Who’s to blame? Follow the money
Throughout this crisis the left has been determined to blame the “unregulated” parts of the financial system, and this has required their defense of some pretty unsavory quasi-public parts of our economy (Fannie & Freddie, FDIC, the Fed, etc) Just to be clear, I don’t mean to suggest that the left doesn’t also have problems with those institutions. They do. It’s just that when conservatives try to blame government meddling for the crisis, the left reflexively reacts and points out that at the peak years of the sub-prime boom (2005-06), private banks were making more sub-prime loans that Fannie and Freddie. And regarding deposit insurance, they usually suggest that it was essential to prevent 1930s-style panics, and/or the moral hazard problem was overrated. (Actually, the bank panics of the 1930s were caused by NGDP falling in half and fear of dollar devaluation.)
Initially the left had some strong arguments. When the crisis first got severe in 2008, it looked like F&F might remain solvent. But what a difference two years makes. The net cost of the bailout of banks is expected to be minus $7 billion, which means the federal government will make a $7 billion profit. I think it is only fair to include the losses in AIG in that total, however, as AIG was bailed out to save banks that had derivative agreements with the moronic insurance giant. The total losses the AIG plus the banks are now estimated by the CBO to be $29 billion. Let’s review all the actors in this unfortunate drama:
F is for failure:
1. The Fed. Losses unknown, but its tight money policy created the severe recession, which dramatically worsened the financial crisis.
2. Fannie and Freddie: Estimated losses $145 billion, and rising fast
3. FDIC, estimated losses $100 billion
4. The UAW: estimated losses from bailing out this adjunct of the Democratic party is $34 billion
5. Banks plus AIG: Estimated bailout costs is $29 billion and falling.
Yep, that sure looks like a failure of laissez-faire capitalism. And I didn’t even mention the FHA, which is furiously at work trying to create another sub-prime fiasco. Why do so many of the villains acronyms start with an F? What does that stand for?
To get serious for a moment, here’s my take on financial reform. We are looking at the wrong problem. Everyone seems to visualize those traumatic days in late 2008 when the entire banking system seemed in danger of freezing up. And of course the subsequent severe recession, which everyone blames on the financial panic. But as readers of my blog know I think the Fed, not the financial system, was responsible for that crisis. It’s not that I am trying to exonerate the banking system, bankers did screw up. But there are really two separate problems that need to be disentangled, and then treated separately:
1. How to prevent another panic/recession
2. How to avoid future taxpayer-financed bailouts
The first problem can probably be eliminated with a 5% NGDP targeting scheme, level targeting. If I am wrong, and the banking system freezes up despite this policy, then I am willing to let the Fed do some “lender of last resorting” (or is it lending of last resort?)
OK, but what if there are still losses to the taxpayer, maybe banks don’t repay those Fed loans. My first response is that if once every 25 years the banking system screws up, destroys many hundreds of billions of dollars worth of bank equity, and oh by the way costs US taxpayers $29 billion, then the public policy parts of this crisis are pretty insignificant. Let’s have the reforms focus on the bigger taxpayer hits. Here is my solution:
1. Gradually phase out F&F. We can’t do it immediately, as it would hurt an already fragile housing sector. But phase them out over a period of 10 years. Other countries do fine without these monstrosities. I recall that even Barney Frank is coming around to this view.
2. Cut the FDIC insurance coverage from $250,000 to $50,000 per depositor. This would still cover the vast majority of Americans. Have Obama give a speech telling Americans with more than $50,000 in the bank that if they are concerned about the safety of their deposits, the extra money should be put in T-securities of MMMFs. (In reality this reform would have to be phased in very slowly.) Require that all FDIC-insured banks keep enough Treasury securities on their balance sheet to pay off all the insured deposits. I don’t think banks would be able to raise enough money from small depositors to finance their activities, so they’d have to rely on higher cost sources of funds. That’s what we want, isn’t it. Bank selling $100,000 CDs would have to offer significantly higher rates than they currently do.
3. Abolish “To Big To Fail,” and replace it with 5% NGDP target, plus lender of last resort in a severe freeze-up of the banking system. If all this still isn’t enough to prevent panics, consider the idea Mankiw discussed where bank debt would automatically convert to equity when a bank got in trouble.
There, that didn’t take 1500 pages. (I warned you yesterday that I was in the mood to develop grand schemes to save the world off the top of my head.)
