Sunday, January 31, 2010

Cassidy - Not the Partridge

My Brother Thomas forwarded me an article from the New Yorker on the financial crisis and below are my reflections. (The New Yorker, January 11, 2010, John Cassidy, "After the Blow Up", pp 28-33)

I might have too high of expectations about what can be done in a journalistic piece when dealing with thorny and complex scientific issues like this one. My basic fundamental response is he short armed it. That is, it is a little light. It is basically a report on how different economists and people who are pretending to be economists (Posner) "feel" about the current state of economics. I realize I'm overstating it and many of the economists (Fama) don't do themselves any favors by apparently not taking the questions or issues seriously but I really feel like I'd rather chase down some of these questions and really dig down to the root and this article does not get there. I heard something similar on NPR the other day where they did a report of the "climate change community" post reports on e-mail leaks. They just talked to different scientist about how they felt about things. They didn't actually talk about the science. But perhaps that is what journalism is supposed to do. Just report on "important" people's opinions. It just does not feel like we are being fully served and empowered to develop truly worthwhile opinions and make effective decisions if that is all journalism is going to do. We'll need more than journalism. That's just my initial gut reaction. Hope I'm not being too harsh.

Now for some more detailed but much more random thoughts.

Fama: As I noted above he seems to not take the issues to seriously. In that sense he seems to fit the stereotype of the tenured ivory tower professor who can't be bothered with his communities/societies real issues when he has much more important academic and scientific things to think about. (If this sounds sarcastic, it is. I really try not to do this but its Saturday morning so I'm being lax.) That being said I do appreciate his perspective that we have been very sloppy with much of the analysis I have seen on this issue using metaphors to describe things we don't understand in the first place like the term bubble. I remember some "experts" being interviewed a while back, again on NPR, and they said that we were facing economic catastrophe. (Referring to our recent financial crisis) The reporter, attempting to be a good reporter, asked what they meant by that? What does that mean? They responded by saying it would be a complete financial melt down. I will now refrain myself from sarcasm and simply say that both of those expert explanations say only something really bad would have happened with no explanation of what that really bad something is. Very sloppy. Unfortunately, the reporter dropped the ball and did not follow up again. I found this type of coverage of the crisis typical and I'm sure this is what Fama is referring to.

Posnar: I'm sure that Alfred Posnar is a great and brilliant guy and I'm sure that these comments will come off to people in the know as the ramblings of an unstudied bumpkin (at least I hope they do because that’s how my ramblings come off to me) but I was completely under whelmed with Posner and didn't really take anything Cassidy represented from him seriously. Again I will slide remorsefully into sarcasm. First, he is not an economist and while I am a firm believer in being self taught and that we should go looking for things that don't come out the "system" it is a strike against him. However, to continue the metaphor many home runs are hit after the first strike. So, on to the next pitch. Dude, seriously! Dude claims to be an economics expert and had never read Keynes's General Theory?!?! Dude's an amateur. Second strike is a broken bat foul ball. Since he is an amateur he probably only brought one bat which is now broken. So, game over. Not reading the General Theory is like someone who claims to be a Modern American Literature expert who has never read the "The Great Gatsby" or someone who claims to be an expert in Greek mythology never having read any Homer. Give me a break. For my thinking if you have not read Smith, Keynes, Freidman and probably Marx there is no way you should be able to pass yourself off as anything more than a hobbyist and certainly doesn't warrant you being interviewed as an expert by anybody except maybe your small home town paper.

Becker: First a comment on Cassidy's reporting: He presents as shocking regarding Becker "-he has gone so far as to suggest that having children is driven partly by financial considerations." This makes Cassidy sound like a novice and very non worldly. With the exception of unplanned teenage pregnancies I can't imagine a couple or a person not considering finances in the thought process on whether or not to have a baby. This makes Cassidy sound like he just fell off the turnip truck. (Sorry for being mean spirited. I'm sure I would enjoy sharing a beer of coffee with Mr. Cassidy. So, if he reads this I hope he does not take it personally.) However the Becker quote "Yeah, markets aren't fully efficient, but the general thrust that markets are more efficient than any alternative - that aspect I don't think is going to change" is in my opinion the key point for free marketeers. I completely agree with this statement.

Rajan: Cassidy's presentation left me most intrigued and interested with Raghuram Rajan (and not just because we are the same age). I definitely would like to read his book when it comes out.

