A big smoking hole in the ground: Moral hazards in many shapes and colors

PRE-POSTSCRIPT: Christopher Caldwell has an excellent article in the London Financial Times setting straight the political reality of this crisis: "pragmatism" not only doesn't work, it's precisely what got us into the crisis to start with. "Ideologues" are supposed to be bad, mean people who block "pragmatism"; in fact, they block politically gratifying but false solutions that just cause more problems down the road. It's too bad there weren't more -- many more -- "ideologues" standing in the way of government-sponsored subprime mortgages. There should also have been more "ideologues" (meaning, people who actually know something) more insistent on deflecting the rescue push in a more helpful direction.

The incoherent response of the US and other governments is also a case of "pragmatism": myopic reaction, shaped by panic, and not calming down and thinking it through. The economic knowledge to thread governments and markets through this mess is available in abundance. But politicians, journalists, and others in the chattering classes often don't want to hear it.
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After a busy week, a few brief items to post.

Anyone paying attention to the financial crisis is aware of the role of subprime mortgages and their sponsorship by Fannie Mae and Freddie Mac. They form the weakest part of the mortgage market, so it's no surprise that the crisis hit there first, then spread.

But why the rest of the housing market? It's because of the powerful collective delusion shared by banks, credit markets, the public at large, and the regulators themselves that housing prices would "have to" keep going up forever at eight or 10 per cent a year. This misperception is a textbook case of "bubble" psychology. In an undistorted market, lenders, home buyers, and everyone else, would have perceived risk more realistically and acted accordingly. Subprime mortgages would still have happened, but at a lower volume and higher interest rates.

This misperception played a crucial role in the subprime mortgage fiasco. If I lend you $500,000 for a house, and you're not a good credit risk, but housing prices rise 10% next year, it's fine. If you default and I foreclose on your house, I can sell it for $550,000. I've made money in this supposedly dire scenario. If I expect housing prices to behave that way into the indefinite future, I'm going to be a complacent creditor, willing to lend to just about anybody.

But if housing prices start dropping and appear ready to keep dropping for at least several years, the picture changes drastically. If you're a good credit risk, I'll lend to you, perhaps at somewhat tougher terms (more down payment, higher interest rate), but let you, the borrower, assume the risk of your house falling in value. (You always have the alternative of not buying at all and renting instead.) If you're a bad credit risk and in danger of default, there's no way to avoid losses somewhere: you will lose if and when you sell your house, or I will lose when you default and I'm left with a $500,000 mortgage attached to a $400,000 (say) house.

It is here that we see how Fannie and Freddie set up lenders for unwittingly assuming big risks. Fan and Fred didn't redistribute income or wealth; they redistributed risk, from home buyers, then to the banks lending the money, and finally to the bondholders who bought the mortgages in the form of Fan-Fred bonds. The F-F business model was to buy the mortgages from the bank as bonds and at a discount, then resell them at full value to bondholders. The bondholders did this because behind F-F was the implicit government guarantee of bailout in case of default.*

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Whence the fuel for the bubble in the housing market generally, that part not subprime?

We've already heard from many about moral hazard, the term economists use for some third party (usually government, although it doesn't have to be) guaranteeing an outcome for a certain class of people, regardless of their own mistakes or outsized risks they take. Fannie and Freddie were complex schemes of moral hazard.

But, all over the advanced world, central banks have also long been in the habit of creating moral hazards from policies of cheap credit, holding interest rates artificially low. The money supply grows too fast, but it's in the form of credit, not cash. The result is not "inflation" as we usually understand it (rising consumer and producer prices), but asset bubbles (stocks, houses) and misinvestment. Overly-easy lending practices make everyone too casual about what they invest in and lull them into a false sense of complacency. It wastes scarce savings (capital). Above all, it creates the illusion that certain favored assets du jour will just keep going up in price. In other words, cheap credit enables and promotes bubbles.

Is this possibility relevant to the recent economic history? You bet: it describes the Fed's behavior in 1995-99, as it enabled a massive stock bubble. As the Fed's commitment to price stability wavered in the late 90s and during the 2001 recession, it describes even better the 2002-07 housing bubble, which was accompanied by other classic inflationary signs, such as a falling dollar and rising prices for imported natural resource like oil.**

People wonder if the huge injections of credit by the Fed and other central banks over the last few years will lead to inflation down the line. The response is, they already have done so. These injections kept housing and natural resource bubbles going for several years. But it's not possible for central banks to keep manipulating economies and financial markets indefinitely this way. Eventually everyone gets wise and readjusts their behavior and thinking. That's what's been happening for the last year or so, and we're now heading into deflation, at least for a while.
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* Where did Fannie and Freddie's profits go? F and F both sold stock to shareholders, and they got some of the net proceeds. The rest went into that Congressional patronage pot already mentioned, the Affordable Housing Trust Fund.

** Slightly older but relevant to the present crisis are the 1980s bubble and 1990s post-bubble stagnation of Japan. Again, the central bank played a pivotal role in spreading lots of cheap credit around and driving up real estate and other asset prices to fantastic levels.

The last credit show

PHOTO OF THE YEAR: I love this picture, taken at the Capitol Friday, just after the bailout passed.

Pelosi hasn't the slightest clue what just transpired. Hoyer's distracted smile suggests he knows something bad is going down, but he can't put his finger on it. Only Emanuel's glum look indicates someone who gets it.

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I don't know about all those bloggers who post every few hours, but I've virtually run out of things to say about the financial crisis.

I'm not happy with some of the conservative talk radio types denouncing businesses for running on short-term credit as a form of money. Modern business activity couldn't proceed at the level it does, accomplish what it accomplishes, and employ the people it employees, on a cash-only basis. Long ago (in the 19th century, actually), capitalism outgrew the cash-only system, just as it eventually outgrew the gold standard. Businesses, consumers, and governments make extensive use of short-term credit because spending and income don't always match at every instant in time. Short-term credit is a way to shift money flows so that it does all balance out. The Federal Reserve counts cash and cash equivalents as basic forms of money (M1). But short-term credit functions as money as well and gets added to form M2. It walks and quacks like a duck. Thus, it's a duck.

Sometimes it strikes me that certain conservatives, unfettered, would abolish fractional reserve banking and credit-as-money, thinking that they're just some slick phony-baloney. I wonder if they think a modern economy could function that way.

