannie and Freddie only sold the most solid mortgage-backed securities.

But the housing bubble itself has little to do with government policies concerning loans to lower income families. The places that experienced the biggest "bubbles" were markets with above average incomes.

No one in the government told countrywide and other mortgage brokers to sell ARMs by telling people that housing prices were going no where but up, and even if the worst happened, they'd be making money if they had to sell their house because they couldn't make their mortgage payments.

(well, maybe Alan Greenspan did -- but he's not "the government" when it comes to housing policy.)
10.21.2008 12:07pm
Robbrl:
TA says

"Obviously, investment that results in genuine growth is no problem, and this relies on credit. The argument is (in part, at least) that government intervention created a moral hazard. You can disagree, but that's the argument."

The argument in the original post was that "easy money" was at least part of the the problem. If that creates a moral hazard then so does cutting taxes. If you are talking about some other intervention, you should make that clear.

My point is that nothing was stopping people from putting the easy money into "good" investments and nothing would stop people from putting money from tax cuts into bubble investments.
10.21.2008 12:15pm
TA:
"If that creates a moral hazard then so does cutting taxes."

"Moral hazard" refers to being protected from risk. You can be foolish with your own money, but if you suffer the consequences yourself, there is no moral hazard.
10.21.2008 12:21pm
TA:

"It should be noted that Fannie and Freddie were PRIVATE corporations -- who got into bundling sub-prime loans because of pressure from its stockholders."


From Fannie Mae's website:

Fannie Mae is a government-sponsored enterprise (GSE) chartered by Congress with a mission to provide liquidity and stability to the U.S. housing and mortgage markets.
10.21.2008 12:23pm
DanO29 (mail) (www):

IMHO, the minute an institution becomes "too big to fail", it should be considered "too big to exist" and broken up through regulations.


A good argument for busting up the grip of the Federal Government has on the economy.
10.21.2008 12:30pm
Ilya Somin:
So your position is that we shouldn't cut taxes and reduce the size of government because the resulting flood of money into the capitol markets will create a crisis? It is a shame that these benighted capitalists can't be trusted to find worthwhile investments to grow the economy when they have the chance.

If Schwartz is right, the crisis had nothing to do with either cutting taxes or reducing the size of government.
10.21.2008 12:31pm
David Drake:
Mr. Lukasiak--

Isn't it also possible that the fact the administration in 2000 was Democratic heading into an election led the media to fail to predict, or even discuss, the possibility of a recession? Compare that with this year, when the media have been predicting recession--and even saying the U.S. was in one--since at least January.
10.21.2008 12:47pm
Adam J:
TA- GSEs are government created, but (mostly) privately owned. 18 of 23 Fannie and Freddie boardmembers are chosen by shareholders, 5 are chosen by the President.
10.21.2008 12:48pm
TA:
Adam J wrote:

"TA- GSEs are government created, but (mostly) privately owned. 18 of 23 Fannie and Freddie boardmembers are chosen by shareholders, 5 are chosen by the President."

Sure, it has corporate structure, but simply calling it another private corporation misses some very important features of the story, especially the relationship between F&F and congress.
10.21.2008 12:58pm
Frog Leg (mail):
Increasingly, libertarian attempts to foist blame of the financial crisis on the government sound just as detached from reality as that of academic communists trying to argue that the Soviet Union was communism done incorrectly.

See also http://www.slate.com/id/2202489/
10.21.2008 1:04pm
Robbrl:
Ilya, TA,

from the original post:

"She argues that the Federal Reserve's "easy credit" policy during the first half of this decade bears a large portion of the blame"

cutting taxes has exactly the same effect of putting more money into the capitol markets chasing exactly the same amount of "good" investments.
10.21.2008 1:36pm
A. Zarkov (mail):
The SEC regulatory exemptions helped lead to the collapse.
"The Securities and Exchange Commission can blame itself for the current crisis. That is the allegation being made by a former SEC official, Lee Pickard, who says a rule change in 2004 led to the failure of Lehman Brothers, Bear Stearns, and Merrill Lynch.