My perspective: Some day I would like to read a fairly comprehensive history of the banking system. Until I do I think all of this will still be a little mysterious to me. However, my impression is that the U. S. banking system has never operated in a truly lassie-fare manner. So, it is impossible to say with certainty whether a truly free market financial system would work efficiently and effectively without the occasional debilitating crash. So, I am still of the belief that it might. The most recent crises occurred in very (though somewhat de-) regulated environment. There seems to be a consensus that two things contributed to this crisis. 1) low interest rates driven by the fed that fueled lending and 2) loose lending practices which fueled sub-prime loans. I watched part of a Ben Bernake speech on CSPAN in which he analyzed this. I found his presentation much more credible than this article and Bernake basically concluded that item 1 was not the primary culprit. Which leaves us with item 2. Cassidy's presentation of Fama depicted a very "sloppy" presentation on the part of Fama but I think he was on the right track. But if Cassidy is to be trusted (which I'm sure he is) Fama did a pathetic job of defending his position. I think the biggest issue was distorted signals about the lending and housing market driven primarily by the governmental push for sub prime loans precipitated primarily by the implementation of government policy by Fannie and Freddie. Cassidy challenged this by saying that at the peak Freddie and Fannie were buying less 1/3 of the sub prime loans. However, the question is what percent where they buying when the sub prime ball go rolling. Because Freddie and Fannie compete in the market with non-government sponsored entities everyone has to deal with Fannie and Freddie. If Fannie and Freddie are doing it, the "private" entities have to follow suit or risk loosing market share which is very challenging for CEOs to pass by. Especially, when their share holders are screaming to make money. Because the Federal Government is considered to be the safest investment in the world it creates the impression whatever they endorse is probably safe as well (Fannie and Freddie). The pressure for private entities to join the party is no doubt overwhelming and Fannie and Freddie have an inordinate influence in this way. Hence Fama's sloppy comment "How much does it take?" Some banks stayed disciplined like U. S. Bank. I talked to a guy who works there and he said a few years ago they were the laughing stock of the financial industry. Now of course they look very smart. In a market environment distorted by government action it is likely that most private players will get sucked in when bad policy or unintended consequences distort the market.

Finally, I believe that "bubbles", when societies put too many resources into one part of the economy, or "anti-bubbles", when a society does not put enough resources into one part of the economy, are real. Humans are not perfect and can make bad decisions and collectively can make really bad decisions. Bubbles are just a reflection of a society making really bad decisions until it eventually comes back to bite them. I think that is what has happened in the housing/financial crises.

Comments welcome.


Thomas said...

First of all, I have to admit that I'm a “hobbyist” when it comes to economics. I come from a literary background. And so much of literature is about the failures of human beings to either understand or achieve what seems to be the right thing. Literature is littered with men and woman who made bad choices or had fatal flaws. Think tragedy. Also think religion, which for the most part is based on stories about humanities’ flawed nature and how they need a God, or gods, or a moral code to keep them from doing wrong. It’s the interplay between freedom and restriction. Too much freedom can bring out the worst in us, while too much restriction can choke the life out of us. As far as the financial crash is concerned, I think it was a systematic problem that tilted the balance too far in the direction of freedom, which created a climate of excessive risk-taking since many restrictions were either struck down or rendered toothless by lack of funding. Human beings need rules, or else they have a tendency to get themselves in a heap of trouble.

On the issue of Fannie and Freddie, I’ve read many different things about its impact, but one thing I’ve noticed is that views on it often seem to be partisan or theory-based, so it’s difficult to get a clear picture on it. Fannie Mae has been around since 1938, but it was “privatized” in 1968, and in 1970 Freddie was made to compete with it. As far as I can gather, the institutions themselves weren’t the fault, but it was a lack of oversight and accountability, just like in the private institutions, that were the problem. (Although, I think a case could be made that Fannie and Freddie may have outlived their usefulness, especially since Fannie was created in the Depression to help people buy homes. I don’t know if lack of home-ownership is a problem anymore. If anything, too much home-ownership might be the problem. Anyway, it’s probably a moot point now. Fannie and Freddie might be too big to dismantle.)

As far as who led who, I’ve read that Fannie and Freddie were not big sub-prime movers and shakers because they had tougher restrictions than more unregulated private institutions, like Countrywide. I also read that F & F’s big problem was their leverage ratio, which made them more vulnerable to any defaults. In my view, private institutions were led by the lucrative market in both exotic derivatives and the loose standards in securities rather than being led by F & F.

In the New York Times today there was an article about how well Canada weathered the financial crisis. Essentially, they didn’t have a crisis, even though their banking system is quite similar to ours, but unlike us, they chose to maintain certain restrictions, especially on derivatives, and to enforce stricter capital requirements. This was done to minimize risk, and they ended up fine.

