Posts Tagged ‘Housing Bubble’

Quantitative Easting 2.0 that is.  I really found Jeremy Grantham’s letter this month particularly insightful in exploring the ways that cheap money does little to advance the economy, while creating asset bubbles all over the places that must eventually be deflated.  He also makes the good point that a housing bubble is much more damaging and persistent than a stock asset bubble.  And, finally, he exposes the Federal Reserve for all of its foolishness and inability to do very much useful, other than kick the can down the road.  His bottom line:  ” In almost every respect, adhering to a policy of low rates, employing quantitative easing, deliberately stimulating asset prices, ignoring the consequences of bubbles breaking, and displaying a complete refusal to learn from experience has left Fed policy as a large net negative to the production of a healthy, stable economy with strong employment.”

Of course, the Austrians knew this a long time ago.  And, it should never be forgotten, the Federal Reserve was put in place in 1913, had much to do with the housing asset bubble of the 1920s, and in spite of its promises to prevent the business cycle, auguered the Great Depression, which, like our current depression, was made worse by various hair-brained fiscal stimulus projects under FDR.

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Banking by corporations and limited liability companies is not essential to free markets. Like bankruptcy, all of these arrangements involve shifting some of the harm caused by risk-takers onto those who did not take the risks. There may be good reasons to socialize (i.e,. disperse) risk. People may be improvident or need some paternalistic guidance. A certain amount of risk-taking perhaps should be subsidized, i.e., venture capital, homesteading. But there are other means to amass capital and spread risk–not least debt obligations and insurance respectively–without shielding decisionmakers from personal liability to creditors and others in the case of civil offenses and breached contracts. The possible value of tying corporate decisionmakers and stockholders to the downside of corporate risk-taking should be obvious, considering the heads-I-win-tales-you-lose mess we’ve gotten into under the influences of many factors that have spread risk: limited liability, financial engineering, leverage, and the ethos that on the downside these firms (and investors in the same) are simply too big to fail. I wrote something about this many years ago along these lines here and Hillaire Belloc, to his credit, long ago distinguished between the character of real property and the “paper wealth” with which it shares so little in common as far as social benefits goes. Conservatives who are found of free markets should be rethinking their attitudes towards banking, corporations, and the combination of loose money and weak regulation we’ve recently experienced.

An interesting symposium at the liberal-leaning American Prospect discussed the problems of risk, particularly risk with public consequences. It offered an interesting defense of the welfare state along the same lines as the bailouts; namely, that it frees people up to take certain risks. Of course, like FDIC insurance, bailouts, and bankruptcy, that’s part of the problem when it becomes too generous.

The polymath Richard Posner weighs in, concluding that sensible bank regulation failed, and combined with easy money this brought about the recent crisis:

Finally, let’s place the blame where it belongs. Not on the bankers, who are not responsible for assuring economic stability, but on the government officials who had that responsibility and failed to discharge it. They failed even to develop contingency plans to deal with what everyone knew could happen in a context of escalating housing prices (it had happened in Japan in the late 1980s and the 1990s). Lacking such plans, the government responded to the crisis with spasmodic improvisations, amplifying uncertainty and mistrust and thus retarding recovery.

And let’s not forget to apportion some of the blame to the influential economists who assured us that there could never be another depression. They argued that in the face of a recession the Federal Reserve had only to reduce interest rates and flood the banks with money and all would be well. If only.

Finally, in a tour de force, Allan Meltzer eviscerates the continuing inflationary practices of the unholy triumverate of Obama, Geithner, and Bernanke, viz.:

IN the 1970s, with inflation rising, I often described the Federal Reserve as knowing only two speeds: too fast and too slow. At the time, the Fed’s idea was to combat recession by promoting expansion, printing money and making it easier for businesses and households to borrow — and worry only later about the inflation that resulted. That strategy produced a sorry decade of slow productivity growth, rising unemployment and, yes, rising inflation. If President Obama and the Fed continue down their current path, we could see a repeat of those dreadful inflationary years.

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There are probably a million ways to game the Geithner bailout plan, just as the TARP has already led to various unintended consequences, such as the continued provision of generous bonuses by AIG and the Merrill Lynch purchase by BofA. James Galbraith has a good article on this today.

The whole premise of the bailout is that these “toxic” assets comprised of various tranches of bonds secured by mortgages are worth a lot more than the market will presently pay for them.  Is this true?  Yes, their cash flows are in order for now, but there are impending waves of foreclosures and defaults as these loans reset in the next few years. 

The Geithner plan amounts to a bribe to investors.  Invest 7.5 cents, TARP will invest 7.5 cents, and the remaining 85 cents will come from the FDIC. Yes, that FDIC, it being the most important component of stability in our banking system that is supposed to be rock solid in all circumstances. If things go wrong, the 15 cents from the private investors and the TARP are wiped out in the manner of equity, but the FDIC has no recourse other than managing, foreclosing, and then unloading these properties. The FDIC will be in the position of foreclosing upon hapless homeowners, but it will face obvious political pressures to play ball with doomed workouts to help the unlucky. We’ll get to see how good of a landlord Obama is when his role is not “community organizin'” but salvaging value from broke people for the FDIC. My guess: not a very good one.