PS: Don’t tell me that the losses to FDIC are not losses to the taxpayers. They are. In a competitive banking industry (with a flat long run cost curve), any mandatory insurance fees are passed on to bank customers, just like an excise tax on cigarettes is passed on to smokers. There are thousands of banks in the US, and the long run cost curve is probably pretty flat. Sometimes I hear news stories about how “progressives” are trying to have the banks pay a fee to cover the cost of future bailouts, so that taxpayers don’t have to pay. (Rolls eyes) I have an even better idea; the state of Massachusetts should re-write the sales tax law, requiring stores to pay the 6.25% sales tax, not customers. Wouldn’t that be wonderful!
Tags: Fannie Mae & Freddie Mac, Insurance
5. June 2010 at 06:59
Scott,
From a market participant’s standpoint, what matters is optimal leverage given the expected volatility of returns. If you tell a hedge fund manager that NGDP will grow at 5% with minimal vol, what would be his optimal leverage ratio? At any positive spread over short term funding (in any currency with consistently low s.t. rates), optimal leverage will be through the roof. This is a simple fact.
Taking that model output — high leverage — what does it imply? Firms will lever up to buy assets. Asset prices will increase. Marginal borrowers will get out of default situations by selling assets or refinancing. Econometric models of credit defaults will show no correlation between underwriting variables (such as income documentation) and defaults. Underwriting standards will fall as a result — RATIONALLY. As standards fall, asset prices rise further. Rising asset prices reduce expected vol, increase optimal leverage, reduce underwriting standards, causing asset prices to rise.
If you have a different view of the likely response of market actors — at the firm level — I would like to hear it. Keep in mind that asking firms to gauge system-wide risk is very difficult, as is asking them to substitute common sense (don’t make no-doc loans!) for econometrics. One only has to listen to Warren Buffet’s (the supposed paragon of common sense) testimony absolving Moody’s for blame in the financial crisis. To paraphrase, “house prices were rising, and every one expected them to keep rising, so Moody’s did what the model told them, and who could blame them?”
BTW, the solution to the above is true symmetry in policy, such that sustained arbitrage of the yield curve (or cross currency such as the Yen carry trade) is not available to speculators. However, if the Fed sets the NGDP level target above trend growth, speculators will face a consistent positively sloped yield curve. In situations in which trend growth has fallen from historical levels, this is a recipe for credit disaster. I would argue that, to eliminate tail risk, NGDP targeting should have a margin of safety: a gap between expected trend growth and target. In the end, there is a logical trade off between growth and volatility. Are you willing to make it?
5. June 2010 at 07:19
@David Pearson
‘Econometric models of credit defaults will show no correlation between underwriting variables (such as income documentation) and defaults. Underwriting standards will fall as a result “” RATIONALLY. As standards fall, asset prices rise further. Rising asset prices reduce expected vol, increase optimal leverage, reduce underwriting standards, causing asset prices to rise.’
This sounds suspiciously like an Austrian Business Cycle! 🙂
5. June 2010 at 07:24
This all makes sense, but even less efficient “progressive” regulation might have been superior to the status quo.
I personally think that simple hard and fast rules, even given what we lose in the effciency that nuance allows, are much easier to follow and enforce.
For example, how about national minimum lending standards, such as not having mortgage payments exceed a third of income at any point in the repayment period? How about forcing all derivatives to be traded on open exchanges, and all assets any public company or too big-to-fail entity holds be clearly on their books? How about size-related limits on leverage?
However, a hard and fast rule on nGDP targeting would seem far superior. Milton Friedman wanted a computer to set interest rates, which now makes sense to me. So, how about reforming the Fed?
5. June 2010 at 08:07
Abolish All Loan Guarantees. Nothing says “Private Gain / Public Loss as Permanent Policy” more than a bank being able to issue debt on a risk-free basis.
5. June 2010 at 08:17
Why invoke the auto bailout in a post that’s otherwise only about the financial sector? And why blame the underlying failure solely on the UAW?
5. June 2010 at 08:34
Doc,
Nothing theoretical about what I posted. Ask any hedge fund manager or ABS trader and he/she will tell you this is exactly what happened from 2003 to 2007. They were all following model outputs, because that is what every economics and finance graduate was taught to do. In fact, the Fed was doing the same: Greenspan himself claimed that the best reason not to fear a mortgage credit problem was that RISING PRICES had created more equity cushion for borrowers. This is just a layman’s description of the fact that LTV’s (loan-to-value) were falling throughout this period, and, as a result, so were expected defaults. This is a big reason for the rise of no-doc loans: the more expected LTV’s fell, the less important the correlation of income levels (DTI’s, or debt-to-income) with defaults.
