Arnold Kling  

Chipping Away at the Narrative

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Intra-National HDI... The Simplest Narrative...

Russ Roberts has a long narrative of the financial crisis. One excerpt:


An unpleasant but unavoidable conclusion of this paper is that Wall Street was (and remains) a giant government-sanctioned Ponzi scheme. Homebuyers borrowed money from lenders who got their money from Fannie Mae, Freddie Mac, and banks that borrowed money from investors who expected to be reimbursed by the politicians who took that money from taxpayers. Almost everyone made money from this deal except the group left holding the bag--the taxpayers. There is an old saying in poker: If you don't know who the sucker is at the table, it's probably you. We are the suckers. And most of us didn't even know we were sitting at the table.

Theories on the crisis tend to break Insider-Outsider more than they break left-right. One narrative of the right, that this was all due to pressure on banks to provide mortgages to minorities, never got much traction. The left is much more strongly united in its main narrative--that the problem was all private-sector greed turned loose by free-market ideology.

But there are Outsiders who do not fit into this narrative structure. Simon Johnson and James Kwak are examples. I am another. And Russ Roberts is another. The Outsider narratives all stress the symbiotic relationship between Big Finance and government.

The Insider-Left narrative is suspect because the policy response is so much at variance with the diagnosis.

The diagnosis is that financial innovation was harmful, and in my commentary hosted by the NYT web site, I conceded that point. Yet it is the Insider-Left that most wants to preserve securitization, while Roberts and I both argue for leaving its fate to the private market place, where we expect that it would die.

The diagnosis is that Wall Street greed ran amuck, yet it is the Insider-Left that defends the bailouts. Roberts and I wish that the bailouts had not taken place.

My conclusion is that the goal of the Insiders is to preserve the status quo as much as possible, and the "financial reform" is a thinly-disguised effort to accomplish that objective. The more radical reforms come from Outsiders, including Johnson and Kwak, and Roberts and myself.

Roberts tries to focus attention on what policy makers do, as opposed to what they say. What the Insiders have done in response to the financial crisis does not square with their narrative of how it took place.


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COMMENTS (11 to date)

The internet however, has made sure that the stupid insider-left narrative is challenged handily. And the continuing public anger over the bailouts contributes to the dissolution of that narrative.

Charlie writes:

Where does the view that this was caused by a bank run on shadow banking in the repo market fit in?

Arnold Kling writes:

I count the "run on repo" story as an insider narrative. It is used by people who think that all the crazy financial shenanigans are basically fine--they just need some protection against runs.

This outsider thinks that the crazy financial shenanigans should be allowed to disappear, not made too-regulated-to-fail.

Charlie writes:

Arnold, thanks for answering. Can you clarify your view one more level? The shadow bank run types argue that bank runs used to be a mainstay of the 19th century, then the FDIC came along and ended financial panics, until banking moved in the shadows starting in the 80s. Then the unregulated sector of banking became susceptible to old-timey runs.

So when you say end regulatory arbitrage and allow various things to disappear, are you saying end the FDIC and let creditors and investors monitor risks?

And if so, why don't you worry about 19th century runs?

Lord writes:

I see bailouts as the problem of where to draw the line, and whether it is even possible to do so. Since the last episode, the 1930s, did not turn out so well, I don't know many that would not want to draw one, so where should it be? Depositors? Depositors and counterparties? Depositors, counterparties, and senior debtholders? How many bankruptcies are too many? How much damage can be allowed to be done before it becomes too great for the Fed to counter? How far can it be allowed to progress before stopping it becomes impossible? (The Eurozone is ill equipped to deal with this even now.) I wouldn't have minded seeing some more disappear, but without a clear line to say this will be safe, this far and no farther, the invitation to destruction was great.

Bruce Wilder writes:

I think you are being a bit unfair to confound the Left's "private-sector greed turned loose by free-market ideology" narrative, with the Insider-Left narrative given imprimatur by the Obama Administration.

Obama rarely ventures any kind of class-war rhetoric, as much as the Democratic Left (including yours truly) would dearly love to hear it. Paul Volcker is as "revolutionary" as they get on Team Obama.