As far as me personally, when it comes finance, I’m very risk-averse. I want to make money, not lose money. And for me, I prefer a stable flow, to busts and booms. (Side note: another article in the New Yorker was about how the most successful businessmen don’t take huge risks. They only make deals when the risk to them is almost nothing. It was very intriguing.)

Anyway, I’m not sure what theory that is. I’ll call it the Thomas Theory of Economics: a steady stream is best.

p.s. What do you mean when you say distortions? Also, your take on bubbles makes a lot of sense to me.

John said...

Well I hate to say it but in reality I am really a hobbyist too. I think your thoughts on freedom are interesting and make sense. I would like throw out some examples; too much freedom might be the freedom for an individual to take whatever they want whether someone else created it or procured it for their own use or worse yet, physically harm another person who contradicts the individual’s goals and to do these things without consequences. Interestingly this use of individual freedom limits the freedom of someone else. On the flip side not enough freedom might be to limit to where an individual travels or what an individual can buy or work to make for themselves.

I think that clearly there was excessive risk taking but I’m not sure the cause was excessive freedom. My suspicion is that it had more to do incentives to drive home ownership (via looser lending practices) implemented by congress. Then again, I understand that congress passed a law that allowed people to sell default swaps even though they did not have a direct interest in the underlying securities. But even the resulting problems (AIG coming down due to over exposure to default swaps) may have been in been impacted by market distortions. Default Swaps are the name of the derivatives that caused much of the problem.

I agree. Fannie and Freddie may have outlived their usefulness and I think may be a conduit to the distortions I feel may be the biggest problem. I don’t have a great handle on their role either. I think they helped to establish the 30 year low down payment mortgage as a standard in America that has allowed lots of middle class people to buy houses but that was a long time ago. My understanding also is that banks at least in part follow their standards for generating loans because they know that if they do follow their standards they (the bank) will have a certain market for the loan. That is F&F will always buy a loan that meets their standard. (Not 100% sure of this. That is my impression.) I’m also convinced that F&F have a huge impact on the market given they cover up to 33% of the market. Wal-Mart has 7.5% and 21% of the retail and grocery market respectively and they are considered a giant and clearly influence everything that happens in retail.

The finding regarding Canada is interesting and there is one “de-regulation” that I think was a real problem. The one mentioned above where entities were able to sell default swaps (insurance policies that pay out if an investment, in this case mortgages, defaults) even though they did not have an interest in the mortgages insured. It’s kind of like Verna taking out a life insurance policy on someone else’s husband. In this case of these default swaps it is nothing more than gambling. AIG was making bets that mortgages would not default and when the mortgages started defaulting they did not have enough money to cover all of their bets. This is not investing it is gambling and should not be done by a financial institution and at one point it was against the regulations. However, my understanding is between the George Busch 2 election and inauguration congress de-regulated that and Clinton signed it. In theory I think that markets could sort some of this out too but I wouldn’t fall on my sword over it.

Warren Buffet definitely falls into the steady stream/low risk investment strategies.

John said...

