Some Politics of Housing

At a few points recently I've heard people argue that housing policy is either not politically salient, or has little to do with the sorts of macro outcomes that led to the housing crisis. So I was interested to receive an e-mail from my senator, Kay Hagan, pointing me to this Politico op-ed she co-wrote with Sen. Isakson and Sen. Landrieu:

Families are working hard to rebuild savings while the housing market remains unstable. Recent news from the Commerce Department shows that U.S. home builders continue to struggle despite signs of recovery in other segments of the economy. According to real estate data released this week, home prices in the first quarter of 2011 suffered their worst decline since 2008.

Yet banking regulators are dangerously close to issuing a rule that would put homes out of reach for many Americans and further cripple the fragile housing recovery. ...

But federal banking regulators last month proposed a 20 percent down payment requirement on QRMs. Regulators went for rigidity, rather than a balanced, flexible approach.

In contrast to our express intent — and despite repeated warnings from other members of Congress, consumer groups and bankers — regulators crafted a narrow definition that could unnecessarily slow the housing market recovery, increase costs to otherwise qualified homebuyers and dampen incentives for sound underwriting.

The 20 percent down payment requirement leaves millions of qualified potential homeowners with two grim alternatives: pay higher rates upfront for a mortgage that falls outside the regulators’ proposed QRM standard or delay homeownership for a decade or more to save for an onerous down payment.

Here we have three senators, two Democrats and one Republican, arguing against tougher regulation that would lead to higher lending standards. They obviously think this issue is salient enough to write an op-ed about it, at a time when most political attention is being paid to budget reform and other issues. And this is the first e-mail of this sort that I recall having received from Hagan's office. In fact, I'm not even sure how I got on their mailing list.

This is merely the most recent in a series of policy choices that incentivize home ownership in the U.S. The most notable of these is probably the mortgage interest deduction, which not only encourages home ownership, but also encourages the building and purchasing of larger homes. And the mortgage interest deduction is pretty firmly embedded in the U.S. political economy. In Showdown at Gucci Gulch, journalists Alan Murray and Jeffery Birnbaum describe how the proposal to end the mortgage interest deduction was almost immediately removed from early versions of the 1986 Tax Reform Act, because it was a political non-starter. Indeed, Congress was better able to reduce and eliminate subsidies to some of the interest groups usually considered to be among the most powerful -- finance and energy -- than subsidies for home ownership.

The 1986 Tax Reform Act did eliminate some loopholes in the tax code that incentivized tax sheltering through real estate investment, but these did not affect primary residences. And TRA1986 also eliminated tax deductions from other types of interest, such as on credit cards and other personal loans. But not mortgage interest on primary homes. Nor was TRA1986 able to reduce or eliminate the exemption of capital gains on home investment, so long as it was a primary residence and the capital gains were under $500,000 (for a married couple filing jointly). Some estimations have claimed that these subsidies increase home values by 15%. Considering that roughly 65% of the country are homeowners, and it is not uncommon for a majority of peoples' equity to be in their homes, it's no surprise that this is a politically salient issue.

This despite the fact that there is a broad consensus among economists, environmentalists, and urbanists that this policy skews behavior away from the social optimum. An inflated market incentivizes speculation and over-purchasing. It leads to too much investment. It also leads to suburbanization, and increased energy usage from heating/cooling/commuting. Consider as well that it benefits the middle-class and wealthy at the expense of the poor, particular those poor that live in urban areas. To make up for it, the government extends loans to lower-income (or otherwise less creditworthy) borrowers through Fannie Mae, Freddie Mac, and the Federal Home Loans Banks. These organizations fund or guarantee over $6tn in mortgages, or over 40% of U.S. GDP, representing nearly half of the country's real estate market. The GSEs are well-known to have a lot of political clout, and have resisted repeated calls for reform during every presidential administration since Reagan, at least. And, of course, they were the biggest originators of subprime (and Alt-A and interest-only) loans, the securitization of which was rewarded by the pre-crisis regulatory structure. (Note that current research indicates that the bulk of GSE losses were Alt-A, which are prime loans, if untraditional.) The GSEs held approximately 45-50% of all mortgages in the country throughout the 2000s. Fannie and Freddie were also the largest purchaser of AAA-rated MBS, which created a market for other mortgage lenders to lend subprime and securitize the loan, which fulfilled their requirements to support affordable housing, particularly for low-income borrowers*.

Other aspects of public policy incentivized home ownership (or real estate speculation) in less obvious ways. The large, persistent current account deficit did not lead to a currency crash as many had predicted, but it did lead to an increase in demand for non-tradable goods. Like housing. This current account deficit is not attributable to any single factor, but persistent budget deficits in the private and public sectors certainly played a major role. The large demand for AAA-rated financial instruments in which to invest a "global savings glut" also led to a demand for securitized home loans. Finance was happy to oblige. There were major geopolitical dynamics at play as well.

