Those stupid bankers and their stupid stupidity

by Daniel on October 17, 2008

It appears to be a commonplace gaining ground every day that the main reason we have a credit crisis (about which I am not writing; this is an essay in recent monetary history) is that bankers created it, and specifically that they created it because they are stupid. Nicholas Taleb (who doesn’t eat foods unless they have a name in Hebrew or Doric Greek, I just bring this up as an interesting fact rather than to suggest that here’s a man who knows stupid when he sees it) has been really quite cutting on the subject, among others. Stupid, stupid stupid. Isn’t it a shame that these stupid people in their stupidity brought this crisis among us? Don’t we need a blue-ribbon commission to make sure that such stupids never have the chance to do so much damage again?

Harrumph.

Remember yer Keynes. Macroeconomic events have macroeconomic explanations, not micro ones. Let us consider the following statements:

1) This was a policy-caused bubble. As I wrote last week, I noted in 2002 that the Federal Reserve, among others, was attempting to engineer a housing bubble in order to soften the landing post the internet bubble. This was not, I perhaps should have emphasised, a brilliant piece of iconoclastic contrarianism on my part. The jokes were quite original, and the Beanie Babies idea was all my own, but that actual analysis was totally commonplace at the time; I can’t remember if the Fed actually said this was what it was doing and suspect it didn’t, but it was generally and tacitly understood throughout the economic policy community that rising real estate prices were a goal of policy. Oliver Kamm remembers it this way too[1].

2) It was not even really a bubble, in much of the world. As Brad DeLong was writing in 2005 (as I say, this one really has to fall into the category of “mistakes we knew we were making”), there’s a more or less direct linkage between interest rates and house prices, via quasi-arbitrage between the rental yield and the bond yield, combined with downward-sticky nominal rents[2]. In some parts of the world, the rental yield/bond yield spread got way out of equilibrium, but not in all of them; in Ireland, for example, house prices simply tracked the local government bond market all the way up, and then back down again.

From these two things, I conclude that a house price bubble was more or less unavoidable.

3) The other element of the crisis was “an excessive dependence on wholesale funding”. Again, at the level of the whole system, it could not have been otherwise. It can’t be put better than in John Hempton’s perfect phrase – “The banking system intermediates the current account deficit”.

Which is to say, that if you have a current account deficit, then domestic consumption exceeds domestic saving. Unless one’s prepared to assume unlikely things about the financial system, this means that the outstanding lending of the domestic banking system will grow faster than the outstanding deposits of the domestic banking system. If this continues for a long time, and in size, then the loans will exceed deposits, and this means that the domestic banking system, as a whole, will be reliant on wholesale market funding.

4) The reasons why the Anglosphere countries ran such large current account deficits over the last ten years are, frankly, not very well understood. There’s a variety of theories – the Ben Bernanke “global savings glut”, Melanie Phillips theory of “a crisis of morality and buy-it-now culture caused by Richard Dawkins” (what do you think I’m lying or something, the intentional undervaluation of Asian currencies, lots and lots of them. But nobody, so far, has come up with a theory under which the entire driving force of the world economy has been the stupidity of stupid bankers[3].

5) It is just about theoretically possible to imagine a world in which the banking system refused to intermediate the current account deficit, and did not respond to looser monetary policy by extending loans. But let’s get this straight – do you really want to go there? What we would be talking about here would be a world in which monetary policy did not work at all. If we lived in a world in which these far-sighted paragons of the imagination ran the banks, rather than the stupid stupids we have now, we would have smarted our way into constant recession[5].

Look, my basic point here is not to exonerate anyone or vice versa (apart from anything, that would stray into writing about the crisis itself, which I’m still not going to do). I am sure that at the levels of individual institutions, stupid things were done and irresponsible risks were taken. But likewise, I would also dare say that during the Great Depression, a lot of the workers who were made redundant were probably a little bit lazier and not quite as skilled or conscientious as the ones who kept their jobs. But if you were going to have your main comment about the Great Depression that it was the time when lots of lazy shirkers got the sackings they deserved, then I think everyone[6] would agree that you’d kind of missed the big picture. The analysis that blames it on stupid bankers, is of a piece with the kind of analysis that regards the 1930s as being the decade when the working class of the world took it upon itself to have a great big shirk.

[1] I might actually be moved to argue that the internet bubble itself was at least partly a result of a soft-money policy aimed at smoothing the landing post the Asia/Russia crisis of 1998. There’s a real sense in which we’re still trying to complete the 1991-1995 monetary policy cycle, having had it interrupted three times already for the Mexico, Asia and dot com bailouts. Note also that Alan Greenspan’s “irrational exuberance” speech was made in 1996!

[2] Or at least, this linkage exists in Anglosphere (plus Spain, for some reason) markets, where housing behaves like an investment good, due to the existence of a large enough privately owned rental housing sector, plus easily available mortgage finance. In markets where housing behaves more like a consumption good it doesn’t. Commercial real estate behaves like this everywhere.

[3] I can sort of see how you might make a model of the economy which closed so that the exogenous factor was the desire of bank executives to get big bonuses and everything else followed from that. But it would be a very weird bass-ackwards post-Keynesian model, and I really don’t think anyone actually believes that this would be a good description of the world. Maybe I missed the memo and we all believe in endogenous money these days, but I have scoured the Nobel Laureates list[4] up and down and Warren Mosler’s name is not on it, so I conclude otherwise.

[4] Can you hear that sound? Just faintly in the distance? It’s the sound of the tiniest violin in the world being played by someone who doesn’t care that it’s actually the Sveriges Riksbank Prize in Honour Of Alfred Nobel.

[5] This might actually be the kind of economy that Taleb would prefer, as it would afford limitless opportunities to sit at home, stroke our beards and sagely note that nobody really knew the nature of the risks one takes by getting out of bed. In a very dignified, aesthetic way.

[6] Except Nobel Laureate[7] Edward Prescott, who actually does believe that the Great Depression was basically a decade-long shirk.

[7] deedle deedle deedle.

{ 197 comments }

1

tom s. 10.17.08 at 5:39 pm

Your Dillow-link in the first sentence is misleading; he doesn’t take the stupid stupids line.

2

dsquared 10.17.08 at 5:41 pm

Perhaps so, but the “rational people facing perverse incentives” line is really just a species of the “stupid” line isn’t it? It’s still a theory based on bank behaviour as if it was an exogenous factor.

3

Gdr 10.17.08 at 5:46 pm

We knew you wouldn’t be able to resist commenting on the crisis.

4

ejh 10.17.08 at 5:47 pm

Ah, I thought it was because they were greedy, rather than stupid. They can’t have been stupid, because they didn’t lose out when it all went the shape of a pear. But greed…

…you’re not saying they weren’t greedy?

5

Maurice Meilleur 10.17.08 at 5:52 pm

Yes, yes, whatever. If the explanation doesn’t fit on one of Sarah Palin’s debate notecards, I’m not interested.

Even Melanie Phillips’s explanation, clichéd as it is, is too wordy.Though the way the foam-at-the-mouth faction of movement conservatives have been openly swinging these last few weeks, the GOP might adopt it and try to punch it up by replacing Dawkins’s name with ‘Jew bankers’.

In all seriousness, Daniel, this is a great post. But for Roubini’s site I feel pretty starved for clear-headed commentary on macroeconomics these days.

6

harry b 10.17.08 at 5:54 pm

That Melanie Phillips piece is a gem. Thanks.

7

tom s. 10.17.08 at 5:55 pm

Well OK, but something has to be exogenous somewhere or nothing changes. And in the end aren’t you blaming it on an outbreak of the stupid stupids among policymakers (who were bankers looking for a change anyway)?

8

Righteous Bubba 10.17.08 at 6:07 pm

My stupid picture of this, being dumb and all, is that X loan turns into X*Y worth of magic money. Isn’t there some smart person at a bank who is supposed to keep an eye on Y so that the value of it isn’t too excessively super ultramagical? Am I allowed to smush a pie in that person’s face?

9

ejh 10.17.08 at 6:08 pm

Thing is – it’s all very well trying to explain this, but who in God’s name does understand it?

Normally, this doesn’t matter much. However, here we are and a load of people are going to lose their jobs. And if you lose your job, you really need to know why.

There are some very comprehensible reasons. You rowed with your boss. Your company reorganised. The product wasn’t selling. The company thought they could do the job with fewer people. The boss reckoned you weren’t up to it. The budget got cut. You did something stupid, or someone said you did.

All these things and many others, people understand. But exactly how and what are they supposed to understand now?

However….if, as a result of losing their jobs for entirely incomprehensible reasons, they get their homes repossessed, on the grounds that they made a financial commitment they couldn’t subsequently meet, they’re liable to understand that this painful and largely inappropriate lesson in fiscal prudence is given them by people who previously made rather more extensive financial commitments that they couldn’t meet.

In these circumstances, should they blame the bankers? If not, why should they not?

10

Seth Finkelstein 10.17.08 at 6:12 pm

I suggest there’s a difference between a “bubble” and “international credit crisis / global meltdown”.

Some hotly contested policy produced a “bubble”.

But “international credit crisis / global meltdown” seems to have been, yes, “stupid” bankers – well, “stupid” is perhaps the wrong word – “irresponsibly and recklessly profit maximizing” seems more the correct concept. The factors that amped the “bubble” into “crisis” seemed to have been some frankly shady financial risk modeling, combined with high leverage – an absolutely toxic combination. Thus, regulation is arguably an appropriate fix.

11

Lex 10.17.08 at 6:16 pm

So it isn’t stupid bankers, it’s stupid politicians?

Or just stupid everyone?

Or just the fact that a growth-based economy is like running downhill carrying a six-foot-high pile of china plates…

12

Bloix 10.17.08 at 6:17 pm

1) The crisis appears to arise from lenders making money available to borrowers whose ability to pay did not justifiy the loans, and then selling the loans to third parties who did not understand the risk they were assuming. The lenders made the loans because the inability of the borrowers to pay was disguised from them sufficiently either to fool them, or to allow them to pretend that they had been fooled. The third parties did not understand the risk because it had been disguised sufficiently either to fool them, or to allow them to pretend that they had been fooled.

You can call all this lying and self-delusion stupid; you can call it reckless self-dealing; but whatever it is, it arises from masses of individual actors acting in ways that benefited themselves personally while exposing their institutions, their clients, and their investors to high and undisclosed risks. When those risks resulted in actual losses, the institutions that assumed them could not bear them.

Now perhaps you are arguing that even if there had been no such thing as liar loans at the bottom and under-capitalized credit default swaps at the top, we would still be in the midst of a crisis due to unresolved structural defects hanging over us from the 1990′s. Is that what you’re arguing? Really?

2) Nobody cares that you don’t care that it’s actually the Sveriges Riksbank Prize in Honour Of Alfred Nobel. It’s just one more thing that you’re wrong about.

13

mpowell 10.17.08 at 6:29 pm

I am inclined to agree somewhat with Bloix and Seth Finkelstein here. I am not particularly qualified to comment on the issue, but it seems to me that it is not right to ask, “what caused this bubble?”. Asset bubbles will happen. The question I have is why did this asset bubble lead to our current state of affairs. Was the bubble simply too big? Or were leveraged agencies (ie, banks) inappropriately exposed to risky asssets?

I would really like to see you address this point, Daniel. Maybe I am misunderstanding you and you are already answering it. But my idea of a good financial system would be one were bubbles could develop, but that the people exposed to them were not leveraged such that when the bubble collapsed, total financial meltdowns occurred.

14

MQ 10.17.08 at 6:41 pm

Seth is absolutely correct in comment 9, and D-sq seems unusually squirrely about this. Conventional wisdom 18 months ago was that the housing bubble could be managed with, say, no more than $150 billion in writeoffs, and would not spread much outside of the relevant sectors. The widespread collapse in financial markets due to deleveraging and balance sheet contagion was not anticipated. And it was driven by the fundamentally stupid decision not to adequately regulate risk in financial markets.

But the bankers themselves were of course not stupid, they got huge bonuses and they’re keeping them. The rest of us were stupid to trust them.

15

MQ 10.17.08 at 6:41 pm

Guess I’m just agreeing with mpowell here.

16

rortybomb 10.17.08 at 6:43 pm

This is really good. Thanks for writing it. I do like people bringing up normal distribution stuff (Mandelbrot!) as if this hasn’t been known for decades; Taleb’s critique is way overrated.

17

Keith 10.17.08 at 6:47 pm

Huh. Melanie Philips does in fact seem to think that we wouldn’t be in this kettle of fish if were all just good old timey Christians. To which I would reply with a spectacular offer on this new variety of Tulip that I have just developed. It’s a good enough offer for any pious, 17th century tulip financier, why not for her?

18

rortybomb 10.17.08 at 6:50 pm

==
But the bankers themselves were of course not stupid, they got huge bonuses and they’re keeping them. The rest of us were stupid to trust them.
==

Mortgage-Backed CDOs had a very high return, especially for a AAA-bond – take my word for it, if your fund carried them, you could post higher, and safer, returns than other funds that did not, and it was very noticeable by investors and management. And of course, with those new numbers, you could steal money away from that other fund not carrying them. (Or alternately, the promotions and bonsues your boss gives from another banker from your boss). Now of course, that othre fund knows that AND can also trade them.

Isn’t the Nash Equilibrium that everyone holds them? Maybe I’m missing something, but that’s hardly stupid.

(And that doesn’t even get into staying solvent now and dealing with risks later vs. raising taxes / funding that pensions and municipalities had to get into.)

19

rortybomb 10.17.08 at 6:51 pm

First two lines there are supposed to be a quote. Sorry.

20

MarkUp 10.17.08 at 6:53 pm

mpowell > ”…but it seems to me that it is not right to ask, “what caused this bubble?”. Asset bubbles will happen.”

Why is it wrong to ask?

21

John Emerson 10.17.08 at 6:56 pm

Well OK, but something has to be exogenous somewhere or nothing changes.

As I understand, this is completely false.

22

chrismealy 10.17.08 at 7:01 pm

Judging from their yachts I’d say bankers aren’t stupid. Investors, probably yes. Isn’t the classic principal-agent problem?

I don’t have an intuitive grasp of trade identities, but it seems to me that if China, Japan, e and other nations want to hold a bunch of dollars (for their own good reasons) then the US is just going to run deficits.

23

John Emerson 10.17.08 at 7:04 pm

What are the chances that this was a deliberate John Galt ratfuck by Greenspan? No one really is in a position to know how Randian and vicious that guy still is, and he seems to have been regarded as God by a lot of people.

24

John Emerson 10.17.08 at 7:06 pm

Old Time Christian-wise, prosperity theology Christians like Sarah Palin make the Dow 32,000 guys look restrained and sensible.

25

Miracle Max 10.17.08 at 7:07 pm

“The banking system intermediates the current account deficit”. . . . Which is to say, that if you have a current account deficit, then domestic consumption exceeds domestic saving. . . . If this continues for a long time, and in size, then the loans will exceed deposits, and this means that the domestic banking system, as a whole, will be reliant on wholesale market funding.

I’ll ask you the same question I did in another universe, far far away, speaking purely in a historical vein without reference to the credit crisis or anything related to your financial machinations. Suppose the savings glut was in the U.S. and somebody else had the trade deficit. Why aren’t there still the same incentives to look for higher yields and find them in a housing bubble?

Secondly, in a similar vein, isn’t the volume of bad paper on top of the mortgages far out of proportion to use values actual savings and associated imbalances in terms of GDP flows?