The SEC allowed five firms — the three that have collapsed plus Goldman Sachs and Morgan Stanley — to more than double the leverage they were allowed to keep on their balance sheets and remove discounts that had been applied to the assets they had been required to keep to protect them from defaults.
See The Big Picture and the links given there.
10.21.2008 1:37pm
davidbernstein (mail):
Again, its nearly impossible to find anyone predicting a recession in the days and weeks prior to the election -- confidence was pretty high.
That's not the way I remember it. In fact, what I remember is Democrats consoling themselves that if Bush wins, he'll get blamed for the recession that everyone knew was on the horizon.
10.21.2008 2:06pm
wyswyg:
"I believe the winner of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, Paul Krugman (rolls off the tongue, don'it?) provides a useful evaluation of her work"




The beginning and end of that sentence contradict each other.
10.21.2008 2:07pm
wyswyg:
"Increasingly, libertarian attempts to foist blame of the financial crisis on the government sound just as detached from reality as that of academic communists trying to argue that the Soviet Union was communism done incorrectly."




Wow's, that persuasive.


Wait, not it's not. It's a childish taunt.
10.21.2008 2:16pm
Curt Fischer:


"She argues that the Federal Reserve's "easy credit" policy during the first half of this decade bears a large portion of the blame"



cutting taxes has exactly the same effect of putting more money into the capitol markets chasing exactly the same amount of "good" investments.


This obviously not true. As much as it might sometimes appear otherwise, tax dollars are not raked into a big pile, doused with gasoline, and burned by the government. Therefore, the mere act of taxation does not necessarily move money out of the capital markets. It might, if the government spends all its tax money on labor and non-capital goods. But usually the government doesn't do that, and it spends a significant portion of its tax revenue on capital projects. Examples might be developing fighter jets, offering loan guarantees to biofuel refineries, or funding new university R&D centers.

Thus, lowering taxes by a certain amount mostly lowers the government's power to distribute money in the capital markets as it sees fit, and does not lead to a corresponding increase in the size of private capital markets.
10.21.2008 2:31pm
Nunzio:
"The decision of Fannie and Freddie to accept sub-prime mortgages probably had a big psychological impact on investers, because of the (false) impression that their securities were backed by the government, and/or the sense that Fannie and Freddie only sold the most solid mortgage-backed securities."

The Chinese and Russian governments, who owned a lot of the FM bonds, believed that the government would back them just like a treasury bond. This belief turned out to be correct, not false. Please find me three FM investors who didn't think the federal government stood behind those companies.
10.21.2008 2:53pm
Mahan Atma (mail):
Here's an analysis that pretty much destroys the "F&F caused the crisis":

Primary Market -- Loan Originations

Fannie Mae and Freddie Mac do not originate mortgages. More than 80% of subprime loans still outstanding were originated in 2004 through 2007. The top ten subprime loan originators in 2006 were: HSBC Finance, New Century Financial, Countrywide Financial, Citimortgage, WMC Mortgage, Fremont Investment and Loan, Ameriquest, Option One, Wells Fargo Home Mortgage and First Franklin Financial. Seven of the ten (the nonbank lenders, who were not regulated by the Community Reinvestment Act) no longer exist, or were merged into banks. The lists for 2005 and 2004 were similar, but also included Washington Mutual. The top ten lenders accounted for about 60% of ALL subprime loans in 2006.

Secondary Market -- Wholesale Loan Buyers

In 2004, 2005 and 2006, securitized mortgages were 73%, 79% and 81% of all subprime mortgages. So for practical purposes the wholesale market was the securitization market. For the same three years, the total volume of subprime loans securitized was $521 billion, $797 billion and $814 billion respectively.