All to say that housing policy is an important political issue. It's important for citizens in the United States, and therefore for politicians. It's important for numerous interest groups, in the U.S. and abroad. The housing bubble wasn't engineered entirely by Wall Street, although they certainly worked hard to accommodate it. There was demand from many corners.

*I'm not trying to argue here, as many have, that the financial crisis was caused by the GSEs. It wasn't. I'm merely trying to demonstrate that public policy is oriented towards promoting home ownership in many ways that take many forms. The GSEs are part of that. The have a public mandate to extend loans to less-qualified borrowers, but that is not all of their business or even the largest part.

Regulation Blues

Viral Acharya and Matthew Richardson, professors at NYU, do a postmortem on the American financial industry:

But wasn’t the risk transferred through credit derivatives?
Somewhat surprisingly, this is not the ultimate reason the financial system collapsed. If this were it, then capital markets would have absorbed the losses, and the financial system would have moved forward. Instead, blame needs to be squarely placed at the large, complex financial institutions (LCFIs) -- the universal banks, investment banks, insurance companies, and (in rare cases) even hedge funds – that dominate the financial industry.
The biggest fault lies in the fact that the LCFIs ignored their own business model of securitisation and chose not to transfer the credit risk to other investors.
The whole purpose of securitisation is to lay risks off the economic balance-sheet of financial institutions. But the way securitisation was achieved – especially from 2003 to the second quarter of 2007 – was more for arbitraging regulation than for sharing risks with markets.

(italics added)

This aspect of the financial crisis is under-discussed. The popular narrative says that the crisis was caused by an extreme market failure, spurred on by self-regulation of financial markets and ratings agencies. But as Acharya and Richardson note, much of the "financial innovations" at the heart of the crisis arose because of regulation. In other words, the banking industry (which, in actuality, is heavily regulated) securitized debt as a means of holding more risk than regulations allowed. The actual workings of how this was done gets complicated very quickly, but suffice it to say that banks have on-balance sheets capital requirements which preclude them from directly accruing too much debt (i.e. over-leveraging). To get around the regulations, banks began holding off-balance sheet "special investment vehicles" that basically served the same purpose as holding excess risk, but with far less transparency. The ratings agencies looked at the balance sheets and saw banks that were within the regulatory rules, and with acceptable balance sheets, so they gave them good ratings.

Of course it was a house of cards. Everyone mis-priced the systemic risk that these derivatives created. But the irony is that the actual risk exposure to the banks would have been much more apparent to investors, and thus priced more appropriately, if there were fewer regulations, not more. Acharya and Richardson:

In a world without regulation, creditors of financial institutions (depositors, uninsured bondholders, etc.) would put a stop to excesses of risk and leverage by charging higher costs of funding, but lack of proper pricing of deposit insurance and too-big-to-fail guarantees has distorted incentives in the financial system. And, for years, regulation – capital requirement in particular – has targeted individual bank risk, when the justification for its existence resides primarily in managing systemic risk.

This is something that proponents of stricter regulation much answer to: if the underlying problem is that of regulatory arbitrage, will more regulation provide more security or more opportunity for risky arbitrage? The latter seems as likely as the former. (It is also instructive to note that the less-regulated hedge funds have generally fared much better in this crisis than the more-regulated banks, despite the fact that hedge fund operations are much less transparent.)

Unfortunately, if there are answers to be had we won't be getting them from Acharya and Richardson. Their proposals for the future of the financial regulatory structure are vague ("enforce greater transparency"; "prevent obvious regulatory arbitrage"), and beg the obvious question: if regulators and policymakers did such a poor job of anticipating this financial crisis, why should we have any faith that they'll be able to anticipate (and head off) the next one?

And, the Rebuttal

Americans don't like the idea of our tax dollars going to bailout a bunch of companies run by massively rich executives.  Chris Dodd's plan is a reflection of the American voters' affinity for fairness (and punitive measures).  While fairness is a laudable goal, it isn't always the best guide for policy creation, and here's why:

At the heart of Dodd's proposal is the belief that taxpayers will invest too much in this bailout to be satisfied with assuming all of the risky debt with none of the potential upside that equity ownership conveys.  I'd first like to remind readers that there is an entire (profitable) industry that buys bad debt at reduced rates and then finds ways to cajole debtors into paying back that debt - ever heard of a collection agency?  Now, I'm not suggesting that the government start making harassing calls to debtors, but I am pointing out that you can make lots of money by buying bad debt obligations.