By the way, watch out for Taleb. He’s a litigious prick.

26

Donald A. Coffin 10.17.08 at 7:08 pm

Re: fn [6]: Two words: Amity Shales. Well, 7 words: Amity Shales is nuttier than Edward Prescott.

27

MarkUp 10.17.08 at 7:27 pm

”You can call all this lying and self-delusion stupid; you can call it reckless self-dealing; but whatever it is, it arises from masses of individual actors acting in ways that benefited themselves…”

Or as Marilee Jones might say, it’s just a little white lie, unless you get caught; or the football tackle after the game dutifully reminding that all the other tackles and guards hold too, it’s a known advantage until you get flagged or caught on film by the scout in the stands with a live video to the bench.

28

mpowell 10.17.08 at 7:29 pm

20: I think the reason is that it is just unavoidable that you will have asset bubbles in a capitalist economy. Maybe in any economy. I think Marx argued that these cycles were a problem with capitalism and that he knew how to avoid them. History would suggest that they’re difficult if not impossible to avoid, but that they don’t have lead to deep financial recessions. So if you have a phenomenon that is inevitable, but doesn’t have to lead to a disastrous result, when you get the disastrous result, isn’t it just a distraction to try to inquire as to the source of the bubble when the real curiosity is why a perfectly normal bubble led to a disastrous financial result?

29

nick s 10.17.08 at 7:33 pm

In Stupidsville, the village idiot is king.

30

blah 10.17.08 at 7:41 pm

The bankers were mostly greedy.

The politicians were mostly corrupt.

And the rest of us were mostly stupid.

31

lemuel pitkin 10.17.08 at 7:43 pm

Remember yer Keynes. Macroeconomic events have macroeconomic explanations

Wisest eight words on the crisis that have been written. Quite possibly, that could be written.

On the other hand, for the strongest, most convincing & sophisticated version of the it’s-the-stupids argument you’re likely to find, check out this piece by the estimable Marxist-Keynesian Jim Crotty: Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New Financial Architecture’ .

32

novakant 10.17.08 at 7:54 pm

Mistakes were made, blahblah…

33

Timon 10.17.08 at 7:57 pm

Taleb is a type, if you like Nabokov and hate Plato you probably like him a lot, as I do. I have felt the same awe as him at the delusional comments of otherwise smart friends at hedge funds and investment banks who really believed they (or whizzes at their companies) had mathematically eliminated risk from their 15x leveraged positions. This is not something Taleb made up, it was widely believed that sufficiently sophisticated investment strategies were bulletproof, and that led people to take idiotic risks.

BTW, Taleb is denying the existence of macroeconomics as a fruitful field of study, not quibbling with your methodology. He seems to view it as primarily useful for coming up with comforting stories about the past (cf this post), but overall not intellectually rigorous.

34

mpowell 10.17.08 at 8:03 pm

I hate to sound repetitive, but honestly, Lemuel, is there anything mutually exclusive about dsquared’s statement and the argument in your link?

35

mpowell 10.17.08 at 8:05 pm

Or to put in another way: if you arrange the incentives so as to create an unstable system, you can always identify the impulse or driving force that begins the escalating oscillation, but that doesn’t mean the problem was the driving force.

36

lemuel pitkin 10.17.08 at 8:16 pm

mpowell-

Yes. In fact, the *entire point* of this post, as I read it, is to dispute arguments like Crotty’s. Crotty focuses on specific financial practice that he beleives caused the bubble and crisis. Dsquared’s argument is that expansionary monetary policy + global savings glut = bubble, followed by crisis. In this version, stuff like “originate and distribute” or the behavior of the bond rating agencies just doesn’t matter at all.

37

J Thomas 10.17.08 at 8:19 pm

Now perhaps you are arguing that even if there had been no such thing as liar loans at the bottom and under-capitalized credit default swaps at the top, we would still be in the midst of a crisis due to unresolved structural defects hanging over us from the 1990’s. Is that what you’re arguing? Really?

“if you have a current account deficit, then domestic consumption exceeds domestic saving. Unless one’s prepared to assume unlikely things about the financial system, this means that the outstanding lending of the domestic banking system will grow faster than the outstanding deposits of the domestic banking system. If this continues for a long time, and in size, then the loans will exceed deposits, and this means that the domestic banking system, as a whole, will be reliant on wholesale market funding.”

We did and do have a current account deficit. Domestic consumption did and does still exceed domestic saving. The domestic banking system was and is reliant on wholesale market funding.

The domestic banking system needed foreigners to lend them money. Each year more money, enough to pay the interest on the old loans plus the new deficit. Foreigners particularly liked US mortgages because they were risk-free.

Demand and supply. US bankers of course tried to give lenders what they wanted. When they ran out of good mortgages to sell them, of course they tried selling bad mortgages — since it was legal.

If we didn’t have this particular housing bubble, would we still have the current account deficit? I see no reason why not. And wouldn’t that give us some crisis? The liar loans etc were a temporary solution to the current account deficit crisis. Now that they failed we lack even a temporary solution except to sell lots of T-bonds.

38

bob mcmanus 10.17.08 at 8:20 pm

28:Hyman Minsky had a program to avoid financial disturbances that mainstream economics has ignored with all its might for about thirty years.

Since I think Minsky might have said it is the same program as Keynes/Kalecki/Galbraith/etc et al, maybe 70 years.

Fun Post, d`. I think it needs to be read exoterically or sumpin. Like, what happened in 1995?

39

mpowell 10.17.08 at 8:23 pm

Okay, but what I am confused about is why this particular asset bubble had to lead to an economic meltdown. Crotty’s argument seems focused on why this asset bubble led to the crisis, not why the asset bubble existed. Those are potentially very different things. Unless the argument is that the asset bubble would necessarily lead to this crisis, which I don’t really see being made.

40

mpowell 10.17.08 at 8:29 pm

37: What if I were to argue that preventing liar loans would have limited the further expansion of the current accounts deficit? And that better regulation of the financial sector would have prevented these liar loans from being sold in the form that they were?

It is very confusing to me that people are now apparently arguing that regulatory structure cannot have macroeconomic effects. Only monetary policy determines these things? Why did we even bother inventing the FDIC then? What the heck is being argued here?

41

John Quiggin 10.17.08 at 8:38 pm

Obviously, given my post a little way below, I disagree. Given the scope of financial innovation, it was inevitable that the bubble would be amplified as it has been. And, with or without this particular bubble, something would have happened to bring about a crisis like this before too long. Of course, that’s not to disagree with the basic point that US macro policy was unsustainable.

42

sg 10.17.08 at 8:46 pm

I would have thought NINJA loans are stupid, objectively stupid. Selling debt based on these is crafty, I suppose, provided people are stupid enough to buy it. But there has to be some stupid involved in this.

43

lemuel pitkin 10.17.08 at 8:57 pm

It is very confusing to me that people are now apparently arguing that regulatory structure cannot have macroeconomic effects.

No. the argument is that regulatatory structure has macroeconomic effects only insofar as it oeprates on the macroeconomy. I.e. if you have fully specified the paths of C, I, G, X and M there is noa dditional, independent role for regulation in explaining the current crisis. Dsquared’s argument — and he’ll correct me if I’m wrong — is that the paths of the macro variables were unsustainable in ways that would inevitably have led to something like the current crisis. And while you *could* argue that e.g. financial deregulation caused teh US current account deficit (I don’t beleive it, but you could argue it) that is not what the “stupids” arguments, even at their best like Crotty’s, do. They draw the causality *directly* from financial deregulation to bubble/crisis, without discussing macro variables at all.

Only monetary policy determines these things? Why did we even bother inventing the FDIC then?

One of the main things that finacial rgulation does is ensure that there is a reliable link from monetary policy to interest rates and liquidity conditions in the real economy. (Crotty’s UMass colleague Bob Pollin has a good recent paper on this.) That is precisely whhy we have things like reserve requirements. But in this case the monetary authorities got exactly the results they intended. The excess of liquidity wasn’t the result of a deregulated financial syystem innovating around attempts by central banks to tighten credit, as has happend in the past. Rather it was, as Daniel says, the result of deliberate policy.

44

sammy 10.17.08 at 8:58 pm

[7] deedle deedle deedle.

See, this is where your whole analysis falls apart.

45

J Thomas 10.17.08 at 9:00 pm

MPowell, Daniel does not say why we have the current account deficit. He lists several possible explanations that various people like. I personally prefer the argument that the chinese and some other governments pegged their currency to the dollar (the minrembi is currently pegged to a basket of currencies with the dollar prominent among them). This is not the whole story but I expect that when the data becomes available this pegging will turn out to be a key part of it.

So to stop the current account deficit we need to export more or import less. Any good ideas how we can export more? I didn’t think so. Me neither.

So, import less. If we entirely stopped importing oil that would reduce the deficit by more than half. (We have enough domestic oil to last us about 900+ days at current consumption rates.) If we closed down our various foreign military bases it would help a whole lot, I don’t know how much since the military doesn’t appear to track those numbers. If we had a great big recession that might do it.

I used to hear the argument that it was our duty to keep spending. It was US spending that kept the whole world economy going. Without the US current account deficit the whole world economy would sink into depression. Were they right? If so, ending the deficit does not solve the problem, it creates a more pungent problem.

So OK, we persuade US consumers to consume a whole lot less while we invest the money to build factories to make all that stuff ourselves. Americans can take the low-paying jobs in those factories. Does this sound like a winning campaign platform to you? Maybe Obama can carry it off, starting after the election. Bush didn’t want to in 2000 or 2004. Remember Bush saying that patriotic americans should contribute to the war effort by keeping their spending up?

46

bob mcmanus 10.17.08 at 9:01 pm

FWIW, I think this particular financial crisis has been building for about thirty years, as the GD I built for 50 years, and that this is only the penultimate stage before the real SHTF. You think this is a meltdown? You ain’t seen nothing yet.

The bubble in treasuries followed by default, now that will be a global meltdown.

47

bob mcmanus 10.17.08 at 9:07 pm

I mean, since deficits don’t matter, and the US needs a lotta fiscal stimulus, and we don’t need no stinking tax increases or stinkin austerity, I guess we just sell treasuries to finance stimulus and sell treasuries to cover the interest and let the sucker snowball us all to hell.

Until Bernanke goes all Volcker. Probably in late 2011.

48

dsquared 10.17.08 at 9:30 pm

However, here we are and a load of people are going to lose their jobs. And if you lose your job, you really need to know why

I think that the explanation given by George Orwell fifty years ago is the only sensible one (from memory) “If two million people are out of work, then a logical consequence of this is that George Jones will be out of work. But while nobody sensible would think to suggest that two million people being out of work is George Jones’s fault, everyone tends to assume that George Jones being out of work is George Jones’s fault. They are wrong”

I really don’t know who to blame, since “whatever caused the big OECD current account deficits” is clearly an empty placeholder. John Hempton thinks (see link) that the ultimate cause is the Chinese one-child policy (which was the cause of the global savings glut and so forth). Personally, I’m more inclined to believe that Keynes/Marx was right, and that the actual cause is “the tendency of complicated and unstable systems to have complicated and unstable dynamics”.

Suppose the savings glut was in the U.S. and somebody else had the trade deficit.

I’m gonna follow my own advice on “how to debate Milton Friedman” here and thus my response will be “no, don’t suppose that”. It is not a random coincidence that this crisis happened in a capitalist system rather than a socialist one. It’s a property of capitalist economic systems that they’re vulnerable to crises.

49

mpowell 10.17.08 at 9:47 pm

Well, thanks, the argument seems a lot clearer to me now. But the conclusion still does not seem quite right. Monetary policy does not directly determine the current account deficit. But it should, as Daniel points out and Lemuel reminds me, influence how willing banks are to lend money. Now we encouraged banks to lend a lot of money, and perhaps too much. But isn’t it possible that there were able to effectively lend even more money than they really should have based on questionable regulatory practices? Now I expect the counter argument would be that if there was too much lending going on, we should have tightened up our monetary policy and that could have unwound the situation more safely. So I guess then this gets into the issue of what we should have been doing with our monetary policy. The prevailing approach in the United States was to watch for inflation. Does this mean Daniel is coming down firmly on the side of saying that monetary policy should be set to avoid asset bubbles and that ‘Greenspanism’ is the real culprit here?

50

Daniel 10.17.08 at 10:08 pm

I literally don’t know (part of the luxury of the “don’t write about the crisis” self-denying ordinance is that I can maintain a state of contradictory ideas in my own head about this, which is a big part of why I’m maintaining it). At the end of the day, this is all about bidder’s curse- although no particular person had to be in the top end of the distribution of optimism with regard to American lending practices, there had to be a top end of that distribution, and the general monetary climate (which as I say, nobody really understands, except Bob Dylan, and he’s not tellin’) ensured that it was that end of the distribution that was economically relevant, rather than the median.

51

Daniel 10.17.08 at 10:13 pm

Wisest eight words on the crisis that have been written

thanks, Lemuel, but I actually think that “the banking system intermediates the current account deficit” beats them as an 8-word summary, and in general recommend John Hempton’s blog.

52

Martin James 10.17.08 at 10:15 pm

You could have just posted “Shit happens.”

The bankers stupidity is not the cause of the collapse of the bubble and of the defaults, but it is the bankers stupidity that the bankers they took the risk they did on these loans.

Furthermore, why isn’t it stupid for the banking system to be more than the intermediary? Wasn’t the whole idea of asset-backed securities for banking intermediaries not to take default risk? Why is a fractional reserve banking system with government insurance not now obsolete and therefore stupid?

53

Bloix 10.17.08 at 10:18 pm

J Thomas (#37) says, “If we didn’t have this particular housing bubble, would we still have the current account deficit? I see no reason why not.”

But I see a reason why not. The housing bubble was premised on the obviously absurd belief that housing price increases could continue to outstrip wage increases forever. But several years ago, we reached the point that incomes, which have been stagnating for a decade, could not support the housing prices. And if housing prices had levelled off or fallen then, Americans would immediately have felt poorer — both because homeowners would have seen their net worth decline, and because people engaged in construction, real estate, mortgage banking, etc. would have lost their jobs. We would have slowed our consumption of imported goods, from SUV’s to Canadian lumber to big screen TV’s, and the current account deficit would have been reduced. And it’s likely that the dollar would have fallen sooner than it did, and exports would have increased earlier, reducing the deficit further. But instead, illusions were deployed to put people in homes that they could not possibly afford and the bubble was allowed to inflate.

54

Daniel 10.17.08 at 10:22 pm

The housing bubble was premised on the obviously absurd belief that housing price increases could continue to outstrip wage increases forever

no it wasn’t. My analysis of the housing boom (I would agree that there were localised bubbles, but as I say above, the majority of the growth in house prices was attributable to the reduction in bond yields) would be that it was the necessary consequence of a step-change downward in the yields of seemingly matched financial claims like long-dated TIPS. If you look at a load of rental yield time series versus government bonds, you don’t reach this conclusion.

55

ScentOfViolets 10.17.08 at 10:22 pm

It strikes me that Daniel has sort of defined any problems like this as being the governments fault. As well as making this an if-and-only-if by saying that business cannot cause problems like this. Uh, I’m not buying that one.

If I’m mistaken in my interpretation, I’d be happy to see Daniel give a counter-example.

56

Daniel 10.17.08 at 10:25 pm

It strikes me that Daniel has sort of defined any problems like this as being the governments fault.

no, not at all; see #48. I think (and was planning to say in the original post) that problems like this are (to borrow Carl Oglesby’s description of the relationship between conspiracy theories and American politics) the normal result of the normal operation of capitalist economies by normal means.