Almost none of those securities were issued by Fannie and Freddie. They were not in the business of purchasing and securitizing subprime mortgages, although they purchased some subprime mortgages to hold in portfolio, and issued about $6 billion in subprime securities in 2004 to 2006 (one-third of one percent of the market.) The top fifteen issuers of subprime mortgage-backed securities, accounting for about 75% of the market, in 2006 were: Countrywide, New Century, Option One, Fremont, Washington Mutual, First Franklin, Residential Funding (GMAC affiliate), Lehman Brothers, WMC, Ameriquest, Morgan Stanley, Bear Sterns, Wells Fargo Securities, Credit Suisse and Goldman Sachs.

Investors in Subprime Mortgage-Backed Securities

After the securities were issued, investors were needed to buy the securities, and thus to fund the mortgages. At this third stage, Fannie and Freddie did play a role, albeit a minor one. As of 12/31/07, Freddie held $234 billion and Fannie held $112 billion in subprime securities, out of a total market of $2,116 billion (i.e. $2.1 trillion). Most of these purchases took place in 2005 and 2006. A significant chunk to be sure (about 15%) but if you took out the GSE purchases, there would still have been a huge subprime market, and there is no way to know whether other buyers might have purchased those same securities if Fannie and Freddie had not (i.e. their presence was probably not vital to the growth of subprime lending and securitization.) Other purchasers of subprime securities included banks and thrifts, foreign investors including sovereign wealth funds, mutual funds, hedge funds, insurance companies, state and local governments, private pension funds, and wealthy institutions and individuals. It is also worth noting that Fannie and Freddie started buying subprime securities late in the game, years after the subprime mortgage market had been launched and its dangerous products deployed.

10.21.2008 2:58pm
TA:
"cutting taxes has exactly the same effect of putting more money into the capitol markets chasing exactly the same amount of "good" investments."


So why not just set the interest rate at 0%? Because interest rates reflect, or are supposed to reflect, the cost of lending money. If you force the rates too low, you create problems you wouldn't create by simply letting people keep more of their own money.
10.21.2008 3:13pm
c.gray (mail):

As much as it might sometimes appear otherwise, tax dollars are not raked into a big pile, doused with gasoline, and burned by the government. Therefore, the mere act of taxation does not necessarily move money out of the capital markets.


Tax rates affect the incentive structure that drives investor decisions about when, where and whether to invest their money to begin with.

Increased tax rates make loopholes in the tax code more attractive, drive investment overseas to locations with more favorable regimes, cause investors to postpone gains realization, and can discourage legitimate investment altogether.
10.21.2008 4:10pm
paul lukasiak (mail):
The Chinese and Russian governments, who owned a lot of the FM bonds, believed that the government would back them just like a treasury bond. This belief turned out to be correct, not false. Please find me three FM investors who didn't think the federal government stood behind those companies.

prior to this summer, when Congress passed a law guaranteeing the FMs securities, they were NOT backed by the government -- but because of the erroneous sense that Fannie and Freddie were government entities, people thought that they were 'rock solid' investments.

*************

(i.e. their presence was probably not vital to the growth of subprime lending and securitization.)

I think that once Fannie and Freddie started issuing securities backed by sub-prime loans in 2005, any hesitation that people had about the sub-prime based securities being issued by the private sector evaporated.

(Fannie &Freddies decision was based on stockholders demanding a better rate of return--and the only way to do that was to compete with the private sector in bundling sub-prime mortgages.)

So while I agree that Fannie &Freddy are in no way responsible for the crisis (because the creation of derivatives based on mortgage-backed securities has significantly expanded the market for them -- F&F got into the business of bundling subprimes late in the game), I think that the psychological impact of their entry into that market played a not-insignificant roll in the scope of the eventual crisis

But the crisis was inevitable -- because the derivatives were based on inflated housing prices and sub-subprime loan practices, that whole thing was bound to fall apart -- and with it the flooding of the secondary mortgage securities market, and the consequent markdown on those assets by financial institutions.
10.21.2008 4:31pm
paul lukasiak (mail):
Mahan -- do you have any data on the nature of the "subprime" mortgages issued by various institutions.