More importantly is that critics of Paulson's plan fail to recognize all the positive externalities that this bailout will afford.  Those externalities (basically, the propping up of the economy which keeps jobs from being cut, keeps pensions and retirement savings accounts secure, keeps access to credit relatively cheap) will provide taxpayers much more economic gains then equity positions in the finance industry could ever afford. And we can access those external gains without all the headaches of legislating the terms of a government equity position (how much equity?, what type of voting rights?, when can the government sell its holdings?, potential for increased lobbying from companies in which the government is invested? etc.).

The reason why Wall Street needs bailing out is because the market cannot adequately and independently self-correct due to a preponderance of externalities.  That is why the government needs to step in - because the government doesn't have a free-rider incentive and the government has the clout and the capital to actually get something done.  It would be a mistake to limit the government to behavior of firms - because the government's ability to bolster the economy at this point comes directly from its ability to NOT act like a firm.

Of course, I am not without criticism of Paulson's plan (I'm a grad student for God's sake, it's my job to criticize everything as much as humanly possible), but I'll save those criticism for another post - I'm well beyond my 50 word limit.

Will - tell me why I'm wrong . . . .

In Favor of the Dodd Plan

(Sarah posted a great comment to my post earlier today. At the bottom of my post, I linked to Sebastian Mellaby's citation of several academic proposals which bear some similarities to Sen. Dodd's counter-proposal to the Paulson plan. In the next few posts, Sarah and I are going argue the merits and demerits of the Dodd and Paulson plans. All of this is off-the-cuff, but hey: it's a blog. Apologies for the length.)

Dodd's plan accepts the basic assumptions of Paulson's: that massive government intervention has become necessary in order to stabilize markets and prevent financial market contagion from sinking the real economy. But Dodd's plan differs from Paulson's in several key areas. In my view Dodd's plan improves Paulson's on balance, but I have caveats. The list:

1. Paulson wants unilateral authority, with no review from Congress or the courts. This is insane, undemocratic, illegal, etc. Dodd wants an oversight committee comprised of the Chairmen of the Fed, FDIC, and SEC, plus two representatives from the financial industry. Paulson would still essentially serve as the CEO of United States, Inc., but his board of trustees would be comprised of this committee, which would presumably report to Congress and be subject to the judicial process if necessary. Dodd's proposal alleviates concern along two fronts: first, that too much discretion would be given to Paulson with too little accountability; second, that potential for moral hazard will be lessened because Paulson's actions will be more transparent and authority will be more dispersed.

2. Paulson wants broad discretion to use the cash in any way he sees fit, and has intimated that this will mostly entail buying "bad debt" so that banks won't have to carry them on their balance sheets any longer. This basically means one thing:

Anyway, I wanted to let you know that, behind closed doors, Paulson describes the plan differently. He explicitly says that it will buy assets at above market prices (although he still claims that they are undervalued) because the holders won't sell at market prices. Anna Eshoo pressed him on how the government can compel the holders to sell, and he basically dodged the question. I think that's because he didn't want to admit that the government would just keep offering more and more.

Why? Well, most of the "toxic debt" is still in the form of CDOs, especially mortgage-backed securities (MBS). These things were never intended to be bought-and-sold like other securities. As such, they don't really have a "market price" in the same way that stocks and T-bonds have. Even if they did, that "market price" is effectively $0 at present; simply put, nobody will buy these MBS at any real price. If the problem for banks is that they are short on capital, selling MBS at a massive loss to the Treasury (or anybody else) isn't going to do any good. In order to balance their sheets, they'd still have to sell more equity or dump assets at fire-sale prices. As Krugman has noted, the Treasury will essentially have to over-pay in order to create the desired effect. But that means that the U.S. government and its shareholders (i.e. taxpayers) will be essentially guaranteeing a pretty major loss for itself in order to reduce losses for banks who made bad decisions. This is corporate welfare in the extreme. If Bush and Paulson want that sort of action, then they should have to properly sell it to the American people and her Congress. They don't want to do that, for obvious reasons, so they shouldn't be allowed to get away with it.

3. One way around this problem is to force banks to stop paying dividends and/or to issue more equity (see the Mellaby piece linked in my first post). No banks will do this on their own, because that is a powerful market signal that that bank is failing, a sell-off will ensure, and the firm's value will fall. If the government forces all banks to do it, then credibility can be maintained. But not all banks are on the brink, so why punish those who managed their money well? You could put downward pressure on an already reeling market. And if you only mandate that "sick" banks act in this way, then that will be a strong signal as well, and firm value will still plummet.

So what to do? Dodd proposes that the Fed provide the needed liquidity for firms to roll over their paper. In exchange, those firms will provide equity equal to the size of the government's "investment". In other words, U.S. taxpayers will get equal value for their dollar by paying present market value for partial ownership. We will still be taking on some risk, but now we have a share of the upside and not just the downside. If the firms do well, we may make money. If the firms do poorly... well, the Paulson plan has us taking on that risk anyway.

