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Paulson is the Problem, Not the Solution:

So says my GMU Econ colleague Russ Roberts:

When no one knows how the rules of the game are going to change — and they seem to change from week to week — who wants to take a risk? Who wants to borrow money? Who wants to invest? Business and consumers are hunkering down, waiting for the storm of change to pass.

The problem isn't liquidity.

It's uncertainty.

Paulson doesn't realize that his erratic attempts at creating liquidity are creating the uncertainty that makes liquidity meaningless.

Read the whole thing--Russ's analysis seems right on to me.

It is hard to see why anyone would start a business or buy, sell, or refinance a house right now when you have no clue as to what the economic framework is going to be even a week or a month from now. And that is just the day-to-day gyrations of the Bush Administration, ignoring what Congress and President-elect Obama might have up their sleeves in two months. Would you buy a General Motors car right now?

Critics of FDR's interventions during the Great Depression have made the same point--regardless of the merits of FDR's interventions, the constant madcap experimentation and lurching around undermined the stability necessary to pull the country out of the Depression.

Big E:
Yeah but FSR's madcap experimentation by in large worked.
11.15.2008 11:14am
Toby:
Spot on. It's what I hear from the Real Estate Agent I am married to, about the converns of her buyers. It what I hear from the Utilities / E-Tech technologusts I talk to about investments in Energy. Its what I heare from the Mortgage companies I sell compliance software to. No one knows the rules; no one knows under which temrs to evaluate a new investment; no one nows what colors even are on the roulette wheel (Black? Red? Hah! You lose. The colors are Lilac and Chatreuse!) so no one places any bets whatsoever.

And yes Big E. If you mean that FDR's experimentation worked to prolong the economic disturbance by 7-8 years. Was that the goal?
11.15.2008 11:20am
cboldt (mail):
Secretary Paulson couldn't push his agenda without being facilitated by Congress. The Constitution presents a rudimentary framework, "Congress [shall] coin money and regulate the value thereof" as well as promulgate rules for bankruptcy.
.
Elected officials tend to look for others to blame, hence, in economic matters, pointing fingers to the Treasury Secretary.
11.15.2008 11:21am
PLR:
Would you buy a General Motors car right now?
Nope, but consumers aren't buying other brands of cars either. It's going to be a while.

I was very skeptical that banks would actually turn around and start making loans with the bailout money, but I don't blame Paulson for trying.
11.15.2008 11:23am
anon345 (mail):
"Critics of FDR interventions". I love the nutso right wing frame that suggests that FDR messed things up. These critics are most definitely not mainstream. There may be some mainstream economists who have a quibble or a suggestion about how things could have been improved, but the consensus is that FDR did a great job in managing the Depression given the circumstances.
11.15.2008 11:24am
Big E:
Toby the facts speak for themselves. After FDR began implementing the New Deal programs GDP increased steadily after being in free fall. Furthermore since we all became Keynesians economic downturns have been shorter and less severe.
11.15.2008 11:25am
loki13 (mail):
Toby,

FDR did not 'prolong' the depression by 7-8 years. That is wishful (by conservatives) thinking.

Here's the facts-
The Great Depression was at its worst when FDR took office.
The use of what we now know as Keynesian economics allowed the economy to expand from that dire point.
The thing that killed the growth, leading to a mini-recession around 1936, was the sudden penny-pinching of the FDR administration (attempt to balance the budget).

It's fun to make up counterfactuals, but here's what we know:

1. Other countries (see Canada) that did not engage in FDR-style economic intervention had a much worse time during the early-mid 30s, and only began recovery after FDR-style intervention.

2. FDR's intervention allowed American to retain something of a market economy, and not fall to either communism or fascism.

3. The intervention, regardless of the economic merits (which are strong), allowed many Americans to survive the Depression. How may current lives are worth a half-point in future growth?

It's fun to make stuff up like "FDR prolonged the depression", but it's also wrong.
11.15.2008 11:29am
JB:
The FDR argument is tired. He improved things, but not as much as he could have if he'd done things differently. The people who point this out have the benefit of hindsight, and discount the value of public confidence and the need to get reelected. On the other hand, we now do know more about economics than we knew back then, so we shouldn't slavishly copy FDR.

FDR critics should frame their criticism of his policies in a "We know more than he did" rather than a "He screwed up" way. That's the only way to convince the FDR-loving majority to do something different from what he did.

That said, this post is spot-on. The recovery will not come as long as institutions stand to benefit by not solving their problems. In fact, all the arguments used against Welfare in the 1990s can be deployed against Paulson's handling of the bailout. Just change a few nouns.
11.15.2008 11:40am
Mikey:

FDR did not 'prolong' the depression by 7-8 years. That is wishful (by conservatives) thinking.


Yeah! That explains this little bit from that bastion of conservative thought, UCLA:

FDR's policies prolonged Depression by 7 years, UCLA economists calculate

"Two UCLA economists say they have figured out why the Great Depression dragged on for almost 15 years, and they blame a suspect previously thought to be beyond reproach: President Franklin D. Roosevelt.

After scrutinizing Roosevelt's record for four years, Harold L. Cole and Lee E. Ohanian conclude in a new study that New Deal policies signed into law 71 years ago thwarted economic recovery for seven long years..."
11.15.2008 11:42am
Big E:
Mikey if you used the Google you would quickly discover that at least on economic theory these guys are conservative.
11.15.2008 11:48am
loki13 (mail):
Mikey,

That's great, just great. First, just because they are from UCLA does not make them 'liberal' (you may want to converse with Prof. Volokh about this attribution error).

Second, the study is BS, using cherrypicked numbers. For instance, the BLS statistics they use does not include *any* WPA members as employed. That would be similar, today, to not counting any government worker as employed (which you might ideologically believe, but it doesn't make sense in the real world).

Third, the study also uses bad dates as for as economic growth goes. By placing the dates around '37-'39 as an end time, they manage to capture the mini-recession brought on by reduced government spending.

Next, the trend GPA is recognized by most economists matches the beginning of 1940 (i.e. if the economy had kept growing at its normal rate from 1929).

It also ignores the great growth from 1933 (end) until 1937 (beginning). Considering what we know about the lag effect of fiscal policy, this makes sense.

Or you can ignore all that, and continue to trust this. Oh yeah, ignore the rests of the economists too. If there's an argument, it's that FDR didn't prime the pump enough (too little government spending) and should not have cut back in 1936 (leading to the 1937 mini-recession).

In other words, FDR was too conservative.
11.15.2008 11:51am
Mikey:
Loki13,

Have you access to the study? I haven't seen it published yet.

If so, could you provide a link?
11.15.2008 11:58am
loki13 (mail):
Mikey,

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=562405
11.15.2008 12:08pm
loki13 (mail):
Mikey,
That should give you the title. To find the fulltext version online, you can either use the Minn. Fed. article at the following (does not contain full revisions):
http://www.minneapolisfed.org/research/wp/wp597.pdf

Or use HeinOnline or a similar service to access the 2004 article.
11.15.2008 12:13pm
pdxbob:

"Considering what we know about the lag effect of fiscal policy, this makes sense. "



FDR's Social Security program has a massive lag effect which, combined with other unfunded mandates provides a current fiscal gap of $65.9 Trillion (according to this paper which appeared in this paper from the Federal Reserve Bank of St. Louis Review from 2006.

When we wake up and smell that $65.9T coffee, we could be in for a hit which will make the currect recession look like a holiday in Marbella.
11.15.2008 12:25pm
Minnesota Reader:
cboldt:

I agree in principle with your statement that Paulson was facilitated by Congress. But remember that Paulson came to Congress and said, in essence, you've got to pass this and you've got to pass it quick. And we've got to buy these toxic instruments - it's the only way out of this mess. We can't have any changes. (And when Congress said no, the markets abetted in things by dropping precipitously.) So Congress was bullied into passing the TARP bill.
11.15.2008 12:25pm
Mikey:
Loki13,

Well, that's interesting. Unfortunately I don't have the expertise to judge how accurate their modeling is.

Still, I can't see how the kind of price-fixing for labor and other anticompetitive measures the NIRA mandated were entirely without effect, even if they did not lengthen the Depression by the seven years Cole and Ohanian assert.

I'll have to read it more thoroughly later, when I have fewer papers of my own to write. Thanks for the link.
11.15.2008 12:26pm
A. Zarkov (mail):
"The problem isn't liquidity.

It's uncertainty."


I agree completely. We should add insolvency to the list of problems. Americans are really poorer than they thought. A lot of business and personal finance problems were masked by the easy credit of the last 15 years. Now the chickens have come home to roost and Americans must consume less and save more. But Congress wants to inject more money into consumers pockets so they will buy more, and continue not to save. This primarily a jobs program for China. Add to that a rescue plan for the auto industry, and we get a prescription for even worse problems in the future.
11.15.2008 12:32pm
ichthyophagous (mail):
Other people may be uncertain, but I'm not. "Neither a borrower nor a lender be." I realize people like me are a menace to the economy.
11.15.2008 12:33pm
loki13 (mail):
Mikey,

No problem. I think the thing to remeember when reading this (and other) articles is that Keynes didn't even publish until 1936, and it took a while for his views to gain prominence. So some of what the FDR administration did was either harmful or not cost-effective. Given those constraints, and world conditions, I think his (curved) grade would be an A- for the economy (perhaps dropped to a B+ with the tightening of fiscal policy in 1936), before taking into account the preservation of our overall capitalist system and the lives saved.

As for Social Security? The majority of economists don't believe that it is Social Security that is a problem; it is Medicare. And if we stopped raiding Social Security for general funding, the crisis would largely disappear with, at most, a little tinkering.
11.15.2008 12:48pm
A. Zarkov (mail):
loki13:

I have not read the Cole paper, but I will. Nevertheless, I really don't care what a "consensus" of economists say, that's the global warming argument. The issue is not consensus, unless you want to relegate economics into the realm of pure politics.

Let's say that FDR's fiscal policies were appropriate for that time and those circumstances. That does not in itself mean Keynesian fiscal policies are what we need now. I suspect not as circumstances are really different. We don't have a lot of idle capacity, today, we have a lack of capacity. We have an overblown financial sector that has caused severe misallocations of capital. While historical arguments about FDR and the Depression are interesting and fun, they are at least partially if not wholely irrelevant.

A lot of history is going to change. Alan Greenspan is now a fallen idol. I think Milton Friedman might join him. This interview with Charlie Rose makes him look clueless. I think it's time to start reading Hyman Minsky and Frank Knight. A lot of free marketeers are beginning to look pretty foolish right now.