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OTOH it has been impressive to see economists, especially younger ones, publicly denouncing the bailout. Part of the opposition is prompted by the bailout's being embarnacled with "sweeteners"; i.e., bribes to get the Congress-critters to pass it. But the opposition also has an intrinsic economic basis: the government shouldn't be pledging taxpayer money to buy up assets with declining prices, when we don't yet have a good sense of what their real prices are.

Most economists -- excluding economists opposed outright to any rescue -- have pushed "recapitalization": essentially, some way of tiding over lenders, equivalent to my pet proposed series of ad hoc, strings-attached, short-term loans.* But it's vital to decouple steadying the credit markets and falling asset prices, precisely so that the asset shakeout can proceed without threatening the financial system. To reiterate: the credit crunch has to be dealt with first.

The larger tidying up, with its lessons about moral hazard and its punishment of the innocent and rewarding of the guilty, will take a few years. The government shouldn't be in the business of buying up and reselling distressed assets, except as part of larger post-bankruptcy settlements. Once an economic actor is bankrupt, it's out of the game, so to speak, and the risk of open-ended commitments and market distortions is much lower.

POSTSCRIPT: Some of the biggest doomer-gloomers (like our friend Fabius Maximus) have been pushing the "end of the American era" as a result of this crisis. But the dollar's rise belies such talk. Related crises are happening in Europe and Asia, and they are in some ways worse than ours.

That's also why investment banking, as practiced on Wall Street until recently, won't be decamping to London or Hong Kong. It really is dead.
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* I was probably too harsh on Krugman for pushing "recapitalization." It's the right idea, but banks and other lenders will eventually have to do something about the mismatch between falling housing prices and yesteryear's mortgages. The credit crunch can't wait for that resolution.

Who are the debtors?

PRE-POSTSCRIPT: Drowning in the firehose of commentary about the crisis and "bailout," I can only recommend my favorites, Instapundit (Glenn Reynolds) and Megan McArdle's joint. Reynolds' entries are terse but frequent; McArdle's less frequent and sometimes a bit long-winded (like I'm one to talk). Both have good links to other places. Megan has a funny screed against bad metaphors for the crisis here. Glenn correctly nudges people to use "rescue" instead of "bailout."*

An idea definitely worth supporting is replacing Pelosi and Reid as House Speaker and Senate leader, respectively. Both have been embarrassments to their party and country. Bush's popularity oscillates between 30 and 40%. This Congress' ratings have never been higher than low 20s and have sunk, at times, into single digits. With good reason, it's the most unpopular Congress since World War Two. Assuming the Democrats maintain control of the House (which they probably will, with a smaller majority), the best choice is Clintonista Rahm Emanuel. Politics makes strange bedfellows: weird as I feel typing these words, everyone's disgusted with Reid-elosi, and the Dems desperately need a counter to the cultish children's crusade that is their presidential campaign.

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The credit market and housing debt crisis continues to gyrate. Strangely, it seems to have boosted the prospects of the party that bears much of the blame for it. Remember: government is now involved in backing about 40% of home mortgages.

While I would have voted for the bailout bill if no alternative were available, I completely understand the motives of the House members who voted against. They got an earful from their constituents and only weak pressure from the House leadership. It's essential to decouple the credit-liquidity crunch from the longer-term asset-decline problem. It's too early to seriously discuss responding to the latter. The former needs a response now.

Finance/economics blogger Fabius Maximus (F.M. from this point) recently published a fascinating and frightening look at American debt trends since World War Two. While his views are always loaded with doom and gloom, this argument is worth a look; he's backed it up with hard numbers ultimately based on what the Federal Reserve tracks. F.M.'s debt ratio charts show various categories of debt from 1952 until now, as a fraction of GDP. (The GDP is gross domestic product, the annual output of the American economy, the world's largest, at a little more than a quarter of the global total). I'll admit: my jaw dropped too.

Such high debt ratios are the deep fact now spooking credit markets and foreign investors, deeper than the immediate credit crisis or falling housing prices. No society can get into as much debt as we're in and not create a huge crisis of confidence among lenders. With no sign that the debt accumulation will stop, they've cut back their lending, even to the creditworthy. We've been lucky that this debt is denominated in our own currency, allowing the Fed to massage the money supply and keep credit crises at bay in the past. But, still, there is a limit. Evidently, we've reached it.

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From these charts, both the numbers and their trends, we can draw some conclusions at some variance with received wisdom.

Government itself, far from being the main debt culprit, is the least. Its ratio reached an absolute peak in 1945 and has not approached it since.

A large federal debt does seem to be a permanent feature of modern America. The period of the 1960s and 1970s, when the federal debt ratio dropped, is misleading in one respect. In that era, government policy was to print money rather than borrow it. The tendency to borrow, established in the 1930s and 40s, returned in the 80s. OTOH, the effect of peace dividends is real: the drop of the federal debt ratio after World War Two and in the late 80s and early 90s reflects the end of one very large and another, less intensive, conflict. Both the 1950s and the 90s were periods of falling federal debt ratios, because the pressure to increase government spending had eased off. The period after 2000 was marked by a smaller, but still significant, surge in federal debt, mostly a result of the Republicans' new eagerness for big government.**

Business enterprises, both financial (banking and insurance, essentially) and non-financial, have developed a large leveraging habit, borrowing in good times -- during economic expansions -- and paying down in bad -- during and just after recessions. They learned to start doing this in the Great Inflation of the 1970s, because inflation makes debt attractive.

But the habit persisted long after high inflation ended in the 80s. The rationale for business debt is simple: borrow now, found or expand a business, and future profits will more than take care of it. While this "leveraging" generally works, it doesn't work consistently enough to prevent major debt crises from hitting poorly performing corporations at every recessionary downturn. It's a risky strategy with extravagant real payoffs, but frequent casualties as well.

Finally, Americans as consumers, individuals and households, have by far the biggest taste for debt -- an extraordinary taste for it, in fact -- much more than corporations and government.

The largest component of this debt consists of mortgages. But it also consists of credit cards, student and home equity loans, and all the rest. Almost 40% of this debt ratio's increase occurred just in the last 15 years or so.