This is not ideal, in my view. There are still a lot of questions to be asked and answered, and I expect Sarah to spell them out in more detail in her post. But we aren't dealing with "first-best" scenarios here. This may be the best we can do in a bad situation.

As an alternative, Arnold Kling proposes instead to drop the capital requirements for banks. He acknowledges that this will still mean more risk exposure for U.S. government since they insure banks. Not only that, but his proposal doesn't kick in for another year and the crisis is more immediate than that. Lastly, if one of the main problems in this financial trouble is too little risk-aversion by banks (or poor risk judgment, if you prefer), then it seems a bit presumptuous to give more casino credit to these banks and practically dare them to gamble with it. Which leads to...

4. CEO compensation. A loaded topic, to be sure. Dodd's plan, contra Paulson, has provisions for punitive damages for CEOs whose firms have done poorly. Executive compensation and severance packages could be arbitrarily reduced, presumably by Paulson's oversight committee (or Congress?) if it "is in the public interest". Well, what does that mean? What is the public interest? What levels of reduction? Matthew Yglesias wants "punitive measures". John McCain says that CEOs of bailed-out firms shouldn't be paid more than the U.S. President ($400k/year). I automatically recoil at vague language like that in the Dodd plan, but even ignoring that for the moment: what's the incentive facing executives if that clause remains? It's for CEOs and their boards to keep gambling and not seek help from the government if that action would mean that their personal compensation is going to fall from millions to mere thousands. It effectively creates moral hazard for these executives, and that's a really dumb thing to do right now. The government can only respond in four ways to executives who choose to take the gamble: do nothing and let the firms collapse, which defeats the point of this whole exercise; unilaterally violate compensation contracts, which would violate centuries of legal tradition; forcibly nationalize firms which don't want to be nationalized, which is a step (or twelve) further than anyone really wants to go; or appeal directly to shareholders. But shareholders are incentivized to gamble too since they will probably lose everything if the government bails out the firm (see AIG). In any case, such a move would likely take too long when firm survival is measured hour-to-hour.

In the grand scheme of things, CEO compensation is not a big deal. A few dozen million might sound like a lot, until you realize that we're really talking about hundreds of billions right now, at the least. Democrats and progressives would be wise to save that fight for another day; it just doesn't matter right now, and might actually be counter-productive. I'm guessing that these CEOs won't be getting salaries quite so big at their next job anyway.

Deal or No Deal (U.S. Congressman Edition)

Hate to make this place all-bailout, all-the-time, but that's the biggest issue of the day.

If I'm a U.S. Congressman, and I'm being asked to give $700bn to the Treasury Department with no string attached, I say "no deal" whether I'm a Republican or a Democrat. If I'm a Republican, I'm ideologically opposed to massive government programs with essentially no oversight. I'm concerned about the fact that the current Treasury Secretary will likely be replaced in five months, and will presumably be seeking a job on Wall Street at that time. The term "moral hazard" has been tossed around a lot in recent weeks; this plan, if enacted, would immediately go in the Guinness book. If I'm a Republican, I'm also worried that I don't know who the new Treasury Secretary is going to be in five months, he's probably going to be appointed by President Obama (still the favorite according to the betting markets), and if the Congress gives up power to the Treasury Department now it may not get to change its mind later. I'm also wary of the provisions which will be added by Congressional Democrats in exchange for their votes. I note that right-leaning economists are very skeptical of this plan, and not just the far-right libertarians.

If I'm a Democrat, I'm thinking that I'm generally not happy with the way the Bush administration has used the unilateral authority it's had in the past. I'm thinking about Iraq (and not just the decision to invade), a host of civil liberties issues, lack of transparency in general, and corporatist tendencies. I'm thinking about the fact that while McCain is still an underdog he still has a 48% chance of winning (per Intrade), and his most notable executive decision so far has been to appoint Palin as his running-mate, which doesn't give me much confidence about his ability to pick capable technocrats in his administration. I'm very worried about the lack of oversight, since in this proposal Treasury decisions are non-reviewable by the Congress or the courts, essentially making Sec. Paulson the Supreme Monarch of Wall Street, and am even more cynical about moral hazards than my Republican counterpart. I'm concerned that President Obama will be constrained in his ability to enact social spending programs in January if all the money is spent today. I note that left-leaning economists are almost united in opposition to this plan, and not just the far-left anticapitalists.

If I'm a non-partisan wonk, I wonder what the point of this is. If the broader problem is still liquidity, then the Fed can fight that on its own. It's true that Treasuries were actually trading negative for a moment or two last week, but they were still trading, so it doesn't yet look like the Fed is "pushing on a string". In other words, it doesn't yet appear that the Fed has used up all its bullets. Additionally, there is still private and foreign capital out there to be had; if it's become difficult to get that capital, then the Fed and/or Treasury can do some regulatory tweaking on the margins to improve the situation without nationalizing all the risky assets in the world*.