In early 2006 I took my idea of shorting subprime to a former PIMCO bond manager running a hedge fund in Newport Beach. His response to my analysis was, “I have stressed (modeled) my subprime tranches under every reasonable worst case scenario, and I still get no losses.” This guy was no dummy — a very successful fund manager. But he did what the model told him to do.
5. June 2010 at 09:07
Sorry, Scott, but you’ve lost me entirely. Are you claiming that the best way to figure out who caused the blast is to look at who suffered the most damage?
5. June 2010 at 09:11
David, I agree, I was just jokingly pointing out that the current recession looked very Austrian.
5. June 2010 at 09:11
“…at the peak years of the sub-prime boom (2005-06), private banks were making more sub-prime loans tha[n] Fannie and Freddie.”
The financial crisis wasn’t about who was making the loans, but who was holding the mortgage-backed securities when the music stopped and everyone was scrambling for a chair. From my understanding most subprime loans, regardless of origination, went through the F&F clearinghouse where they were subsequently chopped up, securitized, and diversified throughout the financial system. F&F did not and never has directly originated mortgages, but bought a billions of the securities from the clearinghouse both prime and sub-prime, held some and resold others. The clearinghouse was their mode of providing liquidity to the mortgage market without having to interact directly with the public and it was open to the industry for investment. F&F were the guys in the middle and had their fingerprints all over everything. At the peak of the housing bubble, the clearinghouse was the first stop for nearly all mortgages regardless of origination. So while it is true that “private banks were making more sub-prime loans than Fannie and Freddie,” it is irrelevant to measuring the extent of F&F involvement in the financial crisis.
5. June 2010 at 09:36
David Pearson:
“eliminate tail risk, NGDP targeting should have a margin of safety: a gap between expected trend growth and target. In the end, there is a logical trade off between growth and volatility. Are you willing to make it?”
That is crazy.
Here is my solution. Let hedge funds go bankrupt if they lend into a speculative bubble. Keep money expenditures growing 3 percent.
More fundamentally, rich fools should not give any more money to hedge fund managers who were trained by “economists” and finance schools to blindly project past trends into the future.
Regardless, I cannot imagine how it is possible to create a gap between the expected trend of nominal expenditures and the target. Periodically create recessions so that actual is less than trend? We going to make that a rule?
Anyway, I am more and more convinced that something about being a participant in financial markets makes people insane.
5. June 2010 at 10:19
A few points:
First, the premise “let hedge funds go bankrupt” is incompatible with NGDP targeting, as it would cause a crash in NGDP expectations. The industry manages $1.8tr, which does not include trillions in bank off-balance sheet carry trade vehicles and on balance sheet prop desks. As much as I would agree they should suffer, since LTCM we have lived in a world where they hold us hostage.
Second, my premise, which remains unchallenged, is that pegging expected trend growth above achievable in a level targeting regime will create a sustained upward sloping yield curve, which market participants will employ in carry trades. Carry traders would respond to asymmetric monetary policy by taking on extraordinary leverage resulting in systemic risk.
Third, the last comment Woolsey makes, while seemingly a viable opinion, would appear to be inconsistent with EMH.
In fact, Woolsey raises a good point. No one should be allowed to blindly forecast historical trends into the future without expecting adverse consequences, whether it be financial participants or Fed officials pegging trend growth.
5. June 2010 at 10:23
No, most subprime did not go through F&F. Subprime was quite small until the investment banks got involved and it then bought the highest rated tranches because they weren’t allowed to do their own. And the bailout of F&F is actually a bailout of the institutions holding the debt. They did hold too much themselves, but 29 billion is as fictitious as it gets.
5. June 2010 at 10:47
David, I really don’t care if private firms leverage up to the hilt, and go belly up. As long as:
1. NGDP keeps growing at 5%
2. Taxpayers don’t have to pay.
That’s the purpose of my reform proposal. Keep NGDP growing and offload risk from taxpayers. Hedge funds took lots of risks, but it didn’t get pushed onto the taxpayer when they failed.