"Subprime" doesn't mean "high risk" -- it simply means you don't meet all the criteria necessary to be considered "prime" and thus eligible for "prime" rates -- and there is a difference between people who can't get "prime" rate because their credit score is low, and people who can't get prime rate because they do have any money to put down, and/or their income is insufficient to pay off the mortgage even at "prime" rates.

HUD and the VA look at different criteria in determining whether to back mortgages, and wind up insuring lots of perfectly sound loans to "subprime" borrowers.

Its my guess that relatively few genuinely creditworthy (people who didn't qualify as "prime" but were buying homes that they could afford) lower income people were in the "sub-prime" market -- these are people who would have been eligible for HUD backed loans had they bought less expensive properties -- and lenders had to have been aware of this.
10.21.2008 4:43pm
paul lukasiak (mail):
That's not the way I remember it. In fact, what I remember is Democrats consoling themselves that if Bush wins, he'll get blamed for the recession that everyone knew was on the horizon.

your memory is faulty -- a couple of years ago, I went back and looked at what the economic predictions were in September and October 2000 -- the consensus was a "slower rate of growth" was coming...NOT a recession.
10.21.2008 4:57pm
David Warner:
Frog leg,

"Increasingly, libertarian attempts to foist blame of the financial crisis on the government sound just as detached from reality as that of academic communists trying to argue that the Soviet Union was communism done incorrectly."

Except that free-market ideas have a legacy of effectiveness throughout history, with periodic exceptions (bubbles), while communism has no such record.
10.21.2008 4:59pm
Calculated Risk:
I also believe the enforcement of criminal law was a non-free market force contributing to the credit crises. After all, without the enforcement of criminal law, we would live a state of savagery and would not have credit markets at all.

Guess what Somin. You still don't get it. Your a kind of sort of smart guy, but you still don't get it.

There is no clear separation between government and the so-called "free market" because without the government there would not be any markets at all!

The distinction is entirely arbitrary and contrived. The Fed is part of the market, and the market is part of the Fed.
10.21.2008 5:02pm
Calculated Risk:

Except that free-market ideas have a legacy of effectiveness throughout history, with periodic exceptions (bubbles), while communism has no such record.


On the contrary. A "pure" free-market (whatever the f*ck that means) has never been tried. How can something that has not been tried have a demonstrated record of success?
10.21.2008 5:03pm
Harry Eagar (mail):
If you're leveraged 30:1, you're going bust, whether you have a reserve bank or not, whatever it does or doesn't do.

I don't know what's so hard to understand about that.

This year's panic is not a failure of markets, it is the efflorescence of markets.

Nobody likes free markets who has to live in one. As we see.
10.21.2008 5:13pm
TA:
Calculated Risk wrote:

"I also believe the enforcement of criminal law was a non-free market force contributing to the credit crises. After all, without the enforcement of criminal law, we would live a state of savagery and would not have credit markets at all."

A "free market" is the unimpeded exchange of goods and services. Obviously, this must be governed by some rules and laws, but a government can still choose to support or hinder a free market.
10.21.2008 5:38pm
Calculated Risk:

Obviously, this must be governed by some rules and laws, but a government can still choose to support or hinder a free market.


Exactly when is a rule just a "background rule" and when it is it an "interference" in the free market? Now, I have no doubt you can manufacture various artificial distinctions. But the fact remains, any distinction that you manufacture will be artificial.

Which is fine. We have to have artificial distinctions.

My objection is when these artificial distinctions are thrust upon a pedestal and mindless worshiped like some unholy pagan god.
10.21.2008 6:59pm
byomtov (mail):
If you're leveraged 30:1, you're going bust, whether you have a reserve bank or not, whatever it does or doesn't do.

A much overlooked point, but a good one.