If the problem is solvency, then I'm questioning the wisdom of putting the solvency of the U.S. government at risk. If that's too much Chicken Little for you, then I'm wondering why the government should, without oversight or even a structure of decision-rules, be nationalizing investment losses while keeping investment gains private. We've all heard of corporate welfare, but this may take the cake. And yes, some pension funds and retirement accounts will go down with the ship. That sucks, but that's what we've got a safety net for. Maybe the $700bn would be better spent shoring up those safety nets rather than bailing out Wall Street?

for more from the right, see Mankiw, Cowen, and Naked Capitalist.

for more from the left, see Krugman and DeLong.

Nadav Manham defends the plan here. Let's say that I think his view is best-case, and we have no reason to think that we're in best-case territory here.

*Sebastian Mellaby channels some academics proposing other solutions:

Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments. Banks don't do that on their own because it would signal weakness; if everyone knows the dividend has been canceled because of a government rule, the signaling issue would be removed. Second, the government should tell all healthy banks to issue new equity. Again, banks resist doing this because they don't want to signal weakness and they don't want to dilute existing shareholders. A government order could cut through these obstacles.

Meanwhile, Charles Calomiris of Columbia University and Douglas Elmendorf of the Brookings Institution have offered versions of another idea. The government should help not by buying banks' bad loans but by buying equity stakes in the banks themselves. Whereas it's horribly complicated to value bad loans, banks have share prices you can look up in seconds, so government could inject capital into banks quickly and at a fair level. The share prices of banks that recovered would rise, compensating taxpayers for losses on their stakes in the banks that eventually went under.

Credible Credibility in Credit Markets

Alex's earlier post posed an interesting question:

If the United States is not going to follow its own advice of not intervening in its own financial market to bail out failing domestic firms when staring down one of the biggest financial crises in its history, why should/would any other nation follow the non-intervention policy when a similar financial panic occurs in their economy?

Has the United States lost all credibility to prescribe strict free-market, non-interventionist solutions to financial panic around the world?

It is certainly a question worth asking. But there's another way to look at it. First, consider that there is a difference between the IMF and the US government. They often act in tandem, but that doesn't mean that the actions of one can be conflated as an implicit act of the other. I know Alex didn't mean that, and was instead looking at broader philosophies, but it's still an important distinction.

Secondly, there is a major difference between one country using its own assets to bail out local companies and another country using borrowed money for domestic corporate welfare. Loans always come with strings attached, and the IMF has traditionally taken a pretty strong line: IMF loans are to be used for short-term balance of payments deficits, not for domestic welfare spending. In exchange, the IMF demands structural adjustments in the hopes of preventing a reoccurrence of whatever problem they are trying to fix. (I'm not defending the history of the IMF here; there's plenty to criticize. My point is simply to make distinctions.)

So the proper analogy isn't between IMF loans and domestic US policy, but rather between the terms of the IMF loans as compared to the terms of the Fed/Treasury loans. The Fed/Treasury loans have all come at a high price: Bear Sterns is dead; Fannie Mae and Freddie Mac cease to exist in their previous form, and appear likely to be broken up and liquidated in a fire sale; Lehman Brothers is dead; AIG is still alive, but their problem was liquidity and not insolvency. In all cases, the shareholders lost almost their entire investments. The Fed/Treasury loans, like the IMF loans, came at a heavy price: the way that these entities had previously done business has been completely eliminated, with major losses for the parties involved. In most cases, these business don't even exist anymore. In short, I can see more similarity than difference between the terms of IMF and Fed/Treasury loans.

As for credibility in the eyes of foreign governments and investors: if I were the manager of a sovereign wealth fund which was highly leveraged in US credit markets, recent actions by the Fed and the Treasury would increased their credibility in my eyes. By granting an implicit guarantee to practically the entire U.S. financial system, U.S. investments now look less risky than they would have if all these businesses were simply allowed to collapse without any further thought, with devastating repercussions for the domestic and global economies. If these moves by the Fed/Treasury work out, then future investors can look at U.S. credit markets with some reassurance, knowing that if their investments are on the verge of completely failing the U.S. government will likely step in provide some relief.

Does that create a moral hazard? Like the world has never seen before. These short-term fixes could prove to be incredibly costly down the line, and that's the worry, which is why Lehman was allowed to collapse, Merrill Lynch was forced into selling to Bank of America: the Fed had to draw the line somewhere. After all, a lot of the current troubles were aided by massive inflows of foreign capital into U.S. markets, which made loans so affordable in the first place. The U.S. credit markets were already perceived as being the safest in the world; with an explicit government guarantee, that safety might look even more appealing to foreign investors, and dramatic flows of foreign capital might keep coming. Right now, we need the liquidity, but in the future if money stays as cheap as its been in the past 5-7 years we might face another crisis similar to this one. Unless we get a lot better at assessing risk, of course.