BTW, I don’t agree that 5% NGDP growth would dramatically raise leverage. And my other reforms would dramatically lower leverage. Banks would shrink.
You said:
“However, if the Fed sets the NGDP level target above trend growth,”
I don’t know what this means. Do you mean above RGDP trend?
I think a three percent target would be fine, with level targeting.
Mike, I’ve proposed a minimum 20% downpayment. That seems in the same spirit as your ideas.
Indy, I agree.
Paul, I was half-joking. I agree the firms were bailed out. I was hinting that the real reason was to save the UAW. It was a part of the Tarp program, so I wanted to remind people that when they hear that Tarp spent 100 billion, it wasn’t all banks.
But I see your point.
David#2, I think my numbers show that these guys have learned a painful lesson. The government bailouts are only a tiny fraction of what they lost. My hunch is that they will be more careful with their own money next time.
Rich, You said;
“Sorry, Scott, but you’ve lost me entirely. Are you claiming that the best way to figure out who caused the blast is to look at who suffered the most damage?”
Yes. The “blast” is defined by me as the huge taxpayer losses. Those who lost the most taxpayer money, made the worse decisions. F&F made horrible investment decisions. FDIC was run very poorly–that’s why I recommended reforms. Their current policies invite banks to be reckless. They need to tighten up their standards. Is that unreasonable?
Bonnie, Very good point. I thought that was true, but didn’t know enough off the top of my head to confirm it. I’m glad you mentioned it. It strengthens this argument even further.
Bill, That’s my view. Except the part about David being insane. 🙂
Good luck in your mayor’s race.
David; You said;
“First, the premise “let hedge funds go bankrupt” is incompatible with NGDP targeting, as it would cause a crash in NGDP expectations. The industry manages $1.8tr, which does not include trillions in bank off-balance sheet carry trade vehicles and on balance sheet prop desks. As much as I would agree they should suffer, since LTCM we have lived in a world where they hold us hostage.”
That is not true. Those are sunk losses. As long as the Fed doesn’t let it spill over into affecting M*V, we are OK. And no hedge fund is going to lose that much money, because they don’t have that much capital. That brings us back to banks. See my banking proposals.
Lord, Read Bonnie’s post—I think she is right. Even Krugman’s graph shows F&F more involved than banks in the early 2000s.
5. June 2010 at 10:48
very little subprime went through f&f. it’s true that the subprime they did hold caused them to become insolvent, but the large majority of loans on f&f’s guarantee book and directly held portfolio was prime 20% down mortgages. it took a very large drop in asset prices to cause these books to go down significantly in value.
f&f’s single family mortgage loan books are about 4.5% non-performing right now versus ~25% non-performing for commercial banks.
f&f under conservativeship have radically different accounting standards to commercial banks. if their losses ultimately come in much lower than your estimate, will you change your opinion?
yes, investment banks handled the bulk of the subprime securitization.
5. June 2010 at 10:53
@sumner: Lord, Read Bonnie’s post””I think she is right. Even Krugman’s graph shows F&F more involved than banks in the early 2000s.
if you keep judging f&f without knowing what their business actually is and was, and if you are making pronouncements about what activities caused what losses without even reading publicly available financial statements, then why should anyone believe your opinion? why do you believe your opinion?
the significant losses in f&f’s portfolios are in the 2006-2007 loan books (and to a lesser extent 2005 and 2008).
5. June 2010 at 11:05
q, I think you misunderstand my argument, as the data you present has no bearing on it. Losses are losses. If only 4.5% of F&F loans were sub-prime, and 25% of commercial banks loans were sub-prime, then I think F&F (and FDIC and FHA) are the main problem, and not the banks, as long as most of the taxpayer money is going in that direction. When banks lose money but don’t absorb taxpayer bailouts, then why should I care?
Yes, if the F&F losses end up being less then $29 billion, I will put less of the blame on the public sector, although I would still favor abolishing F&F. In 2008 I said the private sector was mostly to blame, when it looked like F&F were OK.
You say I don’t know what is going on, but I have read articles by people that do who strongly contest the view that F&F were not heavily involved in the real estate bubble. It’s an open question. But I don’t think that matters. If we found out all of their losses were in non-real estate areas, the public policy implications would be the same: Corporatism is bad–abolish F&F.
You said:
“the significant losses in f&f’s portfolios are in the 2006-2007 loan books (and to a lesser extent 2005 and 2008).”
