The Lamps Are Going Out

That was Sir Edward Gray, the British Foreign Secretary at the time.

Dr Kling:

In reading your post on American, you say:

The other claim that is made on behalf of the bailout is that Treasury will make a profit for taxpayers by buying distressed mortgage-related assets.... If house prices rise, the security holder gains little. He or she is happy to be relieved of the risk of default, but he or she cannot share in the homebuyer’s profit. On the other hand, each drop in house prices lowers the value of the security further.

So if house prices fall, the risk of default results in the loss of that interest and the loss of the value of the principle. If house prices rise, the gain is the value of the principle and the interest paid on it. Can't this be profitable for the holder of the loan?

Yes! It's better than World War I. I was looking for something good about the bailout; I think you've hit on it.

mjh: The profit that Arnold Kling was referring to was the difference between the price an owner sells his house for, and the price he paid for it. No matter how much house prices rise, the mortgage-backed security holder gets none of it.

There was very little doubt in my mind that we would get the bailout. When the House voted it down the first time, I was pleasantly surprised, but it reminded me of the voters in Europe rejecting EU membership. There would be another vote, and if needed another and another, until the correct answer was given.

It was interesting, from a public choice point of view, to see the new vote go first to the Senate and then back to the House. Looked to me like the Senate was giving them an object lesson: "This is how the big kids are voting. Whose side are you really on here?" Almost 60 members switched.

Arnold, I’ve been reading this blog for quite some time, and enjoyed it a lot, but this post is just awful. Bear with me:

- your metaphor about the poker players does not make any sense: the players cannot lose their chips collectively – it’s a zero sum game. If you need a stretched metaphor, you can say that they lost all their money to a con man, and then some (they owe money) – so they are being taken to the debtor’s prison. So, there is no-one left to run the ship…

- I’m sitting on a trading floor in NY. Arnold, the credit has dried up. For Caterpillar, GE, state of California, you name it. To claim that there is no problem is to exhibit either ignorance, or unhinged optimism (“I’ve fallen down six floors, and so far so good”).

- “Accounting rules dictate that the bank's balance sheet must reflect the current market value of its securities.” True, but currently the market prices imply default and loss rates that are simply not going to happen – or, if you believe that they are the true expectation (the mean of a distribution), we should all head for the hills, or down to the bomb shelter (I can give you concrete examples of MBS tranches and implied default/loss rates, but that would be too technical for most readers). Much more likely, they are a product of mass psychology. Treasury, i.m.h.o., has realistic chances of making money by buying mortgages and holding them to maturity (whether they’ll use the gains wisely is another question).

- “Capital forbearance” is worth trying (may be), but it ignores the reason why banks don’t want to lend to one another: they are not sure if the counterparty will default tomorrow, before repaying the loan. Lowering the regulatory capital cushion is not going to instill confidence in banks’ solvency.

- “Because Wall Street firms like Goldman Sachs get huge fees and trading profits from Liar's Poker, and they make very large campaign contributions to key Congressmen and Senators.” – are you channeling William Jennings Bryan? Do you believe Bernanke is in cahoots too? Does your theory extend further – do you believe that Paulson took his current job not from any desire to serve the public, but on some kind of a secret mission?

Sincerely, Ned

Ned, can you elaborate on "the credit has dried up".

When you say this, do you mean that no credit is available at any price, or none at the customary rates for short term credit, or something else?

I'm guessing it means that banks won't lend at any price. What is the bailout bill supposed to do to fix this? Not being a smart aleck, it's a genuine question.

Seems like libertarianism, like all unregulated systems, suffered from mania--e.g. Grover Norquist as an extreme example. It was unwilling to put sensible policies and regulations into place, unwilling to participate in government--instead burning regulations and maligning government.

Libertarianism now seems to be suffering its own form of market crash--reality rushing in.

Frejus,

Our financial system already has lots of government regulation and lots of government influence. Consider the Sarbanes-Oxley legislation that was enacted in 2002. Consider Fannie Mae and Freddie Mac, both creations of Congress in years past. Consider the FDIC. Consider all sorts of other government regulations.