BTW I have never thought markets should run free and unfettered. My argument with the liberals has more to do with their adoption of the Frankfurt School thinking, in particular Herbert Marcuse and the idea of building a movement from the racial minorities, students and the lumpenproletariat. In my opinion, that's just crazy.
11.15.2008 12:55pm
loki13 (mail):
A. Zarkov,

While I realize that the appeal to authority doesn't fly with you, I think it is instructive for this reason: if a researcher publishes another paper about Keynesian economics and the Great Depression, it won't get a second look. If, on the other hand, the researcher juices the data to come with the contrarian idea that FDR prolonged the Great Depression, not only might it get published, but it will be picked up the WSJ and other bastions of free-market idealism.

I think your other points are good, but I think the overall idea (spend during a recession, save during a surplus) remains strong. This doesn't answer the question as to how the government should spend money; massive useless infrastructure projects (to give an example from Japan) are probably not the best use of the funds (although they were in a liquidity trap). I'm agnostic on the bailout- while I think the government needed to act in principle, I am a litle concerned with the was they are acting in reality.

700 billion here, 700 billion there, pretty soon we're talking about REAL MONEY. *grin*
11.15.2008 1:03pm
A. Zarkov (mail):
Loki13:

My understanding of counter-cyclical "pump priming" is as follows. You borrow against the future to make today less painful. In the future you have to pay back the debt which makes the future less wonderful. In other words, you damp the oscillations of the business cycle. But on net you get nothing. The problem today is we have already borrowed and the future is now. We failed to save during the prosperous times for the future problems. Of course my whole prior argument assumes some kind perturbation of linearized system. It might be that in the real world pump priming does produce a net gain. The problem is nobody understands the real economy well enough to say anything reliable.
11.15.2008 1:21pm
Duffy Pratt (mail):

Other people may be uncertain, but I'm not. "Neither a borrower nor a lender be." I realize people like me are a menace to the economy.


People like you get stabbed through curtains, and they deserve it.
11.15.2008 1:34pm
Oren:
Zarkov, the hope is that we elect people like Gore that would forgo tax cuts in a time of surpluses to pay down debt or even build up some government cash.
11.15.2008 1:38pm
Brian K (mail):
Have you access to the study? I haven't seen it published yet.

so you're citing a study that you haven't even read yet as definitive proof?
11.15.2008 1:43pm
Mikey:

Have you access to the study? I haven't seen it published yet.

so you're citing a study that you haven't even read yet as definitive proof?


Did I cite something as "definitive proof?" No.

Thanks, come again.
11.15.2008 1:54pm
Johnny Canuck (mail):
Loki 13:
1. Other countries (see Canada) that did not engage in FDR-style economic intervention had a much worse time during the early-mid 30s, and only began recovery after FDR-style intervention.

2. FDR's intervention allowed American to retain something of a market economy, and not fall to either communism or fascism.


As with so many others, I argue from a vast fund of ignorance. When I was at university, the 30's were too recent to be economic history ( the great tomes of Canadian economic history were on the fur trade and the cod fisheries). I vaguely know the Canadian govt. vacilated between public works spending and a perceived need to not run a deficit. Is there a particular study that compares Canada's economic performance during 30's and US that you rely on?
With respect to your #2. The perceived poor performance of govt during the 30's led to a left wing political party - then known as the CCF (blended with labour support in the 1960's to form the NDP) , which from an American perspective may seem wildly socialistic (for that matter many Americans would find our, to us very right wing Conservative Party, to be socialistic), but from a Canadian perspective the NDP is mildly to the left of the Liberal Party. In fact many ideas which have been incorporated firmly into the fundamental Canadian govermental role were CCF/NDP ideas stolen and implemented by the Liberal Party. e.g. single payer health insurance is so fundamental that no right wing Canadian politician with any actual desire to get elected would do anything except tinkering at the fringes. Do you really think without FDR that US reaction would have been communism or socialism (govt ownership of the means of production)?
I wonder if this is not just as mythologically enhanced as the conservative thought that without FDR the depression would have been over in 1934?
11.15.2008 1:55pm
David Welker (www):
I think Paul Krugman, whose understanding of economics is far greater than yours, has a better explanation for why the New Deal did not pull the country out of the Depression while WWII did. Check out these links here, here, here and here. For some reason, it has become a fad of those on the right to cite the New Deal as an example of Keynesianism not working. Here, Zywicki is citing uncertainty as the big danger. Is uncertainty going to be your new "trump card" argument against all change? After all, any change does involve uncertainty.

By the way, if you think the uncertainty from Paulson's fluctuations is high, the uncertainty from WWII was even higher. Clearly, there are a lot more variables in play than uncertainty. I am not arguing that uncertainty does not matter. I am arguing that you are overplaying it. And also, you are not distinguishing between types of uncertainty. Uncertainty about whether my bank is going to fail will cause me to make withdrawals. Uncertainty about the specifics of how banks are going to bailed out (when I know they will be bailed out in some manner) is probably much less important. And the specifics of precisely what government programs will be used to stimulate the economy also probably are not that important. Will the government do more work on the I-5 or the I-405. I won't invest until I know! Umm.... no, that is not exactly how the world works.

Finally, there are times when uncertainty is preferable to certainty. When we are finally certain that profits are going to be lower than originally expected, the reaction is like to manifest itself more strongly than when there is uncertainty about whether or not profits will meet expectations. The view you have expressed so far seems to be "uncertainty = bad." I suggest you come up with a more sophisticated view. I am not denying that certainty matters -- I am merely suggesting that you need to make the case in a much less blunt and clumsy manner.
11.15.2008 1:56pm
David Welker (www):

I was very skeptical that banks would actually turn around and start making loans with the bailout money, but I don't blame Paulson for trying.


I do blame Paulson. He should have put conditions on the money.

Overall, the man has been a very flawed Treasury secretary. I do not know what he was thinking letting Lehman Brothers fail.

I wonder if we really should allow the former heads of investment banks (Paulson was the former CEO of Goldman Sachs) be Treasury Secretary. Sometimes I think it is a little bit odd that it was okay for Lehman Brothers to fail, but when this set off a chain reaction it wasn't okay for AIG to fail. Also, why is Goldman Sachs always advising the Treasury? (By the way, if AIG had failed, Goldman Sachs would have lost a lot of money -- I am not a conspiracy theorist, but this screams conflict of interest to me.)

Overall, I have been completely unimpressed by Paulson. But it isn't mainly because of "uncertainty." It is because he has let ideology to prevent him from doing his job (it is just fine if Lehman Brothers fails -- creative destruction and all -- oh wait, if AIG fails too, apparently that is creative destruction taken too far...) Oh, we should buy toxic assets from the banks, even though there is no way to price them and the only way we can inject liquidity into the system is buying them at too high of a price, screwing over the taxpayer. Doing the sensible thing -- the thing you would do with your own money -- and buying an equity stake, we cannot do because we don't want to be "socialists."

Paulson's fluctuations have been caused mainly by ideology. He is enamored with certain unrealistic ideals about how free markets are perfect or nearly so and how we shouldn't "interfere" with the market. And this means that it takes him some time to do the right and sensible thing. I do not think his fluctuations have been caused by a conflict of interest as the former CEO of Goldman Sachs. But, I do not think we should allow individuals who have occupied such a high-level position at Goldman Sachs to be Treasury Secretary in the future, at least not until after they have left that position for quite some time.

Overall, I am all for blaming Paulson to some extent. But not in a simplistic manner -- i.e. what is wrong is "uncertainty," end of story.
11.15.2008 2:13pm
David Welker (www):

but the consensus is that FDR did a great job in managing the Depression given the circumstances.


I do not believe that there is any such consensus. But, the "do nothing" right-wing is wrong about why and how FDR could have improved his response to the Great Depression. The problem was that FDR was too cautious. Please see the links to writing by Paul Krugman in the post right above my last one for more.
11.15.2008 2:19pm
PLR:
I do blame Paulson. He should have put conditions on the money.

Such as? You must lend these proceeds to hungry borrowers despite the looming Mother of all Recessions?

At least we have an equity position in our own money.
11.15.2008 2:31pm
trad and anon:
Would you buy a General Motors car right now?
Sure. I wouldn't loan them money, but if someone makes a product I like, corporate mismanagement isn't a reason not to buy it. People talk trash about American car companies, but not all of their cars are trash.
11.15.2008 2:33pm
David Welker (www):
PLR,

I agree with the equity position point. I also think it would be reasonable to require lending. It is hard to see how banks not lending money is going to stimulate the economy.

If your point is that we need more direct economic stimulus (i.e. infrastructure projects) in addition to bank bailouts, I see your point. But, I think more conditions on the money given to banks, whether attached to equity stakes or not, would have clearly been appropriate.
11.15.2008 2:34pm
Bad English:
Given all the supported claims being made here by anonymous posters with a specific political goal, you have to wonder how the study got past peer review and prepublication vetting at a University Of Chicago scholarly journal.

Perhaps the anonymous detractors should back up their claims, put their names on the work, and submit it for similar review and vetting.
11.15.2008 2:51pm
SenatorX (mail):
I know one of the reasons we haven't purchased a house yet is I want to see what mammoth housing stimulus bill is passed by the new president(if McCain won I expected the same). If it looks like something that may work, or works for us particularly, then it might push us over the line into buying as we really want to anyway. If it's lame we will wait for the next one.

If you buy now you get 7.5k that you have to pay back over 15 years. By this time next year it might be 15k you don't have to pay back, and prices will likely be lower to boot. I'll also have to wait out any moratoriums on foreclosures.
11.15.2008 3:00pm
yikesoyikes (mail):
Michael Lewis does a good job explaining how Paulson's ilk got this all started. Paulson, like FDR, ain't solving any problems, only making it worse.
11.15.2008 3:06pm
Harry Eagar (mail):
Home run by Zarkov.

Good points by Welker.

I am going to hold all rightwingers and free-marketeers to their longstanding position that government's prime duty toward the economy is the maintain (or restore) business confidence.

Paulson has destroyed whatever confidence was left -- not much once people realized they'd been swindled. Mahan Atma said here a few days ago, 'Faith-based accounting doesn't work.'

And how.

I will quarrel with Professor Zywicki's characterization of the New Deal as 'madcap experimentation.' The New Deal was a carefully thoughtout, well-founded program of reflation, worked out by the Columbia school of agricultural economists (Tugwell et al) and it worked.

It was then murdered by idiot rightwing justices, and FDR was then forced into a series of experiments.

The New Deal worked. Free markets, if left unsupervised, always crash.

Early New Deal measures are not much help as models now, because we are not in a period of hyperdeflation. s

The reason we are not is that late New Deal measures (government intervention as lender of last resort) forestalled the financial crash that we would have had in March (or perhaps a few weeks later).