When did I deny this? Why does it matter? All that matters is how much taxpayer money goes to F&F. And the estimates seem to keep rising month by month. Perhaps you will be right in the end, but right now all I can do is find the best estimate I can.
5. June 2010 at 11:28
Professor,
I still can’t understand, in your view, what was the cause of everything that happened before tight money in the summer of ’08. What caused the housing bubble in itself?
You have argued that it was not easy money/credit by the fed, then was it instead easy credit due to the savings glut as Greenspan, Bernanke, Krugman, and Delong all assert?
Or was it simply just another screwup that human beings make in the course of investment decisions that everyone just happened to make? Another way of looking it is this way: What would have happened to the housing bubble-caused-recession of ‘o7 had we never had this horrible tight money and enormous financial crisis in summer and fall of ’08. How would things have turned out differently?
At the same time, for the 100th time, I would like just quickly clarify your views on F&F. The right says F&F (and often CRA) were a direct cause of the housing “bubble.” That it was F&F’s actions which caused the bubble to be created, and had it not done what it did the bubble would have either not have happened or would have been merely a blip on the radar. Krugman, on the hand says, that it was not the cause, merely one stupid player amongst many, with private banks doing the exact same thing on their own. According to his logic, had F&F never done what they did, we would still have had the same situation with subprime mortgages because the banks would have continued to act so “stupidly.”
Which side do you fall under?
Thanks you,
Best,
Joe
5. June 2010 at 11:39
Scott, it’s worse than you say. First around eighty percent of aig derivative contracts were with European banks who were holding them in lieu of capital. What we have there is a strong instance of regulatory arbitrage of european banks with respect to continential banking laws.
Second, I too recall the protests that f&f were prime lenders; however there was an IG report several months ago that revealed that f&f had been falsifying their loan classifications and had dominated the subprime space.
This is much more consistent with the aparent evidence that f&f have take horrendous losses but the big banks have largely earned their way out of their charge-offs.
The FDIC has largely bailed out small community banks. Now when the IBD rushed to finger the CRA, the evidence was not yet in. Liberals said show us that losses in thr community banks are higher. I don’t know what the data shows on this point but it’s likely ripe for reexamination.
5. June 2010 at 11:41
Scott,
You raise a good question about trend. Assume trend RGDP growth is 2% and not 3%. The Fed adopts a level target that assumes 3% RGDP and 2% inflation. The economy consistently underperforms at RGDP of 2%, so that actual would fall short of target level without intervention. In a futures targeting regime, this means the Fed would constantly have to buy futures to achieve its level targeting. A Fed that is constantly buying futures would create higher inflation expectations and a consistently upward sloping yield curve. Carry traders would exploit that curve by employing leverage, which can result in systemic risk.
I think it would be interesting to hear from you just how households and firms should respond to a “temporarily high” NGDP target following a banking panic. I think you assume, a priori, that the Fed has credibility. That is, if the Fed promises 9% NGDP growth, and households expect that RGDP will grow at only 2%, then it would be logical to doubt that the Fed would tighten if they saw inflation of 8% instead of 7%. In fact, the markets will always doubt that the Fed will tighten in the presence of an output gap. So either you expect 1) that households will believe the Fed will raise rates in the presence of high unemployment; or 2) that inflation will never overshoot in the presence of unemployment. If its 2), then there is a logical inconsistency at work. Either the Fed can create inflation expectations under ANY conditions (including high unemployment), or it is impossible to have inflation expectations under an output gap. Both cannot be true. So if inflation expectations can overshoot in the presence of an output gap, then why would you expect actors to believe that the Fed would respond to an overshoot by tightening policy?
5. June 2010 at 12:02
Scott,
One last point and I’ll leave it that. I do like arguing with you as you can probably tell, but mostly because I find your blog unique and interesting, as do, apparently, Krugman and Delong.
To the extent it matters, remember that market participants are ultimately concerned with what will be, rather than what should be. I believe you will be right: a lapse in RGDP growth and the global failure of creditism will cause the Fed to agree to an explicit inflation target, probably within the next six months. I have structured my portfolio accordingly, which probably makes me your biggest fan.
5. June 2010 at 15:32
Scott,
You are associating taxpayer losses with amount spent on bailouts, but that’s really not the right measure. As a result of bad loans on bank books, the economy went into a tailspin, etc.; and public debt has gone up by over 100%.
