Arnold Kling  

Speculator of Last Resort?

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The Love of Hierarchies... Not Fannie Mae!...

In an unusual move, The Fed is lending to Bear Stearns.

My view of what is going on starts with The Risk Disclosure Problem. When times are good, a firm like Bear Stearns keeps its risks under its kimono, and nobody minds.

When times are bad, all of a sudden people want to know what's under a lot of firms' kimonos. The firms try to re-arrange what's underneath, to make it look nicer, which means selling some of their riskiers assets, driving down prices. That in turn gets people interested in what's under still more firms' kimonos, and the process snowballs.

One of the results is that all sorts of risky assets become cheap, at least if you are a speculator with access to capital and a willingness to hold on for a while. Enter the Fed, our new hedge fund of last resort.

Maybe what the Fed is doing will let a few firms keep their kimonos on. Meanwhile, though, everyone else in the policy world is trying to keep people in homes that they should not have bought in the first place. I think as long as they keep that up, nobody is going to be able to trust what's under other folks' kimonos.

What we need is for houses to be tradable again, which means that they are occupied by people who can afford them. When houses are trading, then mortgages will be trading. When mortgages are trading, the rest of the financial market will settle down. But the harder the policy wonks work at bailing out the housing market, the longer it will take for that market to straighten out, and the more leaks are going to develop elsewhere in the financial system.

On another front, according to another WSJ blog post,


With the dollar hitting new lows almost daily, Morgan Stanley currency strategist Stephen Jen, in a report, predicts the world's major countries will intervene to support it, though not just yet.

It seems to me that it's asking too much of the Fed to ask it to be doing currency market speculation now, too. And if other countries bear the burden, won't that be a bit awkward? Have them artificially depreciate their currencies? Isn't that what we've been beating the Chinese up for doing?


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TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/809
The author at EclectEcon in a related article titled Is It Speculation When the Fed Moves Against the Market? writes:
    Arnold Kling has an insightful posting in which he refers to the US Fed as a "speculator of last resort":
    Maybe what the Fed is doing will let a few firms ...
    [Tracked on March 17, 2008 12:32 AM]
COMMENTS (5 to date)
roogles writes:

This is really lucid and simple and correct. Thanks!

Anthony writes:

What does it mean for a person to live in a home that they can't afford? I hear that phrase thrown around a lot, but I don't understand it.

Gary Rogers writes:

Everyone has a theory about our economic problems, but so far they all seem to miss the real problem. So, let me throw in my views as a non-economist. I think our economic woes go deeper than risk premiums, a weak dollar or an unsustainable trade deficit. Instead, they are a direct result of years of deficit government spending. When the government overspends, it can either print new money or borrow. The first creates immediate problems and the second pushes the problems into the future. We chose to borrow the money, which politicians love because it allows them to keep the economy running at full steam with lower taxes and low interest rates. Unfortunately, it is just like paying monthly bills on a credit card and must eventually stop.

In our case, much of the borrowing came from overseas. Years of economic stimulation has driven our own savings rate so low that other countries ended up financing our deficits. This was probably exacerbated by the extremely low interest rates that Japan had in place, but the end result was that we were borrowing from our customers. Every dollar that we borrowed from foreign investors did not go to buying our exports. Markets do work and the value of the dollar, like all prices, adjusted to reflect fewer dollars chasing our export goods. We consequently had a long period where the dollar was strong and our trade deficit just about matched our government spending deficit. As economists have said for years, though, trade deficits are unsustainable and eventually balance out. We are about to see the balancing out process because lenders are no longer willing to enable our free spending ways.

The sub prime mortgage situation was the event that started the unraveling, but what has been revealed is definitely serious. The dollar has been falling long enough that continued devaluation is the expectation. This is an especially serious problem with the trillions of dollars we owe to foreign investors. These investors are not likely to stand around for very long and watch their investment dwindle away. If we do not do something to restore confidence, they will. At one point, we probably could have prevented the dollar from starting to slide by not dropping interest rates, but now that it has downward momentum, it will take some serious rate increases to restore confidence. Something approaching the interest rates that caused the 1980 recession. Unfortunately, our economy today is no longer strong enough to handle this kind of shock. The problems we have pushed into the future are here. We are overleveraged, we reached our credit limit and we are still addicted to deficit spending.

There is one and only one way to get out of this mess and that is to eliminate the borrowing that is causing the imbalances. Unfortunately that translates into serious cuts in government spending. Just like a family that gets in over its head and needs to quit abusing its credit cards, our government needs to show that it will be able to do the same. It needs to show that it is responsible enough to pay its debts. At this point I would expect every senator and congressperson to be putting together an emergency budget that will restore confidence in the dollar. Instead we get a stimulus package that gives us more of the irresponsibility that caused the problem in the first place.

Arnold Kling writes:

Living in house you cannot afford could be defined in a number of ways. But the simplest is that if you borrowed money to buy the house and cannot repay the loan on schedule, then you cannot afford the house.

Anthony writes:

"if you borrowed money to buy the house and cannot repay the loan on schedule, then you cannot afford the house."

I'd say that's a confusing way of putting it, then. If you can't make your mortgage payments, then you can't afford the *mortgage*. You might still be able to afford the *house*, for instance if the house's value has dropped significantly (many have), or if your mortgage has a particularly high interest rate (many do). And then there are plenty of people who took out second mortgages or home equity lines of credit and spent the money on things completely unrelated to the house they're living in. Their home values have dropped below that invalid appraisal they got the HELOC on (or maybe it was a 125% HELOC), but that doesn't mean they can't or couldn't afford the house.

There are lots of problems out there, but I don't think people living in homes they can't afford makes up a large portion. After all, if they can't afford them, who can? Are there really that many people out there who *can* afford these homes but are instead renting? Or is it just that people can't afford these homes *at the current prices*.

Maybe it seems that I'm nitpicking, but foreclosing on a homeowner who took out $150,000 in mortgages and can only afford $100,000 home and then selling the home for $100,000 to some new homeowner who can only afford $100,000 home doesn't do anything to make homes "occupied by people who can afford them". At least not any more than a mortgage company admitting they got duped by a bad appraisal or an unexpected fall in house prices and forgiving the $50,000 (or at least working out a temporary forbearance of that amount).

Of course, in cases of fraud, where the buyer lied about his/her income or some other relevant factor, the homeowners deserve to lose their home *and* be prosecuted.

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