The Summers-Geithner-Bernanke axis isn't even all that "Left" -- Bernanke, a right-wing Republican, hardly qualifies as part of an "Insider-Left" and if there's any evidence for Geithner's "leftness" I'm unaware of it. Among Democrats the ideological-tribe label would be neo-liberals.

What is true is that partisan loyalties are being invoked, among Democrats, to support a policy strategy that most Democrats, especially the Democratic Left, would find deeply repulsive, considered on the merits. Some of the apparently most effective appeals are purely tribal -- calling the Republicans the Party of Wall Street, for example, when Obama's campaign finance and some of his top advisers are closely tied to some Wall Street players. And, it gets a Pavlovian response: many Democrats support "financial reform" content-unspecified, simply because the Republicans are supposedly positioned to oppose it, whatever "it" is.

The ruling Democratic coalition is an alliance of centrist-conservatives and progressives, dominated by the centrist-conservatives. Only if the progressives declare their independence from tribal loyalty and go looking for alliances with parts of the principled Right, are we likely to see any kind of radical or coherent reform.

Pandaemoni writes:

Strange to see that reference to people getting loans from Fannie and Freddie, as both of those organizations guarantee mortgage loans. If I want to buy mortgage loans, their guaranty makes it more likely I will be repaid, but they don't lend me the cash to buy the mortgage in the first place usually. The reference may have been to buying loans held by Fannie and Freddie, but I am not sure whay that would be an issue.

Second, I tend to think that securitization would definitely survive market forces, though obviously not at the levels it was at before.

The essense of a securitization is diversification, and crisis or not, no one has yet abandoned the math that says that works.

If I buy a mortgage, I am buying a cash flow and a security interest. Buying a loan subjects me to both the credit risk of the particular borrower and the systemic risk that housing prices will make my collateral worthless and encourage defaults. If I buy 100 mortgages, I reduce my risk because the variance of the cash flows I receive will be lower. Some bborrowers will lose their jobs/cash and default, but it's likely that most won't and the default rate becomes more predicatable as the number of loans increases.

The only addition in the case of a securitization is that they break the cash flow up into tiers. If I am very risk averse and you are less so, then we can negotiate my receiving the first dollars in the door, until I am paid what I am owed that month in full. Once I am paid, the cash starts flowing into your pocket. Any excess for that month is held and applied next month. Since you get paid second, you are taking more of the risk that insufficient funds will roll in, and so you will tend to want a higher interest rate to compensate you for that risk.

There's nothing wrong with that as a product; it's not even that complicated. Like any product, though, there are risks. The entire pool of cash flows might turn out to be bad.

R. Richard Schweitzer writes:

I spent a bit of time today trying to work out just how big a player Goldman Sachs has been in the actual mortgage securities markets, specifically those consisting of Residential Mortgages, but excluding "structured" products which "contained" NO actual mortgages.

What I found was that just the subprime mortgage securities aggregated about $1.3 Tril outstanding. As best I could derive, G-S portfolio of all forms of mortgage securities never approached as much as 100 Bn., It was probably closer to 8 Bn at any one point.

But, at a ratio of say 10 Bn to 1,300 Bn (1.3 BN)
Goldman's role would have been miniscule.

And that would use only the aggregate subprime, not all the mortgage market.

Does anybody have good stats on this?

Michael Gauss writes:

Arnold,
Let me preface by saying I am not a sophisticated investor.

But if we had not had the bailouts would we not have had a 1930s style cataclysmic collapse?

Regards,
Michael

zbicyclist writes:

At a time when Democrats have also been the recipient of large amount of Wall Street contributions, it's tempting to dust off Naderite critiques of the system.

David Pancost writes:

Stiglitz's Free Fall strikes me as the best I've read explaining why we went into the crapper, who & what were responsible, & how we could have avoided the whole thing. As he peals the onion--his metaphor--he comes down hard blaming simple-minded faith in market efficiency. Not, I suppose, a popular idea here. Curiously enough, he, too, thinks the bail out was wrong. I'm not sure his solution--seizing problem banks, zeroing out stockholders, replacing management, & then recapitalizing--was possible, legally, politically, or even economically. But it seems to be the way financial reform is going.

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