As long as you grant that the Fed was not 100% responsible for the entire drop in output; then private losses led to other, indirect taxpayer losses
Here’s a thought experiment. Suppose that Fannie/Freddie were large enough to absorb 80% of the mortgage market; and suppose that their losses were four times as large. Then, even with our too-tight Fed, we would largely have avoided MBS losses; avoided Bear Stearns/AIG/etc; and overall taxpayer losses would have been far lower.
5. June 2010 at 15:51
So what do you peg the subsidy to banks of ZIRP at? Zero? (F/F probably benefit much less from ZIRP than the average FI due to the nature of the guarantee business, portfolio hedging, duration matching etc)
More generally, I don’t understand why you think fiscal impact is relevant for “who’s to blame”. To total size of the NGDP drop outweighs any of the bailout costs.
The elephant in the rooms is the absence of losses to debtholders of the major FIs (including F/F). Equity holders took a hit. Taxpayers took a hit (most especially on F/F, so let’s hope Congress learned a lesson). But how much did bondholders lose again? Why were the yield spreads on risky debt so low in the lead up to the crisis? This is where I would start and end if I was looking for regulatory failure. The lack of credible central policy in the face of ZIRP (i.e. too much vulgar Keynes) is probably an important part of said failure.
5. June 2010 at 16:28
q, Take a look at this post from Raghu Rajan, one of the tiny number of economists that warned Greenspan a crisis was coming:
“I reproduce Paul Krugman’s “econometric” claim above that Fannie and Freddie did not help cause the crisis above (I do not claim the Community Reinvestment Act was a big factor). I respond only because I have received hate mail from his followers. Paul is, of course, a great theoretical Nobel-prize-winning economist, so his attacks must be taken seriously (and I did take his trade theory classes at MIT, in the interest of full disclosure). Unfortunately, much of the “Fannie and Freddie did not contribute to the crisis” battalion makes arguments that have serious holes. Since these arguments are so prevalent they need to be rebutted again and again (the claimed unwillingness to listen to argument can be played on both sides).
The key graph in Paul’s argument is Figure 4. He claims that restrictions on Fannie and Freddie starting in 2004 kept their share of originations of total residential mortgage originations down, even while housing prices inflated. But this is irrelevant to the question. What we care about though is the amount of Fannie and Freddie’s originations in the sub-prime residential mortgages. And from every source I have seen, these took off precisely in 2004. Indeed, as I argue in my book Fault Lines, in the period 2004-2006 these two giants purchased $ 434 billion in sub-prime mortgage-backed securities. A measure of the size of these purchases is that in 2004, they accounted for 44 percent of the market for these securities. Calomiris and Wallison (2008, http://www.aei.org/outlook/28704) argue that Fannie and Freddie’s arms were twisted into doing more of this kind of lending starting in 2004 precisely because Congress had them in a vice because of the scandal.
Readers interested in the relevant data on originations by Fannie and Freddie may also want to see the work of Edward Pinto, a former Chief Credit Officer of Fannie Mae. He offers a detailed analysis of Freddie and Fannie’s lending , and their responsibility for the crisis. His testimony to Congress is at http://www.aei.org/docLib/20090116_kd4.pdf. His analysis of the data can be found on the AEI website.
From a theoretical perspective, the key question the “Fannie and Freddie did not contribute to the crisis” battalion leaves unanswered is why the “greedy” bankers turned to lending to the poor. For as Monika Piazezzi and Martin Schneider of Stanford University show, the housing boom and the bust were most pronounced amongst the lower end of the housing market, unlike previous housing booms. The obvious answer explanation from Progressives is that this was an unexploited segment (in the literal sense) of the population, but the immediate next question is why the greedy bankers did not notice this segment before. I argue that the government and its support to low-income housing made this segment of the market attractive. The government and politicians may have gone in with noble intent (as is usually the case), but with devastating and unintended consequences.
Finally, data are always tricky since they can be, and are, misrepresented. To Progressives like Paul Krugman who want to insist that the government had no hand, perhaps they may be more convinced by this quote from a speech by their bête noire, George W. Bush, to the Department of Housing and Urban Development (http://www.hud.gov/news/speeches/presremarks.cfm) in 2002:
“But I believe owning something is a part of the American Dream, as well. I believe when somebody owns their own home, they’re realizing the American Dream…And we saw that yesterday in Atlanta, when we went to the new homes of the new homeowners. And I saw with pride firsthand, the man say, welcome to my home. He didn’t say, welcome to government’s home; he didn’t say, welcome to my neighbor’s home; he said, welcome to my home… He was a proud man…And I want that pride to extend all throughout our country.
