Arnold Kling  

Finance, TARP, and the Great Recession

The Keynesian Attraction... Vamoose!...

At the unpleasant session yesterday, I did learn something interesting from Doyne Farmer of the Santa Fe Institute, while he was ranting against the state of the art in macroeconomic models. He said that in 2006, the Fed simulated a 20 percent decline in home prices in its model, and the effect was minor.

That sounds highly plausible, of course. But it just adds to my frustration about the infamous Blinder-Zandi black-box simulations purporting to show that the economy would have been much worse without TARP. Such an exercise assumes that we have precise quantitative knowledge of the feedback between real and financial variables. But the exercise that Farmer referred to illustrates just how weak an assumption that is.

These days, we are hearing that TARP is ending, that it will cost less than expected, and that it worked. In an interview at the main event yesterday, Treasury Secretary Geithner says that by injecting capital into large banks, policy makers did something unpopular that would benefit the country. They took one for the team, so to speak.

This may be the true narrative. But there are many unknowns.

Relative to what I expected in 2008, more large banks survived and more small banks failed. That could very well reflect that my impressions were wrong. Alternatively, it could be that TARP raised the franchise value of large banks relative to that of small banks, shifting the government's losses from TARP to the FDIC.

Relative to what I would have liked to see, the process of getting people out of homes they cannot afford and allowing home prices to reach their natural level has been dragged out. This may have redistributed losses across institutions and over time. Perhaps FHA, Freddie Mac, and Fannie Mae are taking losses that otherwise would have been incurred by private banks.

We do not know what is going on with the Fed's portfolio of mortgage securities. Have they appreciated in value, or has the Fed absorbed losses that otherwise would have been taken by the banks?

If AIG survives as a going concern, is that because (a) the losses on its credit default swaps were much lower than people feared two years ago or (b) the value of the lines of business that it sold off since then was high enough to cover large losses?

The insider narrative has always emphasized panic and illiquidity. The outsider narrative has always emphasized bad investments and insolvency. In the insider narrative, the TARP halted the panic and restored confidence. The apparently large declines in bank asset values were due to temporary market malfunction, Now that the market is functioning again, the assets are being restored to reasonable values. In the outsider narrative, the losses were genuine. The dodgy assets did not recover their values. They just got shifted around.

The outsiders ask, if TARP worked, why did the real economy take such a huge hit? The insiders insist that without TARP, the hit would have been even worse.

There are some facts out there that make it difficult to argue for the outsider narrative. There are facts out there that make it difficult to argue for the insider narrative. I recommend trying to keep an open mind.

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COMMENTS (9 to date)
Ted writes:

I'm sure their model assumed a 20% exogenous decline in housing prices - and I'm sure such a model did generate a mild recession and I'm also sure had this been the only factor in the recession the model would have generated at least correct qualitative results.

The proximate cause of the severity of this recession was because the Federal Reserve allowed inflation and nominal growth expectations to plummet in Fall 2008. I'm sure whatever model they used assumed an exogenous 20% decline in housing prices, but kept inflation and nominal growth expectations constant. What happen instead was, according to the Cleveland Fed's estimates, one-year inflation expectations plummeted to 0.7% by November 1st 2008 and inflation expectations even turned slightly negative in March of 2009. I'm sure once you throw in housing prices plus a massive nominal shock the model would generate a very severe recession - just like the one we are seeing.

Whether TARP worked is difficult to know. I don't know enough about Blinder and Zandi's model, but I'll be surprised if we have microfounded structural models that imbeds financial markets in the macroeconomy and are still capable of dealing with policy programs that complex. My intuitive belief is that while I hate the design of TARP, I think it probably did help prevent a break down of the financial sector and did help the real economy to a non-trivial degree (financial intermediation broke down in the depression with all the bank failures and Bernanke's own research was pretty convincing in showing this was very, very bad! - similar logic would probably apply now).

Les writes:

It seems to me that unsupported opinions are fine merely as opinions. But they carry no weight because they are unsubstantiated. So assertions that things would have been worse without TARP have no credibility. There simply is no evidence that this is the case.

By the same token, what evidence is there that TARP was successful? None, that I can think of. Therefore any assertion that TARP attained success has no credibility either.

Steve Sailer writes:

How much of TARP was devoted to housing and how much to non-housing? And how much of housing is continuing to be propped up by the FHA, Fannie, etc.?