57

Tom 10.17.08 at 10:29 pm

I know a few derivatives traders who flogged what in their words was “a crock of shit” and were honest enough to say “we’ve sort of known it’s been crock of shit for quite a while now, but our job is/was to make hay”. This doesn’t make them stupid, but as individuals it probably makes them greedy, venal and short-sighted.

Talking in macro terms is all well and good, but it doesn’t hide the facts that at the individual level, bankers have very often behaved in a despicable fashion. Individuals are free to make choices and one doesn’t have to act like a greedy twat, just because there’s a current account deficit to intermediate. The sum of this shitty behaviour HAS to be partly responsbile for creating the bloated and ruined financial system we’ve ended up with, in which no one is sure about risk and trust no longer exists. You can’t blame it all on macro factors.

58

Tom 10.17.08 at 10:31 pm

“It strikes me that Daniel has sort of defined any problems like this as being the governments fault.”

Last week’s Economist tried a similar trick. Every article on the crisis focussed on goverments, what they had failed to do and what they should now be doing. It was a craven cop out, that left me wondering why I bother subscribing.

59

Daniel 10.17.08 at 10:34 pm

Talking in macro terms is all well and good, but it doesn’t hide the facts that at the individual level, bankers have very often behaved in a despicable fashion

vice versa.

(less facetiously – you’re not going to trap me into talking about the current crisis as easily as that!)

60

Daniel 10.17.08 at 10:36 pm

Every article on the crisis focussed on goverments, what they had failed to do and what they should now be doing. It was a craven cop out, that left me wondering why I bother subscribing

seriously Tom, if it is only because of last week’s Economist that you realised that … well let’s just agree that you’re presumably considering the Gordian solution to the question of “it left me wondering why I bother subscribing” and IMO it’s the right one.

61

Tom 10.17.08 at 10:38 pm

I’m not sure I was laying a trap, but if you’re going to try and define the causes of the crisis, which you have done, it’s a little half baked to ignore systemic institutional and individual failings.

62

Martin James 10.17.08 at 10:48 pm

The US has had large current account deficits before but it hasn’t always been the bankers that came off looking stupid.

63

novakant 10.17.08 at 10:52 pm

I know a few derivatives traders who flogged what in their words was “a crock of shit” and were honest enough to say “we’ve sort of known it’s been crock of shit for quite a while now, but our job is/was to make hay”. This doesn’t make them stupid, but as individuals it probably makes them greedy, venal and short-sighted.

Talking in macro terms is all well and good, but it doesn’t hide the facts that at the individual level, bankers have very often behaved in a despicable fashion.

Agreed – on that note here are the remarkably lucid British comedians Bird and Fortune.

64

LFC 10.17.08 at 10:53 pm

This may be a non-economist’s dumb question, but I’ll ask it anyway.
The post says, under point 3: “if you have a current account deficit, then domestic consumption exceeds domestic saving.”
Why is this necessarily true? At least in theory, why couldn’t a country import more than it exports and also have a relatively high savings rate? The statement seems to assume that a high volume of imports relative to exports means a high volume of overall consumption relative to saving; this indeed is (or was until very recently) the situation in the U.S., but I don’t see why the equation must always hold.

65

Miracle Max 10.17.08 at 10:53 pm

(MM) Suppose the savings glut was in the U.S. and somebody else had the trade deficit.

(DD) I’m gonna follow my own advice on “how to debate Milton Friedman” here and thus my response will be “no, don’t suppose that”. It is not a random coincidence that this crisis happened in a capitalist system rather than a socialist one. It’s a property of capitalist economic systems that they’re vulnerable to crises.
***********************************************

Maybe I should be honored at being compared to MF, or maybe not. But my point was that your argument seems to hinge on an imbalance in savings across countries — the huge U.S. trade deficit — and I wonder why spreading savings around some other way, say perfectly balanced trade everywhere with the same aggregate global savings, couldn’t have yielded the same result. Doubtless I am making some ignorant error in macro-trade accounting, but it is not my regular job. Or maybe I am not.

66

ScentOfViolets 10.17.08 at 10:55 pm

I’m not following you with your #48. Could you please describe, in detail, where something like what is happening right now is the fault of business and business practices, but not the fault of ‘government interference’.

67

Daniel 10.17.08 at 10:58 pm

Tom – I meant #59 facetiously but it’s also a serious point – my basic response to your #57 is “Talking about bankers who have very often behaved in a despicable fashion is all very well and good, but it doesn’t hide the facts that the real reasons for this crisis lie at the macro level”. I probably should have said that more clearly but couldn’t resist the joke, sorry.

68

Daniel 10.17.08 at 11:02 pm

Could you please describe, in detail, where something like what is happening right now is the fault of business and business practices, but not the fault of ‘government interference’.

I don’t really recognise the sharp distinction you want to make here SoV. In the case of “what is happening right now” (by which I assume you mean the US subprime mortgage market), then any individual bad loan is the fault of the person who underwrote it, but the condition of the market as a whole is a result of the macroeconomic facts which stretch back to (by some accounts) such abstruse things as the Chinese government’s one-child policy. We’re looking at different levels of causation here.

(PS: I’ve just realised you might be referring to the current American controversy over whether the anti-redlining legislation in the USA might have been part of the cause of the crisis; I am happy to confirm that one conclusion of my analysis above is that it couldn’t possibly have been).

69

Daniel 10.17.08 at 11:11 pm

But my point was that your argument seems to hinge on an imbalance in savings across countries—the huge U.S. trade deficit—and I wonder why spreading savings around some other way, say perfectly balanced trade everywhere with the same aggregate global savings, couldn’t have yielded the same result

happy to confirm I don’t understand this either.

70

ScentOfViolets 10.17.08 at 11:23 pm

Daniel, let me try again: could you give me a hypothetical market melt-down, or an economic slow-down or recession that was solely the fault of business/private enterprise/what have you, and not the fault of government?

Because right now, it looks to me as if you’re more than happy to name government actions as the root cause of our current financial problems.

I don’t think that what I have written is hard to understand, and I don’t think my request an unreasonable one.

71

MarkUp 10.17.08 at 11:24 pm

The broad fault lays with the two points of commonality; people and money. Individually who carries the larger burden of blame the home appraiser who never found a home worth less than what was offered? The realtor talked up how good a deal it was, a real steal; little did they know… or did they? The lender who was only too happy to pass out money. Those further up who facilitated the flow and repackaging and sales of the sales… on and on it goes, everyone happily getting their cut. Those folks, like Joe the Plumber are us. Well sort of.

It’s gone down hill ever since the Schmiedeleut’s all got phones.

72

Rich Puchalsky 10.17.08 at 11:38 pm

So it’s not anyone’s fault except the system’s, and system, while regrettably prone to instability, is the best one that we know how to make and this re-regulation business wouldn’t have stopped the problem. Amazing! I never could have predicted that that particular answer would just happen to turn out to be the one that Daniel didn’t write about this crisis.

73

John Emerson 10.18.08 at 12:06 am

You can say what you want about structural problems, but in my opinion none of this would have happened if we’d had a lot fewer people lighting candles and a lot more people cursing the darkness. Optimism isn’t always bad, but it does a lot more harm than people are willing to admit.

74

Cranky Observer 10.18.08 at 12:43 am

I wouldn’t exactly call the bankers “stupid”: the top dogs are now sitting in their mansions, bitterly bitterly unemployed, with $100 million in t-bills (or perhaps their German equivalent) in their accounts. As long as the US/European economy doesn’t totally collapse they can ride out any recession/depression in comfort and style then start again on the upswing. Even the midlevel guys should have $2-$3 million stashed away if they have any brainpower at all. It is only we peons who will pay the price. So who’s stupid?

Cranky

75

J Thomas 10.18.08 at 12:52 am

J Thomas (#37) says, “If we didn’t have this particular housing bubble, would we still have the current account deficit? I see no reason why not.”

Bloix (#53) says, But I see a reason why not. …. But several years ago, we reached the point that incomes, which have been stagnating for a decade, could not support the housing prices. And if housing prices had levelled off or fallen then, Americans would immediately have felt poorer—both because homeowners would have seen their net worth decline, and because people engaged in construction, real estate, mortgage banking, etc. would have lost their jobs. We would have slowed our consumption of imported goods, from SUV’s to Canadian lumber to big screen TV’s, and the current account deficit would have been reduced.

So, if the Bush administration had done the right thing, we would have had a great big recession in, say, 2004. Americans would have felt poorer, they would have had significantly less credit and a lot of them would be out of work. And that would have had the good effects we needed.

Can you imagine reasons why the Bush administration might have wanted to avoid that result?

76

Robert Waldmann 10.18.08 at 3:00 am

OK its not the stupid bankers being stupid it just had to happen “at least, … exists in Anglosphere (plus Spain, for some reason) markets, where housing behaves like an investment good, due to the existence of a large enough privately owned rental housing sector, plus easily available mortgage finance.” For what reason is Spain like the Anglosphere ? Been to Spain lately ? Go there and look at the names of banks on branch offices. I would guess many are very familiar.

When I was last in Spain, a Spanish economist told me how wonderful it is that the Spanish government had stopped protecting the greedy thieving Spanish banks from competition by the wonderful English banks which don’t charge you absurd fees for everything and have a low spread between the mortgage and deposit rates.

Get it. There must must must be a housing bubble in countries with banks with headquarters in the US or the UK, because said bankers are generous with the mortgages. Some might say that a crucial cause of the automatic link between interest rates and house prices is stupid stupid bankers who sign mortgage contracts that only make sense if one is not in the middle of a housing bubble.

Also I note that I didn’t note the acronym CDS in your post. It has nothing to do with monetary policy or housing prices. Has a good bit to do with Paulson and Bernanke suddenly deciding that something huge had to be done. Now technically AIG was brought down by stupid stupid ex bankers now working for a stupid stupid stupid insurance company, but it sure wasn’t brought down by the US current account deficit or low interest rates. What if the problem is mostly credit default swaps and not house prices, mortgage contracts, or the particular horrors of mortgage backed securities ? You’re sure it isn’t ? Why not ?

77

bi -- IJI 10.18.08 at 3:12 am

ScentOfViolets:

Could you give a hypothetical large-scale famine that was solely the fault of business/private enterprise/what have you, and not the fault of government?

This is your answer.

 – bi, International Journal of Inactivism

78

Doctor Science 10.18.08 at 4:04 am

It would be nice if those of you who are arguing about macro versus micro effects would take a moment to address the non-economists here, who are foursquare for the “no-one who got personally rich — which is all the high-up bankers — was stupid” approach.

The bankers (et al) socialized risk and privatized returns because they *could*. Why did anyone expect otherwise? I know of no evidence that the bankers — including the CxOs of all the major financial institutions — acted to do anything other than maximizing their *personal* gain, and they succeeded. The FIs were not “institutions”, they were collections of self-serving individuals, and the individuals at the top served themselves extremely well. That is hardly stupid behavior on their part.

Is a plutocratic culture a macro failure or micro? And do the plutocrats even see it as a failure?

79

Dan Simon 10.18.08 at 5:23 am

If we lived in a world in which these far-sighted paragons of the imagination ran the banks, rather than the stupid stupids we have now, we would have smarted our way into constant recession

Isn’t there some middle ground here? Suppose, for instance, that Alan Greenspan hadn’t intervened by, in your previous words, “screwing interest rates down to the floor” every single bleeping time over the past twenty years that the market fluttered a bit, and the economy started to sputter a bit. Mightn’t a few bankers have responded by being just a teeny weeny bit more cautious about pouring money into dubious MBSs this time, given that the Fed was not absolutely, one hundred percent certain, based on past experience, to ride in and save their butts once it all went south?

Just askin’…

80

novakant 10.18.08 at 7:59 am

That is hardly stupid behavior on their part.

See, attacking the notion that bankers were stupid across the board is setting up a strawman designed to deflect from a discussion about business ethics. Some were stupid, some greedy, some were both, some neither, some got rich, some didn’t. To really discuss this in a serious manner, one would have to analyze the key players and what they did in detail.

The bankers (et al) socialized risk and privatized returns because they could. Why did anyone expect otherwise?

Because finance, business and law aren’t solely about what you can get away with, and the people working in those fields are not all greedy and ruthless by default, nor do they have to be to succeed.

81

Timon 10.18.08 at 8:06 am

It is remarkable how unserious economics is, that a computer programmer can make an incontrovertible point (@10), ie:

We concede that macroeconomic policy led to a bubble; is that the same as saying that the bubble led to the collapse of the financial system?

To which the learned economist replies: nothing, or maybe, Did I not already explain how the latest data from this crisis confirms what I knew all along, in light of my Theory?. This is the difference between economics and serious fields — never in the history of dental surgery has a novice suggested a better way of operating on a patient, but inevitably in the comment thread of an econ blog you will find greater insights from observers than those of the lifer.

82

ejh 10.18.08 at 9:02 am

Personally, I’m more inclined to believe that Keynes/Marx was right, and that the actual cause is “the tendency of complicated and unstable systems to have complicated and unstable dynamics”.

Well yeah, but that doesn’t make it unreasonable to blame those who were the biggest proponents of that system, those who were least inclined to agree that it was unstable, those who did most to ensure it was unstable and those who benefitted most from that instability while receiving the most consideration when it all went wrong?

Which is not a policy, of course, but on the level of policy surely it should be addressed by putting some serious clamps on these people’s power to screw things up, and that is so regardless of the fact that of course there are other causes to the crisis? And returning, perhaps, to Marx, isn’t it a problem that everything that could seriously be done both in that line, and in the line of preventing future house price bubbles, would be opposed by almost everybody with enough clout to prevent the policy happening?

So I’m not pretending that this consists of any more than sitting in a bar saying “fuck the bankers”, but I think this is, possibly, reasonable on an intellectual as well as an emotional level.

83

Charlie Whitaker 10.18.08 at 9:37 am

I think it’s worth adding that there are arguments which connect blame and agency: if we blame someone, it’s because we believe that person has some agency (free will). We tend not to blame rocks, or hold them responsible. So if you take blame out of the picture, you perhaps risk taking free will out of the picture at the same time.

Anyway, count me in with those who are saying that if there’s any blaming to be done, it’s on account of greed, not on account of stupidity. There’s clearly no shortage of people wanting a payout in the short term, and a big payout, so they never have to work again.

84

warren mosler 10.18.08 at 12:59 pm

THANKS FOR THE MENTION!

COMMENTS BELOW:

It appears to be a commonplace gaining ground every day that the main reason we have a credit crisis (about which I am not writing; this is an essay in recent monetary history) is that bankers created it, and specifically that they created it because they are stupid.

LENDER FRAUD DROVE THE LAST HOUSING PUSH. FRAUDULENT APPLICATIONS WITH FRAUDULENT APPRAISERS AND FRAUDULENT INCOME STATEMENTS. PARTLY BECAUSE INCENTIVES WERE IN THE WRONG PLACE- BROKERS AND LOAN OFFICERS PAID ON VOLUME, ETC.

NicDon’t we need a blue-ribbon commission to make sure that such stupids never have the chance to do so much damage again? YES, REGULATION AND LIFE IN GENERAL IS A WORK IN PROGRESS. LENDING HAS ALREADY BEEN MODIFIED
AND SUBSEQUENT LOANS ARE DOING REASONABLY WELL.