The goal is, everybody who wants to own a home has got a shot at doing so. The problem is we have what we call a homeownership gap in America… And we need to do something about it… We are here in Washington, D.C. to address problems. So I’ve set this goal for the country. We want 5.5 million more homeowners by 2010… economic security at home is just an important part of — as homeland security. And owning a home is part of that economic security. It’s also a part of making sure that this country fulfills its great hope and vision.”
“And I’m proud to report that Fannie Mae has heard the call and, as I understand, it’s about $440 billion over a period of time. They’ve used their influence to create that much capital available for the type of home buyer we’re talking about here. It’s in their charter; it now needs to be implemented. Freddie Mac is interested in helping. I appreciate both of those agencies providing the underpinnings of good capital.”
Perhaps Paul Krugman will read all this instead of bandying graphs that convince only those who need no convincing.”
So perhaps I know nothing about Fannie and Freddie, but no one can say that about Rajah.
5. June 2010 at 16:53
Joe, I think both the government and the private sector made huge mistakes, and their overconfidence produced the crisis. But I also think that the government’s mistakes (the Fed, F&F, FDIC, etc), were far more costly than the private sector’s mistakes.
I don’t agree with Krugman.
Jon, Thanks, and keep me posted on any new information that you come across. Every day it seems more and more like a government screw-up. Even if you assume we needed to bail out the big banks, and the $29 billion loss was unavoidable, that looks like a smaller and smaller share of the total losses. And your information on European banks even calls that number into question.
David, You said;
“You raise a good question about trend. Assume trend RGDP growth is 2% and not 3%. The Fed adopts a level target that assumes 3% RGDP and 2% inflation. The economy consistently underperforms at RGDP of 2%, so that actual would fall short of target level without intervention. In a futures targeting regime, this means the Fed would constantly have to buy futures to achieve its level targeting. A Fed that is constantly buying futures would create higher inflation expectations and a consistently upward sloping yield curve. Carry traders would exploit that curve by employing leverage, which can result in systemic risk.”
I must have missed something, because I don’t follow you. It doesn’t matter what the Fed thinks the real GDP trend rate is. If they target 5% NGDP growth, and if RGDP growth is 2%, then you get three percent inflation. That does not imply an upward sloping yield curve, as the inflation rate would be steady at 3%. Did I misinterpret you somewhere?
I also don’t understand your second point. What does inflation “overshooting” mean. I oppose all attempts to set any inflation target. I don’t even want us to measure inflation, it is a useless concept. I want to focus on NGDP. Keep the growth rate low and stable, and use level targeting. So your hypothetical makes no sense. The growth rate doesn’t have to be 5%, I picked that because recently the economy had gotten used to that rate. In a perfect world perhaps the trend NGDP growth rate should be 3%.
I really don’t care if inflation is 1000000% or negative 99%, as long as NGDP is on target. That’s because most of the problems that people think are associated with high and unstable inflation, are actually associated with high and unstable NGDP.
david#2, Thanks. Sorry if I didn’t answer your first question, maybe on the next go around I’ll pick up your meaning better.
Thorfinn, You said;
“You are associating taxpayer losses with amount spent on bailouts, but that’s really not the right measure. As a result of bad loans on bank books, the economy went into a tailspin, etc.; and public debt has gone up by over 100%.
As long as you grant that the Fed was not 100% responsible for the entire drop in output; then private losses led to other, indirect taxpayer losses”
I disagree. I think if NGDP had kept growing at 5%, then any losses to society would have been “optimal” in the Austrian sense. You want to punish people who misallocated capital with losses. That is good. The Fed can shield the rest of the economy with a 5% NGDP target. Yes, frictional unemployment will rise a bit, but nothing significant.
Is it conceivable that the private sector would screw up so badly that they’d produce a 100% real recession? Of course. The odds? I’d say 1000 to 1
Thruth, The subsidy you mention is tiny compared to the losses inflicted on banks by the tight money policy that drove down asset values and caused losses to the financial system to skyrocket. That’s not just my view, the IMF estimates of total financial system losses are also highly sensitive to the state of the economy.
