David R. Henderson  

My First EconLog Blog

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We're Not in a Liquidity Trap... Energy Independence...

First, thank you, Bryan, for your warm welcome. And thank you also to the commenters. Before I get to my first topic, I want to appreciate Bryan back. I'm a big fan of his work. My favorite is his piece in which he uses economic analysis to challenge, as Thomas Szasz did over a generation ago, the idea that there's such a thing as mental illness. I hasten to add that he has not totally convinced me, but he has absolutely convinced me that many of the alleged cases of mental illness are simply cases in which the person at issue has different values or goals from those who claim that he's mentally ill. My second-favorite is Bryan's book, The Myth of the Rational Voter. My third-favorite is his article on Communism for my Concise Encyclopedia of Economics.

Second, I want to acknowledge Arnold Kling. I have not met him but I became a fan of his work and his mind after reading many of his articles on TCSDaily.com and, especially, his blogs for about the last six weeks on the financial "crisis." Many of his insights have helped me in my interviews on various radio shows, including the BBC and KQED-FM, the NPR station in San Francisco. Arnold also has an excellent article on International Trade in my Encyclopedia.

Finally, thanks to Lauren Landsburg, the webmaster for this site, for her passion and care in overseeing this site and for her tutorial yesterday on how to do it.

Now to my first blog. A fellow blogger and a colleague of Bryan's, Don Boudreaux, had a link to my article on the financial crisis last week. One of the commenters stated:

My point was mainly that most of the people with strong libertarian positions on the crisis, also, happened to be people that weren't macroeconomists. Whereas, macroeconomists with libertarian leanings tend to be more cautiously positioned or for the bailout. I offered Tyler Cowen as an example, but if I'm allowed to extend beyond GMU libertarian, I could add Mankiw, Feldstein, Taylor, Cochrane, and probably with a bit of research many more.

This commenter, Charlie, makes a good point. I am not a macroeconomist or, more exactly, the macroeconomics I learned in graduate school and still know pretty well is somewhat dated. And certainy I would understand the issue better if I were a practising macroeconomist. But here's where Charlie goes wrong. I don't need to be a macroeconomist to analyze a microeconomic issue. And the microeconomic issue in the bailout is this: Does the government do a good job of central economic planning? That was first answered in 1920 by Ludwig von Mises, who pointed out that central planners could not have the information necessary to do their job well. Friedrich Hayek honed the argument in a series of essays in the 1930s and 1940s. His best was his 1945 article, "The Use of Knowledge in Society." In his 1944 book, The Road to Serfdom, Hayek also did an early Public Choice analysis: he showed that the central planners would have perverse incentives.

Many followers of the bailout, even many astute ones with a solid understanding of macroeconomics, see the bailout and how it is conducted as being a choice of a strategy in a very complex world where the conductor of the bailout does not have much information and could easily blow it. Sound familiar? This is precisely the problem of central planning. In the case of the bailout, the central planning is of financial markets. Unfortunately, many of these same people have undue sympathy for Paulson and Bernanke. I conclude, instead, that central planning doesn't work and that Bernanke, a macroeconomist who also should know some micro, should have seen this.

During the height of Communism, economists who were critical of Communism told true stories about the inevitable distortions caused by central planning and quotas in place of free markets. One of the standard stories was of the nail factory that, when it was assigned a quota for the number of nails, produced tacks and, when it was given assigned a quota for tonnage of nails, produced large nails. We might laugh at these stories but the consequences for the average Soviet citizen were tragic. How does this apply to the current bailout?

Consider these three paragraphs from a recent article in the Wall Street Journal by Liz Rappaport and Serena Ng:

Barely two days after the Treasury announced plans to buy stakes in U.S. banks and the Federal Deposit Insurance Corp. said it would provide full guarantees on bank debt for three years, investors already are making unexpected shifts.

Wednesday, bonds issued by mortgage providers Fannie Mae and Freddie Mac sold off sharply, even though these companies have government backing behind their debt. Traders said hedge funds were forced to sell as they deleverage, and investors were selling some Fannie and Freddie bonds -- known as agency debt -- and shifting money into bonds issued by large U.S. banks. These bank bonds boast higher yields and now also benefit from implied government guarantees, making them appear relatively safe in the eyes of risk-averse investors, for now.