So, this idea that our financial system is a completely free market system and that the problems with it are flaw with the free market system must be incorrect. At least the premise is wrong if the not the conclusion.

I was against the bailout for reasons of personal greed and rubber-necking.

But theory says the rich pay somewhat disproportionately more in taxes then their wealth share, so eventually they would get something in return, and they chose this time and place.

More power to them.

TC: No argument from me. Lots of regulation. Much bad. But I believe the libertarian approach has been to burn down regulations rather than help construct reasonable ones. For me it's a failure of libertarianism. Regulations will exist. So libertarians should help produce good ones. It's hard for them to do. I think they probably spend more time describing why any regulations are bad than trying to help devise workable pragmatic solutions.

Libertarianism will suffer because of it. That's all.

The most common version of the quotation:

"The lamps are going out all over Europe; we shall not see them lit again in our lifetime."
-- Sir Edward Grey, August, 1914

Here's my best argument against the bailout:

For it not to be a transfer from the poorer to the richer, the assets must be undervalued. If they are undervalued, then mark-to-market rules must be underestimating the capital that banks have to back up their loans. If that is the case, then temporarily altering capital requirements or the mark-to-market rule could increase the supply of loanable funds without the need to speculate on any assets.

If the fear is that banks won't be able to pay back their loans to other banks, that seems like a cash-flow problem to me, in which case one would think it would be directly related to a drop in income from MBSs (or if not those, then what?).

Whatever happened to how markets normally react to reductions in supply? Why can't our policies allow for the easier and more speedy creation of new institutions to take the place of failed ones?

Ned,

I don't think any of these people need to be on a "secret mission" or in any sort of conspiracy (although they may be - we have had documented conspiracies in government after all). People are just naturally biased towards their friends, their way of doing things and their own experiences. An ex-CEO of Goldman Sachs is just going to be biased, just like anyone else. You don't need insidious motives to influence legislation that harms the public good. People can rationalize anything, and I'm sure lobbyists are better at that than most.

I may not agree with everything you say on this topic, Arnold, but you're really on a roll with the interesting and thoughtful posts. I hope you keep at it.

This is exactly a frontal attack on libertarian and Free Market. This alone, though, does not say that the bailout is wrong.

The critical question is, what will happen next? I hope Arnold can delay his bike ride and discuss it.

The bottom line is, if Obama wins, and the D controls the whole Congress and the White House, and they deploy more interventions as Pelosi has already declared, AND the next four years we see a boom like that of the Clinton years, then I think I will have to admit that my understanding of economics (not exactly the same as the libertarians) is seriously wrong.

In fact, my bet at this moment is that the October won't be calm. For example, I have yet to see anyone explain to me how the bailout going to help the credit crunch. It is already clear at this moment Treasury won't be able or willing to buy every and any bad asset with $700 b.

That means, the banks still have difficulty lending money to each other. Which in turn means, if the credit crunch is affecting other business (outside finance), then it will still be there for at least a while. Then, after the bailout be carried out, what will happen to the housing market. Will the price be up again? Or will the profit-for-public being proved a lie too soon?

Dr. Kling,

One more dismal possibility to add to your dimming lamps. I live in Michigan where increased government intervention is paraded as the holy grail to each and every economic issue. Simply raising tons of different taxes is old hat; we securitize State tobacco funds for government funds, we pay moviemakers to make money here, we use State funds for direct venture capital "investments" into companies chosen by the ever wise government officials and on and on and on.
But my main point is this - Michigan declares ALL these schemes as not only critical, but SUCCESSFUL in their missions. The public is told, and many began believing, that an economy's prosperity is critically dependent upon government intervention and programs. This government action becomes accepted as PART OF any economy (vs a private sector free enterprise system).
Likewise, I think the worst damning result of the bail out will be the future reporting of its success (regardless of any imperical information) which persuades citizens thinking that we all need future government interventions in our economy. Americans can end up adopting an acceptance, tolerance and even a sought out desire to have government programs ACTIVE in our economy. THIS is the real potent danger lurking with this bail out passage.
I, too, went for a long bike ride this AM and it was enjoyable with Mark Levin on mp3 helping me pump away my thinking about the dismal current events.