UPDATE: Ken Rogoff is thinking along similar lines:

One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it. ...

It is a very good thing that the rest of the world retains such confidence in America’s ability to manage its problems, otherwise the financial crisis would be far worse.

Let us hope the US political and regulatory response continues to inspire this optimism. Otherwise, sharply rising interest rates and a rapidly declining dollar could put the US in a bind that many emerging markets are all too familiar with.

Export-biased foreign countries know that their economic fortunes are tied to ours, so it's likely that they'll keep pumping money into our markets as long as they have no better alternative, keeping interest rates low and the dollar relatively high. If they ever stop, it'll hurt us badly, but it might hurt them worse. Another key: U.S. debt is dollar-denominated, so we don't have to worry about exchange-rate fluctuations when servicing this debt. Indeed, we can just inflate the debt away if it comes down to it. Foreign central banks and sovereign wealth funds know all this; they are incentivized to keep the U.S. markets afloat by providing capital to ease liquidity trouble, just as the U.S. government is.

Good Discussion of the U.S. Economy

Robert Rubin and Lawrence Summers were on Charlie Rose a couple of nights ago. The conversation was very good, although Rubin and Summers are both more pessimistic than some other economists. They spent most of their time discussing ways to improve the U.S. economy in the future, and the dangers of playing political games while the nation's economy burns. The entire episode may be watched here, but a snippet is below.

Fannie, Freddie, and International Relations

Fannie Mae and Freddie Mac, the quasi-private investment groups that own or guarantee roughly half of the U.S. mortgage market, have now effectively been nationalized. The purpose of this blog isn’t to run-down all of the domestic effects of this (for that, see Brad DeLong and Calculated Risk, and keep in mind that Fannie & Freddie own or guarantee about $6 trillion in American mortgages), but there are implications for IPE study as well.

For example, central banks, sovereign wealth funds, and other international investors bought heavily into Fannie Mae and Freddie Mac, because they were under the impression that the investments were as close to riskless as one could get*. As Treasury Secretary Paulson noted, nearly $5 trillion in Fannie/Freddie debt and securities are owned by investors all over the world. To put that into perspective, the combined GDP of the U.K. and Italy in 2007 was less than $5 trillion. There is simply no way that the U.S. Treasury could let the companies fail and allow those nations (and other investors) to take a hit that big. If they did, says Tyler Cowen, the effects would be catastrophic:

The flow of capital from them and from other central banks, sovereign wealth funds, and plain old ordinary investors would shut down very quickly. The dollar would fall say 30-40 percent in a week, there would be payments system gridlock, margin calls at the clearinghouses would go unmet, and only a trading shutdown would stop the Dow from shedding half its value. Most of the U.S. banking system would be insolvent. Emergency Fed/Treasury action would recapitalize the FDIC but we would lose an independent central bank and setting the money supply would be a crapshoot. The rate of unemployment would climb into double digits and stay there. Many Americans would not have access to their savings. The future supply of foreign investment would be noticeably lower. The Federal government would lose its AAA rating and we would pay much more in borrowing costs. The deficit would skyrocket.

Tyler Cowen isn't known as a pessimist, but considering that “when the U.S. sneezes, the world gets a cold,” the prospects for international financial markets as a whole could have been catastrophic if the U.S. had not acted. In short, it’s likely that international political concerns, such as maintaining the credibility of the U.S. government in the eyes of other foreign nations, have essentially forced the Treasury Department to step in, even if they didn’t want to.

The news of nationalization was greeted warmly by nearly everyone. The announcement was made yesterday for the benefit of foreign financial markets trading overnight, and those markets responded by posting large gains. The heads of the European and Japanese central banks spoke positively of the take-over. There is still some pain ahead, especially for domestic banks, but by nationalizing Fannie and Freddie the U.S. Treasury may have dodged a bullet. At least temporarily.

*As it turns out, they were right: these investments were largely riskless since the implicit guarantee of the debt by the U.S. government has now turned into an explicit guarantee. Are there moral hazard concerns? You betcha. But, as the saying goes, "in the long run, we're all dead."

[UPDATE: U.S. markets posted huge gains today in response to the bail-out news. The dollar gained against the Euro, Pound, Swiss Franc, and Yen.]

We're Not So Special

Kenneth Rogoff: "As the United States’ epic financial crisis continues to unfold; one can only wish that US policymakers were half as good at listening to advice from developing countries as they are at giving it. Americans don’t seem to realize that their “sub-prime” mortgage meltdown has all too much in common with many previous post-1945 banking crises throughout the world.

Professor Carmen Reinhart of the University of Maryland and I systematically compared the run-up to the US sub-prime crisis with the run-up to the 19 worst financial crises in the industrialized world over the past 60 years. These include epic crises in the Scandinavian countries, Spain, and Japan, along with lesser events such as the US savings and loan crises of the 1980’s.

