Arnold Kling  

Ten Minutes, Eleven Questions

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I have been invited to speak for ten minutes on the financial crisis. As you will see below, I do not agree so much with President Bush (via Mankiw). Unlike the President, I see no benefit in putting credit default swaps on an organized exchange and I place no faith in the panacea of "transparency." Transparency is to financial regulation what independence is to energy--something that sounds obviously good but on closer examination offers no guidance toward sensible economic policy.

The President channels Tyler Cowen when he says,


I'm a market-oriented guy, but not when I'm faced with the prospect of a global meltdown.

Tyler himself is saying,

in my view "doing nothing" wasn't really an option, again if only because of the preexisting FDIC commitment, not to mention the disaster associated with a plummeting money supply.

The primary need, in my view, was (and is) triage. Insolvent banks need to be shut down. Banks that might be solvent except for temporarily depressed asset prices need to be supervised very closely. Then healthy banks can go out and operate without fear of being dragged down (or competitively driven down) by the zombies.

Any policy that puts off doing the triage is a bad policy. Ergo, TARP was a bad policy, both in its original design and in its revised implementation.

Eleven questions (my answers in parentheses)

1. To what extent were regulatory anomalies responsible for the shift from old-fashioned lending to securitized lending? (100 percent responsible. perverse capital requirements in particular)

2. What role did low down payments and speculation play in the housing bubble? (an essential role; in recent years, more than 15 percent of loans went for non-owner-occupied housing; )

3. Were executives responding to perverse incentives or lack of knowledge? (lack of knowledge; suits vs. geeks divide; Richard Syron did not think he was setting up Freddie Mac to fail, even though he was warned)

4. How should credit default swaps be regulated? (government policy should be "Buyer beware!" There is no natural seller for CDS. CDS exploit a regulatory anomaly. We need to align regulations with reality--if a diversified portfolio of low-rated bonds has a great risk-return profile, then capital regulations should say so. If not, then the regulations should not advantage low-rated bonds backed by CDS.)

5. What can be done to improve transparency? (This is a phony issue, sort of like energy independence. Specialized knowledge is the essence of financial intermediation. The problems that are attributed to lack of transparency are problems of regulatory anomalies.)

6. What can be done about systemic risk? (Every firm is a financial intermediary, and the demise of any firm can be labeled as systemic risk. You don't create a firewall by saving firms. At best, you create a firewall by having a rapid, orderly process for closing them.)

7. What can we learn from international comparisons? (This is a really hard problem, but there are differences, e.g. Canada vs. Iceland)

8. Suppose we had stopped the housing bubble. Would some other bubble have emerged somewhere else? (I suspect that financial crises are inevitable. They might be smaller if people did not get complacent about the ability of government to prevent them.)

9. Who saw it coming? (In the aggregate, no one. Dean Baker and others saw the housing bubble, but as far as I know did not see the financial leverage on top of it--AIG. Ed Gramlich saw the risky subprime loans, but his solution was to have Freddie and Fannie do more in that market. Warren Buffett coined the phrase "derivatives are weapons of mass financial destruction," but then he bought into Goldman Sachs and into the original Paulson plan to have the government try to revive the weapons market.)

10. Should government take from the ants to give to the grasshoppers? (try to keep people in houses they should not have bought in the first place with newly-subsidized mortgages and attempt to keep house prices high, while those who acted prudently and did not speculate or take on unaffordable houses get no positive reinforcement? bail out financial institutions using other people's money? tax people who saved for their own retirement to help pay for the defined-benefit pension promises of auto companies, other private firms, state and local governments, Social Security, and Medicare?)

11. Is government failure avoidable? (Would pro-regulatory ideology and skill prevent crises? As intermediation becomes increasingly specialized, can centralized regulation overcome the discrepancy between dispersed knowledge and concentrated power? If Basel capital requirements were too crude and clumsy for the U.S., how can international co-ordination of regulation more broadly be anything but a disaster?)


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COMMENTS (12 to date)
shayne writes:

Arnold:

Could I talk you into addressing what you perceive to be the most egregious or significant contributing 'regulatory anomalies'?

There appears to be a great deal of discussion about the need for re-regulation, additional regulation, etc. associated with this. The only two significant contributing regulatory factors I can identify are:
1.) the 1999 repeal of that portion of Glass-Steagall that separated Commercial and Investment banks (allowing investment arm leverage excesses to taint viability of commercial/viable components), and
2.) the dramatic increase in allowed leverage ratios - SEC rule change in 2004 (allowing excesses in leverage).

Other than those two, I'm not aware of any 'de-regulation' that was significantly contributory. Rather, it appears that both ignorance (suits) and apathy (failure to adhere/enforce pre-existing regulation) are far greater enabling factors than lack of regulation, ineffective regulation or even regulatory loopholes.

As an aside, I concur with your observations/recommendations that there is little or no advantage for 'credit default swaps' and like instruments to be traded in regulated, transparent markets. And especially with your observation that caveat emptor applies, universally.

PrestoPundit writes:

Say something about how the idea of coordination through markets gets badly damaged when people who don't understand or value the market -- like Bush and the GOP -- set themselves up as the poster boys of the free market.