Powerful institutional and social habits reinforce the preference for personal and household debt. Many of our institutions, both public and private, make debt look and feel very attractive. While bankruptcy was made more punitive a few years ago, lending standards have continued to drop (at least, until a few weeks ago). Inevitably, there will soon be a lot of people in a lot of financial pain and legal trouble. It was fine to make bankruptcy more punitive -- but only if borrowing itself had been made more difficult as well.

F.M.'s charts make me wonder something else. Rather than take on too much debt themselves, government (in relation to housing and higher education) and banks (in relation to credit cards, mortgages, and home equity loans) have instead encouraged ordinary people to take on debt, a lot of it. Preaching prudence and probity, but also enticing us with borrowing and spending, often ready to "juice" the economy with cheap credit, these are institutions at war with themselves, sending very mixed messages.
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* More accurately, Part I (credit crunch) is a "rescue"; Part II (falling house prices) is a "distressed asset collection and fire sale."

But, ah!, a cynical Ann Althouse smirks in the background :)

** An important feature F.M.'s charts is that his current federal debt totals about $6 trillion, not the $9 trillion you usually hear.

The reason is that he doesn't count $3 trillion in past Social Security and Medicare debt, which (as he rightly points out) merely consists of IOUs written by government to itself. It is not part of the federal debt held by bondholders. In any case, present entitlement costs are at this time paid for by present tax revenue. That will start to change in the next decade, however.

What is to be done?

UPDATE: The post below was composed on Friday and Saturday, so the news is a little outdated.

The distinction I made is parallel to the distinction Virginia Postrel makes in her recent post between the "illiquid" (the immediate credit crunch, the unwillingness of lenders to lend) and the "insolvent" (the narrower and longer-term problem of serious restructuring or bankruptcy, caused by mortgage loans not performing or in default). She also makes the wonderful suggestion that any net profit Treasury makes on federal intervention should be rebated directly to taxpayers.
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The Paulson-Bernanke proposal for a financial sector bailout still seems to be floundering in Washington. The House Republicans, at last report, are still split on the idea, and without a united front from them, the Democrats are not willing to jump in alone.

For a moment, set aside the economics of the proposal and focus on the politics. The Congressional Republicans suffered in the 2006 elections from the perception that they had completely lost it on restraining federal spending. They had also spent six years in partisan lockstep with Bush on spending, expanding government, and the Iraq war. Enough conservative and independent voters got pissed off by the Republican abandonment of anything resembling conservative policies that many just stayed home or, in some cases, voted Democratic. The Republicans lost control of Congress.

That painful lesson floats in the background now as the House Republicans struggle with the question of whether to support the plan. Some support it because they think it's a good idea, and others oppose because they think it's bad. What hangs in the balance is how much Bush can call on simple partisan and personal loyalty. He lacks the automatic Republican support he enjoyed in his first term, and thus we see a political cliffhanger.

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Now turn back to the economics of the plan. Paulson and Bernanke got themselves in some trouble because they failed to explain the situation and their proposal completely enough.

Some of the problem is everyone's ignorance about when and where the housing market will bottom. That event will be crucial in determining the final, diminished values of the assets that back the financial paper (bonds and other credit instruments) that many now suddenly mistrust. Those values in turn will determine the ultimate losses that lending institutions, depositors, and bondholders will face. Many will just have a bad day; a subset will suffer large losses; a subset of that subset will go bankrupt. No one knows the full scope yet. Yesterday's Washington Mutual failure threw some more paint on the canvas and filled in another part of the still-incomplete picture.

Paulson and Bernanke are also wrestling with a crisis that has two very distinct parts, subcrises with different origins, time horizons, and consequences. Their plan addresses both at once, which was probably a mistake, and thus evokes a lot of skepticism.

There's a large advantage to separating these two parts. Part two will take a few years to fully work out and make sure that the government is not overpaying for distressed assets. No one can make those judgments now -- it's too early. At the same time, part one can address the credit crisis right away, but through short-term loans, not buying up assets.

Part one, the credit market crisis, is immediate and needs to be confronted quickly. Failure here would cause severe economic problems, as short-term credit acts as quasi-money for businesses, government, and individuals. If banks and other lenders suddenly decide all at once to stop lending, we will have something like the Great Depression on our hands. The Fed is already acting as it should to prevent this, keeping low the interest rates it controls (federal discount and interbank overnight). It also injects cash by buying up Treasury and government agency bonds and exchanges longer-term bonds for shorter-term. All act to keep the money supply flowing, or "liquid," as economists say.*

But it might prove necessary to do more with the credit crisis than the Fed, under its normal rules, can do. The New York Federal Reserve's AIG loan is the model to follow. It's a relatively short loan (twenty-four months) and, during its term, gives the Treasury some say in how AIG is run. The Treasury, by charging AIG interest, is also forcing AIG to pay for the privilege of rescue.** Such an approach is about preventing a short-term credit crisis, nothing else. It should be ad hoc and address serious dangers quickly as they arise with time-limited rescues. It's not about the collapse of underlying asset values (houses, mainly).

Dealing with that collapse is part two of the crisis, where we have to think in terms of a few years or even a decade, not weeks or months. The model should be the Resolution Trust Corporation that dealt with the savings and loan bust of the early 90s. Here's where the RTC-like agency collects distressed assets in a kind of giant fire sale.† It then resells them, not immediately, but over a period of time, to get better prices and not glut the market for those assets all at once. The RTC worked well in the end, costing taxpayers only about $100 billion.†† The initial cost seemed much higher, because the RTC was in buying mode at first. But in resale mode later on, it recouped most of its gross costs. It worked because it spread out the impact of the S&L bust over a number of years, preventing the cost from being felt all at once.
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* Bernanke has a strong interest in the Great Depression, when banks failed in large numbers, as the Fed kept pursuing the exactly wrong policy. In effect, it hoarded gold (the dollar was backed by gold in those days) and starved its member banks.

The Federal Reserve is actually not part of the government. It's a publicly chartered, non-commercial private entity that regulates the money supply, which includes not just cash, but various forms of credit and foreign exchange. It's a "bank of banks," which federally chartered banks are required to join and contribute to. Other banks can join too, if they want.

Recently, proposals have been floated to allow non-bank entities (insurance companies like AIG, for example) to join. They would get the help the Fed can provide in a crisis, but they would also have to pony up some of their assets in exchange and accept a higher level of regulation.