Remember yer Keynes. Macroeconomic events have macroeconomic explanations, not micro ones. Let us consider the following statements:

YES, THE MACRO PROBLEM IS THE FEDERAL DEFICIT IS TOO SMALL GIVEN CURRENT ‘SAVING DESIRES’ (GOING INTO DEBT LESS IS SAVING MORE FOR PURPOSES OF THIS ANALYSIS).

THE SOLUTION IS QUITE SIMPLE- A LARGER FEDERAL DEFICIT.

I SUGGEST AN IMMEDIATE PAYROLL TAX HOLIDAY- HAVE THE TSY MAKE ALL THE PAYROLL TAX CONTRIBUTIONS FOR US (SOC SEC AND MEDICARE) AT LEAST UNTIL THE ECONOMY RECOVERS.

THIS WOULD ALLOW WORKERS TO MAKE THEIR MTG PAYMENTS AND PAY THEIR BILLS, AS WELL AS SUPPORT AGG DEMAND IN GENERAL. IT’S ALSO A HIGHLY REGRESSIVE TAX, WHICH MATTERS A LOT TO MOST POLITICIANS.

THE DEFICIT WAS INCREASED SUBSTANTIALLY IN 03 WITH A FISCAL PACKAGE THAT RESULTED IN ABOUT AN 8% OF GDP ANNUALIZED DEFICIT IN THE THIRD QUARTER OF 03, SPURRING OUTPUT AND EMPLOYMENT.

IT ALSO DROVE THE HOUSING EXPANSION- NOT INTEREST RATES. THIS WAS HELPED BY THE ABOVE DESCRIBED LENDER FRAUD.

HOWEVER, BY 2006 THE ‘AUTOMATIC STABILIZERS’ DID THEIR WORK AND THE DEFICIT WAS BACK DOWN TO TOO LOW LEVELS. AT THE SAME TIME THE LENDER FRAUD WAS DISCOVERED AND THOSE LOANS STOPPED, ALSO SUBTRACTING FROM DEMAND. HOWEVER, EXPORTS PICKED UP THE SLACK AND INCREASING GOVT SPENDING HELPED AS WELL.

1) This was a policy-caused bubble. As I wrote last week, I noted in 2002 that the Federal Reserve, among others, was attempting to engineer a housing bubble in order to soften the landing post the internet bubble.
YES, BUT I DON’T GIVE THEM THE CREDIT/BLAME. IN FACT, MTG RATES DIDN’T COME DOWN ALL THAT MUCH. YES, THERE WERE LOW TEASER RATES, BUT THOSE HAPPEN ANYWAY, AND THE BORROWER IS REQUIRED TO QUALIFY AT THE HIGHER, 30 YEAR RATE TO GET A TEASER RATE. THE PROBLEM WAS FRAUDULENT INCOME STATEMENTS AND APPRAISELS

This was not, I perhaps should have emphasised, a brilliant piece of iconoclastic contrarianism on my part. The jokes were quite original, and the Beanie Babies idea was all my own, but that actual analysis was totally commonplace at the time; I can’t remember if the Fed actually said this was what it was doing and suspect it didn’t, but it was generally and tacitly understood throughout the economic policy community that rising real estate prices were a goal of policy. Oliver Kamm remembers it this way too[1].

2) It was not even really a bubble, in much of the world. As Brad DeLong was writing in 2005 (as I say, this one really has to fall into the category of “mistakes we knew we were making”), there’s a more or less direct linkage between interest rates and house prices, via quasi-arbitrage between the rental yield and the bond yield, combined with downward-sticky nominal rents[2]. In some parts of the world, the rental yield/bond yield spread got way out of equilibrium, but not in all of them; in Ireland, for example, house prices simply tracked the local government bond market all the way up, and then back down again.

HOUSING TRACKS THE FISCAL CYCLES AS WELL. AND THE FED USUALLY SETS RATES BASED ON THE FISCAL CYCLES.

From these two things, I conclude that a house price bubble was more or less unavoidable. YES, BUT FOR FISCAL REASONS. AND WITH FISCAL SUPPORT HOUSING COULD HAVE BEEN SUPPORTED FROM THE ‘BOTTOM UP’ BY SUSTAINING INCOMES.

3) The other element of the crisis was “an excessive dependence on wholesale funding”. Again, at the level of the whole system, it could not have been otherwise. It can’t be put better than in John Hempton’s perfect phrase – “The banking system intermediates the current account deficit”.

THE CAUSATION IS ‘LOANS CREATE DEPOSITS’ WHICH MEANS ALL LENDING IS ‘SELF FUNDED’ -NOTE THE RELATIVELY SMALL AMOUNTS OF NET LENDING BY THE FED AT ANY GIVEN TIME. THE PROBLEM CAN BE THAT ONE BANK GETS EXCESS DEPOSITS AND ANOTHER IS SHORT, AND THEY WON’T LEND TO EACH OTHER. THAT’S WHERE THE FED IS DESIGNED TO COME IN, THOUGH OVER THE LAST YEAR THE FED HAS SHOWN A LACK OF UNDERSTANDING OF IT’S OWN MONETARY OPERATIONS AS WELL

Which is to say, that if you have a current account deficit, then domestic consumption exceeds domestic saving.

YES, BY IDENTITY, WHICH I PREFER TO STATE:

GOV DEFICIT = DOMESTIC + NON RESIDENT SAVINGS OF FINANCIAL ASSETS.

Unless one’s prepared to assume unlikely things about the financial system, this means that the outstanding lending of the domestic banking system will grow faster than the outstanding deposits of the domestic banking system.

NO, AGAIN, LOANS CREATE DEPOSITS. WHAT HAPPENS IS DOMESTIC CREDIT EXPANSION FUNDS FOREIGN SAVINGS OF DOLLAR FINANCIAL ASSETS. THAT IS, THEY SELL US STUFF IN ORDER TO ACCUMULATE DOLLAR FINANCIAL ASSETS. WE BUY IT VIA DOMESTIC CREDIT EXPANSION.

If this continues for a long time, and in size, then the loans will exceed deposits, and this means that the domestic banking system, as a whole, will be reliant on wholesale market funding.

NO, AS ABOVE. WHOLESALE FUNDING COMES IN WHERE SOME BANKS HAVE EXCESS DEPOSITS AND SOME DON’T.

4) The reasons why the Anglosphere countries ran such large current account deficits over the last ten years are, frankly, not very well understood.
QUITE SIMPLY BECAUSE NON RESIDENTS- MAINLY FOREIGN CENTRAL BANKS AND MONETARY AUTHORITIES- HAVE DECIDED TO ACCUMULATE DOLLAR FINANCIAL ASSETS. THEREFORE MARKET FORCES ACT SUCH THAT THEY NET SELL STUFF HERE TO GET THOSE DOLLAR ASSETS.

YES, THEY SUBSEQUENTLY REARRANGE THOSE FINANCIAL ASSETS THAT START OUT AS BANK BALANCES, SWAPING THEM FOR OTHER DOLLAR FINANCIAL ASSETS.

NOTE THAT WHEN PAULSON SUCCESSFULLY TALKED FOREIGN CB’S OUT OF BUYING $ TO WEAKEN THEIR CURRENCIES THE DOLLAR STARTED FALLING HARD.

AND NOW, WITH OIL PRICES DOWN 50%, DOLLARS ARE ‘TOUGHER TO GET’ OVER SEAS AND THE $ HAS RECOVERED SOME.

There’s a variety of theories – the Ben Bernanke “global savings glut”,
WRONG

Melanie Phillips theory of “a crisis of morality and buy-it-now culture caused by Richard Dawkins” (what do you think I’m lying or something, the intentional undervaluation of Asian currencies, lots and lots of them.
WRONG

But nobody, so far, has come up with a theory under which the entire driving force of the world economy has been the stupidity of stupid bankers[3].

I’D CALL THEM NARROW MINDED…

5) It is just about theoretically possible to imagine a world in which the banking system refused to intermediate the current account deficit,
DOESN’T MATTER, AS ABOVE

and did not respond to looser monetary policy by extending loans.
MONETARY POLICY NEVER DOES ‘WORK’ AS EVEN THE FED’S ECONOMETRICS SHOW.

But let’s get this straight – do you really want to go there? What we would be talking about here would be a world in which monetary policy did not work at all.
WELCOME TO THE REAL WORLD! IT’S ALL ABOUT FISCAL POLICY, INCLUDING ‘QUANTITY THEORY.’

If we lived in a world in which these far-sighted paragons of the imagination ran the banks, rather than the stupid stupids we have now, we would have smarted our way into constant recession[5].

WHEN FISCAL GETS TOO TIGHT, GOVT REVENUES FALL OFF DUE TO THE SLOWDOWN, AND TRANSFER PAYMENTS RISE DUE TO UNEMPLOYMENT ETC.
THIS MAKES THE DEFICIT GO UP UNTIL IT’S HIGH ENOUGH TO KICK OFF THE NEXT CYCLE. REMEMBER THE 90′S??? THE 5% OF GDP DEFICITS OF THE EARLY 90′S KICKED OFF THE BOOM OF THE LATE 90′S, AND THE SURPLUSES DUE TO THE SAME ‘AUTOMATIC STABILIZERS/COUNTER CYCLICAL TAX POLICY’ DRAINED THAT MUCH NOMINAL WEALTH AND CAUSED THE SUBSEQUENT CRASH.

THE ONLY 6 US DEPRESSIONS WERE CAUSED BY THE FIRST 6 BUDGET SURPLUSES. THE 7TH SURPLUS IS CRUSHING US NOW, BUT, UNLIKE BEFORE, WE ARE NOT ON THE GOLD STANDARD AND CAN RUN DEFICITS AS LARGE AS NEEDED. THAT’S WHY THERE HAVEN’T BEEN ANY DEPRESSIONS SINCE THE 30′S AND THE RECESSIONS HAVE BEEN RELATIVELY MILD.

Look, my basic point here is not to exonerate anyone or vice versa (apart from anything, that would stray into writing about the crisis itself, which I’m still not going to do). I am sure that at the levels of individual institutions, stupid things were done and irresponsible risks were taken. But likewise, I would also dare say that during the Great Depression, a lot of the workers who were made redundant were probably a little bit lazier and not quite as skilled or conscientious as the ones who kept their jobs. But if you were going to have your main comment about the Great Depression that it was the time when lots of lazy shirkers got the sackings they deserved, then I think everyone[6] would agree that you’d kind of missed the big picture.
AGREED! IT WAS A CLASSIC GOLD STANDARD COLLAPSE OF AGG DEMAND, WITH EVEN THE TSY UNABLE TO SUFFICIENTLY DEFICIT SPEND WITHOUT RISKING THE GOLD RESERVES.

The analysis that blames it on stupid bankers, is of a piece with the kind of analysis that regards the 1930s as being the decade when the working class of the world took it upon itself to have a great big shirk.

[1] I might actually be moved to argue that the internet bubble itself was at least partly a result of a soft-money policy aimed at smoothing the landing post the Asia/Russia crisis of 1998. There’s a real sense in which we’re still trying to complete the 1991-1995 monetary policy cycle, having had it interrupted three times already for the Mexico, Asia and dot com bailouts. Note also that Alan Greenspan’s “irrational exuberance” speech was made in 1996!

[2] Or at least, this linkage exists in Anglosphere (plus Spain, for some reason) markets, where housing behaves like an investment good, due to the existence of a large enough privately owned rental housing sector, plus easily available mortgage finance. In markets where housing behaves more like a consumption good it doesn’t. Commercial real estate behaves like this everywhere.

[3] I can sort of see how you might make a model of the economy which closed so that the exogenous factor was the desire of bank executives to get big bonuses and everything else followed from that. But it would be a very weird bass-ackwards post-Keynesian model, and I really don’t think anyone actually believes that this would be a good description of the world. Maybe I missed the memo and we all believe in endogenous money these days, but I have scoured the Nobel Laureates list[4] up and down and Warren Mosler’s name is not on it, so I conclude otherwise.

THANKS, AFTER THIS MONTH I COULD USE THE MONEY!!!

[4] Can you hear that sound? Just faintly in the distance? It’s the sound of the tiniest violin in the world being played by someone who doesn’t care that it’s actually the Sveriges Riksbank Prize in Honour Of Alfred Nobel.

[5] This might actually be the kind of economy that Taleb would prefer, as it would afford limitless opportunities to sit at home, stroke our beards and sagely note that nobody really knew the nature of the risks one takes by getting out of bed. In a very dignified, aesthetic way.

[6] Except Nobel Laureate[7] Edward Prescott, who actually does believe that the Great Depression was basically a decade-long shirk.

85

J Thomas 10.18.08 at 1:14 pm

How much choice is there?

If it’s true that making the wrong choice means you lose the position and the opportunity to choose, then sacrificing your career gives a limited result.

I hear about Marines doing that. Embassy guards, or guards for a charismatic leader, and they follow their orders about visitors. Senior Congressmen etc get insulted and the Marines get punished and new Marines step in to do the same thing. But then, Marines are selected and trained to sacrifice their lives for limited goals.

I even sometimes hear about Marine generals sacrificing their careers to do the right thing. I hear about that occasionally for Army generals, twice for Admirals, never yet for air force.

It’s a lot easier to sacrifice your career or your life when you believe the guy behind you will also do the right thing, when your sacrifice might eventually mean that the right prevails. When you throw away years of work for nothing — when you know the next guy will give in and do just exactly what you’re refusing to do — then it’s harder.

The guys who were actually approving the loans and misjudging the credit ratings etc — those guys were in a competition where the losers lost their jobs. There might have been a fair number of people who saw that trouble was coming and chose to switch careers, but they didn’t have much effect on the problem. There were plenty more to take their places.

Their bosses would be harder to replace. They were competing too, and could be replaced with new guys with less experience who’d be eager for promotion. They were also farther from the action and might not know. Say one of them does spot checks and finds some bad loans, loans that would be sold to customers. The short-run effect is the statistics look good. The long-run effect is eventually some customers might get mad at them. And if their customers resell the bad stuff, the result might be more that the customers’ customers get mad at them.

The farther up the line you go, the more it diffuses. At the higher levels you have guys who’re supposed to be planning strategy. But if they utterly fail to do so, who would know until it’s too late? Maybe they’ll luck out. This happens in the military too. If an officer does something that doesn’t fit doctrine and fails, he’s punished and his friends are embarrassed to be his friends. But if he is responsible for the fall of the Maginot Line and the capture of Paris, then he at least can suicide to avoid the embarrassment.

At the highest level, how many first-term Presidents would agree to start a recession for the long-run good of the country? How many second-term Presidents? The best time to do that is right after taking office, when you can blame it on the previous guy and hope it’s over long before your next election. Hope it’s over before the mid-term elections too.

So OK, we set up a system that selects people according to how well they get short-run results. Then we want them to sacrifice their own interests for long-term concerns after we chose them for something else. It can happen but it isn’t the way to bet.

Like the song goes,

Love may be strong but a habit is stronger,
as I learned when I loved by the way I behaved.

86

Nimm 10.18.08 at 1:15 pm

Daniel, the problem with your post re: Taleb’s theories is that it seems to mix apples and oranges; namely, confusing the macroeconomic explanations ( bubbles and how they are formed) with Taleb’s point that bankers specifically are in trouble because their risk management models were predicated on such events not happening.

Speculative bubbles don’t always lead to financial crises: after all, the tech bubble formed and passed without causing great distress on the Wall Street. The difference, of course, is that tech stocks weren’t mostly bought using leverage, based on models that said double digit declines couldn’t happen, and then insured with credit default swaps from people (Bear, AIG) using equally flawed risk models.

