Arnold Kling  

Talking Points on the Obama Economic Team

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Recommended Reading on the Fin... Do I Get a Prize?...

For a possible appearance on a Richmond radio program this morning.

--best academic credentials of any economic team in history. Focused on economic growth, not redistribution, suggesting that Obama shares that focus and takes economic policy very seriously

--Larry Summers is brilliant. Peter Orszag (OMB) is very bright and very focused.

--But, at the margin, how much do these folks add to Geithner and Bernanke?

--Academic economics has ignored important real-world developments, such as the change from a manufacturing economy to a service economy, and the rapid growth and evolution of the financial sector.

(not for the radio, but Baily, Litan, and Johnson have a chart showing that credit default swaps went from under $1 trillion in 2001 and less than $10 trillion in the second half of 2004 to over $60 trillion at the end of 2007. Larry Summers might call me a Luddite, but I just cannot believe that it's a good thing for a market to grow that quickly to that size. I do not believe that the economics profession understands credit default swaps. In my opinion, we do not know whether they serve to genuinely increase financial efficiency or whether they serve primarily as vehicles for regulatory arbitrage--I suspect the latter.)

--Because the economics profession has been out of touch, policy is risky. Can we put laid-off bankers to work doing highway construction? I understand what Summers is thinking when he says that policy needs to overreact, but that could be a real "uh-oh."

A major puzzle is how the markdowns in financial wealth came to be such a multiple of the decline in housing wealth. Looking at that multiple, I tend to think that overreaction is what got us where we are today.

Thanks to Mark Thoma for the Summers video and the Bernanke pointer. Thanks to the WSJ blog for the "overreacting" post.


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COMMENTS (10 to date)
y81 writes:

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Boonton writes:

--Academic economics has ignored important real-world developments, such as the change...and evolution of the financial sector

Kind of like an aspiring DJ ignoring the evolution of disco. Seems like we can pass the financial sector off to the economic history department.

Sorry had to get my morning snark in....

fundamentalist writes:

“Academic economics has ignored important real-world developments, such as the change from a manufacturing economy to a service economy, and the rapid growth and evolution of the financial sector.”

As Kling has pointed out many times, macro is a mess. If Obama’s econ team knows only academic macro, then they’re policies will likely be wrong. If Austrian economics is right, their policies will be disastrous. We are living an experiment in economics. Either the neo-Keynesians will be proven right and massive bail outs and stimuli will quickly restore rapid growth, or the Austrians will be right and the massive bail-outs and stimuli will destroy the economy and leave the US deeply in debt and near bankruptcy.

“A major puzzle is how the markdowns in financial wealth came to be such a multiple of the decline in housing wealth.”

What about leverage? It’s common knowledge that when an individual or a company is highly leveraged a very small decline in asset prices can wipe out equity and leave you bankrupt. For example, if a home owner put down $1,000 on a $100,000 house, a 1% decline in housing prices wipes out his equity. That’s no problem if you’re a home owner because the home isn’t your source of income. But if you’re a company and you have pledged your equity as collateral on debt, then you have a problem. You have no cushion if sales fall any. If sales fall, then you can’t pay all of your creditors.

Maniel writes:

I agree with fundamentalist: "What about leverage?"

The elephant in the room is debt, public and private. In the last analysis, an economy rides on products and services that add value to people's lives and stores value in equities. When the so-called "financial sector" is able to use debt to move both equities and debt in ways that mask their underlying value, we are bound to have dislocations. As far as I know, we still produce things of value - food, shelter, etc - and if we don't massacre our currency too badly, we will find our way out of this mess, a little humbler. The long-term solution is a move back to an equity-based culture and economy.

Boonton writes:

What about leverage? It’s common knowledge that when an individual or a company is highly leveraged a very small decline in asset prices can wipe out equity and leave you bankrupt.

True but this is elementary. The question is why? Why would someone give you $10 billion dollars to put yourself (well actually their money) in such a risky position?

Maniel writes:

Response to Boonton.

If your business is to lend - as opposed to give - money (banks come to mind), the assessment of risk is key. This is true in general, but today I assume that we are discussing home mortgages. In the good old days of qualified borrowers and 20% down payments, banks displayed aversion to risk with relatively predictable results. Then it was decided, by government and by banks (much has been written and said about this) that "better" results were attainable by relaxing the rules since, in the case of houses, prices only rise; if we accept that premise, then where is the risk?

fundamentalist writes:

Boonton: "Why would someone give you $10 billion dollars to put yourself (well actually their money) in such a risky position?"