The free marketeers, of course, if they believed their own propaganda, should have wanted the crash.
11.15.2008 3:11pm
vmark1:
SenatorX.

>and prices will likely be lower to boot. I'll also have to wait out any moratoriums on foreclosures<

Waiting is the word. Real estate is expected to drop another 20% before hitting bottom is the most recent guess. Living in Michigan, we never experienced anything like a housing bubble. And yet the housing market is obliterated. Real estate agents say; "No clue where the bottom is..." We've been living the economic nightmare that economist's are now predicting for the rest of the US...near 9-10% unemployment, bankruptcies, foreclosures, talent drain fleeing state, sinking corporate ships...

I guess our Governor has been tapped by the Obama administration to be an economic advisor...wow. God save the Union...
11.15.2008 3:21pm
A. Zarkov (mail):
loki13:

"For instance, the BLS statistics they use does not include *any* WPA members as employed. That would be similar, today, to not counting any government worker as employed..."

How we count employment and unemployment is a vexing problem. Should we count prison inmates and soldiers as employed in the same sense as factory workers? I don't think so. Should we count Depression era WPA and CCC workers as employed? Are they like other government employees? Almost but not really. In theory government workers compete for their jobs in a competitive market. Once upon a time people took a civil service exam, but Clinton did away with that as a parting gesture to increase minority employment (that pesky Frankfurt School again). On the other hand, didn't WPA and CCC workers just have to show up? Suppose we just drafted all the unemployed into the Army and put them to work. Then we would have zero unemployment. Remember in a command economy everybody works.
11.15.2008 3:30pm
Cornellian (mail):
My understanding of counter-cyclical "pump priming" is as follows. You borrow against the future to make today less painful. In the future you have to pay back the debt which makes the future less wonderful. In other words, you damp the oscillations of the business cycle.

The problem is that when times are good and tax revenues are up, politicians can't resist spending the money to curry favor. Then when times are bad and tax revenues are down, it's always "we can't cut back government spending when people are hurting!" So we've got a 1 way ratchet towards increased government spending. Republicans pretend otherwise, then spend like the wind once they get elected. Democrats don't even pretend.
11.15.2008 3:32pm
Malvolio:
Other people may be uncertain, but I'm not. "Neither a borrower nor a lender be." I realize people like me are a menace to the economy.
People like you get stabbed through curtains, and they deserve it.
They don't deserve it, but they'll get it. Shakespeare's point was that Polonius was a pompous fool ("I mistook you for your better.") and his attitude towards credit is a good example of his foolishness.

To not lend is silly. Unless you can personally deploy all the capital you own, you are wasting it if you let it sit around.

To not borrow is often just unwise. If you can make more productive use of some piece of capital than its owner (or you and the owner of the capital both agree you probably can), again, it would be a waste for you not to.
11.15.2008 3:46pm
Doc W (mail):
As little as I think of FDR and the opinions of his apologists, the fact is that it was Hoover's economic interventionism that turned a market crash into a depression. Attempts to prevent prices from falling, the Smoot-Hawley Tariff he signed, raising taxes--he paved the way for FDR, who upped the ante on idiotic interventionism to the point where unemployment rate was still 13% in 1940. Not to mention trashing the Constitution and trying to pack the Court when it balked (however feebly).

Krugman, Paulson, Bernanke--these folks are quacks. Krugman apparently did some good work at one time, just as Keynes did before descending al the way into arrogant interventioniam. Krugman, for his part, apparently thinks if we can just print up enough greenbacks and flood the market with them, all will be well. They have a lot of knowledge, no doubt, rather of the sort that a conscientious professional astrologer might have. There is unfortunately no foundation. Economic interventionism is what brought on the problems, and more economic interventionism is likely to make them worse.

FDR was Hoover's unfortunate legacy to America, not unlike how Obama appears to be Bush's. And if Obama listens to people like Krugman, he can really screw the economy for a long time.
11.15.2008 4:04pm
Lib:
trad and anon:
Would you buy a General Motors car right now?
Sure. I wouldn't loan them money, but if someone makes a product I like, corporate mismanagement isn't a reason not to buy it.
People will (reasonably) hesitate to buy GM cars because of fears that, in the event of GM failure/restructuring, warranties may not be honored, convenient dealerships/service centers will close, repair part availability/cost may be negatively affected, and resale value of GM cars may plummet. It's not just the quality of the car that matters, the health of the ecosystem around the car also matters. (Although, I'm skeptical of a "bailout" of GM - largely due to the moral hazard problem).
11.15.2008 4:05pm
Forgotten Password (mail):
The hue and cry about increasing foreclosures is bailouts and moratoria - we have to keep people in their homes. So people who can't afford to pay are sheltered from the ordinary and expected consequences.

I humbly propose another way. We should stop foreclosures - we should expedite them. If it didn't take months or years to fully execute a foreclosure, what would result?

1) The recovery from the sale of assets would be greater, because the assets are sold before further market declines occur;
2) Due to the shorter lag to dispose of the assets, there is less erosion of value due to its unmonitored vacancy - less neglect, fewer opportunities for vandals &quatters;
3) Lower fees and penalties are attributed to the borrower, reducing their indebtedness.

Creative destruction - redeployment of capital - MORE FORECLOSURES
11.15.2008 4:16pm
ChuckC (mail):
To derail into Shakespeare,
"Neither a borrower nor a lender be,
For loan oft loses both itself and friend"

Polonius wasn't talking about investment banks and capital.
He was telling Laertes not to lend or borrow from friends because of the difficulties in collecting a bad debt and retaining a friendship.
11.15.2008 4:19pm
U.Va. Grad:
Would you buy a General Motors car right now?

I wouldn't buy any car right now, but I see no reason why a GM car would be a worse buy than others. It's not like aftermarket parts and independent repair shops would disappear, even if GM goes away.
11.15.2008 4:26pm
MarkField (mail):

Creative destruction - redeployment of capital - MORE FORECLOSURES


Jesus Christ would lose an election on this platform.
11.15.2008 4:45pm
Bama 1L:
It's been argued that auto manufacturers must be worried about the effects of bankruptcy on consumer confidence. If they weren't, they would have gone through bankruptcy cycles like the airlines have.
11.15.2008 4:50pm
Doc W (mail):
What happens to the banks and the mortgages if the government would just butt out? Some banks indeed go out of business because their liabilities exceed their assets. But the assets--all those outstanding loans--are not negligible. The banks re-structure under new ownership. Then what? Yes, all the homes could be foreclosed on, but then the new creditors end up with a pile of houses they can't sell soon, or for very much. So they have an incentive to re-negotiate loans, either to lower principal or easier terms. That's how things can work out if people are left free to pursue their purposes in a market.
11.15.2008 5:01pm
American Psikhushka (mail):
Senator X-

You paid me a compliment in another thread a while back that I didn't get to thank you for. I was going to thank you after I answered a few other posts but I got caught up in some side discussions and they dragged on, I forgot, and the thread closed. So belated thanks and sorry for the delay.
11.15.2008 5:02pm
American Psikhushka (mail):
icthyophagous-

Other people may be uncertain, but I'm not. "Neither a borrower nor a lender be." I realize people like me are a menace to the economy.

As others have mentioned, many believe that the quote above doesn't mean what it appears to mean on its face.

In any case according to the Austrian School holding on to cash or "hoarding" isn't the horrible menace that the Keynesians and their ilk think it is. It actually incrementally lessens the supply of money in circulation, making cash more valuable in the same way that printing money and increasing the money in circulation makes cash less valuable.

But in any case this is probably going to be swamped by the massive amount of money that the Federal Reserve is creating in money and credit. That is why inflation is so horrible, the value of money already earned is destroyed with a hidden tax. It is also why the Keynesians are wrong on monetary policy and the hard money Austrians are right.

So unfortunately the Fed - through our fiat money system - is destroying your buying power as well, unless you are in certain assets.
11.15.2008 5:15pm
Oren:

I wouldn't buy any car right now, but I see no reason why a GM car would be a worse buy than others. It's not like aftermarket parts and independent repair shops would disappear, even if GM goes away.

You are foolish. You can get a car now for thousands under invoice -- I have quite a few offers but I'm stringing out the sales guys for more massive discounts. Most likely, I will end up with a $21k MSRP car for ~$16.5k + TTL.

Some of the dealerships are really getting desperate -- their loss is your gain.
11.15.2008 5:38pm
SenatorX (mail):
No worries American Psikhushka, you are very welcome.
11.15.2008 5:51pm
Paul Allen:

My understanding of counter-cyclical "pump priming" is as follows. You borrow against the future to make today less painful. In the future you have to pay back the debt which makes the future less wonderful.

That isn't really how it works--which is why fiscal policy has a history of failure. If you borrow money today, you take money from one person today and then allocate it--displacing what the original person would have done. If people "save" by collecting gold coins in their cash box, this system has meaning because it has the potential to take 'idle' money and put it into circulation.

In the modern economy there is scarcely any such thing. People "save" their money in bonds. They save their money in banks. The save their money in capital. The save their money in stocks.

So is fiscal policy worthless? No, but that is because the Federal Reserve Monetizes Debt. This creates immediate effects similar to the original approach (tapping money from boxes), but also fuels further instability. But at this point the line between monetary and fiscal policy is blurred.

Personally, I think Fiscal Policy is superior to monetary policy--if properly executed: namely that governments must actually accumulate monetary balances in good times and spend them in bad-times. With such a policy in place we could relieve the Federal Reserve of its dual-mandate.
11.15.2008 6:22pm
trad and anon:
People will (reasonably) hesitate to buy GM cars because of fears that, in the event of GM failure/restructuring, warranties may not be honored, convenient dealerships/service centers will close, repair part availability/cost may be negatively affected, and resale value of GM cars may plummet. It's not just the quality of the car that matters, the health of the ecosystem around the car also matters. (Although, I'm skeptical of a "bailout" of GM - largely due to the moral hazard problem).
And the price should be appropriately lower, barring some kind of market failure. The market for cars is pretty competitive.
11.15.2008 6:26pm
David Welker (www):

Krugman, Paulson, Bernanke--these folks are quacks.


And exactly who are you? This is a truly credibility destroying statement on your part. Yes, these two world-class economists and the former Harvard Business School educated former CEO of Goldman Sachs are all quacks. And, you, an anonymous blog commenter, are not.
11.15.2008 6:50pm
David Welker (www):

Although, I'm skeptical of a "bailout" of GM - largely due to the moral hazard problem.


The idea that "moral hazard" should stop us from solving major problems is overkill.

First of all, the thing we call "GM" is not a single person that responds to incentives. And, as we have learned over and over again, the CEOs and management of failed companies walk away with millions regardless of our "punishment" of the companies they used to work for.