Bill from Michigan

Dr Kling

Can you put up some credible sources that consider the consequences of the bail out? Most of the media favors the bail in a one sided fashion.

For some reason, I don't like Rogoff's article, it seems too biased.

I don't think a fair description of what I wrote involves the phrase "defender of the GSE's". Maybe you mean this?:

"There is lots to fault in the behavior of Fannie and Freddie and in government oversight of them - the decisions of management, the lobbying efforts that were funded by their ability to extract a premium from the implicit government guarantee - all of this was a big problem."

Nothing I wrote defends GSEs, it simply argues that they weren't the primary cause of the financial crisis.

Here's Russ Roberts in my comments on another post:

"Fannie and Freddie were heavily involved in low-income high-risk loans in a variety of ways. They were not "the" cause of they crisis but they contributed"

I didn't say anything different than that.

[But I do appreciate your admitting that trying to defend the position that the GSEs were the primary cause of the financial crisis is indefensible.]

One more question. Why did you put this phrase in quotes?:

"the secondary mortgage market is a good thing"

I didn't say that, and that's not what I'm arguing in the post, not even close. I don't even use the word secondary, let alone argue for or against secondary markets.

Why would I even want to debate someone who initiates it by falsely attributing a quote (and hence an argument) to me?

Russ Roberts did the same thing. Is this standard practice for you guys?

Arguing about "primary" and "secondary" causes is, shall I say, childish. They do not even have any relatively objective definition in this context.

Clearly they're an "important" factor to this bubble. Will you be satisfied now? Or, will you bring up that infamous butterfly argument?

The question to ask is why the USA became so over leveraged. We had the dot com bubble, the growth in government, the housing bubble, and just before the crash, the short commodities bubble.

Dick "Deficits Don't Matter" Cheney philosophy.

The entire economy began to operate with unsustainable debt to equity, including government, housing, investment banks.

History would likely point to the failure of China to liberalize banking sooner in their development, and the failure of America to recognize that. We misunderstood the great moderation, it was created by high growth rates in China that, for a period, absorbed excess liquidity and we adapted to that as if it were permanent.

When trade restructuring began there we no short term reserves to manage the transition.

When last we heard from Thoma (or at least when last I heard from him, since I do not read him except through links here), regulation of F&F was a well-functioning "life preserver" which failed only because other people forced their way onto it and overloaded it. (I think that was the intent of the metaphor; maybe I misunderstood it.) Now he seems to agree that there was no life preserver and that F&F recklessly threw itself into the stormy waters, and is left only with the idea that they felt they had to since the popular kids were doing it (which may be true enough as far as it goes).

Mark Thoma writes "One more question. Why did you put this phrase in quotes?:"

Perhaps libertarians are want to take liberties with the truth?

Or more precisely, libertarians are selective in their analysis, tending to focus their spotlight on government regulations gone bad rather than on systems as a whole and the emergent regulatory controls that might be necessary in order for that system to meet needs and operate within certain prescribed ranges.

Hence the obsession with Fannie and Freddie.

Elaborating on the Chinese connection.

We have in China a dichotomy between Honk Kong style banking and Central Planning banking. Chinese authorities have to pick the moment when their business managers are ready for the new style, and when the central planning style hold to much capital for its own good.

As the authorities awaited the development of sophisticated business managers, its own economic estimates became noisy as capital accrued, relative to trade flow. Hence they lost their ability to mange the transition.

Outcome in China will b simple, and fairly efficient. Authorities will lose contrl of the transition, and the business class will go through a rapid learning process.

The result will be a period of increasing trade efficiency, better coordination, lower inventory costs, more Internet based money management. This will ripple across the globe, matching efficiency for efficiency.

The sooner all trading partners realize the enormous savings from web based, decentralized trade management the sooner the recovery begins.

