Arnold Kling  

Oh, No!

Vernon Smith on the Bailout... The Duelling Guarantee...

The Wall Street Journal reports,

The government's plan to buy equity in financial institutions, announced Friday by Treasury Secretary Henry Paulson, is an idea that many academic economists have championed from the start of the crisis.

The Paulson plan was so bad that just about anything is better. But I'm ready to rip into academic economists. I've been thinking more about Joe Stiglitz's valid criticisms of what I call the Lost Generation of macroeconomists, and I'm getting more and more steamed. If you stacked up everything written by the leading macro folks of my generation and later (actually, starting a few years earlier also), you would have nothing but an enormous baloney sandwich. Ordinarily, I don't dwell on the fact that these people who were no smarter than me back-scratched each other into the best journals, the prestigious professorships, the important conferences, etc. But sometimes, especially now, I think about how badly they have failed intellectually. They are the precise academic equivalent of Wall Street executives who enjoyed golden parachutes while bankrupting their firms.

Is bank recapitalization a good idea? Probably not, if you think that the main problem with the financial sector is that it is bloated. The best way to restore confidence in banks is to identify the ones that are insolvent and shut them down. The FDIC knows how to do this. They should roll up their sleeves and get to work.

Anyone who wants to stop mortgage foreclosures needs to have his head examined. How many of the bad loans are investor loans, where the borrower never occupied the house? 20 percent of them? 50 percent? 70 percent? We know that in the last years of the bubble more than 15 percent of mortgages were for non-owner-occupied (the true figure might actually be higher than reported, because it is common to fraudulently claim that you will be using the home as a residence when you will not). Investor loans default at a much higher rate than regular loans, somewhere between 3 and 10 times as much. If it's 4 times as much, then already we can be surmise that a majority of bad loans are investor loans. The best thing to do with those is to foreclose ASAP.

My view of the crisis is that every sector of the establishment has been discredited. The financial establishment has been discredited. Government policymakers and regulators have been discredited. And academic economics has been discredited. The fact that we now have all three on the same page about policy going forward is hardly comforting.

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COMMENTS (20 to date)
John V writes:

Personally, I find it bizarre that any writer can say "academic economists" as if he/she is talking about one cohesive group...and do it with a straight face.

I read plenty of "academic economists" daily who haven't had a good thing to say about the bailout.

Mencius writes:

Exactly. Can you say "Lysenko," boys and girls? I knew you could.

The Austrian School are the only people who come out clean on this one. I will not claim that Mises and Rothbard had the answer to everything. But all further work proceeds from them.

20th-century academic macroeconomics - modeling, basically - will be as discredited as alchemy by the time this is over. So will its partner in crime, Hamiltonian central banking.

Pretty much all the classic Austrian works are free and on line. And they are incredibly accessible in an intellectual sense as well. Both M and R were masters of prose, and it's never too late to read them. A good general introduction to Austrian economics can be had by anyone with the patience to work through Theory of Money and Credit and Man, Economy and State.

another bob writes:

Dr. Kling,

In one of your blogs you said that your editorials have been turned down for lack of a good punch-line.

I think it was you or your co-blogger who off-handedly proposed a Supreme Court for Economics. Perhaps along with an Economics Constitution the SCE would be able to veto truly stupid economic policies, like say...guaranteeing that every American can have a loan of $417,000 to buy a house regardless of age, income, savings, height, weight, ethnic background or actually in this case nationality.

Your co-blogger says, voters are economically illiterate in a systematic way. Politicians are elected by voters so economic policy is systematically wrong-headed. I understand and agree.

The same could be said for law...voters are juridically illiterate therefore politicians and their policies are wrong-headed. (eventhough many of them are trained lawyers.) BUT, we have the Supreme Court which has a veto on laws, so, at least we don't make the same mistake twice, or at least not three times...or four times.

What a much better punchline for op-ed pieces - "We need an economics constitution and a Supreme Court of Economics to prevent these same wrong-headed policies from showing up over and over again in different skirts - and here's a first draft".

Its a better punchline than 'everyone is stupid, especially voters, especially these stupic macro-economists and testosterone poisoned GS Chairmen'.

Since all the economics-related positions are political appointtees (Fed Chair included) there's no way to make progress.

We know we're stupid. We're also stupid about foreign policy and immigration policy and nuclear physics and medicine. Each of us is only smart about one thing (if that many). That's why we delegate. I don't know why we don't delegate some veto power to a panel of economics who are appointed by more than one president.

Please, get out there and propose a solution. Any solution. Now is the time.

I'd do it but I'm only smart at one thing and it isn't economics.

Unit writes:

I often joke that the little mid-western town where I live has more banks than cows.

El Presidente writes:

Does anybody have a helicopter they can lend to Uncle Ben? Feels like we're trying to resolve a liquidity trap from the top down, instead of from the bottom up. I'm alright with thinning the heard in financial services, so long as viable competition remains. But, what about this plan will cause incomes to rebound and AD to firm up? If we keep forcing money in at the top, aren't we just pouring gasoline on the fire?