Across virtually all the major indicators – including equity and housing price runs-ups, trade balance deficits, surges in government and household indebtedness, and pre-crisis growth trajectories – red lights are blinking for the US. Simply put, surging capital flows into the US artificially held down interest rates and inflated asset prices, leading to laxity in banking and regulatory standards and, ultimately, to a meltdown.

The US economy is in trouble, and the problems it spins off are unlikely to stop at the US border. Experts from emerging markets and elsewhere have much to say about dealing with financial crises. America should start to listen before it is too late."

You can access the academic paper this op-ed draws upon here.

While the House Burns

Legend has it that shortly after FDR's inauguration in 1932, Congress engaged in a long floor debate on one of the components of the first New Deal. As the debate carried on into the night, a group of legislators began heckling, "the house is burning! the house is burning!" In that spirit, I give you the following.

The Group of Seven meet tomorrow in Tokyo to confirm their unwillingness to work collectively to stabilize the world economy. The list of items on which the world's advanced industrialized countries cannot agree is short but includes practically every policy that matters.
Exchange rates: EU governments are not particularly happy about the dollar's weakness, but the US is unwilling to discuss exchange rates.
Fiscal policy: Governments disagree about the need for a coordinated fiscal response. While the UK is contemplating fiscal expansion, the Japanese and Germans resist. The German attitude is particularly troubling: "Germany’s deputy finance minister has said the blame, and thus the responsibility, lies squarely with the US."
Monetary Policy: The Fed has slashed rates. The ECB remains committed to its current emphasis on holding the line against incipient inflation and shows no indication that it believes that it should shift away from that target (H/T Mankiw). (Brings the old adage to mind: "Generals always prepare to fight the previous war."

I'm not saying that 2007-08 is the same as 1929-1932, but in the face of a pretty serious financial crisis that has raged, with varying degrees of ferocity, since mid-2007, one can't help but be a little concerned (and puzzled) by the systematic unwillingness to consider any kind of cooperative response. Also, isn't it about time we started to invite China to these affairs?

How do We Extract Signal from Noise?

As we head toward the New Year, I offer some fundamental skepticism. In a very cheery examination of the current financial situation, Ambrose Evans-Pritchard seems almost to relish the collapse of the international financial system. He seems uncannily able to find bankers willing to make extreme statements, such as: "Things are very unstable and can move incredibly fast. I don't think the central banks are going to make a major policy error, but if they do, this could make 1929 look like a walk in the park." How's that for a little New Year cheer?

I feature Evans-Pritchard's recent work because it nicely highlights one of two questions I have been pondering for the last two weeks (I will post on the second question tomorrow). How do we humans extract meaningful signal from all the noise? We seem strongly attracted to worse-case scenarios; we compare the current situation to 1929 rather than to other financial episodes that did not produce a global cataclysm (1987, for example, or the bursting of the dot com bubble). The media feeds us quotes with no evidence about where the people quoted fall in the distribution of opinion and analysis. Are the quoted bankers representative of the median view, or is the writer drawing from the gloom-and-doom end of the spectrum? Do the people quoted have incentive (monetary or other) to portray events in a particular manner rather than present "objective analysis?" In short, how does one figure out the "truth" in a world in which the critical question is "what is going to happen?", when the information we have at hand is of uncertain quality and quite possibly biased, but the degree of bias is unknown (and unknowable)?

This seems to be a very hard problem, and yet one we face on a regular basis. For those not interested in the current financial crisis, then ask the same question of global warming. If you are unwilling to fall down the global warming warren hole (and having disappeared into that hole for a full week, I can hardly blame you if you are not), then ask the question of genetically modified organisms. If GMOs do not interest you, then what about economic development? All of these issues pose the same dilemma: we are asked to make decisions today to achieve some future consequence relying on knowledge first produced and then reported by groups of people who may or may not be motivated by the objective quest for truth and that therefore may or may not be biased in ways we cannot accurately measure.

In short, why do we believe what we believe, and should we? How do we extract the meaningful signal from all of the noise, and how do we know that we have extracted the meaningful signal? I don't have the answer, but we seem to believe that the political process is good at selecting the "correct signal." Why do we believe this? Should we?

Krugman on the Fed and the Financial Crisis

"What’s going on in the markets isn’t an irrational panic. It’s a wholly rational panic, because there’s a lot of bad debt out there, and you don’t know how much of that bad debt is held by the guy who wants to borrow your money.

How will it all end? Markets won’t start functioning normally until investors are reasonably sure that they know where the bodies — I mean, the bad debts — are buried. And that probably won’t happen until house prices have finished falling and financial institutions have come clean about all their losses. All of this will probably take years.