Generally, they won't. You'll notice that banks have far higher standards for their customers than they have for themselves. Rarely will a bank loan more money to a business that has a debt:equity ratio of 10. Yet banks maintain a far higher debt:equity ratio. Hedge funds operate like banks. For some strange reason, people think that banks can operate safely at such high ratios when they know that no other business can.

In addition, Hayek describes in "Monetary Theory and the Trade Cycle" the manner in which banks take on more risk in order to compete with each other. The temptation to boost profit with greater risk is overwhelming. And hubris plays a role. Most people who take such risks think they can control things, think they know what is going on, and delude themselves into thinking they will get out before the crash.

James A. Donald writes:

Obviously Credit Default Swap markets are largely about regulatory arbitrage - who owns what is hard to find, and the participants like it that way - they act like people trying slide money out of the grip of regulators. Why is this a bad thing? No one can deny that the recent performance of regulators has been woeful.

Boonton writes:

Maniel,

Then it was decided, by government and by banks (much has been written and said about this) that "better" results were attainable by relaxing the rules since, in the case of houses, prices only rise; if we accept that premise, then where is the risk?

I think the gov't is too easy a scapegoat here. Yes the gov't did cheer the rise of lending and homeownership to low incomes and minorities (the 'ownership culture' had nice potential to replace 'compassionate conservatism' as a new brand) but many of the direct lenders who got caught up in this have taken their hits and gone on their way. We arent bailing out the local bank (and for the most part many small, regional banks are doing ok despite being the front line of the Community Reinvestment Act).

The real question is why did AIG, the big brokerages and the other entities we are bailing out took such huge gambles. There is always a tension between playing it safe and making it harder to get loans and playing it risky and scoring more 'sales' by relaxing the rules. Is it impossible for the capitalist system to manage these two motives without first burning through several trillion dollars of 'on the job training'?

fundamentalist writes:

Boonton: "Is it impossible for the capitalist system to manage these two motives without first burning through several trillion dollars of 'on the job training'?"

I don't want to pre-empt Maniel's response, just add to it. The way that the "capitalist system" manages motives is to punish hubris, greed and ignorance. Some people think that free markets should eliminate bad times. I'm not saying you do. But capitalism creates so much wealth because it punishes those who waste it, and that punishment is often harsh. And it hits people who's only mistake was ignorance.

This is going a little far afield, but Mises has written something to the effect that cause/effect, punishment/reward are absolutely necessary for civilization. Of course, Mises was a paleo-liberal who believed that mankind is born with a tendency toward animal behavior and like other animals must be civilized. Most people today don't believe that and instead believe that people are born perfect and all we need to do is try not to screw them up too badly. Anyway, Mises's idea was that the punishment that life deals out for bad behavior, such as laziness, greed, dishonesty, hubris, etc. forces people to change and adopt good behaviors such as a work ethic, thrift, honesty, patience, humility, etc. That's why punishment like what the market is dealing out right now is vital to the future of our civilization.

So "...why did AIG, the big brokerages and the other entities we are bailing out took such huge gambles?"

I don't know the answer to what causes specific people to do what they do. But in general one answer lies in incentives. What incentives did the AIG managers have for being prudent? Did they reap rewards for high risk? Did they see the punishment for failure as falling on other people and not themselves? Did they suffer from hubris?

Another issue is herd mentality, which Hayek addresses to some degree in "Monetary Theory and the Trade Cycle." Most managers know that it's safer to be wrong and be with the herd than to be right and standing alone. If everyone is taking large risks, and for a while making huge profits, you had better do the same if you value your job. If you're wrong and the herd was wrong, too, then your job is safe. But if you're wrong and alone, you're dead.

Finally, these managers follow mainstream economics and, as a result, see no problems with booms. They think they are normal and many think they will last for a very long time if not forever. Every boom brings out people who claim that the Feds have defeated the business cycle and the boom will last forever. To mainstream economists, the boom is normal, the way things should be all of the time. So the downturn takes them totally by surprise. You would have to be a follower of Austrian economics in order to anticipate the bust after the boom and very few people are.

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