This is what concerns me, and it leads me to believe that the fix is a longer-term fix which will require changes in tax policy. I am baffled by the "oh crap" response from some academics. But, I am heartened by the sober assessment of others that this is, in essence, a situation in which the federal government has been challenged for control of the money supply and must respond to jealously guard its monopoly from encroachment. Of course, it's hardly like the federal government put up a fight in the first place. Extending home ownership could have been a good idea. In my opinion, enacting irresponsible fiscal policy, especially with regard to taxes, was the primary shortcoming that sowed the seeds of a spectacular collapse.

anon commenter writes:

I almost hesitated to post because I have nothing substantial to add but this:

Another great post by Arnold. Short and gets right to the point. Arnold, I used to gravitate toward the flashier, funnier posts of your co-blogger, but you've been absolutely on fire since the credit crisis really got going.

Of course, this doesn't necessarily mean I think you're right. But you're definitely worth reading.

winterspeak writes:

I completely agree with your disappointment towards academic economists. academic macro is a total sham. when i was taught it at U Chicago it never made any sense to me, and it's pretty clear why -- it makes no sense.

worse, you look over what's been published in macro for the last three decades, and you won't see a thing that highlights the problems we are going through now. talk about useless. and fraudulent.

that said, i don't think bank recapitalizations are a bad idea (although I'd like to see triage between OK banks and awful banks first -- we may still get this). our economy is based on a completely faulty system of credit, and therefore money, and i'm not sure i want to live through the awfulness it would take to move that system onto something that was sound.

give the degree to which banks exist thanks to government help, having government help more to keep them in existence is not a big deal, and a good sight more honest than the current system.

academic_macro writes:

first, the stiglitz criticism forgets a lot of interesting recent work which has heterogeneity. (e.g. Kiyotaki and Moore, Bernanke and Gertler, Krusell and Smith, etc.). See the recent debate in the J Econ Perspective bw Solow ( // Stiglitz) and Chari-Kehoe.

in particular, it seems to me that the financial constraint literature is very relevant for the crisis today. this literature has not reached a clear conclusion I think, but check papers by Simon Gilchrist, Anil Kashyap, etc. ;
there's also an asset pricing literature on liquidity ; CDOs and rating arbitrage (incl a recent princeton hire) ; the role of rare events in asset pricing ; the role of heterogeneous beliefs and misspecification (e.g. Hansen-Sargent, Harrisson Hong ,etc.) ; models of bank runs a la diamond-dybvig; etc

second, it's hard to blame academics for not having anticipated what no-one anticipated (including people with substantial money at stake). and not having worked on what many considered a zero-prob event. I am sure that many papers will be written about the financial crisis now.

third, I think there's been a lot of progress in macro in the past 25 y, remember where we were bf 'macro and reality', kydland and prescott, etc.

Rob writes:

Is bank recapitalization a good idea? Probably not, if you think that the main problem with the financial sector is that it is bloated. The best way to restore confidence in banks is to identify the ones that are insolvent and shut them down. The FDIC knows how to do this. They should roll up their sleeves and get to work.

Todd writes:

Winterspeak, I suspect I'm no more anxious to live through a calamitous restructuring of the monetary system than you are, but I do wonder about the government's ability to perpetuate the current system. Do you really think they can keep the fiat regime going forever? If they can't, is it possible for there to be an orderly transition to a sound commodity-based currency? I don't know, but if the answer to the first question is no, and the answer to the second is yes, then we should be pushing to develop the mechanisms to effect the transition. If the answers are no and no, then it still might be better to precipitate the issue now as it is likely to be worse the longer it is postponed, but that doesn't make it any less scary. If the answer to the first question is yes, I'd still be amazed if the current crop of leaders were the ones with the skills to pull it off.

Ed Rombach writes:

Arnold King wrote:

"My view of the crisis is that every sector of the establishment has been discredited. The financial establishment has been discredited. Government policymakers and regulators have been discredited. And academic economics has been discredited. The fact that we now have all three on the same page about policy going forward is hardly comforting."

I couldn't agree more, and I think your observations and those of others about establishment failure and breakdown is a sign that a major paragdigm shift underway. Ron Paul had similar comments to make in an e-mail to supporters on September 24 regarding the pending TARP bailout legislation. Here is an extract.

"Whenever a Great Bipartisan Consensus is announced, and a compliant media assures everyone that the wondrous actions of our wise leaders are being taken for our own good, you can know with absolute certainty that disaster is about to strike."

"The events of the past week are no exception."

"The bailout package that is about to be rammed down Congress' throat is not just economically foolish. It is downright sinister. It makes a mockery of our Constitution, which our leaders should never again bother pretending is still in effect. It promises the American people a never-ending nightmare of ever-greater debt liabilities they will have to shoulder. Two weeks ago, financial analyst Jim Rogers said the bailout of Fannie Mae and Freddie Mac made America more communist than China! "This is welfare for the rich," he said. "This is socialism for the rich. It's bailing out the financiers, the banks, the Wall Streeters."

winterspeak writes:


You are a braver man than I, for although I too answer "no" and "yes", i want the restructuring to happen after I, and my immediate family, are dead. Maybe sometime after 2100.

