Tag Archives: financial crisis

The Future of Too Big Too Fail

As we emerge from the financial crisis, it is important to develop a framework for dealing with failing institutions. In particular, the nature of the doctrine of “too big to fail” must be addressed and re-examined. Recently, John Taylor and Larry White have spoken out about the need for a rule of law rather than a discretionary authority. Their comments and my thoughts are below the fold.

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Can We Please Raise the Level of the Debate?

In all of our self-importance, economists and political pundits have seen the current recession as a time to argue about whether markets clear. Inevitably, the discussion on financial news networks always devolves into a debate about whether markets are efficient, etc.* (Incidentally, can I call cross-talk and yelling a discussion? I am talking to you CNBC.) A prime example of this type of discourse is found in a recent article by John Tamny and a subsequent post by Ezra Klein.

Tamny’s article essentially extols the virtues of free markets. He points out that recessions often lead to falling asset prices, which allow others to purchase these assets and use them more wisely. Tamny is correct that an important part of any recession is the reallocation of assets and capital. However, when making a larger point about the macroeconomy and the policy, it often doesn’t serve ones case to provide anecdotal examples of how markets clear.

Ezra Klein rightfully scoffs at using such examples to sell markets as well as articulating the left-of-center response that although markets might clear, the process can be painful. Unfortunately, Klein continues:

What would a “humble federal government” do, exactly? Shut down the stimulus projects so a couple million more people end up unemployed and a couple million other people can buy their possessions at fire sale prices? Shut down the system of financial supports which are currently sustaining a weakened lending market? Should they have held back from Detroit’s collapse so that the assets of the various companies were simply liquidated, along with what was left of the Rust Belt’s economy? Should they cut off economic aid to the states so infrastructure literally crumbles?

A course these are all loaded questions. For example, even if the stimulus were to save “a couple million” jobs, this would come at the expense of either current or future consumption due to the increase in future tax liabilities that was created thereby causing job losses where this money is no longer spent. (We have been through the literature on this before.) It is similarly questionable why the automakers would have to liquidate upon entering bankruptcy without government assistance.

More:

At the end of the day, it will be a resuscitation of household spending and business expansion that restarts our economic growth. But for now, both have fallen through the floor, with terrible consequences for both individuals and businesses. What little demand exists is being substantially kept afloat by the massive intervention of the federal government.

Define “little”. I would describe several trillion as substantial. Furthermore, there must be a very large multiplier, especially considering much of the fiscal stimulus hasn’t even been spent.

More:

…the idea that the economy will heal itself if the government only steps out of the way is exactly the thinking that led to the deep recession of 1937. What a pity those lessons haven’t been better learned.

I am struggling to understand how the year that FDR decided to raise taxes and the Federal Reserve decided to increase reserve requirements thereby leading to another monetary contraction strikes one as government getting out of the way. It is indeed a pity that those lessons haven’t been learned.

I don’t mean to pick on Klein or Tamny, but rather highlight the fact that this debate is rather silly. We did not live in a world of laissez faire prior to the financial crisis — nor prior to the Great Depression — and thus it seems more than a bit self-important to sit around and debate whether markets clear as though we are living through the quintessential moment in which this argument will be won. It is also important to realize that the fact that markets fail does not imply that government can perform any better.


* I find this entire debate to be quite a bit tiresome as well considering that banks are one of the most heavily regulated industries in the country (by this I mean the actual regulation that is supposed to be enforced, not what actually is enforced) as well as the fact that the Federal Reserve, whose power is derived from the government, plays such a central role in this entire fiasco.

Leijonhufvud on the Financial Crisis

Axel Leijonhufvud has written an excellent policy paper for CEPR. Some highlights after the jump.

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The Stimulus Debate and the Stimulus Package

Will Wilkinson has been ridiculing macroeconomics for the last few weeks for the apparent inability of theory to provide a consensus view on the stimulus package. While I admit that there is a great deal of debate among economists about the desirability of the stimulus package, one must understand both macroeconomic theory and the nature of the debate to actually make sense of the bantering. The simple “macroeconomics sucks” mantra, while provocative, is not a legitimate criticism.