87

dsquared 10.18.08 at 2:24 pm

Speculative bubbles don’t always lead to financial crises: after all, the tech bubble formed and passed without causing great distress on the Wall Street

but this was more or less entirely because of the Greenspan response to the tech bubble, which created the real estate bubble. There was plenty of potential for a crisis in the tech crash (which was also a global telecoms crash, and there was plenty of leverage in Enron, WorldCom and Global Crossing).

The products here matter a lot less than the talkng heads think they do – what we are looking at here is a real estate crisis, and you can have them with simple bank lending, ask the nearest Japanese person. The problem is the problem itself, not particular features of how it’s played out in this particular crisis. As I say, it’s the normal result of the normal operation of the capitalist system working normally.

Taleb’s point about risk models is really beginning to irritate me. The risk model of a zebra crossing assumes that drivers aren’t going to plough straight through it. It’s just not true that bankers thought that there couldn’t be a real estate crisis; they assessed the risks and made the loans accordingly. Some people got their risk assessment wrong, but the optimal frequency of crises is not zero. More or less everything (except staying in bed, rereading your copy of Cavafy and eating unleavened bread) that human beings do, requires some baseline assumptions about how the world’s going to go on working, and the nature of the world is that sometimes these assumptions are going to be wrong. I have a lot of sympathy with Eric Falkenstein’s view that there is not much more to Taleb’s theory of the world than the bumper sticker “Shit Happens”.

(actually that’s unfair – there’s quite a lot of good stuff in some of Taleb’s books and I think he does make some important points. But he really has been doing himself no favours with some of the interviews he’s done recently).

88

MarkUp 10.18.08 at 2:59 pm

”that human beings do, requires some baseline assumptions about how the world’s going to go on working, and the nature of the world is that sometimes these assumptions are going to be wrong.”

The one area that hasn’t been “wrong” is the to date well proven assumption that ‘justice’ is sensitive to monetary stimulation and in financial/white collar/corporate crime risk and punishment are mo well distributed than the potential rewards.

89

Mike Alexander 10.18.08 at 3:15 pm

I agree that interest rate cuts helped created the housing bubble. I would add the 2003 capital gains tax cuts that provided the coup de gras. A tax policy intended to encourage capital gains (i.e. increase asset prices) when assets are already overvalued, will necessarily produce a bubble if the policy works. The same thing happened in 1997. Once the tax cut was passed, a bubble was in the works, or so I thought at the time and stayed fully invested until 1999. And it happened just as I expected.

The stock and housing bubbles were not bugs of tax and monetary policy–they were features. The goal of conservative economic policy in the US has been to restore as many of the features of the pre-New Deal economy as feasible. For example, taxes on the wealthy were lowered and the level of income inequality has risen to levels similar to those in the 1920′s. AFDC was rolled back, but the attempt to fatally weaken Social Security failed.

The value of output demanded is ultimately tied to the ability of the broad population to pay for it, that is their income. The value of an economies assets is tied to the income of the broad population.

Over the past 30 years income inequality has increased; the income of the rich ( i.e. the investor class) has risen wrt to the income of the broad population. That is, investor income has risen wrt to the value of the economy’s assets. Since the demand for assets ultimately depends on ability of investors to pay for assets (investor income) asset demand has risen wrt to the value of the assets. If asset demand rises with respect to asset value (i.e. supply) then the price of assets must rise. A secular rising trend in asset prices must necessarily become an asset bubble at some point.

Thus, asset bubbles are a necessary feature of economic policies that encourage accumulation of wealth at rates faster than broad income growth. Before 1930, high levels of income inequality, asset bubbles and financial panics were a regular feature of economic life. In the early 1930′s taxes were raised to very high levels and held there for fifty years. Income inequality fell. The result was no bubbles or financial panics over the 1934-1980 period. Since 1980 as the investor class got richer wrt the broad population, the ability of the economy to “blow bubbles” has increased.

Since policymakers wish to avoid the consequences of bubbles that have acted to try to prevent full deflation of the bubbles, meaning that bubbles can quickly reappear. If the current interventions are successful and taxes on the rich not raised substantially, I believe we will see another crisis within a decade of this one.

Regulations won’t work, because in a bubble (financial mania), investors will always find a way around the regulation in order to participate. And as long as income inequality remains high, there will be bubbles.

90

Bunbury 10.18.08 at 3:46 pm

Adopting Brad Delong’s proposed definition of Greenspanism, roughly keep the engine running at all costs, the central bank can sort out any problems it might cause, you can say it was just putting off the inevitable or you can ask why it worked before but didn’t this time.
Even accepting the first point I think asking what went wrong this time is still interesting and the banks don’t come out of it very well. They pushed for relaxation of capital requirements, abolition of dividing lines between different types of business and toleration of businesses that were too big to fail and too complicated to understand form the outside. Whether that counts as stupid or not I’m not sure but it seems pretty damaging. If the US banking system had the structure it did leading up to the savings and loan crisis, wouldn’t we just have had another savings and loan crisis?

Even within institutions the investment banks seem to have performed a medley of greatest hits from the annals of banking disaster. There’s Barings (We don’t know anything about this lending lark but it seems to be making lots of money so lets not worry thhat our balance sheet is en times the size it used to be), there’s LTCM (We don’t need capital, we have these excellent models) and there’s split cap trusts (The market seems slow to understand the true value of this tranche but maybe if we stuff it in this other one over here no-one will notice. If that doesn’t work we’ll keep it ourselves). However since banks get into trouble so often perhaps we should just accept that regular screwups are to be expected and that giving a banks cheap money is like feeding a Mogwai after midnight.

91

MarkUp 10.18.08 at 3:54 pm

”Regulations won’t work, because in a bubble (financial mania), investors will always find a way around the regulation in order to participate. And as long as income inequality remains high, there will be bubbles.”

True so long as the perceived reward far exceeds the risk and [/ of likely] punishment; like speeding in Montana, or most states really, since most all have a built in tolerance for 5-9% over the limit. Add a detector and the risks drop further as does driving in a herd. Moo.

92

Bunbury 10.18.08 at 4:38 pm

Point 2 only makes sense if you think that ordinary people don’t realise that a fixed payment in a low inflation environment is more onerous than in a high inflation one.

If housebuyers are paying as much as they can afford you would expect exactly the relation between house prices and interest rates noted here and also a bubble. Such behaviour might well be motivated by unrealistic expectations of future house prices. After all nobody seemed very scared by yet another year of house prices rising by percentages in the double digits.

In favour of the macro case however is a look at what a bank is supposed to do if it thinks there is a bubble. If it is the first to put on the brakes it will lose business instantly while if it does nothing there will be no immediate price to pay. Throw a significant amount of uncertainty into the mix and what’s a bank to do?

93

TheWesson 10.18.08 at 5:02 pm

I suppose one could evolve a line of thinking about this, such that bad macroeconomic conditions exert pressure that seeks out the evil / stupid, in the same way that inflating a balloon finds the holes in it.

So did macroeconomic conditions cause the crisis? Yes.

Did evil / stupid bankers cause the crisis? Yes.

Did deregulation cause the crisis? yes.

The distinction being that under some conditions of regulation controlling the evil and stupidity of bankers, there would have been some other asset bubble anyhow

94

J Thomas 10.18.08 at 5:13 pm

The distinction being that under some conditions of regulation controlling the evil and stupidity of bankers, there would have been some other asset bubble anyhow

That’s my take on it. We would have had another bubble. Or we would have had a severe recession, which could have been postponed if only we had managed an adequate bubble.

Or perhaps there was a way to invest in something really worthwhile. I figure we desperately need to invest in alternate energy. There’s the technical question whether we should do that *yet*. We could sink a lot of money into a particular alternate-energy technology and next year we get something so much better that all that early development was wasted.

But if we’re going to waste a lot of investment money, I’d rather waste it on alternate energy with the hope we get something even better, than something we don’t actually need.

95

Rich Puchalsky 10.18.08 at 5:31 pm

“As I say, it’s the normal result of the normal operation of the capitalist system working normally.”

Shorter: nothing you can do, don’t even try.

Again, very strange that this is exactly the response that I would have expected. I wonder why that keeps happening?

96

dsquared 10.18.08 at 5:40 pm

Well, Rich, if you constantly reinterpret everything you read to fit in with your preconceived idea, then you will never be surprised by anything. Happy trails.

97

virgil xenophon 10.18.08 at 5:41 pm

Some minor points. J Thomas@#45 Closing overseas military bases won’t help as much as you think, as host countries (mainly in Europe and Japan) provide financial offsets that in some cases make it cheaper to house troops in Germany than in the US.

Daniel@69 While subprime mortgages made to minorities as a result of the anti-red-lining were admittedly a small part of the bubble, the legislation itself created the atmosphere and mindset within the banking/mortgage industry that allowed the expansion of these loans into the general population. Most of the “stated income” loans actually went to otherwise creditworthy individuals who simply either wanted more house than they could afford or to speculators trying to flip the property for quick profit. It is like the case of Social Security which began as a program for the poor but morphed into a middle-class “entitlement” program. The middle class is always where the action is, because that’s where the numbers are.

98

bob mcmanus 10.18.08 at 6:17 pm

92:Good grief, Rich, of course there is lots of stuff you can do about Capitalism. Bombs, guillotines, firing squads, barricades, really big puppets, etc.

You just can’t attempt to reform Capitalism or make it work well for anybody but the bosses.

I am sure that’s what dsquared meant.

99

Tom 10.18.08 at 6:35 pm

I think part of the problem with Taleb is that other people have mis-interpreted some of what he’s trying to say. Ed Smith, supposed brain of cricket, did an interview with Taleb in The Times last week which, apart from being horribly cloying, got the concept of a Black Swan event totally wrong.

In it, Smith says “Last season, breaking my ankle was my black swan.” Which given he noted earlier that “a black swan is an event that you are unable to predict on the basis of past experience” is total and utter balls. As a sportsman he must have expected, at some point in his career, to miss some games through injury.

The fact this awful horseshit got printed does Taleb know favours at all.

100

Tom 10.18.08 at 6:36 pm

Heavens. “Does Taleb “no” favours at all.” Obviously.

101

J Thomas 10.18.08 at 6:42 pm

Closing overseas military bases won’t help as much as you think, as host countries (mainly in Europe and Japan) provide financial offsets that in some cases make it cheaper to house troops in Germany than in the US.

Virgil, it’s hard to do the accounting on this stuff. When we look at the current accounts balance for the whole economy, it isn’t just running the bases but also the money that our servicemen and their families spend wherever they are and also a host of other things.

If we were to bring the troops home and also discharge a lot of them, we could cut costs considerably and some of the savings would be current account savings too.

But it would tend to increase unemployment, it would free up lots of resources we might not immediately find uses for.

102

Roy Belmont 10.18.08 at 7:03 pm

#94-“…the legislation itself created the atmosphere and mindset within the banking/mortgage industry that allowed the expansion of these loans…”

Well of course it did. We all know how susceptible those banking/mortgage executives, and their mindsets, and their corporate atmospheres are to the pernicious influence of legislation. Especially even legislation originally conceived as helping the (unfairly) disenfranchised get a little house to live in and call their very own.
It’s important to keep accurate track of exactly where on the timeline that influence began, too.
It wasn’t until the legislation was passed right? Not until it became law, and began to seep into those corporate boardrooms with its toxic fumes of anarchy and laissez-faire etc.
Not like anybody tracked it through the House or anything, from conception. Bumping Congressman This and Senator That toward small but significantly amenable addenda.
Not like the pandemic greed that ate the American future was a pre-existing condition or anything.
Our system may have its flaws and its faults, but it does safeguard us against unethical behavior on the part of the powerful. So that didn’t happen.
Couldn’t have.
No greedheads drooling as the covers came off the chafing dishes.
Just a seductive climate of anything goes, caused created and enabled by bleeding heart liberals trying to give away to their pet miserables what should have been just as hard-earned by them as it was by the rest of us.
There were obviously some bad judgment calls. And yes, some chicanery, on the part of a few rogues. Who were not in any way typical of the industry as a whole. Who have since been banished to somewhere, and will remain in anonymous obscurity, as is only fitting.

103

Bunbury 10.18.08 at 7:27 pm

Virgil, I don’t think the banks needed much encouragement and, as you say, many of the “stated income” loans went to people not traditionally excluded from access to mortgages.

104

virgil xenophon 10.18.08 at 7:58 pm

Roy Belmont: I’m trying to decide which of two mental pictures of you that I’m forming in my head are correct; the one in which you are drooling and foaming at the mouth, or the one in which your sarcastic tongue is so firmly planted in your cheek that it would take a plastic surgeon to remove it.

105

Roy Belmont 10.18.08 at 9:09 pm

V.X.:
Try forming a third, more accurate one. Say maybe the one that watched Cynthia McKinney perfectly nail the repulsive absurdity of complaints about the integrity of ACORN’s voter registration drives, set against the bizarrely tabulated yet legitimized by the Supreme Court national elections of 2000 and 2004.
One of which if not both being essentially stolen by fraud.
You do know there’s a pretty steady drive to reconfigure the sub-prime thing(s) as essentially, precipitously, the fault of those who strove to get the Lords of the Economy and the Gods of Money to help finance house-ownership for the folks near the bottom of an already corrupt but at the time still relatively stable economy…at least in the minds and hearts of the Plumbers of Main Street.
You must know that.
Possibly you agree? That it can be traced to misguided liberal sentimentalists and the financially irresponsible objects of their pity?
That was my mental picture of you, Virgil Xenophon.
Possibly you don’t agree. If so my mental picture of you would be inaccurate and inappropriate, and will be acknowledged so.

106

MQ 10.18.08 at 9:30 pm

the majority of the growth in house prices was attributable to the reduction in bond yields

I don’t believe this was true for the U.S. — well, maybe the *majority* of the growth but very far from all of it. Real bond yields were historically low but just eyeballing the historical relationship between drops in bond yields and growth in housing prices, you still don’t see a runup like this.

One way to think about this is that DD is saying the bubble was inevitably inflated by the central banks pumping a ton of new money into the system, which the banks just mediated. But financial institutions were also directly increasing the money supply by increasing total leverage in the system, even faster than the central banks were pumping resources in. Ummm, I can’t prove this, but I suspect it’s true.

107

Nick 10.18.08 at 11:27 pm

Daniel, in the good old days at the dacha, it was very simple – when we uncovered a group of deviationist Menshevik wreckers at work in our banking system, we simply summoned Comrade Beria and his machine-gun and soon everything was working properly. Now, it is very tiresome, there are key performance indicators, and annual bonuses, and idiot Geordies lending people money on absurd terms, and human resources departments, and it is all very complicated and not like the old days . . . .