Essentially, the government will keep doing whatever it can to patch up and prop up the old system, until that fails, and it will fail catastrophically at some point. What comes next is anyone's guess--it may not be an improvement.

But the world as a whole has great interest in keeping the $ the reserve currency, so there are many actors trying to take things back "to the way they were." I hope they will succeed. You can keep an unstable and bad system going for an extremely long time.

Yancey Ward writes:


Amen. Everyone is trying to hide the bad debts and insolvent institutions rather than haul them kicking and screaming into the sunlight. This global fix is simply an attempt to keep the bloated financial sector from being liquidated.

Winterspeak and Todd,

I would favor trying to change the system now. I certainly understand the desire to avoid pain for one's self and family, but I am of the opinion that the present fix will not delay (if it does at all) the ultimate catastrophe more than a decade. The US government faces a debt default and a tax revolt coming together when the demographics collide with the entitlement programs. This is less than a decade out, tops.

tc writes:

"second, it's hard to blame academics for not having anticipated what no-one anticipated (including people with substantial money at stake). and not having worked on what many considered a zero-prob event. I am sure that many papers will be written about the financial crisis now."

As Milken said to Myron Scholes, "You get full points for telling me things before they happen, not afterward."

The Simple Accountant writes:

Rich Bernstein of Merrill Lynch has been making the argument for quite some time (> 1 year) that there is excess lending capacity in the global economy, and that like any other excess capacity situation, some amount of it will have to be destroyed for the financial markets to stabilize.

Why then was there excess lending capacity? Does it not indicate excess financial capital seeking return, and accepting increasing risk in search of it? And how did we get to this excess financial capital situation?

The purpose for this line of questioning is to consider whether any of the proposed solutions address the root problem, assuming that the root problem has been correctly identified. How about it economists? A simple accountant seeks to understand.

Mencius writes:

To be as scholarly as possible about who anticipated what, I draw the reader's attention to the following:

For the activity of the banks as negotiators of credit the golden rule holds, that an organic connection must be created between the credit transactions and the debit transactions. The credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. More exactly expressed, "The date on which the bank's obligations fall due must not precede the date on which its corresponding claims can be realized."

Ludwig von Mises, Theory of Money and Credit, 1912 (2nd ed: 1928).

I urge readers to investigate the personal story of Mises, which I find inspiring. His economics is pretty good as well, of course.

Steve Sailer writes:

Investors buying homes often wind up dragging down the property values in the surrounding neighborhood because, when they get pinched for cash, they often rent the homes out to Section 8 folks being moved out of housing projects and to transients such as crews of construction workers. That's a quick way to turn a booming exurb into a slum.

We shouldn't bail out investor-owned mortgages. They should be foreclosed and sold off to homebuyers who will move and take care of them, even if the price has to be cut from $500k to $200k.

winterspeak writes:

academic_marco: you are too kind to your namesakes. I studied under kashyap and diamond, and while they are both nice, bright people, their academic focus has not been on the complete instability of the current financial system.

there *have* been individuals who have written, at length, about the instability of the financial system, and they have been proven exactly right. but those individuals were thrown out of the Academy a long time ago. The Austrians (apart from Schumpeter, who was recently rehabilitated) played no role in my economic education at U Chicago. "whocodanode" is something we're hearing all over the Government and the Academy right now and it's clear to me it's BS because I node, and i node lots of other people who node too.

i have no doubt a huge number of papers will be written about this crises once it is over. a huge number of papers have also been written about whether physics equations are gendered, and i would put these two sets of papers in the same category.

but if you can show me a paper that begins with "we were wrong. we had no idea how the economy worked. and our models were bunk" then I will retract all of this and admit I was off base.

I'm still looking forward to Greenspan saying that keeping rates at 1% for a year was a mistake. Please let me know if you can find that anywhere in print too.


jb writes:

I've learned a couple things about the government over my 38 years.

First - nothing the government does ever works nearly as well as they say it will.

Second - nothing the government does ever seems to cause the kind of catastrophes that people say they will.

I'm not saying that these bailouts will be good, or that the long term will be consequence free, but I have a hard time feeling like the situation is dire - simply because we've always muddled through before.

Now, if I end up unemployed for a long period, I may revisit my analysis :)

Augustine R. writes:

Well gentlemen it looks like there is everything today except common sense! And that’s the major problem with human kind and the problems that we are increasingly facing today.
People go about investing in stocks without even understanding the fundamentals of companies. Such people are not ignorant people they are just plain greedy. Governments should not step in and bail out greedy people who very well know that all this is nothing less than plain gambling.

I will ask all the learned people out there with a simple question, Why should I trust you with my money? And would you be as careful as I am with my money?

Please read Atlas Shrugged by Ann Ryand, that should make a better reading than any of these “Macro Economics” books.

To conclude, “Who is John Galt?”

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