Again, it is not that I do not think that "moral hazard" is a valid concept. But, I object to the simplistic way you are wielding it in this context. You have to ask, who are the decision-makers and how do you hold them accountable. Punishing dispersed shareholders and bondholders may not be the best way to hold decision-makers accountable. And furthermore, one should think of a "punishment" that fits the crime and also one that ideally doesn't also punish too many innocent parties in the process.

Did we really gain a lot in terms of avoiding "moral hazard" problems when we let Lehman Brothers fail and really let bondholders lose tons of money? Maybe in theory-land. But in the real world, the lesson that bondholders learned is that you cannot trust even the most established and prestigious American companies. It is that crises of trust that afflicts us now.

Overall, I am not too impressed with moral hazard arguments as yet another reason to not act in the face of a disaster. It is like saying that you should not save someone who is drowning because they shouldn't have gone out in the water in the first place.

The bottom-line is this. It is quite possible to overplay the "moral hazard" card just as Zywicki has been trying to overplay the "uncertainty" card. These are, of course, valid concepts. But they must be deployed in a much more careful way. You don't allow the United States to lose the most important companies in its industrial base (especially right now when the economy is already in bad shape) based on flimsy moral hazard arguments. Save the drowning swimmer first, talk about learning lessons second. It is not as if, when you save the drowning swimmer, you can't attach some strings to modify his behavior in the future.
11.15.2008 7:02pm
Davebo (mail):

Would you buy a General Motors car right now?



Would have a year ago? Seriously, even a "high end" GMC product?

They sell crap and if I want to buy crap I can get a Hyundai, Suzuki, or whatever for a lot less money with a longer warranty.

Buy American! Americans love crap!

Me, I stick with German.
11.15.2008 7:15pm
cathyf:
That the recession of 1937-38 is the sharpest downturn of the US economy in history is not a matter of opinion. And the economists who placed the blame on the Federal Reserve doubling the reserve requirement on member banks between August 15, 1936 and May 1, 1937 is not some new analysis, either -- it dates back to Melvin Brockie in 1950.
11.15.2008 7:18pm
Doc W (mail):

And exactly who are you?

Well, I can tell you who I'm not. I'm not someone drunk with power or the prospect of wielding same. I'm not someone whose ego so far exceeds his intellect that he imagines he can steer the economy like he steers his car down the street. I'm not nuts enough to believe that printing up more greenbacks will produce more wealth and bring prosperity.
11.15.2008 7:18pm
Doc W (mail):

Punishing dispersed shareholders and bondholders may not be the best way to hold decision-makers accountable.

Are you actually trying to draw an equation between a) declining to rob taxpayers to bail out a company and b) "punishing" stock and bond holders?
11.15.2008 7:24pm
CaDan (mail):
I find it interesting that the "blame the Frankfurt School!" idea has spread like wildfire amongst the crazier of the fundamentalists and has now spread here.
11.15.2008 7:24pm
Oren:

Well, I can tell you who I'm not. I'm not someone drunk with power or the prospect of wielding same.

This thread has truly become obnoxious. As far as I know, Krugman's power consists of writing op-eds in the NYT to be read by people that already agree with him. Drunk with power indeed.
11.15.2008 7:52pm
Curt Fischer:

David Welker: You don't allow the United States to lose the most important companies in its industrial base (especially right now when the economy is already in bad shape) based on flimsy moral hazard arguments. Save the drowning swimmer first, talk about learning lessons second. It is not as if, when you save the drowning swimmer, you can't attach some strings to modify his behavior in the future.


A fundamental idea behind your arguments seems to be a conception of corporate identity that differs substantially from Econ 101's. I think the prevailing view is that corporations are just vehicles for the owners to pool resources and make profits in a way which indemnifies them from business and financial risk.

Do companies compose a nation's "industrial base"? For example, will the automobile manufacturing capacity currently owned by GM be destroyed if GM goes bankrupt? Why is it important to protect the companies that comprise a nation's industrial base, as opposed to the industrial base itself? I.e., do we care whether GM or Toyota owns our car manufacturing facilities, or do we simply care about whether our car manufacturing capabilities will continue to exist? If the government just decreed that GM had to split up into three companies named Buick, Olds, and Pontiac, would our industrial base erode?

Have any economists constructed any widely-respected theories wherein the distribution of capital between various corporations is a determinant of prosperity?

I'm seriously asking because I don't know the answers here. (I always wish I knew more about economics.)
11.15.2008 7:58pm
Doc W (mail):

As far as I know, Krugman's power consists of writing op-eds in the NYT to be read by people that already agree with him.

"...or prospect of wielding same." Try reading my post.

Think Krugman just might have some influence with the incoming administration?
11.15.2008 8:04pm
lumpy (www):
Would you buy a General Motors car right now?

I would not buy a GM product. GM is a supporter of liberal/left wing cases. An example is the amicus brief in the Bollinger case:

I will not support the UAW, to which the workers of GM are forced to pay dues.
11.15.2008 8:10pm
Aron Zuckerman:
Roberts observation is one made long ago by Hayek in "The Road to Serfdom" in chapter 6. The "Rule of Law" principle is that as long as the rules of government are fixed and permanent (at least long term) the individual is free to pursue his desires and means and the "liberal" system is maintained, but any government that assumes arbitrary power, meaning the establishment of ad hoc laws and regulation tailored for specific situations, even under the guise of democracy necessarily restricts individual liberty and the free market.
11.15.2008 8:21pm
David Welker (www):

I'm not someone whose ego so far exceeds his intellect


If you think you are qualified to call Bernanke, Krugman, and Paulson "quacks" then I do in fact suspect that your ego far exceeds your intellect.

Again, you fail to mention your own qualifications. Probably because to do so will reveal exactly how unqualified you are to assert that these highly gifted and intelligent individuals are "quacks."

I do not agree with everything these individuals say or do, but I also would not denigrate them or their accomplishments. Especially if I was as unqualified to do so as you presumably are (given your failure to explain who you are).
11.15.2008 8:26pm
David Welker (www):

I think the prevailing view is that corporations are just vehicles for the owners to pool resources and make profits in a way which indemnifies them from business and financial risk.


On the contrary, I think the prevailing view among those who know anything at all is that there are agency problems involved in corporations. In particular, the interests of shareholders and other stakeholders (bondholders and employees) are not fully aligned with those who actually exercise control over the corporation (the directors and management).

People differ on how serious these agency problems are, but rarely on whether they exist.

With respect to your question concerning our industrial base, it is quite clear that when you majorly disrupt the status quo (i.e. the bankruptcy of GM, Ford, and Chrysler) that those disruptions are likely to affect our industrial base. When a GM factory shuts down, it may or may not be replaced with a Toyota factory. Automotive engineers who are laid off for a significant period of time unable to find jobs are likely to eventually enter other professions. Those contemplating education in the field are likely to choose other majors in light of the fact that many fewer jobs are available.

You are right that mere changes in ownership do not totally destroy the underlying assets. But, you cannot pretend that these disruptions are not likely to have major long-term effects as well. It is not like, one day GM is owned by X and the next day it is owned by Y, no big deal.
11.15.2008 8:34pm
cathyf:
In fact, the 1936-37 Fed-caused deflation and the 37-38 recession are a canonical example of Todd's point. The Fed observed in 1935-36 or so that banks were keeping reserves at more than twice the level that the Fed required. So they had the brilliant idea that they could double the reserve requirements, and it would be empty political moralizing that would give great satisfaction to the puritan streak that runs below the surface of the American people. It wouldn't have any effect -- because the new requirements were still lower than the reserves banks were actually holding.

Instead what happened is that bankers took the new reserve requirements as a signal that they were supposed to panic. So they started hoarding cash by refusing to lend, which had a huge deflationary effect, which plunged the US into the sharpest recession in history. (Does any of this sound eerily familiar?!?)

One of the most bizarre policies that the Fed has proposed recently is that they have proposed to pay interest on bank reserves. This might have been a good idea at the height of the real estate bubble (or tech bubble, for that matter) but to do it now is frighteningly reminiscent of the doubling of bank reserve requirements in 36-37. Right now the problem is that banks are putting their reserves at the Fed rather than lending it out. They shouldn't be rewarded for doing this with interest. If anything, there should be a negative interest rate on reserve deposits (they can call it a "service fee" that's the traditional ploy.)
11.15.2008 8:42pm
p. rich (mail) (www):
Government intervenes in market. Government screws up market. Government "fixes" market. Repeat.

If you believe in free markets, that is an incredibly stupid repeating algorithm. If you don't, then apparently that is a viable algorithm per FDR, Johnson, Carter, Clinton and soon to be added Obama. Beginning for present discussion purposes with Fannie and Freddie, we are still suffering for FDR's "accomplishments" and those of his Dim successors, and they haven't improved with age.

So, liberal Pookie, FDR was not an infallible demi-god. He was one of the worst presidents in history measured by the magnitude and duration of both his domestic and international policy errors - and those exceeded only by his massive ego. The good news is, he isn't still in office. The bad news is, one of his ardent worshippers will be come January 20.
11.15.2008 8:59pm
David Welker (www):
cathyf,

So, is your thesis that meaningless policies with no actual effects are dangerous because they cause "uncertainty" that cause supposedly "rational" market actors to panic?

Well, if "rational" market actors are really this irrational, we have more serious problems on our hands than I thought. It seems the argument you are advancing here is "Do nothing, because market actors are crazy and panic even over policies that have no effect. Imagine how they would react to policies that actually did something." Yet, we are supposed to believe these same market actors are the most "efficient" at allocating resources at the same time???

I think you need to go back to the drawing board with this one. I have a little more faith in the free market than you do. There is certainly something to the idea that uncertainty (i.e. risk) requires premiums and that, all things being equal, there are some efficiency advantages that may manifest themselves as a result of lowering uncertainty. But, really, this is over the top. We are to believe that uncertainty about policies that do not even matter (because they have no effect) causes "rational" market actors to panic?
11.15.2008 9:07pm
David Welker (www):

If you believe in free markets


Does "believing" in markets mean you have to think they are infallible and attribute any problems that occur to the "evil" government.

I am curious, when was the last historical "utopia" when government did not "interfere." I think Hobbes described such a state in Leviathan, but I do not think it has actually ever been put into practice.
11.15.2008 9:13pm
Doc W (mail):

On the contrary, I think the prevailing view among those who know anything at all is that there are agency problems involved in corporations.

Curt's post is not inconsistent with agency problems. Agency problems exist virtually everywhere that people attempt to act collectively. Agency problems between corporations and stockholders pale in comparison with those between the political/bureaucratic complex and the public, for reasons that have been elucidated in detail by, for example, the Public Choice school.