Frejus,

I'm not sure what your talking about, especially since Kling doesn't appear to be terribly libertarian about financial markets. Nevertheless, I'll respond:

Libertarians tend to believe that the "prescribed ranges" of a market are known only to the participants of that market. Governance is needed to deal with externalities (which Kling has posted about before, e.g. CDSs), but libertarians tend to believe that most governments do not have the incentives or knowledge to regulate effectively, and so any needed governance should come from emergent organizations within the market itself. They also tend to believe that government regulation creates harmful incentives within the system (e.g., when a state expands its powers over industry X, players in X now have the incentive to rent-seek by lobbying that state).

Fannie and Freddie are precisely the examples that illustrate this. The federal government did not have the knowledge or incentives to regulate them properly, and their association with the feds meant that they had strong incentives to lobby Washington for special privileges. In this case, the warped incentives also took the form of excessive risk-taking in part due to their implicit government-backed status.

There has been a lot of stuff written on how free banking would operate, and whether or not it would deal with the systemic risks we see today.

Any chance that the recent 'strength' of the dollar reflects panic selling of assets and conservation of capital, and that when the imaginary dollars created by CDOs and other derivative leverage evaporate we'll be at risk for DEflation (as there'll be fewer total dollars in 'circulation')?

Ned wrote:

- I’m sitting on a trading floor in NY. Arnold, the credit has dried up. For Caterpillar, GE, state of California, you name it. To claim that there is no problem is to exhibit either ignorance, or unhinged optimism (“I’ve fallen down six floors, and so far so good”).

It must look bad from there.

(Incidentally, GE is a common example, but it seems like a really bad one to me, because GE is a bank and a big lender. According to Wikipedia, more than half of GE's revenue comes from financial services. It stands to reason that banks are having trouble getting credit.)

I think folks who make their living trading paper from lenders to money market funds must think that all short-term credit goes through their market. They know more about the business than I do ...but my impression was that that's a secondary market. Small and medium-sized businesses are still able to borrow, from what I hear, and rates are still fairly low. So there must be some supply somewhere.

"The lamps are going out all over Europe; we shall not see them lit again in our lifetime."
-- Sir Edward Grey, August, 1914

The lamps were back on again in only ~5 years; albeit 5 horrible years.

... and the GOP reigned during this time

Nick-

I would note that things were all right until the Democrats took over Congress. Does that prove that they caused it? That's quite as logical as blaming Bush.

Matt C,

I will attempt to answer your question in the simplest terms. Additions and corrections are welcome from other commentators.

Credit all around is tight. Large companies are having difficulty getting short term credit. Because of the size of their need, lenders are reluctant to spool out that amount because 1) it may jeopardize the lender's capital requirements in light of the depreciating value of its other loans or 2) there is little interest among potential purchasers of a bond issue or stock issue (ie no new paper is being written) or 3) the stability of the borrower is suspect in light of other outstanding obligations or 4) other reasons along a similar vein. In essence, the traditional centers of capital are holding onto their cash and are reluctant to lend it out until asset values (real estate, bond, stock, etc.) reach a level of stability. Right now it is SELL SELL SELL!

Nevertheless, these large businesses need cash to function on the day-to-day. Payroll has to be met, suppliers, rents and licenses have to be paid, products and services have to be delivered. To meet these obligations, cash has to come from somewhere. Sales will fill some of the gap but if a sale is fulfilled in three months, you still have to pay people today in order to have the product to deliver in 3 months.

Regarding small and medium sized businesses, they have opportunities to get this short term credit in part because their needs are much small footprints on the lending institution's capital.

However, if this situation persists, these companies too will feel the squeeze.

From what I can gather, the initial plan of the buyout was to take all of these toxic assets with rapidly declining prices out of the market into the secure den of the Fed temporarily. Banks could breathe a little easier, albeit bruised, start lending to one another, secure in the knowledge that the counterparty isn't going belly up. Because everybody would have cleaned out their toxic stuff at the same time, sentiments would calm down. Later on, these MBS/CDO/SIVs would be sold out to the public piece by piece. As Ned has written, the intrinsic values of these things are above what the market is offering for them now. But people are in a panic and we are witnessing a deflationary price process in action. These are historically very rapid.

Sad to say, Paulson, et al. did not have enough time to explain this. They could not really sell the message because the situation became so dire so quickly and they didn't want to compound to the panic but they still needed to get approval from Congress. A very delicate process that unfortunately, the lobbyists on the left and the right couldn't allow to happen without their interests being heard.