** From the government and taxpayer point of view, a loan is better than a guarantee. It makes AIG's assets collateral in case of default. The conditions are more spelled out than a guarantee usually is, and the term is limited in time. Someday, people will thank Paulson and Bernanke for this.

† By themselves, assets are not "distressed." They become so when a loan or some other financial obligation is attached to them that assumes a value well above what they can actually be sold for. Selling the asset raises some cash, but not enough to fully cover the attached obligations.

†† I know, I know - "only" :)

Do you remember where you were?

I mean, do you remember where you were in October 1929?

The Brits usually do this better than we do: some comic relief while the financial crisis continues to lurch forward. It's impossible to get through these things without some gallows humor.

There's no stopping Biden's gaffe-o-matic:

When the stock market crashed, Franklin Roosevelt got on the television and didn't just talk about the princes of greed," Biden told [Katie] Couric. "He said, 'Look, here's what happened."

'Cuz when the stock market crashed in 1929, FDR had already become president, and there was a television in every living room -- really :) There's a real point there, somewhere: the level of political eloquence and plain-speaking has, on the whole, dropped noticeably since then. And it's not a forte of our current president or, actually, almost any of our current politicos.

But this brings up a more serious point. Another one of those encrusted, hoary myths is that the 1929 stock market crash "caused" the Great Depression, even though the American economy wasn't in depression territory before 1932. It was, however, already in recession at the end of 1928, according the the National Bureau of Economic Statistics, founded in 1920, an outgrowth of the World War One era's burgeoning interest in statistics and planning.

It would be more accurate to say that the stock market in late 1929 was, relative to an economy already in recession, wildly overvalued by speculative excess (by a factor of about six to eight, an overvaluation not seen since then). The crash was a sharp correction to that overvaluation.

Meantime, what was a severe recession need not have become the "Great" Depression. It didn't, for example, in Britain and France. But the string of bank failures that started in late 1930 ensured that it would. By early 1933 (when Roosevelt actually became president), one US bank in three was shut. Following exactly the wrong policy, the Federal Reserve caused the money supply to contract by about a third, and a severe deflation followed (about a 40% drop in prices), ruining debtors -- like home mortgagors.* Instead of keeping their money in banks, people started putting it under mattresses, where it did no good.

It's not so much that these monetary and banking failures caused the Great Depression; they were the Great Depression. Of course, they caused more negative developments, like 26% peak unemployment, and prompted governments in reaction to essentially shut down international trade and raise taxes in a vain attempt to balance their budgets -- making everything even worse.

POSTSCRIPT: Why do these financial crashes seem to happen in the autumn? Is it the falling leaves, perhaps? The end of summer and intimations of mortality?

POST-POSTSCRIPT: The cure has been found for wild financial market behavior: estrogen. Seriously: that, plus some old guys.
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* Deflation is hell on debtors: they have to pay back fixed money amounts in dollars that are worth more and more each day that passes. Creditors love deflation for just that reason.

Conversely, debtors love inflation: they pay back fixed money amounts in dollars that are worth less and less as time passes. Creditors, and indeed, investors and savers generally, hate inflation for the same reason.

The conflict between debtors and creditors is one of the great perennials, a key "class conflict," if you like, in American history, going back to the days of Hamilton and Jefferson.

They were a nice middle class couple, just buying a house

They keep saying it, and it's true: an era is ending on Wall Street. In fact, "Wall Street" as defined for the last 30 years, centered on independent investment banks seeking large returns by taking large risks, will be only a memory in a few months. Wall Street's two remaining large investment houses (Morgan Stanley and Goldman Sachs) are seeking to become much more like commercial banks. They will still do investing, but it won't be their sole business any longer. Diversified commercial banking is apparently the future of finance. Investment banking as an independent activity is about to disappear, at least as an institutional phenomenon.

The origins of this almost-gone era lie in the Great Inflation of the 70s and the reaction of investors desperately seeking higher returns to compensate. One asset bubble after another followed: commodities, such as gold; loans to developing countries, leading to an early 80s bust; the savings & loans (S&L) bubble and crack-up in the late 80s; the stock bubble of the mid- to late 90s; and lastly and most grandly, the 30-year-long housing boom that culminated in a bubble (2002-2007) and bust (2007-?). The housing boom lasted as long as it did because of the demographic bulge of the Baby Boomers, who entered their prime house-buying years in the mid-70s and exited just a few years ago.

The whole investment landscape is rapidly changing. Expect thinking and practice to become much more traditional, "square," and 9-to-5-ish. The era of the frantic, 14-hour investment banking workday is surely finished.

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The new government intervention in financial markets is evolving in strange and not necessarily good directions. The danger is that the Treasury Department and Fed have developed a premature, pre-emptive, and open-ended intervention -- the risk and cost to taxpayers are vague and potentially large.

Unlike previous government bailouts, there's no clear criterion of which actors really are in distress and which are just having a bad day. The supposed model of the current intervention, the Resolution Trust Corporation (RTC) of the late 80s, resold assets from savings and loan institutions that were already bankrupt and, in the end, didn't cost taxpayers that much. The present crisis hasn't progressed far enough to make such judgments. Treasury's seizure of Fannie Mae (FNMA) and Freddie Mac (FHLMC) drew its authority from the nature of their charters: their assets were essentially collateral pledged to the government anyway.

Ensuring liquidity and promoting greater transparency in the murky interconnections of bonds and the institutions that own and trade them are good things for Treasury and the Fed to be doing now. But much of more of a shake out is needed. The epicenter of the crisis is the subprime mortgage collapse. But in line with its major role in creating this particular crisis, the federal government is on the road to sorting out the resulting mess.

The larger question has no answer yet: where is the bottom of the housing market? Prices have been falling for about a year and a half. But there is still a large glut of houses in many parts of the country. The national average market time for selling houses is around 10 months; in some areas, it's much longer. Economists estimate that the housing market was about 20-30% overvalued in late 2006. Prices have fallen roughly 15 to 20% since then. The bottom might be near, or it might be another year or more away.

The lending markets are scared of this situation because, while not non-performing, many house mortgages are now collateralized by assets (houses) worth significantly less than the face value of the mortgages. Even a modest default rate on such mortgages puts many lending institutions at risk.