...it is quite clear that when you majorly disrupt the status quo (i.e. the bankruptcy of GM, Ford, and Chrysler)

Who is the "you" in that sentence?

When a GM factory shuts down, it may or may not be replaced with a Toyota factory.

Exactly--that's how resources and labor are shifted from less productive to more productive uses in a market economy. That's part of how an economy grows rather than stagnates.
11.15.2008 9:18pm
David Welker (www):
Doc W,


Curt's post is not inconsistent with agency problems.


To the extent he was questioning my basic assumption, that ensuring that the shareholders and bondholders of a corporation "suffer" is equivalent to holding management accountable, his comment was in fact inconsistent with agency problems. Furthermore, his statement below asserts that corporations are "just" these places where resources are pooled and risk limited. That is, that is the whole story. That sounds to me like a fundamental denial of agency problems.

Curt wrote:

I think the prevailing view is that corporations are just vehicles for the owners to pool resources and make profits in a way which indemnifies them from business and financial risk.


Agency problems between corporations and stockholders pale in comparison with those between the political/bureaucratic complex and the public, for reasons that have been elucidated in detail by, for example, the Public Choice school.

Oh, the "public choice school" (code word for a bunch of libertarians) think that agency problems between shareholders and management are minor. I should care why?

The "public choice school" also thinks that all government action in favor of the public interest is impossible because government agencies are inevitably "captured" by the industries that they regulate. They also believe that "change" in the public interest is basically impossible. Wow, imagine that. A bunch of libertarians who are excessively cynical about positive results from public policy. Amazing! And they say that agency problems in corporations are no big deal. It must be true! There are public choice THEORIES that prove it. And we all know that one particular competing theory among many tells us everything we need to know about the real world.


Who is the "you" in that sentence?


The "you" in that sentence is the policy maker who chooses to act or not act after evaluating the particular situation. If we decide to allow GM, Ford, and Chrysler to go bankrupt, we are making a choice. A choice with consequences we will have to live with for a long time.


Exactly--that's how resources and labor are shifted from less productive to more productive uses in a market economy. That's part of how an economy grows rather than stagnates.


Query: In your view, is it entirely irrelevant whether or not the United States has an industrial base or not? As long as it is the "natural" result of free market forces?

You would think that the failure of the government to regulate and the problems it has caused would give you libertarians pause. But no, we wouldn't want reality to actually matter for theory! It is all Fannie Mae's and Freddie Mac's fault! Yeah, that is the ticket! That is how we are going to save our theory from reality!

Remember, any problem that exists can always, in some way, be traced to government. If you can't think of how, you just aren't being creative enough!
11.15.2008 9:40pm
cathyf:
Well, if "rational" market actors are really this irrational, we have more serious problems on our hands than I thought.
The bankers in 1936-37 were not acting at all irrationally. They took the Fed's actions as indication that the Fed had some information that some horrible event was coming down the pike.

These guys all had intimate recent experience with the exact mechanisms of the vicious cycle of how bank runs cause the entire banking system to collapse. The first run is on the mismanaged banks, causing them to fail. This causes more bank runs which cause weak banks to fail. Which causes the run that kills the medium -to-weak banks, then the moderately strong banks, finally the strong banks go. These bankers were the survivors of the last banking catastrophe, and the only reason that they had survived is that they had enough cash in their vaults to survive the bank runs.

So the Fed thought that they were doing empty moral posturing by raising the reserve requirements. But the bankers thought that this was the government, and that the government was acting like they knew something, and that the government was certainly in a position to know something that the bankers didn't know.

It's like when the police chief in your town is your neighbor, and he takes you aside and tells you that there might be some trouble this weekend and you should park your car in the garage and lock it, and lock your doors and windows and stay inside. And you react by taking your family, loading them in the car, and going to visit out-of-town relatives for the weekend. Are you irrational? Are you willing to risk your family's safety to avoid the accusation of "irrationality"?
11.15.2008 9:40pm
A. Zarkov (mail):
Let's talk turkey about Paulson, or more accurately-- dollars.

Paulson overpaid by about $5 billion for the Goldman Sachs warrants he bought. We know this by comparing what Warren Buffett paid, and what he got versus what Paulson paid and what he got. The two purchases took place in the same year.

Buffett paid $5 billion to Goldman for preferred stock and warrants. These warrants give Buffett the right to buy $5 billion in common shares in Goldman at a strike price of $115 per share within 5 years. Thus Buffett gets 43.5 million common shares in Goldman. So what are the warrants worth? According to the Black-Scholes formula, $1.8 billion. Thus Buffett effectively spent $3.2 billion for the preferred shares. Preferred shares pay a high dividend and are redeemable at a premium. However there are tax disadvantages. If Buffett redeems them in 10 years his return will be 19% per year.

Now the deal Paulson got for the taxpayers was not nearly so sweet. He paid $10 billion for warrants and preferred stock under different and less favorable terms. The warrants are worth $500 million and stock $4.5 billion. The stock is valued by setting the return to be equal to Buffett's. So he paid $5 billion too much. See here for the details and discussion of the calculation.

This looks pretty bad for Paulson. He and Treasury were either financially inept or Paulson decided to make a gift of $5 billion in the taxpayers money to his old cronies at Goldman.
11.15.2008 9:44pm
David Welker (www):

They took the Fed's actions as indication that the Fed had some information that some horrible event was coming down the pike.


Because the government always has superior information to private actors. That is why private actors allocate resources more efficiently! Sorry, no dice. Especially in light of the fact that it was often bankers who provided the government with information they obtained first and not vice-versa.

The government knows something, but they won't tell us what. Let's panic! Because we are rational.
11.15.2008 9:45pm
David Welker (www):

This looks pretty bad for Paulson. He and Treasury were either financially inept or Paulson decided to make a gift of $5 billion in the taxpayers money to his old cronies at Goldman.


It does look bad for Paulson. Again, I think we should avoid making former CEOs of investment banks into Treasury Secretary where they are in a position to benefit their former bank.

It is also obscene the bonuses that they are giving out at Goldman Sachs, given the fact they received a bailout.
11.15.2008 9:51pm
cathyf:
As for the automaker bailouts, I can't see that the automaker execs should actually want a bailout. What's in their best interest is a Chapter 11 bankruptcy. Right now automakers are really just giant social-welfare bureaucracies that happen to make cars on the side. If they go bankrupt, then the government is on the hook for all of the retirees' health benefits, and the government is on the hook for unemployment benefits to all of the laid-off workers. The companies then reorganize without their union contracts, and negotiate new employment arrangements with any former employees interested in having jobs in the new post-bankruptcy companies. (Prediction -- the market wages will turn out to be about what Toyota pays its American workers.)

Pretty much what has happened in the airlines.

So listen carefully to those auto execs "asking" for a bailout. It sounds suspiciously like, "please don't throw us in the briar patch!"
11.15.2008 9:55pm
Oren:

Paulson overpaid by about $5 billion for the Goldman Sachs warrants he bought. We know this by comparing what Warren Buffett paid, and what he got versus what Paulson paid and what he got. The two purchases took place in the same year.

I paid $4.35 for gasoline in September and $2.05 today. Those two purchases took place in the same year (quarter!) therefore, I got ripped of in September.
11.15.2008 10:29pm
Oren:
Snark aside, quite a bit changed in the market between those two purchases.
11.15.2008 10:32pm
John Moore (www):
Paulson's original actions were designed to remove uncertainty. The credit derivative market had grown to amazing proportions (hundreds of trillions) and, since these were all private contracts, nobody knew (or knows) which ones were polluted by toxic mortgages and which ones were not.

Hence the attempt was to provide enough liquidity that people would be comfortable trading to unwind that mess and increase market information.

Uncertainty is always a factor in economics. It can be thought of as something which increases costs (or lowers expected returns or NPV).

Markets normally operate to reduce uncertainty. They are distributed information processors.

However, the derivative markets have turned into huge gambling operations, and the CDO's were sold in such a way as to conceal information. Hence CDO's made up of the better risks of totally risky bundles became AAA rated - for no rational reason (there is a huge agency, and frankly, incompetency problem with the ratings organizations).

If the government continues to thrash around, it will cause problems. The question is whether the uncertainty created by this thrashing is worse than whatever it is the thrashing is trying to correct.

I'm not optimistic.

Finally, as far as I can tell, nobody on earth really can predict what is going to happen. This is a highly dynamic non-linear system with complex feedbacks (sound familiar - yep - it's like weather or climate). It is simply not predictable.

We can only hope that things will recover without too much damage.
11.15.2008 10:38pm
Doc W (mail):
David Welker:

Corporations can be JUST a way for people to pool resources, AND suffer agency problems. Agency problems in market institutions are significant of course, and a fair amount of work has been done on them—Oliver Williamson comes to mind. I don't ever recall Public Choice economists denying that, but what they've done is show how massive and pervasive the same sort of problem is for government. Too long a topic for this moment, but if you're satisfied with dismissing Public Choice as a bunch of libertarians and therefore not to be listened to, go ahead and cover your ears.


If we decide to allow GM, Ford, and Chrysler to go bankrupt, we are making a choice. A choice with consequences we will have to live with for a long time.

If those companies go bankrupt, it will be the result of choices made over many years by management, unions, and the politicians they had more or less in their pockets. The choice to bail them out is also a choice whose negative consequences we will have to live with for a long time. But it's time to cover your ears again, because those consequences have more than a little to do with—here goes—moral hazard.

Query: In your view, is it entirely irrelevant whether or not the United States has an industrial base or not? As long as it is the "natural" result of free market forces?

I don't accept the implied premise that free markets are incompatible with the US having an appropriate range of productive industries. In fact, lots of cars are being made profitably in the US, just not by GM et al in Detroit.

You would think that the failure of the government to regulate and the problems it has caused would give you libertarians pause.

On the contrary, government meddling in markets is responsible for a lot of the problems. The rest of your post descends into bald innuendo not worth responding to.

But—I want to thank you for one thing. I have decided to stop posting anonymously here (although, to be sure, if you were actually interested in my identity, clicking "mail" above my post would have given you all the information you need). I haven't checked out who you are, or others posting here, because if you can't win the argument on its merits it doesn't much matter to me what field your PhD is in.
11.15.2008 11:03pm
Paul Allen:
Cathy remarks:

As for the automaker bailouts, I can't see that the automaker execs should actually want a bailout. What's in their best interest is a Chapter 11 bankruptcy.