5. June 2010 at 18:05
“Of the 26 million subprime and Alt-A loans outstanding in 2008, 10 million were held or guaranteed by Fannie and Freddie, 5.2 million by other government agencies, and 1.4 million were on the books of the four largest U.S. banks. “
5. June 2010 at 18:16
I blame the “Politically Correct” mentality for the mortgage “problem”. In 1992, Richard Styron was CEO of the Boston Fed which did a study showing discrimination in mortgage lending. THIS LED TO MODIFICATIONS IN THE CRA which became more “rigorous” towards banks. In 2004 Richard Syron was CEO of Freddie Mac. He would go out to mortgage brokers and bankers meetings and say:
“send us the mortgages of people with bad credit history. We want these people to have a chance at homeownership”!!!
5. June 2010 at 22:31
“Abolish “To Big To Fail,” and replace it with … lender of last resort in a severe freeze-up of the banking system.”
And yet, “lender of last resort” is the same thing as “too big to fail”. TBTF isn’t a law we can repeal, it’s a practical observation about the government’s rational response to organizations whose smooth functioning has become crucial to the economy. To abolish TBTF, you have to either prevent any organization from becoming that crucial (which is harder than just breaking up the couple largest banks), or you have to prevent them from failing in the first place (likely through regulation). A stable 5% NGDP growth rate would go some way toward preventing these organizations from failing, but David Pearson has a point that low volatility makes riskier bets worthwhile.
6. June 2010 at 05:52
Jon, Thanks for that very revealing data.
Marcus, I don’t know about the CRA. Some people insist that it wasn’t involved in most of these mortgages. The fact that banks invested in many of these MBSs (which was not at all required by the CRA) suggests that the CRA wasn’t the main problem. Bankers, even sophisticated bankers at big banks, really thought these MBSs were good investments. having said that, the CRA was an extremely bad law based on very shoddy empirical work
JeffreyY, That’s good question. I am not an expert on lender of last resort, but I was under the impression that it was different from addressing solvency issues. I had thought that the Fed did lender of last resort loans throughout 2008, but in October it was felt that this wasn’t enough, as the problem wasn’t just liquidity, but also solvency. At that point (or soon after) the federal government injected a lot of capital into banks.
In other words, I assume discount loans are given precedence over the banks debt in a bankruptcy proceeding. My assumption is that the TARP was aimed at bailing out bank creditors. Is that right? I oppose that. I was just talking about adding liquidity. If a bank credit panic occurs I’d prefer Mankiw’s suggestion that bank debt automatically convert to equity in a crisis. But I am not expert on this, and am open to suggestions.
3. May 2011 at 23:02
Lowering bank insurance coverage to $50,000 could be enough to cause a run on banks. Obama giving a speech warning the people that there deposits might not be safe could cause a run on banks. Lowering insurance coverage to $50,000 combined with a presidential warning about deposits not being safe would almost certainly cause runs on banks and bankrupt the insurance industry. Wouldn’t it?
4. May 2011 at 07:46
Mike, There was no deposit insurance in Canada until 1966, and they didn’t have bank runs. We had them in the Depression, but NGDP fell in half.
I’d like to see us adopt the pre-1966 Canadian system.
4. May 2011 at 08:15
There’s a paper by Mark Pennington (“Social Capital: the Achilles Heel of Classical Liberalism?”) that addresses the issue of guaranteed bank deposits. Basically, by guaranteeing bank deposits, governments remove the incentive of depositors to bank carefully; this reduces the value of social capital in the financial sector; consequently, the social capital to be gained by responsible banking is diminished.
Guaranteeing bank deposits failed to save Northern Rock from a bank run here in the UK. What it DID do was make it easier for banks like Northern Rock to do investment banking-style lending with high-street bank deposits, which is arguably fradulent and at the very least destabilising.
When you think about it, it’s not surprising that social capital would be eroded by the state turning a loan (because “deposit” is more or less a name for a loan to a bank) into a sure-deal. The first principle of finance is “know to whom you are lending” (the flipside being that social capital is at a premium) and the system is destabilised when this principle becomes obsolete.
The best single law to promote financial security would be the abolishion of guaranteed bank deposits by the state and the implementation of a “bank bankrupcy” law that would have a clear mechanism for the transfer of bankrupt banks into administration. As stakeholders, depositors would be the first priority of the administrators.