While Treasurys remain popular now, because of a flight-to-quality trend that feeds off their safety, another unintended impact may be in the wings. The bailout plans will result in massive new issuance of U.S. Treasurys, sold to pay for it all. This likely would dilute the Treasury bond market, drive down prices, push up yields and cause mortgage rates to rise.

Welcome to the the problems of central planning.


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CATEGORIES: Finance



COMMENTS (13 to date)
doug bennett writes:

webmaster for this sight

should be "site"

[Thanks! Fixed now.--Econlib Ed.]

dearieme writes:

If central planning worked, God wouldn't be so disappointed with us.

ionides writes:

"I conclude, instead, they central planning doesn't work".

"they" should be replaced with "that".

[Thanks! Fixed now.--Econlib Ed.]

Andrew writes:

Hi David,

I was reading one of your articles on the financial crisis and you placed much of the blame on Fannie Mae and Freddie Mac. Other economists such as Mark Thoma and Menzie Chinn say that they accounted for only a small percentage of subprime loans. I was hoping you could address this in a future blog post.

Andrew

Caliban Darklock writes:

"If central planning worked, God wouldn't be so disappointed with us."

I don't follow the logic. If my car breaks down, I may certainly be disappointed with it, but does it imply that automotive engineering doesn't work?

liberty writes:

Love the reference to the lessons of central planning. We need to recognize what we can learn from that experiment, and apply it to our current policy analysis much more. Hammering this home is a pet project of mine.

However, I wonder if a wide audience can see the analogy of the nail factory with the financial markets. Those who believe that it was not government planning that distorted the markets to begin with - but instead think it was free markets and speculation or unregulated derivatives - may think that providing a target to nationalized factories and injecting liquidity into broken financial markets have nothing in common.

I think that Austrian (and other) economists are generally right when they point to these similarities, highlighting that any intervention is a disruption in an evolving self-regulating process, and that especially trying to control outcomes in highly dynamic markets won't work.

However, I think that lessons from socialism can be much more specific. The Soviets controlled their banking system, and directed investment centrally. That would be one place to look for lessons. There are also highly specific lessons about e.g. interest rates, which the Soviets at first didn't believe in at all (surplus value would be eliminated, socialist accumulation would not depend on it), and then which believed they could control.

In trying to control investment with a centrally controlled interest rate system, they were faced with having to evaluate investment proposals for profitability at the same time as having to determine what interest rate to charge - which would then be part of determining the profitability. But they needed to know the profitabilities to set the interest rate.

Anyway, there are core lessons throughout the Soviet experience that touch on the issues we are facing today.

-- oh, and why in the world do you like that Caplan entry on communism? It is terrible; and I say that as someone who appreciates a lot of what Caplan writes. The entry on socialism by Heilbroner is excellent though.

I'd like to respond to the commentator who wrote that "most of the people with strong libertarian positions on the crisis, also, happened to be people that weren't macroeconomists. Whereas, macroeconomists with libertarian leanings tend to be more cautiously positioned or for the bailout."

Some macroeconomists (people with refereed professional publications in money/macro) who have taken "strongly libertarian positions on the crisis," i.e. in favor of letting the market sort things out, include Steve Landsburg, Jeff Miron, Jerry O'Driscoll, George Selgin, and me. Anna Schwartz, who has some street cred, is also strongly against government injecting capital into insolvent banks. Others I've missed?

Tim writes:

It's interesting to consider David's post with reference to Alan Greenspan's "mea culpa" about "flawed ideology" (..the last bubble he blamed on "irrational exuberance" which was presumably never going to happen again).

Just because the central-planner-in-chief professes some admiration for free markets hardly makes his dominion a free market.

James A. Donald writes:

What we are seeing is the classic crisis of state control - state controls lead to disastrous unforeseen consequences - which in turn result in the demand for more state control.

If the government implicitly or explicitly guarantees business debt, it has to run those businesses - disaster ensues, therefore supposedly it has to run them even more than it was running them.