You have it entirely wrong. The board of directors--not the executives--initiate a bankruptcy. Such an action opens the board members to suit--individually and collectively. So it decidedly not in their interest.
11.15.2008 11:51pm
David Welker (www):

Too long a topic for this moment, but if you're satisfied with dismissing Public Choice as a bunch of libertarians


I don't dismiss people's arguments because they are libertarian. If I did, this would hardly be a blog worth reading. But, I do not accept simple citations to the "public choice theorists who say so and so" as being worth much without an actual engagement with the particular ideas in question and their application to the particular circumstance.

Further, I recognize bias and ideology when I see it, and the extreme cynicism that characterizes the public choice school is pretty hard to miss. It is also hard to miss that libertarians, by and large, tend to gravitate towards this particular school of thought. That obviously does not prove much. But, it does prove just as much as your superficial citing of the "public choice school" as some sort of authority without engaging in any actual or particularized analysis.


But it's time to cover your ears again, because those consequences have more than a little to do with—here goes—moral hazard.


Once again, I did not dismiss the problem of moral hazard. If you read just a little more carefully, that should have been perfectly clear. What I said was that this point is overplayed.

The benefits of letting people learn lessons from their mistakes, which is what the fancy phrase "avoiding moral hazard" can be reduced to colloquially, has to be balanced against the costs. Also, when assessing those benefits and costs, one has to consider the consequences to outside actors. A lot more than just the people who made mistakes will suffer negative consequences if GM, Ford, and Chrysler were allowed to fail, especially given our current economy.

But, overall, I am not surprised that you have chosen to reduce my argument to a straw man, even though I was already quite clear that I was not dismissing moral hazard. I will quote myself: "Again, it is not that I do not think that 'moral hazard' is a valid concept. But, I object to the simplistic way you are wielding it in this context."

Question:
Why would you choose to characterize my argument in a simplistic manner as "dismissing moral hazard."

Answer:
Because engaging with the real argument is something you are not equipped to do. By mischaracterizing my argument, you easily dismiss it without engaging with it. Ironically, the very thing you accuse me of doing.

Question:
Why would you dismiss Krugman, Bernanke, and Paulson, all of whom are far more accomplished than you are or ever will be, as mere "quacks?"

Answer:
Because you are ill-equipped to actually engage with their arguments. In general, you resort to ad homininem attacks to *gasp* dismiss the arguments of those you disagree with. Again, and just as ironically, this is precisely what you falsely accuse me of doing.

Overall, you should be embarrassed by your performance here. Calling people who are more accomplished than you ever will be "quacks" is no way to have a conversation. Nor is blatantly and obviously mischaracterizing someone else's argument.


I don't accept the implied premise that free markets are incompatible with the US having an appropriate range of productive industries. In fact, lots of cars are being made profitably in the US, just not by GM et al in Detroit.


I am glad that you don't accept that premise. Especially since it is not a premise I actually made. Maybe in the future you could stick to answering the question rather attacking so-called "implied premises" that are not there.

This appears to be part of the same pattern of you looking for ways to dismiss the ideas of those you disagree with rather than engage with them.

I haven't checked out who you are, or others posting here, because if you can't win the argument on its merits it doesn't much matter to me what field your PhD is in.
11.15.2008 11:58pm
David Welker (www):

I haven't checked out who you are, or others posting here, because if you can't win the argument on its merits it doesn't much matter to me what field your PhD is in.


This is actually funny. Because it appears to me that the last thing you have been doing is actually arguing on the merits. Instead, you are engaged in various logical fallacies such as ad hominen attacks and constructing straw man arguments so you can be dismissive.

"Oh, I would talk about public choice, but that would be too involved. I prefer to engage in ad hominen attacks or construct strawmen, because that is so much easier."

Well, I will give you credit for one thing. At least you acknowledge that the merits are most important. At least in theory, right? Now, if you would actually turn that theory into action, that would be all the more impressive.
11.16.2008 12:03am
David Welker (www):

Snark aside, quite a bit changed in the market between those two purchases.


Indeed. And one of the things that changed is that Warren Buffet had a stake in the company, which surely would tend to increase confidence.

Nonetheless, it is very difficult to assess the right price to be paid. One hopes that Paulson had nothing to do with that determination, given the obvious conflict of interest.

Here is my question. Did Paulson ensure that people other than himself priced the deal with Goldman? I don't know the answer to that question, but I am betting that he did.
11.16.2008 12:12am
Elliot123 (mail):
"FDR did not 'prolong' the depression by 7-8 years. That is wishful (by conservatives) thinking."

Of course he didn't. When the stock market crashed in 1929 he got on TV and reassured the nation.

"FDR was Hoover's unfortunate legacy to America, not unlike how Obama appears to be Bush's. And if Obama listens to people like Krugman, he can really screw the economy for a long time."

A few months ago Krugman told us Fannie Mae was sound and hadn't purchased any subprime mortgages. Now, there's a guy with his finger on the pulse of the economy.
11.16.2008 12:23am
David Welker (www):

A few months ago Krugman told us Fannie Mae was sound and hadn't purchased any subprime mortgages. Now, there's a guy with his finger on the pulse of the economy.


Link?
11.16.2008 12:47am
David Welker (www):
Here is an interesting video from the Wall Street Journal discussing the possibility of a GM bankruptcy.
11.16.2008 1:44am
BGates:
Krugman:

Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.&L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.

Partly that's because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn't do any subprime lending, because they can't: the definition of a subprime loan is precisely a loan that doesn't meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.

So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.

If only more companies were run like Fannie and Freddie.

The good news is under the new administration, more will be.
11.16.2008 1:46am
David Welker (www):
And a related article, also from the Wall Street Journal.
11.16.2008 1:52am
A. Zarkov (mail):
Oren:

"Snark aside, quite a bit changed in the market between those two purchases."

Buffett bought Goldman stock and warrants on or about September 23, 2008, and Paulson bought them on October 10, 2008. What changed? Moreover, any changes in information about the company is reflected in the price of the common stock, which was $120.78 versus $111. Market changes are reflected in the cost of risk free borrowing, 3% versus 4%. In other words, Black-Scholes updates for new information and those updates were slight.

It looks like you either don't understand what was written or did'nt read very carefully. Try again.
11.16.2008 2:22am
David Welker (www):

Also, they didn't do any subprime lending, because they can't: the definition of a subprime loan is precisely a loan that doesn't meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.


Basically, Krugman is correct in that Fannie and Freddie did not do any subprime lending based on the particular definition of subprime lending that Krugman is using.

It should be noted however, that this definition itself did fluctuate, and Fannie and Freddie did start taking on loans that were somewhat riskier than they were allowed to take before.

I am assuming that Krugman would assert that these marginally more risky loans were not the loans at the center of the mortgage crisis, but instead those subprime loans that meet his definition of subprime were.
11.16.2008 3:44am
Laura S.:

Basically, Krugman is correct in that Fannie and Freddie did not do any subprime lending based on the particular definition of subprime lending that Krugman is using.

And playing linguistic gymnastics. Loans to borrowers with low credit scores are subprime per se; regardless of whether the loan structure is conforming. Krugman is being particularly duplicitous because the "subprime" problem has focused on borrowers, not whether mortgages were Jumbo.
11.16.2008 4:48am
Arkady:
On FDR.

Folks will argue about the technical effectiveness of FDR's progams in overcoming, or prolonging, the Depression. But what's lost in all the discussions I've read is an acknowledgement of the psychological effect of FDR on a dispirited and fearful nation. I know that anecdotes aren't data, but I'll always remember what my grandmother told me once (she from the rural, farming South). I asked her about the Depression, and what she told me about life in the South during that time was pretty grim. But then, without my asking, she said, but sometimes just hearing FDR the radio made her feel that there was a way out that nightmare. I don't know if it's possible to quantify that effect, but it was real and important.
11.16.2008 7:13am
davod (mail):
This shows how the problem started Cuomo at HUD explains everything.
11.16.2008 7:53am
davod (mail):
PS:

"Basically, Krugman is correct in that Fannie and Freddie did not do any subprime lending based on the particular definition of subprime lending that Krugman is using."

My 11.16.2008 post shows Krugman to be lying.
11.16.2008 8:00am
TCO:
Krugman is a trade economist who did some good technical wokr there. He is not a monetary economist. Nor is he above sophistry.
11.16.2008 8:59am
REdinburgh:
Just skimmed the posts above....let's see:
-Taleb says Bernanke, Paulson, and Greenspan are quacks. Did a quick search of the message board - I'm the first to mention Taleb. You are all clueless. Whether you agree with Taleb or not, his not getting a mention just shows an ignorance of the subject matter.
-Wittgenstein's Ruler: when you speak about something you know nothing about, it says nothing about the subject at hand and everything about the speaker
-The posts above are littered with the "post hoc ergo propter hoc" fallacy - economy bad, new deal, economy good, ergo new deal worked...
-I'm sure many of you are plenty smart (and much smarter than I), but I doubt many of you are as smart as you think you are. Have some humility! When you don't know anything about the subject, then kindly STFU!
11.16.2008 9:00am
A. Zarkov (mail):
"I'm the first to mention Taleb. You are all clueless. Whether you agree with Taleb or not, his not getting a mention just shows an ignorance of the subject matter."

How is that? Taleb has not be a major player or an important analyst on the credit crisis. No one has mentioned Roubini either-- one of the earliest to ring an alarm. This essay provides some perspective on Taleb.
11.16.2008 9:24am
Curt Fischer:
David Welker, Thanks for the replies. Focusing on agency problems certainly seems to have moved the discussion forward.

It still seems that there are two distinct issues. One is the simple agency problem that you mentioned. Management, sharehholders, and debt holders may have conflicting goals. When the company is in dire straits, one or more of these agents may prefer bankruptcy, but I think it is safe to say that if the choice is between prosperity and bankruptcy, all of the agents would chose prosperity.

But another, distinct problem is the problem of government / industry relations. I grant that if GM goes bankrupt, some of their manufacturing facilities may be shut down. But my naive expectation is that much of the capacity could be best exploited (at least partially) by other auto manufacturing agencies, such as Toyota, instead of just e.g. recycling all the steel.

But suppose this is not the case. That is, suppose the continued existence of GM as GM is important to maintain America's industrial base. Then we have thrown the American public into the mix. Agents with a stake in operations are now shareholders, management, debt holders, and the entire American people. Once we accept that point, statist or socialist regulations seem like the only sensible economic policies. Surely the public interest of the entire American people should trump that of the management or the shareholders. Right?

And of course this isn't true only for GM. If the particular agencies that control various economic capacities are important determinants of capacity, those agencies should all be protected. Even the creation of new domestic agencies, e.g. by entrepreneurship, could be a threat to the Nationally Important Agencies, and should be disincentivized.