It happened with Hoover, and it's happening again.

aaron writes:

Greenspan almost saw it.

The major contributors of the crisis were debt increasing, but the return on debt decreasing. Combine this with irrational exuberance, increasing interest rates, and increasing expenses and risk explodes.

Greenspan knew this despite his loose monetary policy. He wrote in the Age of Turbulence last year:


Over time, ever-growing proportions of US households, non financial businesses, and governments, both national and local, have funded their capital investments from sources other than their own household income, corporations' internal funds, or government taxes... The growing (and risk-prone) tendency to borrow in anticipation of future income by a significant proportion of Americans is reflected in a persistent rise in both houshold and corporate assets and liabilities relative to income.
A detailed calculation by Federal Reserve Board staff employing data from more than five thousand nonfinancial US corporations for the years 1983-2004 found that growth in the sum of deficits of those corporations where capital expenditures exceeded cash flow persistently outpaced the growth of corporate value added. The sum of surpluses and deficits, disregarding sign, as a ratio to a proxy for corporate value-added exhibits as an average annual increase of 3.5%/year... A separate and less satisfactory calculation of only partly consolidated financial balances of individual economic entities relative to nominal GDP exhibits a rise over the past half century in the absolute sum of surpluses and deficits that is 1.25%/year faster than the rise of nominal GDP...
...Since 1946 the assets of US financial intermediaries, even excluding the outsized growth in mortgage pools have risen 1.8%/year relative to nominal GDP...
...from 1956-1996, nonfinancial business debt rose 1.8% faster than gross business product, and from 1996 to 2006 1.2% faster.
A rising debt-to-income ratio for households, or of total nonfinancial debt to GDP, is not itself and indicator of stress... But debt is rising faster than assets; that is, debt leverage has been rising. Household debt as a percentage of assets, for example, reached 19.3% by the end of 2006, compared with 7.6% in 1952. Non-financial corporate liabilities as a percentage of assets for form 28% in 1952 to 54% in 1993, but retreated to 43% by the end of 2006, as corporations embarked on a major program to improve their balance sheets.
It is difficult to judge how problematic this long-term increase in leverage is. Since risk aversion is innate and unchanging, the willingness to take on increased leverage over the generations likely reflects an improved financial flexibility that enables leverage to increase without increased risk, at least up to a point Bankers in the immediate post-civil war years perceived the necessity to back 2/5 of their assets with equity. less was too risky. Today's bankers are comfortable with 10%. None the less, bankruptcy is less prevalent today than 140 years ago. The same trends hold for household and businesses. Rising leverage appears to be the result of massive improvements in technology and infrastructure, not significantly more risk-inclined humans. Obviously, a surge of debt leverage above what the newer technologies can support invites crisis. I am not sure where the tipping point is. Moreover, that late-1950s experience with consumer debt burdens has made me reluctant to underestimate the ability of most household to [manage their financial affairs].

I think what Greenspan missed was that irrational exuberance combined with loose money allowed borrowing to accelerate and expectations to push up demand for oil gasoline above unrealistically high levels. This had disastrous effects on risk as incomes fell and expenses rose relative to debt, increasing risk. This caused the market for new debt to evaporate, washing way the value of assets.

Gary Rogers writes:

I agree with you, but that may be because I read your blog on a regular basis and understand the background behind your thinking. I hope 10 minutes is enough to get the point across. I am afraid that you could easily spend an hour on each topic before most people whould finally come around to some level of understanding. Good luck.

Maniel writes:

Taking the view that we - the unwashed - are the source of government, then to follow AG, we might want to consider moving from a debt-based to an equity-based philosophy and, ultimately, national economy, one citizen at a time (or all at the same time).

Mr. Econotarian writes:

"the 1999 repeal of that portion of Glass-Steagall that separated Commercial and Investment banks (allowing investment arm leverage excesses to taint viability of commercial/viable components)"

Except that "combined" banks did fine in this crisis (and in truth, did better during the Great Depression as well). Investment banks and non-combined commercial banks are the ones that have tended to actually fail. Glass-Steagall came into effect through a combination of political gifts in a time of overall fear, not based on actual data.

A friend of mine argues that Glass-Steagall repeal lead to combined banks putting more money into questionable leveraged investments that, while maybe not hurting them, hurt others through contagion. I'm not sure I buy into that.

I try to compare the current crisis with 9/11. On 9/10, the risk of hijackers flying into buildings was under-weighted by the majority of americans in both private industry and the government. On 9/12, the risk was understood by all. Today, we understand the risk of >80% LTV loans with ARMs, and understand that bundling them together does not help you if everyone's real estate prices are falling.

Another parallel is expect unproductive "regulatory theater" after this crisis that "fights the last war" similar to the "security theater" that slows us down at airports without truly making us safer.

aaron writes:

There was a good post at Marginal Revolution on Glass-Seagall, etc. in the earlier weeks of the financial BS. Basically, it didn't contribute and if anything kept things from being worse. It allowed the institutions and purchases that kept lots of banks from blowing up.

shayne writes:

aaron, Mr. Econotarian:

I would emphasize the word 'taint' as the operational term in my statement/question above.