It's hard to see why the Treasury or Fed should be entering with a bailout in such an unripened situation. They have no knowledge, superior to the knowledge of private actors, of when and where the housing market will bottom. While the Fed did enhance the housing boom into a bubble with cheap credit over the last decade, the federal government has no particular legal obligation here. Better to catalyze private buyouts and rescues while waiting until the most serious systemic dangers have been isolated.

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The current problems are concentrated in the bond and money markets, not the stock market. Why the media and others are obsessed with stocks is therefore a mystery. That crisis is having impact elsewhere -- insurance, the money market, and short-term credit -- but it's far from the end of the world.

Other undying myths keep popping up in the media and the blogosphere, and I suppose I should do my part to debunk them. I'm not sure how much good it'll do, but I'll try.

A popular one is that the financial sector's problems were made possible by the "repeal" of the 1933 Glass-Steagall Act, which separated investment and commercial banking. The latter continues to be more regulated and conservative in its practices and carries some level of government insurance for individual depositors; the former does not. The 1999 Gramm-Leach-Bliley Act didn't abolish this distinction, although it did make it possible for commercial banks to get indirectly involved in investment markets.

The present crisis has nothing to do with the commercial-investment distinction. As many of my more sensible journalist and blogger confrères and consoeurs have pointed out, the trouble is in the housing and debt markets. Banks, brokerages, and investors heavily in the mortgage market are the ones in trouble. Like the stock market, diversified commercial banks are not in trouble; in fact, what's striking is how well they're weathering the crisis. They're doing well, in part, because they're diversified and not especially exposed to the mortgage mess. Allowing commercial banks to diversify has built a large additional quantum of safety into the system, not made it more fragile.

Another pseudohistorical absurdity making the rounds is that the "securitization" of mortgages in recent decades is to blame; that is, the packaging, sale, and resale of mortgage debt as bonds. Actually, this has been going on since the 1970s and poses no problems as long as accurate credit information is available. Mortgage bond buyers scrutinize such numbers carefully. There is a certain amount of unnerving ignorance in the bond and money markets right now about who's financially sound and who isn't. But that is driven by the two factors already mentioned: the subprime sector of the mortgage market not having accurate credit information, with the distortion of governments guarantees for non-creditworthy borrowers; and the more general problem of no one knowing exactly where the housing market bottom is. Whether the mortgage creditor is a bank or a bond owner is irrelevant.

Ditto for the attacks on "short-selling." Short-selling can't drive down the price of a sound security, at least not for long. Short-selling only works on securities that are weak to begin with. The public service that short-sellers do is to expose weak securities; that way, people will not waste their money buying more of them.

Finally, certain commentators and the media generally have tried to deflect criticism away from the political figures, mainly Democrats, who played such a large role in setting up the Fannie Mae-Freddie Mac failure. The larger housing market woes are indeed shaped by many decades of government policy promoting the overbuilding and overbuying of houses, stretching back to the 1940s.

But the narrower crisis of subprime mortgages -- the epicenter -- is of more recent origin, specifically in the Clinton years, when a strong push was made to make owning a house a government-backed entitlement. Fannie Mae and Freddie Mac's profits were partly funneled back into a patronage pot called the Affordable Housing Trust Fund. And, yes, politicians, mostly Democrats, were up to their ears in it, doling out this fund to friends and supporters.* Certain others, like Joe Biden and Barney Frank, played a pivotal role in setting up the disaster. Biden helped to push the states into getting rid of lending standards. Frank is a one-man wrecking crew, being the main Congressional protector of Fannie Mae and Freddie Mac's special status and pushing to virtually eliminate regulatory oversight of both corporations. In 2005, the New York Stock Exchange and the Securities and Exchange Commission were bullied into continuing to list Fannie Mae as active, even though it had stopped reporting on its financial condition, and its bonds could no longer be accurately rated as to their quality. That year, the first signs of trouble were already apparent (rising defaults and foreclosures). From then until now, an important part of the mortgage debt market has been flying blind, in a cloud of ignorance about its true situation.

The main fault of the Republicans? Not putting up strong and consistent opposition to these schemes. Occasional fits of opposition, an episode of hard questions from the Bush Treasury in 2004 -- that was about it. Rubin and Summers, both Treasury Secretaries under Clinton, did raise questions about Fannie Mae and Freddie Mac in the late 90s. But such questions were not part of the Democrats' political agenda and were ignored.

POSTSCRIPT: Another half-baked theory has been floated by New York Times economics columnist Paul Krugman, that the financial sector's problems are due to not having enough capital. In fact, the problem is the (too-low) ratio of good assets to total assets. More capital might help and is generally a good idea. But shedding bad assets is a more certain way to reduce the financial sector's immediate agony. Hence, the attempts to create a public RTC-style clean-up/rescue company, to collect and resell bad assets. The problem with the proposed bailout is that no one yet knows the full identity and scope of these bad assets and which institutions are in the deepest trouble. In fact, until the housing market hits bottom, we can't know -- at least, not fully.

Krugman's overrated lucubrations are a sad spectacle of outstanding technical economics talent wasted on dumb politics. Krugman's political obsessions, over and over again, get him into trouble with his economic reasoning. If you want a serious journalistic treatment of economic and financial matters, read the Washington Post's Robert Samuelson instead.
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* Obama's friend, Tony Rezko, is merely the best known of these characters.

There is also the long list of former Congressmen and Senators, former staffers, and relatives who became FNMA and FHLMC employees and part of the army of lobbyists working on Congress to maintain their special status.

Mae I help you?

PRE-POSTSCRIPT: Within the "MAE/MAC" story are wheels within wheels. They're government-backed and subsidized. But they also have their own PACs and spread the campaign donation funds around to Congress. Nonlinear feedback government corruption!

Read here for more from the Wall Street Journal, which was all over this long before it became "news."
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The non-recession continues, with strengthening economic growth figures. Since we live in an age when the media is its own parody, leave it to the Onion to tell it to us straight.*

But what about rising energy prices? That's due more to the falling dollar than anything else. The falling dollar does boost exports. Among other things, strong exports are keeping us from slipping into recession.