In all the hubbub about lousy mortgages, etc. let's remember that if you leverage way up, and buy risky (not necessarily unsound, just risky) securities that are difficult to value you're asking for trouble.
10.21.2008 7:33pm
MarkField (mail):
If anyone wants to know what actual economists think, you can find some comments here.
10.21.2008 8:07pm
Le Messurier (mail):
Lukasiak--

That we were in a "bubble" or "boom" in early 2000 and before was obvious, at least to me, and I believe, to any thinking person. The question was when it was going to bust, as these things ALWAYS do. Greenspan has much to answer for in the recession that followed, just as he has in the current financial crises (along with Barney Frank and Christopher Dodd)

Ilya-

you refer to an economic crises in the title of your post and to a financial crises in the body of your post. We don't have an economic crises (yet) but we do have a financial crises. This may seem like nit picking, but there are important differences between the two. And the differences can have a significant effect on policy.
10.21.2008 8:52pm
Brian Macker (mail) (www):
"Is it your position that the government should not regulate the money supply?

That is absolutely my position.

This whole mess is Alan Greenspans fault. The fundamental error was to put a price ceiling below the market price on interest rates. Price controls are known to cause problems.

Lowering the market price below crossover point on the supply/demand curve results in a mismatch between the consumer and the producer. The consumer will consume too much and the producer will produce too little. In this case the consumer is the saver, and the producer is the borrower.

There are some unique aspects to interest rates as a price that leads to problems that other price controls don't experience. Interest rates is both a temporal price and a monetary price. The former, causes any problems caused by price controls to be shifted forward in time, and the latter means that it will effect all prices.

Greenspan goofed big time. He was not aware of the difference between deflation caused by productivity increases/population growth, and fractional reserve deflation. He interepreted the productivity deflation caused by the Reagan/Thacher revolution as bad and tried to stablize prices. That is he targeted "inflation" but was actually preventing productivity induced deflation.

This meant that he was holding interest rates way below market for a long period. All the signs were there that he was making a mistake during his term. Holding interest rates below market causes reduced savings, increased borrowing, asset inflation, market manias, overinvestment in long term projects (like internet companies, fibre optic networks, housing), trade deficits, and commodity price increases. (The next stage being consumer price inflation).

Furthermore Greenspan abandoned the idea that the market should punish failure, and provided bailout after bailout.

The mania and all the things the follow from it are standard operationing procedure during a run up in asset prices during a prolonged period of monetary inflation. The monetary inflation happening first and the mania second. The tulip mania, the south sea bubble, the post revolutionary french mania, and the roaring twenties were all caused by monetary inflations.

One can go an read the warnings given during the French post revolutionary run-up by those who wanted sound economic policy. They pleaded and pleaded for sanity but the government just would not listen. Stock jobbing, shady loans, and a trade deficit were all there. They harkened back to how this kind of behavior had ruined many a country. It was old news even back then.

What is especially interesting during these periods is the political pressure that the profits caused by the loose monetary policy induces. There is always enormous policial pressure to keep the game afoot.

Yet somehow, most of you are entirely ignorant of these facts. Most of what you guys see as cause is in fact effect. In fact this most recent bailout is an effect.

The bad effects are NOT what I hear being popularly expressed. Here or elsewhere. We just had a period of mania driven by loose money, by maintaining a price ceiling on the time cost of money, interest rates. Yet the political solution is to inject yet more money into the system.

Having a counterfieter move into town sure makes people think they are rich for a while. That is until they realize that the extra cash is not chasing extra goods.

There is the additional problem of our fractional reserve system, our leverage. This compounds the problems of below market interest. It allows a leveraged run up of monetary supplies, which is totally out of the control of any party to prevent. This leverage can and will deleverage when the sham economy is exposed over time. That deleveraging is what I refered to as fractional reserve deflation.

By pumping money into the system to prevent that deflation, will be highly inflationary in the future. We are adding very quickly to the base money supplies against which future leveraged run ups will be built upon.

I didn't even touch on the actual distortions this causes in the structure of production. Low interest rates cause over investment in long term vs. short term captial that reduces our overall standard of living.