Under the Geithner plan, banks will sell their “toxic” assets at whatever price they want. Under this scheme, the hope is that somewhere above today’s 30 cents or less in value. The idea is that they’re “really” worth somewhere closer to 60 or 70 cents on the dollar, and that having the banks now take 70 cent (as opposed to 30 cent) losses would be an unnecessary and short-sighted exercise with systemic consequences.

But banks and investors like to make money and avoid losses. That’s in their blood. Why wouldn’t a bank take 7.5 cents of its own deposits to buy certain assets from itself at the requisite 60 or 70 cents, in spite of the fact though the assets are in fact only worth 30 cents, when 85% of the bid price is nonrecouse pain absorbed by the FDIC?  I mean, why not bid 100% if it’s just a question of minimizing losses. That way they can still reduce their collective exposure to 10% or less of what it was, because they would take no losses now and push them off into the future. At most, the gap of 70 cents from actual (i.e., 30 cents) to the $1.00 par value would only cost 7.5 cents to wipe out, and the cost of 92.5% of that shift would be borne on a nonrecouse basis by the FDIC with the remainder by the TARP? Why wouldn’t bank A and bank B do this for one another on a handshake if the self-purchase was too unseemly or prohibited?  What rules would prevent that?

Tim Geithner’s and Obama’s bullishness in general and their talk about the real value of the assets ignores all the impending defaults on the underlying mortgages.  As I already stated, they are probably worth 30 cents at most, and that generous estimate too depends on the continued vitality of home buyers on the scene who will set the market price for the various overpriced and oversupplied 2004-2006 homes. This whole plan shifts the worst banks’ risks on to the most responsible banks and ultimately the taxpayers by giving the FDIC and the Treasury the bill: specifically, at least 92.5 cents of exposure on this plan for every dollar of losses avoided by the banks. Who knew Obama would become the worst banks’ best friend?

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I’ve recently become intrigued by the writings of Nicholas Taleb.  They resonate with me because his criticism of mathematical modeling of markets–i.e., the central activity of “econometrics” and the basis of so much Wall Street activity–has long been a theme of the Austrian School of Economics. The same skepticism of predictability that leads the Austrians to reject socialism also casts a shadow over so much of the noise-making activity of Wall Street. 

Stressing instead, the unpredictability of markets, the role of idiosyncratic (and changing) individual preferences, and the heroic role of the entrepreneur and experience-driven gambles about unmet demand, the Austrians have long condemned the idea that the government, central banks, or even individual investment houses could reliably predict market movements in advance. There is a huge “X Factor,” namely, human action.

Taleb stresses that our social scientific hypotheses and data sets are likely misleading.  We craft comforting narratives from past events, even though these explanations may have little predictive value and can lead to positively dangerous “false positives” going forward.  We are, in essence, stumbling around, looking for answers, with various baffles and blinders. 

Like Taleb’s insights into Black Swans, the nice thing about the Austrian School is that it does not promise utopia.  Instead, it promises the least systemic damage because an authentic free market system–particularly one divorced from central banking and fiat money–is the least systematized.  There may be longer and shorter chains of production, misallocations of capital, and supply shocks, but these problems are dispersed and rooted in the unavoidable uncertainties of market activity.  Unlike the “modern” world of central banking based on fiat currency, temporarily correct but disastrous false signals cannot arise without the harmful pressures of central banking coupled with fiat currency.  Your loss is my gain in a true free market system, and speculators tend to cancel one another out without the false signal of inflationary monetary policy.  Wealth creation might be slower than in the present world of monteary-policy-driven economic bubbles, but so too are the crashes less frequent and less severe. 

Murray Rothbard was fond of pointing to the relatively short-lived 19th Century panics in contrast to the decade-long Great Depression and the repeated multi-year-post-war recessions.

One would have thought the econometricians would have retreated after the failure of Long Term Capital Management in the late 90s, but no such luck.  They returned with the same bravado and cock-sure certainty again, enabled by the same kind of monetary policy that presumes to “create growth.”  Of course, no one can manage the economy, not least the government who, unlike private actors, is concerned equally with social goals and concentrated public choice players as it is with profits and wealth creation.

I was happy to see some criticism of the economists counseling government intervention in today’s Wall Street Journal.  Yet this criticism will likely be drowned out by calls for intervention.  So long as Wall Street’s economists embrace the wrong kind of mathematics in an attempt to predict the unpredictable–with extreme confidence, in fact, backed up by the wrong kinds of statistical reasoning–then the theoretical framework supporting central planning and government intervention will remain.

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