Norman Pfyster writes:

AIG's default was purely liquidity driven. They couldn't meet collateral calls on their swaps. Even after AIG took the losses on its cds portfolio and securities lending (actually, the latter was the bigger piece of the loss), AIG's assets exceeded its liabilities by a considerable margin. AIG was a paradigm case of a liquidity insolvency as opposed to a balance sheet insolvency.

fundamentalist writes:
Such an exercise assumes that we have precise quantitative knowledge of the feedback between real and financial variables. But the exercise that Farmer referred to illustrates just how weak an assumption that is.

That's because mainstream econ has no theory of capital. The the feedback link between finance and real variables runs through the structure of capital. Get capital theory right and the connection will be obvious: it's the Ricardo Effect of Hayek's. (PS, don't confuse the Ricard Effect with Ricardo Equivalence. They have nothing in common.)

david writes:

Didn't Kaldor conclusively discredit Hayek's Ricardo effect?

The structure of capital is suppressed by presuming that the financial market is efficient - that investors cannot be systematically fooled. In general, for nominal variables to affect real variables, someone, somewhere, must either be suffering from money illusion or the money market must be endogenous.

fundamentalist writes:

david, It seems that most people think that Kaldor discredited Hayek's Ricardo Effect. You'll have to read them both and decide for yourself. My experience with most critics of Hayek is that they fail to read him carefully and therefore get wrong what Hayek was trying to say. O'Driscol privides an example:

"A single firm, faced with different rates of return on different investments, would attempt to equalize them at the margin (net of risk differences). The firm would borrow at the going rate of interest and invest in capital goods until the marginal rate of return on all investments is equal to the rate of interest. Kaldor assumed that this model applied to the economy as a whole.*38

"Hayek responded that it is a non sequitur to apply the model of a single firm to the model of the entire economy. In so doing, the resource constraint is violated." from

Also this:

"Mark Blaug's is undoubtedly the standard textbook treatment of the Ricardo effect. I do not believe, however, that Blaug correctly followed Hayek's argument at all points....Blaug generally employed comparative static analysis to criticize Hayek's analysis of a dynamic process of adjustment. Blaug, moreover, employed aggregative concepts that Hayek specifically eschewed (as, for example, "'the' rental price per machine")...Blaug's casting of Hayek's dynamic analysis into comparative static terms is his most egregious error. As a result, he entirely missed Hayek's argument about the discoordinating features of a disequilibrium rate of interest.*95

"95. "The Ricardo Effect" (1942) should not be read apart from "Profits, Interest, and Investment" (1939), as Blaug evidently did (judging from his criticisms and his bibliography). The 1942 work is a virtual amendment to the 1939 work and is not completely understandable by itself. Significantly, Blaug did not mention "Profits, Interest, and Investment" in his bibliography on the Ricardo effect; he did, however, cite Kaldor's "Capital Intensity and the Trade Cycle" (1939), but as though it were a criticism of work that postdated it by three years (Blaug, Economic Theory, pp. 571-72). "

Keep in mind that graduate level micro texts and some undergrad texts today include a version of the Ricardo Effect. They teach the labor vs capital equipment trade off, which is true of every business. Standard micro theory says that firms will ajust the ratio of labor and capitla used in production so that the marginal product of each is equal. All Ricardo and Hayek did was to show how that trade off fits in with business cycles. When many consumer goods makers shift from capital to labor, they cause a collapse in demand for capital goods. They do this most often by having workers work overtime while putting off buying new equipment, such as computers.

fundamentalist writes:

I posted a longer response about Kaldor, so while it's awaiting approval I'll address the EMH issue. The only way that people are being fooled is in thinking changes are sustainable, but that may not even be the case. In Hayek, changes in interest rates change the prices of capital and consumer goods relative to each other, and changes profits. Businessmen respond to those changes in prices and profits. Some may be fooled into believing the changes are permanent, but that's not necessary for the Ricardo Effect to work. Businessmen may have no alternatives; prices, profits and investment have changed so they have to change plans in order to survive in the short run. Or they may think they are clever enough to get in, make a buck and get out before the collapse. Actually, there may be hundreds of reasons that businessmen do what they do. It's dangerous to assume that they were simply fooled and shows a complete lack of imagination on the part of most economists.

Gitoutta Dodge writes:

According to Wikipedia, TARP cost the taxpayers "at most $50 billion."
WHAT? Someone needs to update the page.

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