108

virgil xenophon 10.18.08 at 11:54 pm

Roy Belmont: LOL If you really knew me you would know that I’m the LAST person to worship at the alter of the Gods of Money or the Lords of the Economy. In fact, by utter disdain comes for having worked for a number of years as an ex-academic in the “Belly of the Beast” in several major brokerage houses and insurance companies, finally leaving after coming to the conclusion that I was ultimately unhappy for the same reason I chose not to attend Law School,i.e., I didn’t think I had enough larceny in my soul to be truly successful. In fact I once “endeared” myself (much to the chagrin and mortification of my wife) at a cocktail party in a major city with many of the prime “movers and shakers” present by saying that there was nothing that would improve the city’s economy so much as taking the stodgy head of every financial institution out into the nearest open field and shot “pour l’encourager les autres.” (And I DO have witnesses to confirm this)

My only point that I wished to make was that the old “give em an inch and they’ll take a mile” applies here–as well as “the road to hell is paved with good intentions.” I, like I am sure you, have read the studies upon which the CRA was based which showed that many of the traditional metrics did not adequately capture the ability and motivation to pay amongst large segments of “the poor” and upon which the legislation was based; my point was that the very institutions that fought it like Dracula avoiding the Cross, the program being enacted they became like Dr. Strangelove and “learned to love the bomb” in that they realized they could extend this concept to the entire population and make oodles more scheckles/moola/dineros-whatever. As that great psychologist and philosopher Lilly Tomlin once said: “Don’t worry in the middle of the night that in your soul you have become too cynical–you can never match the real world.”

109

virgil xenophon 10.19.08 at 12:04 am

PS to #107: I think Lilly also added “and paranoid” in there also.

110

blah 10.19.08 at 4:48 am

This hedge fund manager thinks the bankers are stupid:

Recently, on the front page of Section C of the Wall Street Journal, a hedge fund manager who was also closing up shop (a $300 million fund), was quoted as saying, “What I have learned about the hedge fund business is that I hate it.” I could not agree more with that statement. I was in this game for the money. The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy, only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America.

http://www.portfolio.com/views/blogs/daily-brief/2008/10/17/hedge-fund-manager-goodbye-and-f-you

111

nick s 10.19.08 at 5:35 am

112

magistra 10.19.08 at 7:05 am

Dsquared said:

Taleb’s point about risk models is really beginning to irritate me…It’s just not true that bankers thought that there couldn’t be a real estate crisis; they assessed the risks and made the loans accordingly. Some people got their risk assessment wrong, but the optimal frequency of crises is not zero.

If some people got their risk assessments wrong then surely you’d expect only a few institutions to be in trouble: the ones (like Northern Rock) that took particularly risky decisions, while the more sensible ones would be fine. If large numbers of a class of institutions are in trouble (almost all the UK banks, all the US investment banks, lots of hedge funds etc) that suggests something more systematically wrong with the risk models of the whole sector. And what specific government legislation forced financial institutions to make bad decisions? Lax regulation make permit risky decisions, but it doesn’t require them. Can you explain either of these points to a non-economist?

113

derrida derider 10.19.08 at 7:13 am

Nothing to add to all this except that it’s a brilliant post – and far from the first one from Dsquared.

Daniel, you’re wasted in stockbroking. If the crisis costs you your job it may be a blessing for the world – surely we can use your talents better.

114

Mike 10.19.08 at 10:50 am

Because finance, business and law aren’t solely about what you can get away with, and the people working in those fields are not all greedy and ruthless by default, nor do they have to be to succeed.

Maybe not, but that’s the way to bet.

115

dsquared 10.19.08 at 10:54 am

If large numbers of a class of institutions are in trouble (almost all the UK banks, all the US investment banks, lots of hedge funds etc) that suggests something more systematically wrong with the risk models of the whole sector

Or possibly (as is my argument) that we’re looking at a macroeconomic problem that doesn’t have much to do with risk models.

116

Alex 10.19.08 at 12:10 pm

Also, the whole argumentum ex Taleb, indeed the whole of the guy’s intellectual reputation, is based on the idea that the crisis wasn’t predicted. It was predicted. Repeatedly. With numerical detail. By authoritative voices (Setser, Roubini, Hamilton, Krugman…) And by not so authoritative ones. I remember random bloggers talking about the coming reset of the Option ARMs as early as 2004; the Bretton Woods II paper came out around then; Calculated Risk started in 2005, I think; Ed Hugh at AFOE was predicting an epic housing crash with banking sequelae back to 2004, though for different reasons. Mark Kleiman of the RBC not only called the top in 2006 but sold his house in LA and rented.

It was blindingly obvious something like this would happen; in fact it was possible to predict with some accuracy when it would happen on the basis of the publicly available mortgage data, which is what Tanta and Co did. Hey, I was well aware of the bubble and the inevitable crash and I spent quite a lot of 2005-2006 discouraging my partner from trying to buy property through doom-mongering.

Actually, if you’d been reading good econ blogs you’d have been out of the market by early 2007 at the latest and you’d now be laughing. Quite simply, the price-rent and price-salary ratios were insane and had been insane for some considerable time; and quite simply, when it all came crashing down, whoever bought all those MBS was going to get killed.

117

ogmb 10.19.08 at 2:45 pm

118

Cranky Observer 10.19.08 at 2:51 pm

> While subprime mortgages made to minorities as a result of the
> anti-red-lining were admittedly a small part of the bubble, the
> legislation itself created the atmosphere and mindset within the
> banking/mortgage industry that allowed the expansion of these
> loans into the general population.

Before Talman Savings & Loan in Chicago was forced to merge with a bank due to Senator McCain and Mr. Keating’s little event, it made quite a nice living for itself and its stockholders by writing mortgages in the areas that the banks redlined (and having lived in a redlined area I can assure you that CRA or no CRA redlining continues full force to this day). They were just very careful and very prudent about what mortgages they wrote and on what terms. But anyone who was realistically qualified – meaning a 10% cash down payment and enough regular income to cover the payments – could get a mortgage from them no matter how “bad” the neighborhood. At one point half my lower-working-class neighborhood had mortgages with Talman. So I have a hard time buying this business about the CRA being in any way involved in the collapse of derivatives of based on jumbo mortgages; a typical mortgage in a Talman neighborhood was about $30,000 in 1990 dollars and didn’t qualify for packaging in those day.

Cranky

119

Walt 10.19.08 at 3:06 pm

I don’t understand your argument, Daniel. It’s not a big mystery what happened here, where we need to invoke macroeconomic factors. I’m sure that there are deeper causes, but the immediate cause really is bad banking practices. Banks bet that a completely predictable event, the popping of the housing bubble, wouldn’t happen. Other banks bet that the first set of banks were well-capitalized, when they weren’t, etc. Plausibly the housing bubble had a macroeconomic cause, and its bursting had a macroeconomic cause, but the bankers should have known better, but didn’t.

120

John Emerson 10.19.08 at 3:08 pm

My nihilistic side is cheered by Dsquared’s revelation that what just happened is just an inevitably emergent glitch in a complex system, but I find the idea that no one is to blame highly offensive. It seems to me that inevitably emergent glitches come from God, and that they’re His ways of telling us to scapegoat some horrible people on the lynch mob’s “maybe he wasn’t guilty of this, but he’s guilty of lots of other stuff” principle.

I feel confident that, with individual exceptions, the people who profited most from the up side of the glitch will very successfully transfer the costs of its crash to those below them on the food chain. For all I know, that’s inevitable too, and also for all I know, it might have been done already.

121

Kevin Donoghue 10.19.08 at 3:54 pm

…I find the idea that no one is to blame highly offensive.

When dsquared says is that “macroeconomic events have macroeconomic explanations, not micro ones”, that doesn’t commit him to the view that “no one is to blame”. After all, somebody is responsible for macroeconomic policy.

122

Bob B 10.19.08 at 4:40 pm

As for me, I’m with Keynes:

“The cover of Time magazine in December 1965 quoted Milton Friedman saying: ‘We are all Keynesians now.’ Friedman later said he had been misrepresented by selective quotation, but the point held good. Charles L. Schultze, then US budget director, felt able to tell Time: ‘We can’t prevent every little wiggle in the economic cycle, but we now can prevent a major slide.’”
http://www.ft.com/cms/s/0/a754a046-9c79-11dd-a42e-000077b07658.html?nclick_check=1

123

dsquared 10.19.08 at 5:19 pm

Plausibly the housing bubble had a macroeconomic cause, and its bursting had a macroeconomic cause, but the bankers should have known better, but didn’t.

As I say in the article, what you’re talking about here would be a perfect-foresight, rational-expectations world in which monetary and fiscal policy would be impossible. Such a world could exist (we even have, courtesy of Friedman, Muth and Lucas, models of what economics would look like if it did exist), but I for one would be pretty scared of living there.

124

functional 10.19.08 at 5:24 pm

So who is “Nicholas” Taleb?

125

Alex 10.19.08 at 6:16 pm

“Macroeconomic events have macroeconomic explanations, not micro ones”

That phrase makes me take your entire post much less seriously. There is no such thing as “macroeconomics” — “macroeconomics” is the most disreputable part of economics, and economics doesn’t have much to write home about to begin with. And there are no macroeconomic phenomena that are not fundamentally microeconomic ones.

As for Taleb’s stupid bankers: If they didn’t know about non-normal distribution being ubiquitous in the social world then they were clearly stupid. If they knew about such things, but still took highly leveraged positions then they were also stupid. You can’t avoid the risk of failure, but you can avoid making highly leveraged bets against failure.
If you want to say that the institutional structure made them take perverse bets to get short term bonuses at the expense of long term survival, then that’s true — but this doesn’t seem to be the point you’re making and it is also something that Taleb mentions.

So you failed miserably in refuting Taleb’s point about the bankers’ stupidity. If Taleb says that banker stupidity is a complete explanation of the crisis then he is wrong — but I don’t think he said such things.

I also need some help in reconciling your claim that 1)”This was a policy-caused bubble” and 2)”it’s the normal result of the normal operation of the capitalist system working normally.”

126

Bob B 10.19.08 at 7:16 pm

Watch this delicious sketch to learn what you need to know about how the financial markets really work:
http://uk.youtube.com/watch?v=mzJmTCYmo9g

127

Bob B 10.19.08 at 7:24 pm

All this stuff about the importance of microeconomic foundations reminded me of the following quotes:

“Nobel laureate James Tobin reports that one of his Yale students went to work for the Chicago Mercantile Exchange as an assistannt to an active trader who was a former economics professor. After a few weeks, the young man asked about the long-run calculations that governed the trades. He was told ‘Sonny, my long-run is the next ten minutes.’”
Robert Solomon: Money on the Move (Princeton UP, 1999) p.14.

From Burton Malkiel: A Random Walk Down Wall Street, on the South Sea Bubble of 1720:

“The prize must surely go to the unknown soul who started ‘A Company for carrying on undertaking of great advantage, but nobody knows what it is.’ The prospectus promised unheard of rewards. At nine o’clock in the morning, when the subscription books opened, crowds of people from all walks of life practically beat down the door in an effort to subscribe. Within five hours a thousand investors handed over their money for shares in the company. Not being greedy himself, the promoter promptly closed up shop and set off for the Continent. He was never heard of again.”

128

dsquared 10.19.08 at 7:27 pm

There is no such thing as “macroeconomics”—“macroeconomics” is the most disreputable part of economics, and economics doesn’t have much to write home about to begin with. And there are no macroeconomic phenomena that are not fundamentally microeconomic ones.

yes there is, no it isn’t, yes it does, yes there are.

129

Dan Simon 10.19.08 at 8:02 pm

Banks bet that a completely predictable event, the popping of the housing bubble, wouldn’t happen.

I suspect they bet more specifically that when the housing bubble inevitably popped, the “Greenspan/Bernanke put” would intervene to save the day, minimizing investors’ losses–just as it had in the case of the umpteen previous bubbles to burst on Greenspan’s watch.

That’s the problem with macroeconomic miracle cures–once people understand how they work, investors can bet on their being used. Eventually the cost of paying off those bettors becomes greater than the cost of forgoing the cure.

130

J Thomas 10.19.08 at 8:13 pm

The most disreputable part of economics is surely Econ 101, which teaches naive business majors that unregulated free markets are the only effective way to allocate resources because they always reach the correct equilibrium while no other system reaches any equilibrium at all much less a self-correcting one.

Econ 101 teaches naive business majors that unregulated free trade always produces the most product, that every nation is better off not to impose any regulation on foreign trade even if all other nations do so, that the value of “better off” for which this is true is the only correct value.

Econ 101 teaches naive business majors that any government action distorts the economy into something that produces less stuff and produces the wrong stuff. This is true of all government action including taxing, spending, deficit spending, environmental regulation, pollution control, veterans’ pensions, etc.

Maybe macroeconomics is the worst part of economics, but Econ 101 macroeconomics is the worst part of macroeconomics.

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

And there are no macroeconomic phenomena that are not fundamentally microeconomic ones.

There’s some truth to that. Like, you have no brain activity except for the activity of brain cells. And you have no brain cell activity except for the activity of organelles in the brain cell. And you have no organelle activity apart from individual chemical reactions. And your chemical reactions all involve individual electrons.

So maybe to understand what you’re thinking we ought to look at what the electrons do because really that’s all that’s going on.

On the other hand, maybe sometimes the electrons behave in ways that are more predictable in the mass than from the individual transactions. Any ideas about the details of how that happens would have to be tested, but it seems pretty likely to me that something like that might be going on.

131

John Quiggin 10.19.08 at 8:14 pm

But as its turned out, the GB put hasn’t been that useful to shareholders – even in the bailouts, they’ve been pretty much wiped out. The real safety net here is limited liability.

132

J Thomas 10.19.08 at 8:21 pm

I suspect they bet more specifically that when the housing bubble inevitably popped, the “Greenspan/Bernanke put” would intervene to save the day, minimizing investors’ losses—just as it had in the case of the umpteen previous bubbles to burst on Greenspan’s watch.

People mostly don’t keep chickens any more. My grandmother lived through the Depression, and she had chickens. Every day she’d throw around a pile of chicken feed and the chickens would run up and peck away at it. On rare occasions she would grab one of the chickens and wring its neck. This did not keep the other chickens from running up for their chicken feed the next day. A chicken who stayed away wouldn’t get its share of the chicken feed.

Did the chickens even think that sometime she might kill off the whole flock? What good would it have done them to think about that chance? A wary paranoid chicken might run away and take its chances in the wild. Chickens don’t generally have great success that way. Or it might stay away from the chicken feed, at least. But scrawny chickens who didn’t produce their share of eggs were likely to be eaten first.

It just doesn’t pay to think about the long run when you’re a chicken.

He was told ‘Sonny, my long-run is the next ten minutes.’

133

ogmb 10.19.08 at 8:23 pm

which teaches naive business majors

That’s where I stopped reading. The set of naive business majors is the null set.

134

Walt 10.19.08 at 8:27 pm

Daniel: Funnily enough, I was going to accuse you of succumbing to believing in rational expectations, but I figured that that wasn’t the kind of accusation you made in polite company.

I’m not expecting bankers to have perfect foresight; I’m expecting them to have as much foresight as I do. I knew that the housing bubble was going to burst and that the banks were lending at interest rates that were too low. Honestly, I thought the reason why banks were so eager to bundle mortages was so that they could lay off the risk of the inevitable bubble bursting on gullible pension fund and hedge fund managers.

135

J Thomas 10.19.08 at 8:28 pm

OGMB, would you say that most business majors are naive about economics, or would you say they’re self-serving liars who understand their economic lies? Can you come up with a third choice?

136

Alex 10.19.08 at 8:28 pm

“yes there is, no it isn’t, yes it does, yes there are.”

No there isn’t, yes it is, no it doesn’t, no there are not.

What’s good for the goose…

137

Alex 10.19.08 at 8:37 pm

J Tomas wrote:

“On the other hand, maybe sometimes the electrons behave in ways that are more predictable in the mass than from the individual transactions. Any ideas about the details of how that happens would have to be tested, but it seems pretty likely to me that something like that might be going on.”

That could be, but macroeconomists make the mistake of recording their predictions for everyone to see. The results are not encouraging.