Distortions. Permit me to take a step back and talk a little theory and then attempt to try to explain what I understand to be distortions. I think best in terms of examples. So, let’s suppose that we have a small village that has a small hole that produces clay and pot makers can produce pots with that clay. Let’s say that pot makers can make 10 pots a day with the clay that they can get from the hole and that is it. So, the first day they take their 10 pots to the market and they think they can sell pots for 10 bucks a piece. When they get to the market they find that 20 people want pots. How do they decide who gets the pots since they only have 10. Instead of selling them for 10 bucks they have an action. The 10 highest bidders get the pots. With the auction they find that they can actually sell the pots for 20 bucks a piece. The pot makers are loaded and 10 consumers are happy and 10 are bummed because pots are just too expensive these days. So, a couple of the pot makers have a great idea. There is clay whole that is a mile from town that produces enough clay each day for 20 pots. No one every used that clay before because it takes a lot of time to walk out and get the clay and bring it back and make it. They thought it was a waste of time when you have clay close to town. But if people will pay you 20 bucks for a pot it is probably is worth it. (The market sent a signal with the price of pots that we (society) should make more pots.) So two of our potters go out to the other clay pit and get clay for pots. Even though there is enough for 20 pots they only get enough for 15 because with all the travel time they can’t make that many pots. Of course other potters produce 10 pots from the close clay hole. So, now they bring 25 pots to market. Well again there are 20 people who want pots but with so many pots available no one is going to pay 20 bucks. Another auction ensues and today because there are more pots than buyers the auction price ends up being $8 a pot and some people who didn’t even want pots said hey at that price you can’t go wrong and bought pots anyway. So, all 25 were sold. (the market sent a signal through the price that we now have more pots than society needs). One of the potters that went out a mile away decided that is was not worth it to travel a mile just to get 8 bucks a pot. So, he drops out next day but the other guy is stubborn so he sticks with it. So the next day there are 17 pots and still 20 buyers so the price bounces back up to say 14 bucks. In this way the market rations goods and service in society based on the prevailing price of various goods and services. High prices are a signal that society can use more of something and suppliers can afford to expend more resources to supply that good or services. Low price signals that society has enough of a good or service and that suppliers should stop expending so many resources to supply that service. Price is just a signal that says what society needs more or less of on the one hand and whether at a given price how much resources should be expended to meet societies needs. Now what if on the first day the government found that the price of pots was $20 and that many people could not afford pots at that price. A government regulation might be put in place that said pots must be sold for 10 bucks. If that regulation would be put in place it would distort the signal that the market was sending that pots are valuable and we should make more of them. Instead the pot makers would say well if 10 bucks is all you can get then it’s not worth expending more resources and all we’ll make is 10 pots a day. The signal is distorted and not enough pots are made. It can work the other. The government can feel bad for the potters and say those guys need a break were going to set the price at 20 bucks. At 20 bucks they start making more pots but nobody wants to buy them. (All governments, the US included distort the markets in this way.)

John said...

In the mortgage market price is the interest rate and set based on the availability of money for lending and risk of repayment. If there is not much money available for lending then the interest rate will go up. Telling society that money is scarce we need to be careful how much we use of it for building houses. If there is a lot of money then interest rates go down signaling that hey society has more money. So more people should be building houses. The other variable is risk. When making the loan banks want to try to loan to the least risking people. If they loan to higher risk people they are going to charge more interest. The high interest rate to risky borrowers is a signal that maybe these loans should not be taken at this time. In this case the mortgage market was potentially distorted in two ways. By the Fed when the kept interest rates low signaling that there is plenty of money for loaning for houses and the congress via F&F by saying make loans to risky borrowers. This caused more borrowers to get loans than should have because the signals were distorted.

This is a gross simplification and leaves out some important items like the impact of derivatives (default swaps) which I don’t think were the fundamental problem but made the fundamental problem much worse and the goings on in the housing market which is where the bubble was. But I’m tired. So, I’m going to leave it at that.

I hope you don’t feel this example is to simplistic or like you already knew all that but this is the basic premise of the efficiency of the market economy even from Adam Smith’s time. Markets set prices which send signals to society about how most efficiently to use scarce resources. When governments do things to impact the price setting mechanisms those signals get distorted and society starts to allocate resources less efficiently.

Please let me know what you think of this. There are gaps and I was thinking out loud some but I would like to get your take.

Thomas said...

I understand how letting the market set the price in a local market makes more sense than setting a fixed price. And I see how an artificial price can distort the market and make pots less available. However, what happens when the market expands beyond the local level?

For example, let’s say a more developed country next door is able to mass produce pots at a cheaper price. In an effort to expand their business, they enter the local market of artisan pot-makers with pots marked way below the local market prices to drive out competition and corner that local market. With the presence of this new cheaper product, the local artisans aren’t able to compete. Now, would the mass-produced low-cost pots from the more developed country also be considered a distortion when introduced into the less-developed local market? Wouldn’t those cheap post, which don’t reflect the market in the local economy, be a similar distortion? I guess my question is—are all markets created equal? Can the products from a more developed economy distort the prices in the underdeveloped economy and cause problems?

Thomas said...
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Thomas said...

On a related note, would subsidies and tax credits for businesses also be considered distortions?

This from a recent article in The New York Times:

“According to a letter sent in June to the Senate Finance Committee, BP used a tax break for the oil industry to write off 70 percent of the rent for Deepwater Horizon — a deduction of more than $225,000 a day since the lease began.

And for many small and midsize oil companies, the tax on capital investments is so low that it is more than eliminated by various credits. These companies’ returns on those investments are often higher after taxes than before.

Oil industry officials say that the tax breaks, which average about $4 billion a year according to various government reports, are a bargain for taxpayers. By helping producers weather market fluctuations and invest in technology...”

Since the producer are not bearing the true cost of production, does that then distort the market price and send the wrong signal to society (i.e. gas is cheap, so I’ll use it)?