But what about the mortgage/finance crisis? That's real, but it effects only one part of the economy. Its roots lie mostly with bad government policies, although demographics play a role too: the Boomers have exited their prime house-buying years. In fact, I wouldn't be surprised if this thing doesn't end with the government-backed mortgage sector going through a controlled disintegration. It's just like the savings and loan crisis from 15 years ago, except Fannie Mae, Freddie Mac, and Ginnie Mae are government-created and government-guaranteed. If their loans go bad, government has to step in and make good on them for their investors. That's what "government-backed" means. Don't expect that fact to stop a lot of whining about "bailing out investors." If we want to not do that, we should stop the government from backing private-sector loans.

The Wall Street Journal has waged a lonely, decade-plus-long campaign against the reckless credit practices of the government-backed mortgage industry. (See this from a year ago.) Reality has caught up, at last, but -- alas -- not the rest of the media.

Boogie Nights return: Here's a depressing item from Megan McArdle on a recent, ignorant declaration by a bunch of University of Chicago professors protesting the positive influence of two of the school's crown jewels, its Economics and Finance departments. Here is more of the Boomer, New Left "progressive" illiteracy at work. Instead of telling people the truth (which is known in the "global south," by the way) -- that the accelerating integration of economies has been immensely beneficial to poorer countries -- we get stale neo-Marxist blather from the 1970s.

Even trained economists who should know better, but who are also infected with desire to relive their long-haired youth -- like Krugman -- are swooning for specious arguments against free trade. And don't mistake it: such willed ignorance is foretaste of an Obama administration, wiping out 30 years of economic progress on an altar of Boomer nostalgia.

We really do seem to be slipping back 30 years or so, what with inflation, the disappearance of a conservative alternative in American politics, and the revival of discredited leftism. Similar policies (an explosion of public spending) lead to similar results. The only things missing are the bad drugs, bad sex, and polyester leisure suits.

But I do hear a cheezy ABBA soundtrack in the background ....
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* Of course, Samuelson does get it right, as he always does. He routinely puts the rest of the media to shame.

The non-recession continues

More evidence continues to appear that the US economy, while struggling, is not in or headed into a recession. The first-quarter annualized growth rate has been revised upward to +0.9%. Employment has continued to rise, although very slowly.* Retail sales have been doing better for several months. Exports are rising strongly, boosted by the cheaper dollar.

That's not to say that parts of the economy aren't in serious condition. The picture continues to be very mixed, with housing and related sectors (construction, finance) doing poorly. The strength of other sectors is currently enough to compensate.

Housing remains the major sore spot. It's sometimes called a "crisis" (what doesn't the media label a "crisis"?), but the collapse of the recent housing bubble is actually the end of a crisis, the crisis of housing unaffordability. Something big has changed: what's ending is the long, demographics-driven 35-year housing boom, the era in which rising house prices practically guaranteed "house = piggy bank." That is a shock to people who planned on housing prices rising at unsustainable rates forever.

The trouble in the housing sector can be gauged in one way by the supply available. In healthy times, the housing stock available for sale is about a four- to six-month supply. Right now, it's about 11 months and still climbing. The housing bubble implosion won't be over until that last number starts dropping.

Should there be a government bailout of the housing sector? No. It's especially important that falling prices be allowed to seek a new equilibrium, rather than attempt to hold them up or bail out the housing construction sector. That will only prolong the backlog of unsold houses. There is a case for a more limited government buyout of low-income housing buyers who were suckered into buying houses by cheap credit and government-sponsored enterprises (GSEs, like Fannie Mae). Government itself played a large role in converting what, under any circumstances, would have been a housing boom anyway into occasional bubbles. There was a brief housing bubble in the late 80s and another, much larger one recently, both sustained by spurts of low interest rates from the Fed.

The bubble clean-up should be treated as the savings and loan clean-up was in the early 90s. That too was the aftermath of a government-enabled bubble. The Federal Reserve responded by encouraging banks to buy out the S&Ls. Congress made one-time payouts to the depositors hurt. At the same time, the S&L industry itself was phased out and a new regulatory structure put in place that limited the government's exposure to bank deposit insurance risk. It would be hard to guarantee that a future Fed won't again flood the economy for sustained periods with cheap credit in order to allay recession fears. What can be done, however, is to phase out agencies like Fannie Mae and Freddie Mac. They're obsolete relics from the 1940s and 50s, before the rise of the modern mortgage industry.

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Some observers have pointed to inflation as a much more serious threat than recession, and Bernanke seems to have shifted closer to this view. Certainly the evidence so far supports it. We've seen jumps in raw material and food prices reminiscent of the early 70s and the Great Inflation. As it was then, a falling dollar is a major factor.

At the same time, there are strong countertendencies not present back then. The drop in housing prices, which will continue for at least another couple years, is one. Productivity and export growth remain strong. There is no push upward on wages and salaries beyond what productivity growth can sustain. All these factors are strong inflation dampers. What we're likely to see in the next few years, therefore, is a limited-inflation environment punctuated by brief but sharp, repeated raw materials price changes. This is a "price shock" environment that economists talked about so much back in the 70s, but without the structural factors that promoted sustained inflation.

Still, it's disturbing that tendencies from the Nixon-Carter era long thought dead have re-appeared: chronic inflation, weakening dollar, raw materials price shocks, the specter of "stagflation." The combination of a large surge in government spending and loose monetary policy, resulting in bubble and bust, is the culprit.
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* It might seem like a paradox, since the unemployment rate increased three of the last five months. But the unemployment rate isn't just people laid off; it's also people looking for work. The latter group has surged in the last couple months, as people neither employed nor looking for work have re-entered the job search pool. The economy hasn't been growing fast enough to absorb all of them into jobs.

The New Deal reconsidered: The forgotten man

After looking at the rise and fall of collectivism over the last century with Jonah Goldberg, let's focus more narrowly on the New Deal itself with Amity Shlaes, author of the recent and remarkable The Forgotten Man: A New History of the Great Depression. The history is again not hidden, merely forgotten. After voters largely repudiated the New Deal in the 1938 midterm elections, the truth about the 30s became more and more obscured in a haze of myth. FDR's reputation, which was sinking from the end of 1937 on, was utterly transformed by his wartime leadership. America's triumph in 1945 put the reality of the New Deal behind a fog of nostalgia.