I realize I may be pushing your arguments to an extreme, but I suppose the debate is where to draw the line between preserving certain agencies to avoid catastrophic disruption and allowing creative destruction to rejuvenate the economy. There just doesn't seem to be a natural place to draw the line.
11.16.2008 11:18am
David Welker (www):

And playing linguistic gymnastics.


I disagree. One of the most common definitions of subprime mortgage is one that will not be bought by either Fannie or Freddie. If the standards regarding what loans Fannie or Freddie by changes, then so does the definition of subprime loan. Simple enough.

Now, it is true that Freddie and Fannie did change their standards, and so loans that would previously be classified as subprime would no longer be so classified. But, these loans that are not all that far from what would be considered prime loans under the old standards. This is nothing more than adjustment at the margins. It isn't the case that this reclassification is somehow responsible for the mortgage bubble.

Lenders continued to make subprime loans to those who did not fit the definition of prime mortgage under the new standard.

So, here are some questions the answers I would be interested in knowing, but do not have time to research -- at least not right now. To what extent did this reclassification contribute to the housing bubble? How many people benefited from this reclassification? How many people who benefited from this reclassification have later run into trouble? Compared to those with subprime mortgages under the new standard? How about compared to those who would have qualified for prime loans under the older standards?
11.16.2008 11:37am
David Welker (www):

There just doesn't seem to be a natural place to draw the line.


Agreed. There is no easy place to draw a line. It is messy.

But let me suggest that during a major downturn in the economy is probably not the best time for major experiments in "creative destruction."
11.16.2008 11:42am
Johnny Canuck (mail):
There just doesn't seem to be a natural place to draw the line.

In Canada, after WW I we had 3 transcontinental railways, financial troubles, the govt took over two and formed Canadian National (CN). As a government owned railway it operated and competed against privately owned Canadian Pacific until CN was privatized in 1995.

My impression, contrary to American mythology, is that the government owned CN operated as effectively as the privately owned CP.
11.16.2008 11:45am
A. Zarkov (mail):
"My impression, contrary to American mythology, is that the government owned CN operated as effectively as the privately owned CP."

Perhaps the Canadian government can, but other governments don't do so well. The French government nationalized the Renault automotive company after WWII. The company ran at a loss until privatized. There are many other similar examples. Once nationalized company employees become a political pressure group who fill fight for subsidies. They generally get their way because it's easier for the government to give in and pass the costs to the taxpayers. After all, it's not their money. It's very easy to be generous out of someone else's pocket.

As for you RR example, I suspect that the Canadian government so heavily regulated the private RR that in effect you pretty much had two similar operations. Bad example.
11.16.2008 12:02pm
Curt Fischer:
Most of us seem to agree that there is no natural place to draw the line between policies to favor certain corporate agencies or policies to foster (disruptive) turnover and economic renewal.

In my ideal world, the government would seek to minimize undesired disruptions as best it could without catering to the needs of any particular agency. For example, if GM files for bankruptcy, it might buy GM's assets and auction them off to potential buyers, but give discounts for buyers who agreed to stipulations that the assets must be used for automobile manufacturing.

I realize that practically speaking, it may be difficult to design such solutions, and that many of them may have prohibitive transactional costs. But we can all dream.
11.16.2008 12:34pm
loki13 (mail):
Curt,

I am just checking in, but I am somewhat befuddled by your last post ("without catering to the needs of any particular agency"). I'm not sure what you're talking about.

The classic agency problem of corporate governance is that the agents (the management) and the principal (the shareholders, aka the owners of the company) will have misaligned incentives; in the past, the concern was that management would not be sufficiently incentivized to perform their best. That is why they begin compensating in stock options (if the stock, i.e. the company and its shareholders did well, management would prosper as well). Unfortunately, we have found that this has been easily gamed and causes management to look at the short term instead of worrying about steady growth; in addition, the rise of golden parachutes has arguably created an incentive for management to engage in risky behavior, since either the risk will pay off (massive stock option increase) or it won't (golden parachute).

Anyway, I think the original point is that perhaps the shareholders of GM shouldn't be punished (Chapter 11) for management's mistakes. I'm not sure I agree with that (actually, I don't) but I'm not sure what you're talking about.
11.16.2008 12:57pm
davod (mail):
LCB, who posted an excellent appreciation of the situation at Ace of Spades kindly gave permission for me to post it elsewhere:

9 I don't normally chime in, but I have a very strong economics background. Let me be clear: Paulson sucks ass. Is this a complicated situation? Sure. Can complicated situations be fixed in simple ways? You bet. Our crisis essentially exists on paper. Are there non-paper components? Yeah, but the crisis exists on paper. Let's fix what we can fix easily and then deal with the rest.

Fix mark-to-market and the situation improves DRAMATICALLY. The mark-to-market rules defy common sense. Since when the hell do we retroactively apply new valuation rules? We don't, because then shit like this happens. Require all new securities to be valued on mark-to-market, allow old ones to be grandfathered in. Mark-to-market is forcing companies to take huge writedowns and put up lots of collateral in a market where they need liquidity. Okay, but why is that bad?

It is bad because it forces them to release quarterly reports that say, "Yikes we lost a lot of money this quarter." Berkshire Hathway (Warren Buffet's company) made money last quarter, infact they made a BOATLOAD of money. However, one investment that MADE 4 billion required 6 billion in collatoral because of mark-to-market. This killed their quarterly results. The difference between investment companies, banks, and insurance companies posting okay returns versus bad losses is one bad rule. Let's consider that again: one of their strongest assets is requiring 6 billion in colateral b/c of a bad rule.

Paulson has only made things worse. Banks should have been recapitalized from the get-go. Lehmen should never have been allowed to fail. The government has no business getting into these toxic assets (which are toxic in part b/c of mark-to-market). Intervene and force renegotiations of some mortgages, allow all mortgage payments nationwide to be tax deductible across the board for 10 years, don't force banks to make bad loans, and slowly start inching up the minimum required payment on CCs, and so on.

There are a lot more effective ways to deal with this mess, but it all starts with mark-to-market. And Paulson is a f'ing moron. His erratic actions have made this much worse.

11 When you're on a roll you're on a roll, so here goes part 2:

General Motors bailout. Let's ignore everything wrong with GM, and pretend that we live in magic pixie land, and act like bailing GM out will fix all of GM's problems.

Okay, so GM gets a bailout. TONS of jobs are saved in America. If GM goes under a million+ people lose their jobs overnight. These folks make things for GM. Widgets. Pipes. Steering wheels. Whatever goes into a car so I can drive to the store and buy beer.

But what happens 5 years from now? Even if GM's fundamentals are fixed (using pixie dust on their business plan and union commitments), what happens 5 years from now? In 5-10 years we will see transitions to plug-in hybrid vehicles. It's not unreasonable that we may even see fully functional electric cars getting 200+ miles per charge and selling at normal cost (look up Tesla Motors for more).

These jobs are ALREADY lost. The cars of tomorrow have no moving parts other than the wheels. If you make engine lugnuts you are already out of a job, you just won't find out for 5-10 years, because the days of the internal combustion engine are numbered. If you make super high tech batteries and electric components that aren't yet in vehicles, then you have a job.

And if I'm wrong about car technology changes (which I'm not) car sales dropped 45% in October alone. So you bail out GM and use the magic pixie dust. Who the f is going to buy the cars GM makes?

In other news, GM's bonds are trading for 25 cents on the dollar, with an 8ish % interest rate. That means the bonds are paying 32% per year. Who likes government guaranteed money? I'll be reinvesting my coupon payments into foreign car companies in non-dollar currency.

Posted by: LCB at November 15, 2008 01:28 PM (lpLHM)
11.16.2008 1:15pm
Laura S.:

I disagree. One of the most common definitions of subprime mortgage is one that will not be bought by either Fannie or Freddie.

No. It is common for all non-conforming paper to be called subprime irrespective of other factors, but not all subprime paper is nonconforming. All A are B does not imply that All B are A.

If you've been following the situation closely, you'd know that the 'subprime' for which we've all been chattering is not exclusive to the non-conforming paper. Ergo, this sort of shell game is misleading.

The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 specifically directs the GSEs to purchase what qualifies as 'subprime' paper--namely CRA loans. By 2007, these FHEFSSA directed purchases amounted to 1/3 of Freddie's business.
11.16.2008 1:55pm
David Welker (www):
Laura,

First, there is no one single standard agreed upon definition of subprime.

One acceptable definition is that anything that conforms is prime, and anything that does not is subprime. That is clearly the definition that Krugman was using.

You may still insist that this definition is somehow "the wrong definition." Fine. Overall, I am not interested in a superficial argument about definitions that is sure to resolve nothing substantive. I think the more interesting and substantive question is what were the effects of Fannie and Freddie changing their standards for the loans they were willing to classify as conforming.
11.16.2008 2:07pm
Harry Eagar (mail):
Curt asks: 'will the automobile manufacturing capacity currently owned by GM be destroyed if GM goes bankrupt?'

Pretty much. I didn't notice anybody buying up and continuing to use the vast amount of abandoned plant Detroit has made available over the years.

The question is, is that a bug or a feature?
11.16.2008 2:36pm
Curt Fischer:
loki13: I was trying to address what I read to be David Welker's argument for government support of GM because GM is a component of America's industrial base. That is, GM is important not only to its management, shareholders, and debt holders, but also somehow to America's national interest in h having a strong national industrial base. Ergo, the American People are in some sense a stakeholder in GM's existence and prosperity.

To some degree this is just because having prosperous companies is good for everyone, but my understanding of David Welker's argument was that beyond that, letting GM fail right now would create a huge economic disruption at a time when the economy is already weak. Even if years from now a newer, stronger entity (perhaps e.g. a subdivision of Toyota) has taken control of GM's current assets and is operating them profitably, I read him as saying the disruption to the US economy caused by a GM bankruptcy right now would be a disservice to America's national economic interests, presumably because it might take time to redistribute all of GM's capital to those better able to use it, and because not all of it may get redistributed -- some may just be junked.

If you grant that fact, it seems inescapable to me that the US government has a legitimate role to play in managing/bailing out/meddling with GM. That's a problem separate from the classical agency problem because now a new party (the American people as represented by their government) is a stakeholder in the fate of GM.

So when I said I would prefer policies that didn't cater to any particular "agency", perhaps it was bad diction. I meant particular corporations. I can see the need to preserve particular economic assets or types of capital
11.16.2008 2:42pm
Laura S.:

One acceptable definition is that anything that conforms is prime, and anything that does not is subprime. That is clearly the definition that Krugman was using.

Again, go back to the logic. All As are B, is not the same as saying All Bs are A. Krugman calls upon the first relationship which is accepted, and then pivots to using the second. This isn't a dispute over definitions. He is just wrong.
11.16.2008 4:39pm
David Welker (www):
Laura,

This is just a dispute over definitions.