Meanwhile, anyone who expects the Fed or anyone else to come up with a plan that makes this financial crisis just go away will be sorely disappointed."

Pushing on a String?

Keynes argued that the Great Depression persisted in part because of a "liquidity trap" wherein banks are unwilling to lend regardless of the nominal interest rate. In such a world, monetary policy is useless--he equated trying to use a monetary expansion to stimulate lending to trying to move a weighty object by pushing on the end of a string.

One might ask if global credit markets have now entered a period in which monetary policy amounts to pushing on a string. Credit markets are frozen because banks are uncertain about which banks among them hold how much bad debt (non-performing sub-prime mortgages and associated instruments). Because no one wants to lend to banks who hold a lot of this debt, and no one knows who these banks are, no one is willing to lend to any banks. Consequently, credit markets freeze. The underlying problem is an information asymmetry of the kind that for which Joseph Stiglitz won a Nobel Prize (well, not technically a Nobel, but you get the point).

Yesterday's announcement that US and European central banks will cooperate to provide liquidity to credit markets is best interpreted in this context. "The Fed has not only opened its vault doors to the banking industry, they are now trucking it to their place of business," said Scott Anderson, a senior economist at Wells Fargo, in a written report. "If that doesn't get the banks excited about lending again, nothing will...The Fed's action attempts to deal with a difficult problem confronting the world's central banks: Financial institutions globally are so worried about losses from U.S. mortgage securities and other exotic investments that they are hoarding cash, unwilling to lend it to each other except at unusually high premiums."

I don't know whether to be scared or reassured by this latest development. That is, does this unprecedented action mean that the central banks have things well in hand, or does it mean that things are worse than we realize?

US Sneezes; World Gets Sick

While the US struggles to manage the sub-prime problem, Europeans are beginning to feel unwell. A story in The Daily Telegraph (UK) nicely spells out the European Central Bank's dilemma--caught between slowing growth and rising inflation and then wonders whether EMU is at risk.

"Interest rate spreads between government bonds in France, Spain, Germany and Italy have lately got wider and wider. In other words, believe it or not, the markets are increasingly betting on the eurozone breaking up – as political tensions rise, and the needs of inflation-averse nations like Germany can’t be reconciled with much weaker debt-driven members like Ireland and Spain. Could it happen? Why not? Every other currency union in the history of man has broken up – unless, like the US and UK, it has been preceded by generations of political union, and held together with a federal tax system. It sounds far-fetched, I know. But the ultimate victim of this sub-prime crisis could be nothing less than the single currency’s existence."

Wishful thinking from a euroskeptic? Perhaps, but this is the first real test of the EU's ability to weather a real economic problem (and an asymmetric shock) with a single monetary policy.

A thousand miles north, a tiny Norwegian town above the Arctic circle struggles to recover from the losses it suffered from investing in assets derived from sub-prime mortgages. The town government invested a quarter of its annual budget of $163 million, and lost a substantial share of the investment (how much is not fully clear).

Residents are unhappy: "As the losses begin to bite, the political finger-pointing has begun. Down the hall from Ms. Kuvaas, the town’s opposition leader, Torgeir Traeldal, is calling for an investigation of how and why Narvik could have made such an ill-advised investment. “Heads are going to roll,” Mr. Traeldal said, repeating the phrase a few times to drive home his point."

Weak Dollars, Subprime Messes, and Monetary Policy Dilemmas

When does the dollar's depreciation become serious? When Chinese officials start talking in public about shifting its $1.43 trillion of reserve holdings out of dollars and into other currencies. The markets are already a bit skittish; loose talk does not help.

Can the U.S. do anything to bolster the dollar? It appears that the U.S. is caught between the classic rock and hard place. On the one hand, domestic financial difficulties resulting from the subprime mortgage mess has encouraged the Fed to cut rates and inject liquidity to ease market conditions. Rate cuts and extra liquidity, however, weaken the dollar. If the Fed wants a stronger dollar, the required higher rates will squeeze financial institutions. Not much of a choice; bolster the dollar at the short-term cost of worsening the financial crisis; inject liquidity at the short-term cost of a weaker dollar.

The Fed's current dilemma is hardly unique. It is not fundamentally different than the dilemma Thai and Indonesian governments faced in 1997; not fundamentally different than the dilemma Austrian authorities faced in 1931. Not fundamentally different from the dilemmas posed by financial crises throughout history (the 1907 and 1894 panics come to mind as well). In all of these cases, monetary authorities had to choose between actions that saved key domestic financial institutions and actions that stabilized the currency. Yes, the contemporary US is different--no fixed exchange rate as a focal point for speculation; no precious metal reserve constraint--yet still, it must choose between internal and external objectives.

What surprises me is that even those at the Fed who oppose further rate cuts make no mention of the dollar as a reason for their resistance.