Get ready to feel the pinch.
10.22.2008 8:58am
Harry Eagar (mail):
I am not aware of those facts because they are not facts.

If it was monetary inflation and not the Tommy gun that made the '20s roar, why couldn't farmers get credit? Agriculture went bust in '22 and the country banks had been slaughtered well before stocks crashed.

There was plenty of 'productivity deflation' and to spare and that continued right up to the war and beyond.

But thanks for a new (to me) excuse for the failure of unsupervised markets. I thought I had heard 'em all.
10.22.2008 2:49pm
ohwilleke:
Not buying it.

Easy credit does encourage more lending and more debt. This may even encourage more leverage (the tax code is probably the bigger culprit on the leverage incentives point).

But, easy credit from the Fed does not encourage bad underwriting of loans, and certainly does not encourage inaccurate descriptions of risk in the secondary lending market. Yet, the former was absolutely central to the subprime crisis, and the latter, which is also a species of bad underwriting, was a core cause of the financial crisis that followed.

Interest rates that are a few percentage points lower (which is about as much as the Fed can hope to push the economy at its best), do not make loans with a significant change of default and of being unsupported by collateral, worthwhile. At the fifty percent plus default rates over the life of the loans that we are seeing on subprime ARMs with zero or near zero down payments, and losses of 20% to 50% when individual loans go bad, it takes interest rates much, much higher even than those found on subprime loans to break even, let alone make a profit.

So, why was mortgage underwriting so bad? One key factor was the housing bubble. If housing prices are rising at double digit percentage rates every year, any loan that limps along without going into default for even a year or two amounts to a hard money loan, where the lender is held harmless because there is sufficient equity in the collateral at the time of default to make the creditworthiness of the borrower irrelevant. The prevelance of "liar loans" (i.e. no document underwriting), reflects the fact that the banks had this attitude.

The circumstantial evidence that easy credit from the Fed created the housing bubble is weak, because while commentators sometimes sloppily talk about a national housing bubble, it really wasn't. Some important regional housing market bubbles did exist. California, Florida and Nevada were grossly overvalued, for example, a reality that was becoming clear in late 2005 and early 2006 to those looking at the relevant data. But, large swaths of middle America were not nearly so grossly overvalued.

So, why did financial institutions and investors, en masse, ignore signs of a housing bubble that would make their bad underwriting disasterous?

Part of its is bad disclosure (even now when it has all come to pass, investors still can't figure out how risky mortgage backed security portfolios are because the right information hasn't been disclosed), which is fundamentally a securities law problem, not an interest rate problem.

The other problem is that too many key decision makers didn't have a balanced mixed of upside and downside risk. Ignoring the housing bubble was certainly the surest path to riches in the short term before it burst. The bad underwriting business model works well as long as housing prices keep rising.

But, the key decision makers, senior corporate managers primarily compensated with stock options, never actually lose money if their bad judgment comes to roost in the long term. They simply lose the future income that they failed to cash in while the going was good. With no risk of actual loss, why not err on the side of more risk for more reward, instead of a more conservative business strategy.
10.22.2008 6:13pm
Harry Eagar (mail):
That sounds about right, although because I do not believe unsupervised markets won't crash, if it weren't mortgages, it would have been something else.

There was 0 incentive for retail mortgage brokers to inquire into the risk of the borrowers and plenty of incentive to fake applications.

There have been innumerable comments on this subject at VC, but so far (unless I missed it), nothing about the rakeoffs small fry brokers could generate. A friend of mine in the business tells me she could easily extract $20K-$30K in writing up the instruments for unsophisticated borrowers (she says she didn't).

And a fair number (I don't know what percentage) of sour loans were not written for non-owners with no income but for long-time owners with plenty of genuine equity. One of the nastier little wrinkles in my county was that sharp youngsters got licenses and then persuaded older aunties and uncles to refinance 'for the family.'

It was as free a market as I've ever seen in my lifetime.
10.22.2008 8:32pm