The solution of course is to pull back these guarantees - you will notice that countries are afflicted by this crisis more or less in proportion to the extent of their implicit or explicit guarantees - Australia not much affected, for with a low limit on guarantees of bank accounts, financial companies for the most part refrained from risky behavior. But of course, the Australian government responded to the crisis by greatly expanding guarantees.

Tom West writes:

you will notice that countries are afflicted by this crisis more or less in proportion to the extent of their implicit or explicit guarantees

Actually, most of us will notice no such thing. There's essentially no correlation of bank success/failure to high or low levels of regulation. For example, Canadian banks are more highly regulated and have come across almost okay (except the crisis may destroy them anyway).

The idea that banks that have guarantees engage is less risky behavior is also nonsense. The banks that are suffering the most in the US are the investment banks that had very few guarantees.

Moreover, the massive success (until recently) of what turned out to be risky strategies threatened the existence of any banks that were not emulating their peer's risky behavior (and massive profits). Leaders of banks that didn't engage in such behavior were facing replacement by those who would. Countries with banking systems that either wouldn't or couldn't enter such risky markets were faced with either sinking into obscurity or being bought out by the 'successful' banks, etc.

And finally, of course, when the risk-takers catch fire, we, living in the wooden houses next store) catch fire and burn down with them (which makes being prudent a losing strategy - you don't collect when times are good and you sink with the rest of the your risk-taking brethren when the crash occurs).

Is this an argument for tighter regulation? Of course not. Who actually believes that regulators would have spotted the inherent risk in the strategies before the banks did? Not me.

But to pretend that somehow the free market would avoid the current crash is utter nonsense. Utterly free markets are just as capable of destroying their economies as command economies.

Bill Stepp writes:

"Welcome to the problems of central planning."
You hit the nail on the head. Mises and Hayek are cheering in Austrian heaven.

Some sorts of government planning are more central to the economy than others though (I am using the economy in the sense of a "centrally-planned" household as oppposed to a decentralized catallaxy). Rothbard liked to point out that the business cycle has its roots in the monetary sphere. Money is involved in every exchange, and prices transmit the information that enables economic (or rather catallatic) coordination and the employment of resources, as well as the information that causes catallactic discoordination and the unemployment of resources.

The main central planning villain must therefore be a central bank. It can't be a program funneling subsidized mortgages to subprime home borrowers, who in any event ocnstituted about 21% of all U.S. home borrowers in 2006. Their mortgages of $600 billion constituted about 20% of the U.S. mortgage market. Still less can it be the Community Reinvestment Act of 1977, the dodgy Boston Fed study around that time, and the Clinton clique-junta's effort to turn the CRA into a Christmas tree. It's a real stretch to go from the CRA in 1977 to the bankruptcy of Bear Stearns and Lehman, the sale of Merrill Lynch and Wachovia, and the transformation of Goldman Sachs and Morgan Stanley in 2008.

The ultimate cause of the panic of 2007-8 and the ill-conceived intervention of the U.S. government (as well as that of other states) was the discoordination caused by the Fed.
When the Fed lowered the Fed-funds rate, it eventually caused real interest rates to become negative in 2003 and 2004. Even before that time, rates were lower than they would have been in a free market. This caused entrepeneurs, especially home builders and mortgage originators, to invest too many resources in the real estate market.

In a nutshell, in a free market banks are not regulated by the state, but by the rule of law, so there is freedom of entry in the banking business and freedom of note issue. Under a free banking system (such as Scotland's in the 18th and first half of the 19th century), the rate of interest on bank loans is roughly equal to the natural rate of interest, which is determined by people's time preferences (the preference for consuming vs. saving). The natural rate clears the market for investible resources, or the capital market more broadly conceived (which translates into both equity and debt capital). In this scenario (and it is a scenario, not a living reality in our statist world), there can be no business cycle and no "cluster of entrepreneurial error," as Rothbard called it. In other words, no Wall Street meltdown, if that is the right term, and no real estate collapse (ditto).