The stimulus debate is largely centered around two questions:

1. Can we create a stimulus package that will boost real GDP in the short run?

2. Can a stimulus package get us out of the recession?

The problem with the debate is that those in favor of the stimulus package answer question 2 in the affirmative while actually providing evidence for question 1. On the other hand, those who oppose the stimulus package do not believe that the it will get us out of the recession, but argue on the grounds that it cannot even boost real GDP.

I have already discussed what macroeconomic theory has to say about a potential stimulus package and so I will not belabor the point. Suffice it to say that, if designed correctly, a stimulus package could provide a temporary boost to real GDP. It will not, however, get us out of the recession.

Of course, this brings us to the actual stimulus package. The problem that we are dealing with is that what is being proposed is not based on any type of economic theory, but is rather a grab-bag of goodies to be handed out under the guise of being of the public interest. This is, of course, something that is implicitly assumed by many stimulus skeptics and ignored by many of the stimulus advocates. Nevertheless, the stimulus in its current form likely renders this debate to have been for naught.

A Note to Critics

The belief that macroeconomic theory is garbage and that it has nothing to say about the current crisis (and policy) is pure myth. This is one of the points that I tried to make in writing my piece on the stimulus package.

Will Ambrosini (who has been added to the blogroll) suggests that critics actually survey the literature before leveling their charges.

Thoughts on Stimulus, UPDATED

The debate over stimulus is growing quite divergent. First, there is understandable disagreement about the nature of stimulus policies in and of themselves. Second, the is a growing debate as to whether or not the Obama stimulus plan itself will be successful. (I have previously offered my thoughts on stimulus here.)

The first debate is laid out explicitly by Robert Barro, who in today’s WSJ discusses the multiplier associated with government spending:

Back in the 1980s, many commentators ridiculed as voodoo economics the extreme supply-side view that across-the-board cuts in income-tax rates might raise overall tax revenues. Now we have the extreme demand-side view that the so-called “multiplier” effect of government spending on economic output is greater than one — Team Obama is reportedly using a number around 1.5.

To think about what this means, first assume that the multiplier was 1.0. In this case, an increase by one unit in government purchases and, thereby, in the aggregate demand for goods would lead to an increase by one unit in real gross domestic product (GDP). Thus, the added public goods are essentially free to society. If the government buys another airplane or bridge, the economy’s total output expands by enough to create the airplane or bridge without requiring a cut in anyone’s consumption or investment.

The explanation for this magic is that idle resources — unemployed labor and capital — are put to work to produce the added goods and services.

If the multiplier is greater than 1.0, as is apparently assumed by Team Obama, the process is even more wonderful. In this case, real GDP rises by more than the increase in government purchases. Thus, in addition to the free airplane or bridge, we also have more goods and services left over to raise private consumption or investment. In this scenario, the added government spending is a good idea even if the bridge goes to nowhere, or if public employees are just filling useless holes. Of course, if this mechanism is genuine, one might ask why the government should stop with only $1 trillion of added purchases.

Barro then uses World War II spending to estimate the multiplier effect of government spending. What he finds is that the multiplier for this period is about 0.8. What this means is that for every $1 that the government spent, GDP increased by $0.80. For times of peace, he finds that the multiplier is statistically insignificantly different from zero (we cannot reject the hypothesis of a complete crowding out of private expenditure, for non-econ nerds). Indeed, this is consistent with Hayek’s critique of Keynesian policies. Hayek pointed out that while Keynes criticized classical economists for assuming full employment, Keynes was implicitly assuming unemployment of resources.

Barro’s peacetime finds warrant further investigation as he does not state whether this measurement is for all periods or times of less than full employment as well as whether he is referring to temporary or permanent government purchases. However, it is clear that his findings regarding World War II fail to satisfy the ceteris paribus assumption needed for such analysis. As Paul Krugman explains:

Consumer goods were rationed; people were urged to restrain their spending to make resources available for the war effort. Oh, and the economy was at full employment — and then some. Rosie the Riveter, anyone? I can’t quite imagine the mindset that leads someone to forget all this, and think that you can use World War II to estimate the multiplier that might prevail in an underemployed, rationing-free economy.

Nonetheless, the debate about the multiplier is perhaps the important question regarding the stimulus package and despite the possible flaw in using World War II data, I think that Barro’s conclusion regarding the multiplier being below 1 is likely correct. After all, I don’t think that we can make the claim that there is no crowd out effect or that the multiplier overwhelms any crowding out.