Personally, I am a free marketeer but there are circumstances like invasions, manias (upward price movements) and panics (downward price movements) that the state must intervene in order to restore civil order.

Plus, we should be happy that we have restored the economy to the point in which we can experience a good old fashioned 19th Century style deflation! Keynesian policy truly has passed on if we are having a deflationary panic! The proof is in the pudding.

Also, Matt, these instruments are technical but not impossible to understand. Somewhere, someone might have links to simple, clear, concise explanations of credit default swaps, mortgage backed securities, tranches, etc. Posting it here might be helpful to all.

During the first half of September, bank lending increased by $162 billion.

During the month of September, commercial paper outstanding decreased by $200 billion. However, commercial paper issued by nonfiancial firms decreased by only $21 billion.

The interest rate on commercial paper has increased to about 4%. The federal funds rate targeted by the Fed is 2%. For a many years, the interest rate on the commercial paper market tracked the Federal Funds rate. Now, it is two percentage points higher.

The prime interest rate is 5% and tracts about 3% points above the Federal Funds rate.

"Mainstreet" borrows from banks and pays the prime interest rate. Banks are lending and the prime interest rate has remained at 5%.

Wall Street has borrowed at close to the Federal Funds rate. And, of course there are some nonfinancial borrowers as well.

The nonfinancial borrowers should go to the banks and pay the prime interest rate-- like Mainstreet already does.

Of course, if your job is selling commercial paper, then a move to traditaional bank fianance creates a personal problem.

Frejus,

... Seems like libertarianism, like all unregulated systems, suffered from mania ...

I hate to inform you of this but this mess was created by Democrats first and Republicans second, with next to no "libertarians".

Libertarians account for approximately 1% of the votes out there so to blame this mess on them is laughable. Don't you feel foolish making claims like this?

Our economic system is definately not run on free market principles and has never been fully free market. It is behaving exactly as a libertarian would predict given the choices made by Democrats and Republicans.

Libertarians have been complaining about this monetary expansion for at least twelve years now and warning that Alan Greenspans blowing of financial bubble after bubble would lead to trouble.

Well now you got what your side put in place since you sound like a democrat. Enjoy the consequences.

Bill from Michigan:
My brother and sister live in Michigan.
I had been wondering what was going on. At a time when the rest of the country was doing OK, MI was falling into the pit of despair. And yet, they kept returning Dem politicians to office so they could continue the same failing policies.
Thanks, I have a glimmer of an idea what is going wrong now.

Chaz, Bill, thanks for the comments.

Jim from MtnView CA,

Michigan remains in trouble because of failing government policies (i.e. State first, entrepreneurs second) promoted by Dems and tolerated by spineless elected Repub and others.

Only about 20% of the Repubs, Independents and Libertarian officials have the guts, willingness and energy to stand for free enterprise. Decades of entrenched protectionist policies to overcome.
Officials try hiding behind the shifts of departing auto mfg - but its bunk with Southern states growing in that same industry. You can see boarded up windows in Detroit that were boarded up SINCE the 1980s with no change.

We need more Hayek, more citizen activists, more elected officials with a spine and need to just say NO to about 1/2 the State's budget. The unseen is the split up of families due to the unemployment and lack of jobs in MI. The cost is greater than financial.

But, most unfortunately, many MI residents keep voting for officials who promise them MORE government as the solution. Libertarians are very lonely people in MI and not understood.

Officials just voted to remonopolize the 2 largest power companies as a supposed solution to increasing employment. VonMises would just shake his head in disbelief if he could observe it. Our governor returns from trips to Sweden (to get really good ideas and deals) and stands next to Repub Corp 100 CEOs in announcing her plans for State "investment". Every week, the State's econ pros are picking supposed winners and losers for some type of State funded subsidy.

The State's standing in nearly every economic measurement is a DIRECT reflection of failed, anti-market driven government. We ARE the laboratory to prove that government intervention really DOES fail!! Maybe we could better publish those lab results and raise some money for the State coffers ..........

Bill from MI