Let's do a free banking thought experiment. Assume a free banking system with no housing market subsidies. Now assume, if it's not too much of a stretch, that the government starts to subsidize home mortgages and encourages, or even mandates, mortgage lenders to make loans to subprime applicants for ten years. Then the libertarians ride into town and put an end to the real estate interventions.
Would this cause a business cycle?

I think the answer is no, if the loan rate doesn't diverge from the natural rate. To be sure, there would be bad investments and dislocations in the real estate market during the Fun City era, which would be reversed when a free market was restored. Many home buyers would lose their homes and become renters, and maybe some mortgage companies would take writeoffs, with a few going bankrupt.
But would there be a market "contagion"?
Would big banks go bankrupt, and not just in the U.S. (assuming the continued existence of political boundaries, which are of course an absurdity in a free market)?

I don't see how you get from 20% of the residential real estate mortgage market being subprime to the bail-out making events of the last year without the intercession of the Fed and its head monetary central planner and now denier and liar in chief, the "free market" apostate Easy Al.


Francois Melese writes:

David,
Excellent observations about the risks of relying on central planning to escape the current crisis.

Bernanke and Paulson are chief planners, but Congress--not to be outdone, and fixated on market failures--is threatening regulatory fixes.

Instead of re-regulating financial markets launching more unintended consequences, a constructive piece of Congressional action would be to credibly eliminate implicit/explicit government guarantees.

This concrete step would instantly align interests of many mortgage brokers, CEOs and others that collect fees for writing loans, packaging, buying and selling mortgage-backed securities, etc., with the success of those products. Companies would closely tie compensation to the performance of those loans and securities. Fees earned for writing loans and packaging securities, would now be tightly paired with concerns those loans performed.

If we call this alternative approach "change," do you think Congress might consider it instead of relying on central planning to take over companies, and distort markets with new regulations?

Loan giants Freddie Mac and Fannie May (F&F) got into trouble because central planning's "political correctness" trumped hard-nosed "market decisions."

F&F's top leadership heavily lobbied Congress to keep their hands off, and Congress agreed so long as the two continued to buy risky mortgages to keep constituents happy back home.

Too much cosiness of these giant Government Sponsored Enterprises with Congress is what put us in peril in the first place. Add to that an implicit government guarantee and why wouldn't AIG and other insurers, banks and brokerages feel like the down side would be covered...

And now Paulson and Bernanke are bailing them out by buying in and purchasing bad debt...government-guided capitalism on the way up...socialism on the way down...a recipe for future failures.

Easy money (Greenspan) combined with well-intentioned (and sometimes not)attempts by Congress to cajole F&F into making bad (sub-prime) loans to make home ownership more "affordable" left the country with grave unintended consequences.

If home ownership is the central planners' goal, then direct subsidies for poor working families is superior to market distortions. If Congress wants to promote home ownership, break up and privatize F&F asap. Then take some of what remains of the $700 billion in taxpayer's money and give it to poor working families to use as a down payment for foreclosed and abandoned homes. Forced to live with central planning, I'd rather it be transparent. FM

Greg writes:

I'm going to go on a tangent based on your praise for Caplan's psychiatry article. I think it's an excellent example of an economist succumbing to skepticism as a fetish and failing to apply that skepticism equally. Caplan, like Szasz, is skeptical of psychiatry because psychiatrists are often rent-seekers. Yet the same is true of Szasz, who made his popular publishing career on his anti-psychiatry positions. This fact somehow elicits no skepticism from Caplan. In a similar vein, Caplan jumps from a case that alcoholism may simply demonstrate atypical preferences to applying that same argument to "hard-core" mental illness. I think this is just foolish. An 80/20 argument makes much more sense. Perhaps a large number of behaviors that have been classed as mental illness are not truly illnesses, but I think it's obvious that some are. I see the final logic of Caplan's argument as follows: Some people are prone to killing themselves or others, injuring themselves with compulsive actions, seeing things which aren't there, or throwing their feces on the wall, all of which appears to have a strong genetic component and/or neurologic component, but we should only consider this a case of extreme preferences which requires no reference to the concept of disease. There is no such thing as mental disease.

I hope we can expect more nuanced analysis from you, Mr. Henderson. Your note about not being completely convinced is encouraging.

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