Understanding the New Deal period and its legacy makes it easier to understand how the rise of the federal welfare state and vote-buying created the interest groups that now dominate American politics. Before, there were local and state governmental welfare functions, but (veterans apart) no federal welfare role. After, the US had something like today's federal welfare state. More pieces have been added since (Medicare, Medicaid, partial federal funding and control of education), but the New Deal remains the watershed. While the New Deal is remembered as a period of experimentation with central planning and government ownership of certain sectors of the economy, those quasi-socialistic features had a short life and were mostly gone by 1939. But the New Deal transformed the older state and local Democratic party machines that doled out money and patronage to Democratic-voting groups (urban ethnic voters, white Southerners, other groups later) into a truly national political machine of "tax and tax, spend and spend, elect and elect."*

That wasn't the way the New Deal was viewed at the time. The Great Depression was an unprecedented emergency of uncertain origins that demanded a reaction. Deeply impressed by experiments in collectivism in Russia, Italy, and Germany, the conventional wisdom for much of the decade was, if not "red," at least a "pink-brown" mix. Even otherwise conservative types (businessmen, Republican farmers in the Middle West and West) were bewitched, for a while, by the false promise of central planning and state ownership (all facts, BTW, conveniently forgotten by the 1950s). Shlaes makes effective use of the large body of work by economists and historians done since the 1930s in better understanding the causes of the Depression. In 1930, while America was still a largely rural country, its farmers had become so productive that there were simply too many of them, trying to hang on by borrowing, only to see grain and other food prices crash periodically, wiping them out. Meanwhile, Europe, America's largest export market, was no longer able to pay its way after 1918. Major European countries had become indebted to the US. But the US, like almost all wealthy countries after World War One, imposed high tariff barriers on the very European goods that could have paid off those loans. American farmers were shut out of their most important foreign markets, leaving that sector weak well before the October 1929 stock market crash. In fact, the US was already in a serious recession by the end of 1928.

What turned a serious recession into the Great Depression was the combination of protectionism, which ended most international trade by the early 1930s, and extraordinarily bad decisions by the Federal Reserve, which had been created in 1913 precisely to prevent from happening what proceeded to happen, a monetary collapse. In order to defend the value of the dollar against the price of gold (the US was on the gold standard in those days), the Fed in effect raised interest rates to member banks to levels never seen before or since. Banks never have enough money to pay all their depositors at any one time in any case, but the resulting deflation (as the money supply contracted sharply) put US banks in a terrible bind. Depositors began to stand in long lines to get their money out, and pretty soon, a third of the country's banks were closed. Without money and credit, a modern capitalist economy comes to a stop. Twenty-six percent of the work force were unemployed. Similar banking collapses happened in certain other countries - most fatefully, Germany and Austria - leading to similar results.**

At the time, various competing theories, most of them partly or completely wrong, were widely debated and believed in: Marxism ("the end of the capitalism"), what eventually became Keynesianism (inadequate aggregate demand), and other, loopier theories. People were desperate, and political niceties like constitutions were looked upon as luxuries. It was in this atmosphere that FDR was elected in 1932. Contrary to later myth, federal reaction had already started under Hoover, including government intervention similar to the New Deal, albeit on a smaller scale. One of the largest mistakes of these policies was their attempt to keep prices and wages up at any cost, instead of letting them float downwards to a new equilibrium, which would have returned the economy to something more like full employment. These measures amounted to a make-believe of wrong-headed, politically decreed prices and wages (see here for a look back at these).

Shlaes takes her title from the late 19th century writings of William Graham Sumner, a forgotten man himself these days, but once a significant light in post-Civil War America. In his earlier work, he was a follower of the Herbert Spencer, the English popularizer of "social Darwinism" in a libertarian, quasi-pacifist form palatable to English-speaking audiences. While he modified his views in later years, Sumner, like most serious social thinkers of that era, never totally abandoned the Spencerian paradigm of peaceful, decentralized social evolution. Such thinkers were already under pressure at the end of the 19th century from various directions: the imperially-minded preaching the "white man's burden," the militaristically-minded who saw (with some reason) the commercially-oriented societies of western Europe and north America as not prepared to face the rising might of Germany, and social reformers who wanted to use government power to coercively bring about social changes and perhaps a planned utopia. Few wanted to abandon political democracy, yet these programs conflicted with the most important features of liberal society. In America, they were called the Progressives, and their frequently misguided crusades form a pre-history of later collectivist ideologies - the "liberal fascism" of Goldberg, with all its inherent internal contradictions.

Sumner put his finger on the core problem with all such collectivist schemes. A agrees to help B at the expense of C. If A and B are organized and vocal pressure groups, they can get away with it for a while, at least. But C must remain oblivious for A and B to keep it going. If C becomes conscious of being exploited and revolts, then A and B are in trouble. The scheme has to be abandoned, at least if democratic practice is to be maintained. The only alternative, Sumner concluded, is violent revolution and coercive dictatorship to keep C in his place. Sumner did not live to see the communist revolutions in Russia or China or the various types of fascism that flourished in the 1920s, 30s, and 40s - but he already had their number. In democratic societies, C is the unorganized majority.

The evidence of this central failure of the New Deal was widely understood by the end of the 30s. Voters started to see that it was impossible to, say, improve the lot of workers overall by raising wages and prices in one industry while making everyone else pay for it. Such policies never made any economic sense. As the New Deal faded away, what was left was something different from 19th century laissez-faire, although well short of socialism: the modern redistributive-regulatory state. It didn't abolish private ownership or markets, but it did come to regulate them, sometimes heavily, and redirect the larger society's consumption and investment patterns. The political heart of it was just the Democrats' old machine politics, but now writ large on a national scale. Favoring certain groups with federal largess, making state and local politicians dependent on federal hand-outs, the New Deal began the move of political life in America away from local and state governments toward Washington (including the beginnings of the centralization and consolidation of political journalism) and the end of federalism.

What kept this system from flying apart were strong political parties and the imperial presidency. These held the underlying centrifugal tendencies in check. But starting in the 1960s, this self-discipline broke down. After Nixon's resignation and the end of the imperial presidency, it was no longer possible to control the abuse of governmental tax, spending, and regulatory power. The modern lobbying industry, born in the 1970s, descended on Congress looking for favors on a scale far larger than before, and Congress was only too happy to oblige - and help itself to pork as well. Sometimes, these favors were sold to voters at large as serving the larger public good (which was rarely true). Modern conservatism started as an attempt to push back against this trend. But it was only partly successful and for a limited time. By the late 90s, the forces of "tax and tax, spend and spend, elect and elect" got the upper hand again - except now, curiously, they were "borrow-spend-elect" Republicans.

