Arnold Kling  

Who is a Realist?

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I did not care for Paul Romer's claim that realists support the Paulson plan, while model-addicted fundamentalists oppose it. In my view, there are realistic reasons to oppose the Paulson plan.

First, many "realists" say that we need to boost home prices. But Ed Glaeser argues persuasively that trying to boost home prices is unrealistic. And if home prices have much farther to fall, then the premise that mortgage securities are undervalued is unrealistic.

I do not think it is realistic to say, "Credit markets are seizing up. Therefore, we must support the Paulson plan." In fact, if credit markets are seizing up, then something like what the Fed is doing today, as discussed by Tyler Cowen and Alex Tabarrok, makes more sense.

The theory that you can fix credit markets by "removing the clog" of mortgage securities is just that--a theory. My guess is that it will not work. I am sure that other things will have to be tried sooner or later--probably sooner. I hope the other moves work. I do not think it is at all realistic to rely on the Paulson plan. Trying to revive the mortgage securities market is not a realistic solution--it is a very unfortunate distraction.


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COMMENTS (13 to date)
Acad Ronin writes:

1) Something must be done.
2) The Paulson Plan (Rev) is something.
3) Therefore the Paulson Plan (Rev) must be done.

aaron writes:

I suspect that not only will it not work, but we'll find it makes things worse.

Thomas Dinsmore writes:

The Paulson plan will "work" in the sense that it will deliver a subsidy to current MBS holders and enable them to trade trash for cash.

But that does not mean lending will be restored to former levels. The legal, regulatory and tax climate for business will be negative for years to come, and there will be an ample supply of Treasuries available for investment.

El Presidente writes:

Arnold,

On this one, I wholeheartedly agree. Wrong tool for the job.

Brad Hutchings writes:

I wonder how far away we are from concluding that boosting home prices is not only unrealistic, but undesirable. Higher prices seem to primarily benefit homeowners who wish to borrow against their equity and local governments that rely on property taxes.

Jim Glass writes:

many "realists" say that we need to boost home prices.

Price fixing never works and almost always makes things worse.

My understanding was that this was perhaps the one thing that economists of all stripes most agreed upon.

But when push comes to shove in the real world, maybe they don't agree on anything until well after the fact.

aaron writes:

Brad, and interest rates. I suspect actions will also keep interest rates up. They should have continued to fall.

If banks want to grow, they either need to lend to riskier people or lend at cheaper rates to the less risky.

Cdn Expat writes:

It doesn't follow that if housing prices must fall further that mortgage securities cannot be undervalued. If mortgage securities were being actively traded, their prices would reflect the expectation of future price declines. Go and look at the S&P/Case-Shiller futures prices for a market-based look on what those who would normally be pricing mortgages would be basing their expectations on. It isn't pretty. Right now, there is no trading in a great many securities. Their prices are effectively zero. If an over-the-counter price were established, it would be very low in reflection of the ongoing illiquidity. Now have the Treasury buy some back using some reasonable method. It takes some toxic debt off the market and establishes a price for those that are not (yet) off the market. The price discovery mechanism can, itself, raise the value of the extant securities by removing the uncertainty associated with the illiquidity.

Will it work? Maybe. Maybe not. It's got a decent shot. Does it make sense? Is it internally consistent? If they can do it quickly enough, I would argue that it does make sense.

Derek Christiansen writes:

What is the maximum healthy % of Americans who can reasonably own a house?

Is it possible that the glut of supply in the residential real estate market cannot be drawn down for quite some time?

In deflationary times shouldn't real rents be falling as well?

El Presidente writes:

Derek Christiansen,

"What is the maximum healthy % of Americans who can reasonably own a house?

Excellent point. That's one that concerns me too, even though I was for the expansion of credit/ownership. If we want to have a relatively mobil workforce, then the transaction costs of real estate sales act as an inhibitor to that mobility. On the other hand, if we are committed to training people into jobs they will keep, then they can more reasonably buy wherever they are, provided their incomes are sufficient. Renting is an efficient behavior for many, perhaps for more than we might think. And maybe that's a pretty good thing. I wonder if there is any work calculating the consumer surplus to renters and how that analysis would shape up.

Derek Christiansen writes:

Renting is an efficient behavior for many, perhaps for more than we might think. And maybe that's a pretty good thing.

Prez,

My thought was that the distortion of the market by the government could be so massive that we don't know...what is the real price of health care in the absence of tax sheltered insurance premiums?

What is the real rate of home ownership which can
be sustained by our economy?

don't have answers, but do have concerns.

El Presidente writes:

Good thoughts, DC. Good thoughts.

Paul Romer writes:

As I wrote in my blog, there was a group of economists who supported congressional passage of the plan or broad discretionary powers for the administration. You may not agree on the label to use to describe their position, but it is important to think about their motivation.

Lots of them I'm sure have the same reservations that opponents have with the strategy of buying assets. The key difference was in the sense of urgency. The letter from the group that I called fundamentalists who opposed the Paulson plan asked Congress "not to rush, to hold appropriate hearings ..."

My sense is that the group that I am calling realists felt that in the wake of the Lehman bankruptcy, the crisis was moving so fast that rapid adoption of a plan giving broader powers and additional resources (with some scope for discussion and refinement) was better than delay, extended public debate, and refinement of the plan.

The key issue here was the degree of urgency not asset purchases versus equity injections. Realists were raising alarms about urgency. Fundamentalists were more sanguine.

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