I'm not certain as to the degree of contribution the G-S repeal may or may not have had, but I would argue no one else does either. A lingering artifact of this mess is that the full story of who 'owns' what, and what is it worth, has not been forthcoming.

But there is indisputable evidence the G-S repeal has had a non-trivial effect in 'tainting' commercial banks and other financial institutions (AIG as an example, although it isn't/wasn't a commercial bank). Check today's closing stock market prices for every member of the financial sector (Commercial, Investment, combined), relative to those of 1 year ago. I don't think there is any evidence that "combined banks did fine in this crisis". There is an absence of evidence that they are as exposed as the pure investment banks such as Lehman, but absence of evidence is not evidence of absence.

My point being, it is reasonable to assume the entire Commercial sector could have been deemed at least relatively immune from the effects of investment bank leveraging excesses had the pre-existing G-S rules been in place. That at least was the original intent of that aspect of G-S legislation in 1933.

Grant writes:

Has Arnold gone into detail on why CDSs exist? I understand his point that they have no natural buyer, and thus may be a result of some weird incentives in the system somewhere. But which ones? What regulation causes this anamoly?

shayne writes:

To Grant:

Dr. Kling has provided a great deal of information on the rationale and flaws associated with CDSs - I highly recommend the following:

http://econlog.econlib.org/archives/2008/11/kling_on_financ.html
http://econlog.econlib.org/archives/2008/10/my_fantasy_test.html
http://econlog.econlib.org/archives/2008/10/more_fantasy_te.html
http://econlog.econlib.org/archives/2008/10/the_fantasy_tes.html

Lauren writes:

Grant asked:

Has Arnold gone into detail on why CDSs exist?
Yes, in the recent EconTalk podcast Kling on Credit Default Swaps, Counterparty Risk, and the Political Economy of Financial Regulation.

Bill Woolsey writes:

Commerical banks are having difficulties because they are heavily invested in home mortgages They also own mortgage backed securities. Housing prices fell 30%.

No matter how insulated banks are from investment banking, they would have these difficulties.

Glass Steagal never prevented commerical banks from making home mortgages or buying bonds. There have long been restrictions on what bonds commercial banks can buy. Glass Steagal had nothing to do with it.

Glass Steagal prevented banks from underwriting securities. So, if a commerical bank was bundling mortgages and selling mortage-backed securities, then this could have been illegal. The risk Glass Steagal protects banks from is primarily being left holding portfolios of stocks and bonds that they cannot sell. Depositors' money would have already been turned over to the firms issuing the stocks or bonds. And before the commercial/investment bank had sold the newly issued stock, the stock market crashes. Of course, the collapse of the mortgage backed security market would be the same sort of thing.

So, if a commericial bank was using depositor money to underwrite mortgage backed securities, and then, that market froze up with the commerical bank holding a bunch of those securities that they had yet to sell, then, we could say that maybe loosening glass steagal caused the problem.

I say "maybe," because what was the alternative? If the commercial bank would have been holding (or was holding) the mortgages, then they take the loss anyway. The argument against Glass Steagal has been that "securitization," moves risky loans off the banks' balance sheets. (If the banks are still guaranteeing them, protecting the holders of the securities against loss, then this is an illusion.)

Again, commerical banks could always buy bonds from investment banks, as long as they were of sufficinetly high quality. And banks have always been allowed to make mortgage loans.

It is arguable that investment banks were involved in commerical banking activities. Perhaps, commercial banks would have created political pressure to enforce glass steagal against the investment banks.

Investment banks didn't create something called "deposit accounts," and they didn't have direct access to check clearing system. They weren't making commercial loans.

However, they were acting as financial intermediates, and their borrowing was a lot like commerical banks. Borrowing overnight is little different from offering saving accounts and 90 day commercial paper is a lot like a negotiable CDs. Of course, they aren't insured.

Investment banks could always borrow "call money" and other short term funds and use it to finance securities.

It is just that in the tradtional underwriting business, the investment bank was trying to sell off these securities, not hold onto them.

The short borrowing was financing the underwriting business, not holding portfolios of bonds.

To me, it seems like the investment banks were operating a business that replaced the old S&L industry. They were financing home mortgages with savings accounts. Overnight borrowing is a bit like a saving account. Holding mortgage backed securities is a bit like making mortgage loans. The "leverage" (or the capital ratio for those of us more focused on banking) was a lot like the old S&L industry.

Apparently, those involved in these investment banks thought that the liquidity of mortgage backed securities (that they could be rapidly sold off as needed) allowed them to finanance large portfolios with overnight and other short term money. If they had to pay off, they could sell the securities. They wouldn't be like the S&L's with portfloios of mortgages only gradually paid off if depositors wanted their share accounts (read saving accounts) now.

The S&L industry failed because of something that impacted all mortgages--a huge spike in interest rates. This new, pseudo-S&L industry operated by the investment banks failed because of a drop in housing prices.

It is not clear, however, that Glass Steagal would have probited investment banks from doing this.

So, both investment banks and commercial banks were financing real estate loans with deposit like instruments. Real estate prices fell, so both are in trouble.


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