Arnold Kling  

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Huge News Story I Missed in De... Let Them In...

John Taylor is interviewed. I recommend clicking on "interview transcript," since it is faster to skim and read than to watch an interview. At one point, the interviewer poses a question from Scott Sumner on whether the Fed was too tight with money in the fall of 2008. Taylor replies,


I think the Fed cut interest rates during that period just about right. I think it was basically coming down, it could have been a little faster at that point, and of course, GDP did fall tremendously. But I think if they had kept the interest rates along the same path it would have been fine.

The problems I saw were not so much a monetary policy at that stage, but the really ad hoc chaotic interventions that occurred around the time of the rollout of the TARP, not clear kind of actions with respect to what happened to Lehman Brothers. So, a lot of surprises and ultimately a lot of panic.

[UPDATE: Scott Sumner finds this response a tad unconvincing.]

The Financial Times reports,


The Federal Reserve is sitting on billions of dollars in paper profits from its controversial effort to unwind credit insurance contracts that AIG provided to banks such as Goldman Sachs, people familiar with the matter said...

At the time of their purchase, the CDOs had a face value of $62.1bn and a market value of $29.6bn. Now, the estimated market value of the CDOs is at least $45bn (£27.5bn), according to several people with direct knowledge of the portfolio.

This is consistent with the view that the problem was a liquidity problem, not a long-term solvency problem. It suggests that Bernanke was right and I was wrong. Time will tell. Thanks to Mark Thoma for the pointer.

The Wall Street Journal reports,


This year, of the world's 20 largest economies, the U.S. suffered the largest drop in overall economic freedom. Its score declined to 78 from 80.7 on the 0 to 100 Index scale.

Read the whole thing. Economic freedom is now higher in seven other countries--Hong Kong, Singapore, Australia, New Zealand, Ireland, Switzerland, and Canada. If I were rich, I would buy properties in several of those countries, as a hedge against a U.S. fiscal meltdown.

Haiti ranks 141st, which puts it ahead of almost 40 other countries. The Dominican Republic ranks 86th.



COMMENTS (8 to date)
Jack writes:

Yves Smith at Naked Capitalism had a pretty detailed post calling into question the valuations on the AIG CDOs in that article:

http://www.nakedcapitalism.com/2010/01/ft-joins-ranks-of-shameless-fed-boosters-runs-front-page-story-with-incredible-claims-re-aig-cdos.html

david writes:

On the 2010 Index - Canada is penalized pretty lightly for having consistent but stably higher tax rates and a welfare state (universal health care and so on). On the other hand, the US is penalized pretty heavily in financial freedom and property rights, both of which seem tied to the short-term political storm.

This isn't a new pattern; Singapore's government outright owns and runs a huge proportion of its GDP via it state investment arms, but consistently ranks high on the Index. The Index just weights stability very, very highly, even over the strict idea of free markets.

This, on the other hand, is a more accurate reflection of US vs. Canadian government roles in the free market, I think.

Mark writes:

You are rich!

ThomasL writes:

My vote is for NZ. Remember, with a telephone, YOU make the call!

ThomasL writes:

Just in case one doesn't pick up that NZ reference straight off:

http://www.youtube.com/watch?v=JMvtKy1zFfY

John writes:

Even if the numbers are correct, that would mean that the securities have retraced 50% of their decline. Wouldn't that mean that at best 50% is liquidity-related? After all, they aren't trading at 100 cents on the dollar.

Paul writes:

How come there's not a ETF that shifts money around between country indexes based on the economic freedom index or some equivalent. Is the lag in how often th economic freedom index is updated simply to slow that the market has already priced in all those considerations?

Mike Rulle writes:

The reason I always believed this was a liquidity problem (I wrote about this obsessively on my blog in 2008 and early 2009) was through a "bottoms up analysis"---the best of which was performed by William Lucy of UVA. The "implied foreclosure" rates (think implied volatility during a crisis) were so high as to not be plausible for the long run.

Of course a liquidity crisis can lead to a solvency crisis, so there is always circularity in these arguments. This is one reason the Fed is sitting on AIG CDS gains. As of this summer, at least, AIG had not yet suffered a default in its CDS portfolio.

This was a bad problem made almost catastrophic by government misunderstanding, and a literalistic interpretation of the meaning mark to market accounting. We did have a problem---but it was smaller than perceived. But the loud guys (read--"Goldman" and others) had a bigger problem than did the financial system---which they happily equated as the same thing.

Now we have various "fixes" proposed which are non-sequiturs. If we had simply forced financial firms to use the same margin rules in CDS as they do in their repo books (or on futures exchanges), AIG and others would have been a fraction of their size---as would have the CDO/MBS market. (Imagine also if Fannie and Freddie had no de facto government guarantee? How plausible would a global real estate bubble have been?). The proposed "bank fix" announced today is both besides the point and probably harmful, as it is bound to lower liquidity.

We also don't need "Greenspan caused the bubble" theories to explain the magnitude of the 2007--2008 problem, even if the Fed got the ball rolling.

At least in 1998, Greenspan did not put taxpayer dollars at risk. AIG and LTCM were identically caused---they demanded and received huge non-collateralized credit lines. These single handedly put the financial system at tipping points from a liquidity perspective. But if normal futures/repo cash collateral rules applied, no one could ever get that big. Liquidity crises, in these two instances at least, were caused by allowing these entities to have "infinite" leverage. We continue to make this more complex than it is.

The irony is I disagreed with the Paulson/Geithner solution, even as I agreed with their liquidity analysis. Why should companies be bailed out from liquidity problems? They should solve it themselves (think 1907). Solving a liquidity crisis is the first line of defense against a solvency crisis. Look how quickly we recovered in 1907 and 1998. No Fed in 1907 and no Govt bailout (arm twisting is different than money given) in 1998.

Still, the real estate losses were overstated in 2008. Why do you think the financial institutions have such high profits in a weak economy? Where do you think a good chunk of those over stated 2008 losses went?

To 2009's income statement.

[blog link fixed--Econlib Ed.]

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