POSTSCRIPT: Shlaes gave this talk last fall at Hillsdale College. Consider also this review by David Boaz of another recent book on the 1930s, German historian Wolfgang Schivelbusch's Three New Deals: Reflections on Roosevelt’s America, Mussolini’s Italy, and Hitler’s Germany, 1933–1939.

A somewhat older classic on the rise and fall of 20th century collectivism is Robert Skidelsky's The Road from Serfdom, an excellent complement to these books by Shlaes and others.
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* Harold Ickes' words from 1938.

** Britain and France experienced no banking collapses and so suffered less. But even they faced high unemployment from the late 20s on, especially Britain, which insisted on overvaluing its currency and pricing its exports out of world markets.

Greenspan: Not really all that?

A few postings ago, I attacked the Fed's post-1995 performance as helping to enable the two great asset bubbles of the last two economic expansions, the stock bubble of 1996-2000 and the 2002-2007 housing bubble, now deflating and taking subpar housing borrowers with it. In both cases, recession scares (only a scare in 1994-95; a real, if mild and short, recession in 2001) misled the Fed into keeping credit too cheap for too long. Cheap credit, among other things, then fed the asset bubbles.

An interesting book-length attack on Greenspan has appeared recently, William Fleckenstein and Fred Sheehan's Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve. Their attack aims at essentially the same targets as we have here at Kavanna, points not original with either us or them. But they develop the thought at length and back it up with compelling evidence.

From just skimming the book, the attack seems somewhat overdone. Greenspan's performance from 1987 until about 1995 was quite good, including holding everyone's hands after the 1987 stock market crash and negotiating the savings and loan crisis of the early 90s. After 1994, however, Greenspan lost his fear of inflation - inflation in the conventional, everyday sense of consumer and producer prices - while becoming strikingly blind to asset inflation, as in stocks and real estate. He failed to fully grasp the growth of speculative forces in the economy and how certain governmental policies fed those forces.

We can only hope that Bernanke doesn't repeat these mistakes. Of course, he could make others: there is real risk now of conventional price inflation returning, with all those raw materials prices rising. This risk is more real than the risk of recession. But the Fed only controls a few things. Many unbalanced features of the world economy - especially Asia's tendency to oversave and underconsume and its inability to find adequate investment opportunities except here in America - result from long-standing policies and unforeseen twists in global economic evolution. The cheap loans we get here results from all those international savings being dumped on our credit markets. And far more than the Federal Reserve, those government-backed loan agencies (Freddie Mac, Fannie Mae et al.) and Congress have been pushing home buying hard for more than a decade, with scant regard for whether the borrowers could afford it.

The Fed is a collective, collegial body, with regional boards as well. Concentrating on the Fed chief is misleading and overpersonalizing. Such bodies can be subject to herdthink, but they also allow important information into decision-making that might be otherwise blocked out.

POSTSCRIPT: Fleckenstein, it seems, is a busy man. He's got a blog over at MSN Money.

Lots of economist types, especially the followers of the laissez-faire Austrian school,* have been criticizing Greenspan for a long time on just this issue. Of course, it's the Fed itself they don't like. Just search on "greenspan fleckenstein".
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* Boasting two of the greatest economists of the last century, Hayek and his mentor, Mises: more refugees from the Hapsburg Austro-Hungarian collapse and final representatives of Europe's pre-1914 belle époque.

Stimaholics Anonymous

What a strange recession hysteria we've been experiencing the last month or so. Everyone seems to have forgotten what just happened in the housing market. And it's a failure to understand what a bubble is and what to do about it. The Federal Reserve now has a disturbing decade-and-a-half record of stoking financial bubbles with too-loose monetary policy and ignoring the key truth about bubbles:

The bigger a bubble is, the bigger the collapse afterwards.
The more frenzy at the top, the bigger the mess to clean up afterwards.

With memories of the Great Inflation of the 70s still fresh, the Fed reacted reasonably after the 1987 stock market crash (a result of a sudden change in currency values and interest rates). But its reaction to the late 1994 recession scare was bad: it suddenly flooded the world with dollars and didn't stop until a few years later. The Fed's reaction to the 1997-98 Latin American-Asian crisis was materially implicated in the final phase of the 1996-2000 stock bubble. Its reaction to the 2001 recession (the mildest on record) was to keep the cheap credit spigot wide open long after it needed to be, helping to fuel a classic asset bubble in housing.

There are few signs of a recession in the offing, apart from the media's relentless and ignorant shrieking. All signs point to, if anything, inflation, not deflation and recession. The prices of gold and other commodities have risen by factors of two or three in the last few years. Deflation means a currency gaining in value, not losing (like now). Unemployment is low, below five percent. The big bump in the growth and job numbers happened in September. Jobless claims fell last month. How does that add up to a recession? *

Could it be the real problem is that two sectors of the economy, sectors with high visibility in the media - housing and finance - just drilled a hole in the ground, even though the rest of the economy is doing well? And didn't the housing bubble just suck people into buying houses who couldn't afford it? After all, a classic sign of a bubble is people buying assets just because they feel they can sell them at a higher price to someone else later. That sort of mania induces people to take foolish risks, and it described the US housing market from late 2002 until early 2007. And home ownership rates did rise to historic highs, well above the roughly 60% mark that is the historical average - even while housing prices soared far beyond anything justifiable in terms of building costs or affordability.

The Fed should continue to help larger and more solvent institutions bail out smaller and weaker ones, encouraging the liquidation of bad debt, etc. And by the way, that is exactly what the Fed was forced to do, in the end, in 1990-92 and again in 2001-02, after the "stimulus" drug had lost its effect. The Fed will be doing the same in two or three years, when the real recession arrives, ending the current economic expansion that started in late 2001. But by then, the presidential election of 2008 will be over. Influencing that election with a fantasy "economy" and a fantasy "recession" is the mainstream media's real game here.
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* Recall the definition: two consecutive quarters (six months straight) of contraction in a nation's economic output.