I took the phrase “there is no such thing as macroeconomics” from the J. B. Clark prize winner Franklin Fisher, who shares the same dismal view of macroeconomics.

138

J Thomas 10.19.08 at 8:41 pm

“yes there is, no it isn’t, yes it does, yes there are.”

No there isn’t, yes it is, no it doesn’t, no there are not.

http://www.unco.edu/PHILOSOPHY/python.html

139

J Thomas 10.19.08 at 8:54 pm

Alex, microeconomists sometimes have useful strategies that business owners can use. But how do their predictions come out, hmm?

I took Econ 101 from the Finance Minister of kuwait, who told us he was taking a leave of absence to teach economics in the USA. He strongly defended the macroeconomics of his day. He used to say, “We successfully predicted GDP to within half a billion dollars. And what’s half a billion dollars among friends?” And he’d do a little giggle.

It only occurs to me now that I never thought to ask him whether it was USA GDP or kuwait GDP they predicted so successfully.

140

notsneaky 10.19.08 at 8:56 pm

Agree with Daniel in 127 100%.

141

notsneaky 10.19.08 at 9:09 pm

Or to say a bit more, I think there’s a general “Impossibility of Microfoundations for Macro Phenomenon” theorem hiding somewhere, yet undiscovered but most likely true. You can give your models ‘microfoundations’ but they’re gonna suck and often times they will actually have negative value added in terms of increasing the production of useful knowledge generated by the model.
They’re either going to be ‘ad hoc’ as in the old IS/LM approach (which, with minor modifications is what’s still taught in Macro-Econ 101 – so it’s not about ‘unregulated markets are great’ at all). Or they’re not going to work unless you make some really unrealistic assumptions which is what the whole rational expectations/representative agent/aggregate production function approach does. Or they totally sidestep the whole problem by creating a model where demand doesn’t play a role at all as in all the Marxist/Cost of production theory of value models.
Looking over those choices the ‘ad hoc’ approach, as long as it’s done with some common sense probably works best as a general approach for getting some answers.

And Franklin Fisher takes his GE a little too seriously. I’ll agree with him when he can produce a (real)GE model with imperfect competition, and a sensible price adjustment process.

142

Alex 10.19.08 at 9:12 pm

“Alex, microeconomists sometimes have useful strategies that business owners can use. But how do their predictions come out, hmm?”

They can avoid that problem by not making many predictions about the entire economy.

More seriously, solid economics is difficult business — but I don’t see why so many people are so fascinated by the barbaric simplifications and aggregations in macroeconomics. At least in microeconomics you can tell yourself that you are trying understand what is going on in terms of entities that actually exist, even if exact predictions may be hard to come by. I have yet to understand what “total factor productivity” stands for in the real world.

143

Alex 10.19.08 at 9:19 pm

Notsneaky,

If you can not find microfundations for macroeconomics, then maybe the conclusion is that people should not put so much import on macroeconomic models — rather than concluding that we should use crappy models because that’s all we have.

I don’t think that Franklin Fisher is a GE fanatic — but he is probably fanatic about being able to describe your aggregates in terms of actually existing entities.

144

J Thomas 10.19.08 at 9:20 pm

They can avoid that problem by not making many predictions about the entire economy.

OK, let them predict an individual business. Predict its sales, its costs, its profit. How much money will it invest in new capital equipment? Surely a good microeconomic model should be able to predict that for a single business, right?

No? Well, how about telling the business owner how much money he *ought to* invest in new capital equipment, and which equipment. What kind of microeconomics do you have if you can’t give definitive results for a little problem like that?

145

Alex 10.19.08 at 9:32 pm

“What kind of microeconomics do you have if you can’t give definitive results for a little problem like that?”

You can make some predictions about, say, the results of monopoly power and there are some things, even basic things, for which you can not make microeconomic predictions.
But you miss my point, which is that if you want to understand the economy, by thinking in microeconomic terms you can at least tell plausible stories. A lot of macroeconomics consists in working with “estimates of nothing.”

146

MarkUp 10.19.08 at 9:32 pm

Perhaps we need a way to inject anaerobic bacteria in to microecon bubbles to gobble up the various bits of methane and sulfur so that when they combine in a macroecon bubble they have less capacity for catastrophic harm, further a filter screen series layered with self releasing fullerenes could be deployed to prevent the aggregation of large bubbles w/o balls.

147

J Thomas 10.19.08 at 9:35 pm

If you can not find microfundations for macroeconomics, then maybe the conclusion is that people should not put so much import on macroeconomic models—rather than concluding that we should use crappy models because that’s all we have.

What do you use macroeconomic models for?

If they get used to inform government policy then somebody will tell the government something. It might as well be a good economist doing the best he can, as somebody else.

If they get used by businesses to help them choose strategies, then I’d think a thorough explantion of the uncertainties would be best. What might be ideal is to provide a computer simulation that can be run repeatedly and that produces different outcomes with the probability distributions the good economist thinks are most plausible, and managers can look at their risks. Not just average outcomes but get some sense of the distribution of outcomes.

Like it or not, there’s a market for predictions. It’s one of the big things nonacademic economists get paid for. Unless economists do their best to fill this demand, it will be filled by astrologers. (Of course, if the astrologers get better results they’re likely to get the business anyway.)

148

J Thomas 10.19.08 at 9:37 pm

But you miss my point, which is that if you want to understand the economy, by thinking in microeconomic terms you can at least tell plausible stories. A lot of macroeconomics consists in working with “estimates of nothing.”

I see. Well, if a lot of macroeconomics is being done badly, that would indicate a market opportunity for somebody who can do it better.

149

notsneaky 10.19.08 at 9:40 pm

Alex, given that policy makers and Joe Plumbers care about economic aggregates such as unemployment, inflation, and total income, you will need a macroeconomic model of one sort or another. I guess you could disaggregated all this into a model where unemployment is studied market by market, as are changes in prices and wages, but as soon as you let those markets interact with each other you’ll get one big mess and micro economics will be of zero help. Currently there’s no successful or even plausible microeconomic model which looks at the economy as a whole (i.e. considers more than just one market in isolation) so unless you’re happy with just the elephant’s toes, you’re gonna need some macroeconomics.
Or to put it in an other way, all those theorem which say “aggregation is hard” apply not just to existing macro models but to any micro economic attempts at doing macro, FF included.

150

notsneaky 10.19.08 at 9:47 pm

151

Alex 10.19.08 at 9:48 pm

“Unless economists do their best to fill this demand, it will be filled by astrologers. “

I’d rather have an economist making the predictions than an astrologer –the economists will at least know many theories which should be avoided. But I’d rather have an economist who is all too aware of the deep flaws of his models, rather than a cocky one who thinks that the best models we have are good enough.

“Well, if a lot of macroeconomics is being done badly, that would indicate a market opportunity for somebody who can do it better.”

Maybe, or maybe we’ll have to find a way to manage working without a macroeconomics with lots of unambiguous implications.

152

notsneaky 10.19.08 at 9:49 pm

153

Alex 10.19.08 at 10:04 pm

Notsneaky,

I’ll look at the Hoover paper. I vaguely remember having read the paper, but I’m not sure.

Bracketing Hoover, I don’t see why one can’t make clear the microeconomic assumptions that lead to one’s conclusions about macroeconomic phenomena. The entire minimum-wage and unemployment relation discussion is an example of such thinking.

Dreaming of a complete general theory is probably utopic for now, but you don’t need a general theory to reach at least some conclusions about macroeconomic phenomena from microeconomic thinking.

154

Roy Belmont 10.19.08 at 10:14 pm

Virgil X:
My mental picture of you appears to have been at least somewhat inaccurate, and is acknowledged so here.
Though you do cling to that “good intentions” bit.
Whereas what happened had almost nothing to do with the inappropriateness of the original intent, and virtually everything to do with the blood-locating abilities of the horde of parasites that then dominated economic affairs.
And dominates them yet, whereas programs and legislation that might enable things like home ownership in the (unfairly) disenfranchised are becoming galactically remote.

J Thomas #131:
That view of a flock of chickens, as a collection of self-interested individuals making decisions whether or not to compromise immediate safety for longer-term survivability, maps pretty well onto a lot of people’s views of human society, not least economists’.

But it doesn’t consider the flock as a thing with survival parameters of its own that don’t rely on the survival of individual chickens any more than individuals chickens rely on the survival of individual feathers, or eggs for that matter.

Getting a sense of the flock itself as a living organism whose needs aren’t necessarily aggregates of individual members’ needs, and analogously humans-as-species as a living organism whose needs etc., may be kind of important.
It does seem to have had some influence on moral thought over the years.

155

J Thomas 10.19.08 at 10:40 pm

Getting a sense of the flock itself as a living organism whose needs aren’t necessarily aggregates of individual members’ needs, and analogously humans-as-species as a living organism whose needs etc., may be kind of important.
It does seem to have had some influence on moral thought over the years.

But not yet on bankers.

156

Alex 10.19.08 at 11:37 pm

Some notes on the K. Hoover paper:

Hoover talks about how macroeconomic variables “supervene” microeconomic variables and how one macroeconomic value can correspond to many underlying microeconomic realities. What Hoover doesn’t talk about is the “macroeconomic variables” for which it is in general logically impossible to find a microeconomic reality, for instance, the macroeconomic production functions. Hoover doesn’t have anything to say about such commonly used “macroeconomic variables.”

Secondly, he argues that “if you can manipulate them, they exist” is a principle that can be used to show that macroeconomic variables are ontologically real. I don’t know much about ontology, but this doesn’t contradict the principle that you should be able to find microeconomic explanations for the results of your manipulations, if those results are not spurious.

Thirdly, he argues that microeconomic actors use macroeconomic theories and indexes in making predictions. But if you can provide an explanation which has the individual economic actors’ theories as data then you have a microeconomic explanation.

In conclusion, I am not sure what K. Hoover’s argument achieves. If he wants us to concede that price indexes are ontologically real, then fine, they’re real. He doesn’t show in what sense other macroeconomic constructs, like production function parameters, are real, nor does he show why we should expect future such macroeconomic theories to have better results than previous ones.

157

Dan Simon 10.19.08 at 11:44 pm

But as its turned out, the GB put hasn’t been that useful to shareholders – even in the bailouts, they’ve been pretty much wiped out.

Well, let’s see, now…prior to the current unpleasantness, the NASDAQ composite (sometimes used as a proxy for high-tech stocks) peaked in October 2007 at 2860, or 2130 in inflation-adjusted in 1998 dollars. The composite reached that level in…December 1998. So if you had heard something about this whole dotcom thing sometime in 1998 and threw in a few bucks, your shareholder value would have been preserved into 2007 (and you would have earned a tiny dividend yield, to boot). If you’d managed to get in by January 1998, in fact, you’d have earned a nice 3 percent real return by the peak in 2007. (Of course, you’d also have gotten the benefit of both the 1998 and 2000 editions of the “Greenspan put”.)

Broader-based S&P 500 investors have fared similarly. Blue-chip Dow Jones Industrials investors would have done even better–they’d have had to have invested within a month of the 2000 peak to lose money in real terms by the 2007 peak. That’s what the “Greenspan put” did for shareholders.

Of course, today’s bubble investors may not be so lucky. But that’s the whole point: investors appear to have finally made a bet on the success of the “Greenspan put” that’s too big for the “Greenspan put” itself to cover.

158

Jeff Rubard 10.20.08 at 12:13 am

“The cover of Time magazine in December 1965 quoted Milton Friedman saying: ‘We are all Keynesians now.’ Friedman later said he had been misrepresented by selective quotation, but the point held good. Charles L. Schultze, then US budget director, felt able to tell Time: ‘We can’t prevent every little wiggle in the economic cycle, but we now can prevent a major slide.’”

You know, I had always heard that “Keynesians now” quote attributed to Nixon: I guess it’s one of those “Rich Dad/Poor Dad” deficits of information on a topic that Internet resources are generally clearing up.

159

Jeff Rubard 10.20.08 at 12:19 am

(For example, I found this rather interesting; “Franco-Americans” might try their own luck with the Archives.)

160

notsneaky 10.20.08 at 12:44 am

Alex,
We might wanna leave production functions out of this since this is a bit of the red herring in this context. Hoover’s talking about things like the consumption function, investment function etc.
But yeah, this is also generally why I think models with production functions are fine, on the same grounds as ad hoc relationships in the IS/LM model are.
And yeah, if you can tell a good micro story to back up your macro story that’s fine. Great even. But usually those stories are gonna have problems too, once scrutinized sufficiently. Basically a macro model needs more than just a claim of microfoundations.

161

Jeet Heer 10.20.08 at 12:54 am

What’s the source for the Melanie Phillips quote about “a crisis of morality and buy-it-now culture caused by Richard Dawkins”? I can’t find it on the article linked to. It sounds like the craziness she would write but I’d like to see the original article.

162

virgil xenophon 10.20.08 at 1:33 am

Roy Belmont: Perhaps you didn’t read me closely enough. The “good intentions” I spoke of were those of Congress, not of the Bankers.

163

dsquared 10.20.08 at 8:06 am

What Hoover doesn’t talk about is the “macroeconomic variables” for which it is in general logically impossible to find a microeconomic reality, for instance, the macroeconomic production functions

This is going a bit too far – there are plenty of macroeconomic variables for which there is no problem of aggregation. Unemployment is a simple headcount, for example. And in most cases (I realise as I type this that Radek is going to make me regret saying it about a thousand times in the future, but none the less), a simple average can do most of the work of an aggregate production function. (seriously, saying something like “most of the growth in Irish GDP over the last twenty years is attributable to women entering the workforce plus net immigration” is clearly an implicit use of an aggregate production function, but if someone were to seriously object to that statement and claim that it was totally impossible to do even order-of-magnitude growth accounting like that, I’d say they were taking a good thing much too far).

Jeet: I think my description was a fair paraphrase of:

“I see this financial breakdown, moreover, as being not merely a moral crisis but the monetary expression of the broader degradation of our values – the erosion of duty and responsibility to others in favour of instant gratification, unlimited demands repackaged as ‘rights’ and the loss of self-discipline. And the root cause of that erosion is ‘militant atheism’ (emphasis added -dd) which, in junking religion, has destroyed our sense of anything beyond our material selves and the here and now and, through such hyper-individualism, paved the way for the onslaught on bedrock moral values expressed through such things as family breakdown and mass fatherlessness, educational collapse, widespread incivility, unprecedented levels of near psychopathic violent crime, epidemic drunkenness and drug abuse, the repudiation of all authority … (ctd page 94)

164

dsquared 10.20.08 at 8:07 am

ahhh, the famous CT strikethrough feature, catches all of us sometimes.

165

ejh 10.20.08 at 8:17 am

Unemployment is a simple headcount, for example

You sure about that?

166

Michael Turner 10.20.08 at 9:45 am

“What are the chances that this was a deliberate John Galt ratfuck by Greenspan?”

Slightly greater than the chances that it’s all Richard Dawkins’ fault. What might be the reasoning worked out by the Collect, under that holographic projection that shields those more-evolved-than-thou utopians nestled in the Rockies in a hidden vale atop Mount Improbable. It might go something like this:

(1) “Starve the Beast” is still the last best hope of beating creeping S*cialism,
(2) What better way to Starve the Beast than to trash the economy, thus reducing tax revenues?
(3) What better instrument for trashing the economy than the apostasy of fiat money? (Remember: Greenspan was a major gold bug as a Randite.) Use it to inflate catastrophic bubbles, one after the other, if not two at a time.