First, you have something that divides things into categories A and B. Well, that is all fine and good. But let us not pretend that all things in the A category and all things in the B category are exactly alike. Especially when you are dealing with a continuous variable, like credit risk, any division in simple binaries is going to result in some distortions.

Not all loans that one would label "prime" are equivalent. Not all loans that one would label "subprime" are equivalent.

Probably, the difference in risk between the best "subprime" loans and the worst "prime loans" is less than the difference between the worst prime loans and the best prime loans. That is what you get when you take data that exists on a continuous spectrum, like risk, and use a simple binary classifier on that data.

What Fannie and Freddie did was decide to start accepting the best subprime loans. That is, they changed this binary boundary on the margins. In the process, according to one definition of subprime, the category that these loans were in changed.

Your argument is that these loans that were previously considered subprime still should be considered subprime. You think that while the definition of subprime was originally made in reference to what was accepted by Fannie and Freddie, that when they change what they accept, that should not change the classifier.

Never mind that the precise boundary between "prime" and "subprime" is and must be arbitrary to begin with and at the margins, while this classification may have great practical significance to the borrower, the difference in risk lies on a continuum and the difference in risk between the worst prime loans and best subprime loans will not tend to be that great.

Basically, since the division between prime and subprime is and must be arbitrary in the first place, the difference in opinion between you and Krugman regarding the placement of that boundary is more linguistic than substantive. In his view, the boundary between prime and subprime shifted, because the loans that Freddie and Fannie would accept and would not accept defined that boundary originally in the first place. In your view, while you accept the original boundary, you do not accept the idea that it can shift.

That is fine. I think either view of the definition of subprime is reasonable. This is an inherently flawed binary classifier regardless.

The substantive question is this. What was the substantive result of Fannie's and Freddie's decisions to purchase loans that they would not have before (whether we call them subprime or not)? What was the magnitude of this decision's contribution to the housing bubble?

That to me is much more interesting than any definitional debate.
11.16.2008 5:13pm
cathyf:
The substantive question is this. What was the substantive result of Fannie's and Freddie's decisions to purchase loans that they would not have before (whether we call them subprime or not)? What was the magnitude of this decision's contribution to the housing bubble?
I think Laura already answered that question:
The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 specifically directs the GSEs to purchase what qualifies as 'subprime' paper--namely CRA loans. By 2007, these FHEFSSA directed purchases amounted to 1/3 of Freddie's business.
Pretty clearly that's not a marginal change. The only question is whether the GSEs substituted subprime for prime, or they added the subprime and increased their total business.
11.16.2008 6:47pm
David Welker (www):
cathyf,

Actually, Laura's point, while helpful, does not answer the question.

The question is not merely what percentage of in their portfolio fall under the definition of "subprime" under one arbitrary definition or another. One also has to ask how these loans have actually performed compared to other loans in the portfolio and other loans that are "subprime" under any definition.

See, the issue is that the label itself does not resolve questions of performance. If we insist on calling these loans "subprime," they were probably the least risky of loans that fall into that category and thus likely have different performance characteristics than other subprime loans.

That you initially thought that the mere categorization of these loans answered the substantive question I think illustrates quite nicely how definitional issues can be distracting. Okay, so lets call these loans "subprime" and lets say they constitute one third of Freddie's portfolio (what about Fannie portfolio?). How did they perform compared to other loans in different categories?

Now, if I was super curious and wished to allocate more time to this question, I would look up the answer to that question myself. As it is, I am just going to flag it for now as an unanswered question that has not in anyway shape or form been addressed by this definitional debate.
11.16.2008 7:01pm
Elliot123 (mail):
If we work at this we can probably fix the whole mess by discovering there are no subprimes.
11.16.2008 9:43pm
cathyf:
One also has to ask how these loans have actually performed compared to other loans in the portfolio and other loans that are "subprime" under any definition.
That's only somewhat interesting. The real issue is how these loans will perform in the future. Which is dependent upon a whole lot of things. How the economy performs (if people make enough money to pay their mortgages, then most will.) Whether there are laws passed which abrogate mortgage contracts (or, more to the point, any laws which increase or decrease the incentives to default.) The speed with which new service industries spring up to minimize wealth destruction in foreclosures and other defaults (huge amounts of wealth is simply destroyed in a foreclosure; anybody who figures out how to prevent a significant amount of that will change things significantly.)

If the economy hits the skids hard enough, the subprime mortgages are going to hit default rates which are more like 60-70-80%. And the prime mortgage default rates are going to go through the roof if we have 15-20-25% unemployment rates. Lots of people who took at prime mortgages with completely reasonable payment-to-income ratios are going to have to default when they lose their jobs.

The problem is that all of the valuation models basically assume that you can borrow as much money as you need at some interest rate, which in normal times is more or less true. I think that the 1936 comparison is particularly apropos: in 1936 the only surviving bankers were the ones who had enough money either as gold or cash in their vaults when the depositors lined up around the block and demanded their money in the bank run. If we "teach" our current bankers to keep the banks' money in overnight deposits at the Fed rather than loaned out to productive businesses, then we are in absolutely desperate straits.
11.16.2008 10:21pm
David Welker (www):

That's only somewhat interesting. The real issue is how these loans will perform in the future.


At this point I am compelled to agree. This is the more interesting question.

I also agree with you about how it would be a very bad idea indeed to "teach" our bankers to not loan money to productive businesses. What we need right now is fiscal stimulus.

Thank you for you for your interesting comments.
11.16.2008 10:39pm
David Welker (www):
Apropos this discussion, here is an interesting NY Times article on the possibility of foreign automakers taking up the slack of American automakers were to fail.
11.16.2008 10:51pm
David Welker (www):
Oh, and I couldn't resist providing links to two very interesting and contrasting blog posts by Richard Posner here and Gary Becker here.
11.16.2008 11:05pm
Smokey:
I notice that the U.S. television manufacturing industry [Zenith, RCA, etc.] didn't get a government bailout, even though the rationale for bailing them out was the exactly same as for the automobile industry.

The economy didn't crash and burn because the U.S. TV industry was out-competed. In fact, the unemployment rate is much lower today than when the last U.S. TV was produced. Imported TV's were both cheaper and better. By letting competition work, tens of millions of consumers got a better deal.

Wasn't it the Luddites who smashed spinning jennies, believing that their jobs were at risk? What happened, though, was an increase in employment; the new factories needed skilled workers to run and maintain the machines, leading to both higher employment and higher pay.

Unemployment insurance is the safety net. Like anyone else who loses his job, there are other jobs. Bailing out auto workers is being discussed only because of their numbers. But other workers who become unemployed have just as tough of a time. And no one is helping them.

Schumpeter called it "creative destruction." Letting inefficient industries fail is necessary to avoid an ossified economy producing substandard products.

And sometimes there is a true turnaround, as when Harley Davidson petitioned Congress to lift protective tarriffs. Harley had an attitude adjustment, an epiphany, and decided they could take on the Japanese imports toe to toe by producing quality motorcycles. Look at how successful Harley is now.

It is possible for U.S. car companies to do the same thing. But it will never happen unless their only option is to sink or swim.
11.17.2008 11:10am
Smokey:
[My comments above re-posted to a more appropriate thread: "Memo to Detroit: Make better cars".]
11.17.2008 11:48am
David Welker (www):
Smokey,

Your argument might make sense if the economy were not currently falling off a cliff. Even well run companies are in a position to sink right now.

Basically, you seem to be asking GM to not only swim in normal water, but to swim out of a huge maelstrom. And the last thing people who already laid off is a bunch more competition from yet more laid off people.

You argument seems to go like this. "Since A is laid off, and we are not doing much for A, we shouldn't worry if B is laid off either. In fact, it would be unfair to A if we decided to do anything to help avoid B being laid off."

What this fails to take into account is that B getting laid off hurts both A and B. I am not saying that we shouldn't do more to help A. But, you can't use the fact that we are not doing enough to help A (in your view) as a reason to adopt a policy that hurt both A and B. (Not to mention C, D, E, and F.)

The bottom-line is this. Even if it would make sense to allow GM to go into Bankruptcy in normal times, it doesn't make sense now. It would be very difficult for GM to get the financing necessary to operate under Chapter 11 given the credit markets. Not only that, the last thing we need is to add millions of people to the ranks of the unemployed. (Remember, a GM liquidation would likely affect not just GM, but its many suppliers as well. Not to mention the risks it would cause both Chrysler and Ford who share much of the same supplier network.)

There may be a time for "creative destruction," but that is probably not the greatest thing when the economy is falling off a cliff.

Besides, I notice that most people who advocate "creative destruction" fail to periodically disrupt their own lives. Maybe the destruction part of that phrase sometimes exceeds the creation part??
11.17.2008 2:21pm
Soronel Haetir (mail):
DW,

I have to disagree, bad times are the period best suited for letting failure reign. Good times mask the rot, it is only exposed when everyone is hurting. So it hurts more instead of being a festering wound covered with a nice gauze bandage.

Seems a lot like the arguements people have about adhesive bandaids, is it better to yank them off all at once or is a little at a time to be preferred?
11.18.2008 8:52am
David Welker (www):
Well, since the economy is not exactly like a "festering wound" it actually is better if adjustments are more company-specific than industry-wide, more gradual than sudden.

At least, that is true if you think people extract some value to being able to plan their lives, live with a sense of social stability, and not experience increased crime, divorce, and suicide rates.

You may recall that last chance we had an opportunity to "yank" the whole bandage off at once. That was called the Great Depression. Instead of making the patient feel better, it made the patient lose too much blood all at once.
11.18.2008 1:13pm
Soronel Haetir (mail):
DW.

Well, I'm certain my vision for the world wouldn't catch on with many US citizens, or those dependant on US citizens for that matter. A nice long new Dark Ages would do humanity a world of good. And while I don't now I have lived pretty close to that level, 7 miles from my nearest neighbor without electricity or running water. Americans are just flat too comfy. Hardship is its own valuable lesson.
11.18.2008 6:54pm
Aslam (mail):
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11.21.2008 2:07am
Damn Yankee (mail):
Comptroller Dugan Says CRA not Responsible for Subprime Lending Abuses:


"Mr. Dugan said that CRA lending has generally been safe and sound. For example, he said, single family CRA-related mortgages offered in conjunction with NeighborWorks organizations have performed on par with standard conventional mortgages.

"Foreclosure rates within the NeighborWorks network were just 0.21 percent in the second quarter of this year, compared to 4.26 percent of subprime loans and 0.61 percent for conventional conforming mortgages," he added."


HTH
11.21.2008 4:22am