Then, either you get Communist U.S. government in the backlash, which causes the collapse of society globally, the tabula rasa needed by Galt et al. to remake the world in their own image, or — everybody digs out Atlas Shrugged, (re-)reads it, and sees the light in time to prevent the collapse of society.

Risky, risky. Greenspan is, inconveniently, a wrinkled old Jew banker, not a tall blond engineering genius. So what happens if the masses seize upon a certain tried and true explanation, instead of Atlas Shrugged, for why the world’s fucked? Read my 1000+ page novel (“At Lash, Rugged!”) to find out the answer. Buy it now, off Amazon. I need cash to finance my purchases of gold.

167

dsquared 10.20.08 at 9:57 am

Well, claimant count is exactly what it says, which is why it’s one of the first figures out (in the UK at least). There are broader measures of unemployment that require a bit more surveying and interpolating, but these are incidental measurement issues – Alex appears to be talking about things like aggregate production functions, where there are serious conceptual issues whether they exist at all.

168

belle le triste 10.20.08 at 10:11 am

i’ve been rackin my pore tired brains these last few days tryin to recall what mad mel’s rants are remindin me of: after a proper sleep (first in days) i realise it is ezra pound’s Canto LXV, “WITH USURA”

169

Alex 10.20.08 at 10:14 am

I should point out that the Alex since comment 115 isn’t me.

170

John Emerson 10.20.08 at 2:10 pm

<a href=”http://www.spectator.co.uk/melaniephillips/2447021/the-culture-war-for-the-white-house.thtmlMelanie Phillips

171

Alex 10.20.08 at 2:22 pm

Let’s ignore conceptually problematic aggregative concepts like aggregate production functions and let’s ignore that in many macroeconomic models, things like equilibrium stability are incomparably easier to establish, than equilibrium stability in disaggregated models.

Suppose we only deal with aggregated variables that are at least logically unproblematic – say unemployment and some measure of inflation – and we want to find some relation between those variables. Such variables represent many possible underlying microeconomic realities as per K. Hoover’s paper.

Why exactly should we assume a priori that the many possible underlying microeconomic realities lead to the same relation between the aggregated variables? You can tell some microeconomic stories where inflation and unemployment are negatively correlated and some microeconomic stories where they are not correlated. If you want to make predictions, you’ll have to look at more microeconomic details.

But if you must look at microeconomic things anyway, then why not simply start there?

And remember that in this discussion I’ve ignored at least the two big, ugly rhinoceroses in the room mentioned in the first sentence.

172

Nick 10.20.08 at 2:45 pm

i’ve been rackin my pore tired brains these last few days tryin to recall what mad mel’s rants are remindin me of: after a proper sleep (first in days) i realise it is ezra pound’s Canto LXV, “WITH USURA”
Belle, whatever the state of Idaho Ez’s mind (a friend of mine who met him twice during hs incarceration reckoned he really was more than a little touched . . .) you would surely concede his style ( both poetry & prose) is rather more pleasurable than Mad Mel’s?

173

Alex 10.20.08 at 2:46 pm

dsquared wrote:

“[S]omething like “most of the growth in Irish GDP over the last twenty years is attributable to women entering the workforce plus net immigration” is clearly an implicit use of an aggregate production function”

I don’t see why the claim above can not be formulated microeconomically, without the logically problematic aggregate production functions. The only aggregated concept that is a necessity here is the GDP.

Maybe you have in mind some specific paper which does use APF. If so, then treating the paper with some suspicion because it uses suspicious concepts is perfectly warranted.

174

MQ 10.20.08 at 5:06 pm

I don’t see why the claim above can not be formulated microeconomically, without the logically problematic aggregate production functions. The only aggregated concept that is a necessity here is the GDP.

your last sentence is a whopper. You can’t get the aggregate impact on GDP without a general equilibrium analysis, since in partial equilibrium it is unclear whether the new women entering the labor force simply displaced existing men or actually increased production, etc. You could do it without an aggregate production function if you had confidence in your complete general equilibrium model of the entire open economy of Ireland and the other countries it dealt with. Such a complete GE model based on firm microfoundations would be the biggest breakthrough in the history of the social sciences.

P.S. I don’t think much of aggregate production functions either, but then I have my doubts about econ in general.

175

MQ 10.20.08 at 5:08 pm

Looking upward, I was basically just repeating 148.

176

dsquared 10.20.08 at 5:21 pm

See, for example, JM Keynes on “The Economic Consequences of The Peace”, for a wonderful piece of back-of-the-envelope macroeconomics which, if you had to unpack it into a model, would have to contain an utterly indefensible aggregate production function which was linear in all inputs.

177

J Thomas 10.20.08 at 6:55 pm

OK, say you were doing physics. You come up with the Ideal Gas Law. It mostly works. What makes it work is that you have a collection of macro variables that represent average behaviors of individual gas molecules, and your equation that describes how they macro variables fit together actually does match up very well to the actual behaviors.

Suppose you were to apply the ideal gas law to a very small chamber containing only 10,000 gas molecules. Then it wouldn’t work as reliably. You might likely notice things like brownian motion.

And if you applied it to 1000 gas molecules or 100 it would be even worse.

So, you want to think about equilibrium in markets where there are often only 5 or 10 suppliers, dominated by one large supplier. You’ve got troubles.

But for some things you can try to average over the whole economy. Like, interest rates affect everybody who lends or borrows money. You can make some sort of macro conclusion about results of interest rates.

But the micro details matter a whole lot. Who is it who borrows the money and what do they want to do with it? It doesn’t make sense for people to borrow money at variable interest rates to buy consumer stuff when they don’t know how they’ll pay it back. A reasonable model would say that doesn’t happen much. And yet it does. (I had a girlfriend once who kept three credit cards maxed out. Every now and then she’d make enough money to pay one of them down some, and then she’d max it out again. I paid off the one with the highest interest rate and they immediately cancelled it and she got mad at me. She wanted to have that credit card! I realised this was not somebody I wanted to marry.)

You’d like to know how much new borrowed money will go to investment and how much to consumption. How can you predict that without knowing a whole lot of micro details? For that matter how well can you measure it? What was Ponzi after all except a guy who borrowed money for consumption and pretended it was for investment….

And yet there are things you can reasonably say, and some of them might be useful. It’s kind of similar in ecology. You can have a biome with thousands of plant species and lots of animals and many millions of kinds of fungi and bacteria, and you can look at production and turnover of biomass, you can look at mineral cycles, etc. You can get a sense of bigger patterns. Chapparal and southern pine both build up a lot of flammable detritus and then occasionally have a big fire that preferentially burns out their competitors. Is the business cycle anything like that? You see ecological succession after a disaster that pretty much wipes out an ecosystem in some limited area. First you get pioneer species that are good at living in the disturbed area. Once they change things around some then other species that are better at living in the changed environment take over, and you get repeated takeovers until you finally get an assemblage that’s good at taking the ground and holding it. Is that analogous to what happens with technological innovation?

Economists ought to be able to do everything ecologists do, it’s directly analogous. Except that an ecologist can uproot every plant in a square meter of prairy and dissect them all, while it’s illegal for an economist to do the sort of industrial espionage that would let him learn details about individual corporations. And ecosystems usually have much larger numbers of individual plants than economies have individual people. Ecosystems have much longer histories so they might be more evolved, but maybe economies can evolve faster.

I dunno. It ought to be possible to do something useful. It might be possible to do macroeconomic simulations where human beings take the different roles and decide whether what the model predicts for them makes sense, and override it when they think best.

178

Walt 10.20.08 at 6:58 pm

Didn’t the main prediction of “Economic Consequences of the Peace” turn out to be wrong?

179

MQ 10.20.08 at 7:15 pm

Economists ought to be able to do everything ecologists do, it’s directly analogous.

and psychologists ought to be able to predict individual human behavior just as well as horticulturalists predict individual plant behavior and animal trainers predict animal behavior.

180

dsquared 10.20.08 at 7:26 pm

Didn’t the main prediction of “Economic Consequences of the Peace” turn out to be wrong?

The main prediction was that Germany would go into economic collapse with horrible political consequences, so no.

181

Walt 10.20.08 at 7:42 pm

The main prediction, as I remember it, was that Germany would go into an economic collapse with horrible political consequences because it would be unable to pay war reparations. Is that how it happened? My impression is not.

182

notsneaky 10.20.08 at 7:48 pm

I think that’s cause the amount of reparations got marked down as the realization that Germany wouldn’t be able to pay became obvious. Sort of like modern day bail outs and such.

183

J Thomas 10.20.08 at 7:50 pm

and psychologists ought to be able to predict individual human behavior just as well as horticulturalists predict individual plant behavior and animal trainers predict animal behavior.

MQ, I’m pretty sure that if psychologists spent 20 generations or so breeding lab-humans to be predictable, we could predict them as horticulturalists.

Animal trainers don’t predict real well, they look hard for individual clues (cues) that let them get desired results with individual animals. And they try to make the consequences for the animal as consistent as they can.

If a psychologist wanted to get college students to do cute animal tricks with complete reliability, and he paid off in $100 bills or co-eds, he might get a pretty good result. College students are in general hard to train because it’s hard to get their attention.

184

notsneaky 10.20.08 at 7:51 pm

Here was the final axe
http://en.wikipedia.org/wiki/Lausanne_Conference_of_1932

but they got rescheduled and the like even before that. Basically France couldn’t scrap the agreement wo loosing face but for all practical purposes, Germany WAS unable to pay up.

185

Righteous Bubba 10.20.08 at 7:54 pm

Animal trainers don’t predict real well

It was a bad analogy. Just give up.

186

J Thomas 10.20.08 at 7:54 pm

I think that’s cause the amount of reparations got marked down as the realization that Germany wouldn’t be able to pay became obvious. Sort of like modern day bail outs and such.

I heard stories about hyperinflation and people dying on the street of starvation. Did the bailouts come quickly enough or strongly enough? I think if we got enough inflation that peoples yearly social security payments would buy them a loaf of bread, and we got significant numbers of people starving on the sidewalks, we might get some horrible political consequences even if there were some bailouts.

187

Walt 10.20.08 at 7:55 pm

I’m not trying to say that ECofP is anything other than an awesome book (it’s an incredibly interesting read), but I thought that the consensus was that it was not as hard for Germany to pay its reparations as Keynes had thought.

188

J Thomas 10.20.08 at 7:57 pm

It was a bad analogy. Just give up.

But economics with ecology is a good analogy.

189

lemuel pitkin 10.20.08 at 8:01 pm

The essential fact to rememebr about german war reparations is that there were no German war reparations. Or at least, none that were paid by Germany. The paymetns taht were made were etnirely financed by American loans, which were then forgiven following the second world war. Actual payemnts would have required Germany to run a curent account surplus on a scale that was inconceivable in the post-WWI environemtn, especially given political resistance to corresponding deficits in the rst of Europe and the US — that was the central argument of Keynes’ book. But asPeter Temin points out in Lessons from the Great Depression (which I happen to be reading): “Despite the nominal obligation of reparations, Germany had a deficit on current account in every year from 1924 through 1929. … Reparations had no direct effect on the German economy.”

Since the predictions in Economic Consequences were conditional, they weren’t so much falsified, as proved irrelevant. But the judgement on the book’s prescience still has to be basically negative. Dsqaured’s general point still holds, of course.

190

lemuel pitkin 10.20.08 at 8:03 pm

I can’t decide if it’s cute or creepy, that J Thomas thinks he can reinvent economics from scratch in a blog comments section.

191

dsquared 10.20.08 at 8:08 pm

No, I think Keynes still gets prescience points. The point of calculations like that one is to show that there’s no way in which the numbers can be made to add up to a good result, not so much to pick a specific bad result that’s going to happen. Krugman didn’t actually predict that the Asian Tiger would end up a series of currency crises (and indeed was quite wrong to focus on Singapore), but he gets the points because he was the only one showing that there wasn’t a miracle going on. Also, of course, the straightfoward argument about the sustainability of the reparations was won in the first five minutes after Versailles, so much so that a lot of people thought Keynes was being needlessly nitpicking and trivial by treating the Treaty as an actual commitment when “everybody” knew it would immediately be revised.

192

MarkUp 10.20.08 at 8:18 pm

” Sort of like modern day bail outs and such.

I heard stories about hyperinflation and people dying on the street of starvation.”

At least now the Banksters have a pool of some 70 billion for bonus payments to go along with the bail… Rescue monies. Starvation will be curtailed.

193

Alex 10.20.08 at 8:30 pm

The empirical record of macroeconomic predictions is not something that gives them much credibility.
So the macroeconomic models work, except when they don’t.

194

lemuel pitkin 10.20.08 at 8:35 pm

Dsquared-

It’s a while since I read it, but as I recall the “economic consequences” in question more or less all flow from the persistent current account surpluses Germany would be reuqired to run to pay reparations. No surplus and the argument is irrelevant.

Of course it’s true that even as a dead letter, the reparations did stoke German resentment. But so did lots of other things, and anyway that’s not an economic consequence.

As a matter of fact, the main economic effect of reparations was to raise the volume of US government loans to Europe through the Dawes and Young plans — notionally loans to Germany, in practice to England and France. Since Europe needed to finance a current account deficit with the US, just like after WWII, but unlike after WWII there was no political consensus in the US to finance European reconstruction, it’s hard not to see the strictly *economic* consequences of Versailles as positive.

It’s not enough to say that Keynes was right to expect trouble; there has to be some correspondence between how he thought it would come, and how it actually did.

(I believe he himself acknowledged later that ECotP basically got it wrong, but I could be mistaken.)

195

J Thomas 10.20.08 at 8:39 pm

Lemuel, it’s clear that somebody needs to re-invent economics. I’m stuck in northern virginia several miles southwest of the Vienna metro, far from any economists who might talk to me in person. Why not try out some beginning ideas here, wherever they fit? There’s always the chance that somebody will make some sort of response.

196

notsneaky 10.20.08 at 9:24 pm

Re: 193 (not sure which Alex this is)
In “normal times” macroeconomic models do pretty well at predicting the direction of change if not the magnitude. When Volcker raised interest rates everybody knew – based on a fairly simple macro model – that recession was in the cards and that inflation would be brought down, the only questions where how long would it take and how deep the recession (in fact the micro-founded macro models predicted a much shorter adjustment process than the clunky IS/LM style ones which got it more right). When Germany reunified, converted the marks at 1:1, fiscally expanded and monetarily contracted and so on, everyone knew – based on a simple Mundell-Fleming macro model – that I’d be hard for Britain to stay committed to the ERM, though not many saw Soros coming with his billions. And so on.

Also, as an aside, Krugman gives Alwyn Young a lot of credit for the underlying analysis for his article on the Asian Miracle (or lack of it), so he wasn’t the only one. And Young’s is basically a growth accounting excercise based on measuring macro inputs. This is also where he got the mis-focus on Singapore since Singapore comes out worst in that paper out of all the Asian Tigers.

197

notsneaky 10.20.08 at 9:26 pm

All in all, there just isn’t a convincing micro model that is capable of studying macro issues out there and there may never be. All we have is macro models that claim to have “micro foundations”. But here “micro foundations” basically mean “something somewhere gets maximized”. Other than that those micro foundations are as ad-hocy as those in the older style macro models.
(which isn’t to say that the search for those micro foundations, misguided though it may have been, hasn’t yielded some practical and useful insights, like, say, the stuff on time inconsistency)

Comments on this entry are closed.