On this point, Casey Mulligan has offered some interesting thoughts. His main conclusion is as follows:

Government spending will reduce private spending virtually anywhere it may be targeted. The case for government spending should thus be made on its intrinsic, not stimulation, value.

I think that this is perhaps the best way of thinking about stimulus. I agree with Barro and Mulligan in that the multiplier is likely between 0 and 1. I do not buy the argument that it is zero in the current environment. Thus, if it is close to one, there is an argument that can be made for spending based on its intrinsic value. For example, the modernization of government facilities and the rebuilding of infrastructure represent these types of ideas. Ultimately, the multiplier is dependent upon the spending itself. For example, if spending is temporary (as is implied in the examples just given) the multiplier is likely to be larger than if spending is permanent. In the latter case, there is substantial reason to believe that the multiplier is quite small and perhaps near zero.

This brings us to the question as to the likelihood of success of the Obama stimulus package. Mulligan warns of the particular aims of the stimulus:

Despite the recent increase in unemployment rates, I see little reason why the multiplier situation is realistic. For example, President Obama’s economists have explained that about half of the jobs they plan to create (both directly and indirectly) are for women. But the large majority of this recession’s employment reduction has been among men. Thus, the Obama spending plan is not intended to primarily draw on the pool of people unemployed in this recession.

President Obama has a vision to spend more on health care, largely for its intrinsic value. Its stimulation value is minimal because unemployment is low in that sector; health sector employment has actually increased every single month during this recession.

I am not optimistic about stimulus in terms of lifting us out of the recession and, in particular, I am not optimistic about many aspects of the Obama stimulus plan. Further, the assumption of a multiplier of 1.5 is incredibly unlikely. I would much rather see meaningful tax reductions (e.g. lower marginal rates, lower corporate tax rates).

UPDATE: There has been a great deal of discussion in the blogosphere surrounding the nature of the rhetoric, especially with regards to Krugman’s comment that Barro’s analysis was “boneheaded.” In this respect, I think that Tyler Cowen’s comments sufficiently summarize my view:

Either way you cut it, there aren’t any boneheads in the room.

Indeed. After all, Robert Barro essentially wrote the book on government from a macro perspective. The tone of the debate is trending down and I think that we would all do well raise the level of discourse to a respectful tone.

Again, my view (free of name-calling) is that:

1. Stimulus will not get us out of the Depression.

2. The multiplier for government spending is likely between 0 and 1, which means that $1 spent by the government results in less than a $1 increase in real GDP.

3. Given (2), the proponents of the stimulus package must make their proposals based on intrinsic value rather than on promises that are impossible to keep. On this point, Barro is right on, “Back in the 1980s, many commentators ridiculed as voodoo economics the extreme supply-side view that across-the-board cuts in income-tax rates might raise overall tax revenues. Now we have the extreme demand-side view that the so-called ‘multiplier’ effect of government spending on economic output is greater than one — Team Obama is reportedly using a number around 1.5.”

Questions For Tim Geithner

The NYT is running a piece in which economists (and others) propose questions for Tim Geitner. My favorite questions come from Anna Schwartz:

1. Ordinary taxpayers would like an answer to this question: Why have they been billed more than $45 billion to rescue Citigroup from failure when, as president of the Federal Reserve Bank of New York, you were its primary supervisor? Three major problems led to Citigroup’s downfall: bad investment policy; overexpansion, which overwhelmed Citigroup’s management; and an inadequate capital base. Why was Citigroup’s supervision inadequate to deal with these problems?

2. The Treasury and Federal Reserve have been selecting which companies in American industry and finance will get taxpayer money. What criteria do you use to decide?

3. During the banking crisis of the late 1980s, assets of failed savings and loans were acquired by the government’s Resolution Trust Corporation. The trust corporation then sold off the assets in an orderly fashion. Would you consider requesting Congress to revive the Resolution Trust Corporation, so you would not have to decide which companies to save and which not to save? Would you consider re-establishing the trust corporation now for commercial banks that are likely to fail?

— ANNA JACOBSON SCHWARTZ, an economist at the National Bureau of Economic Research and the author, with Milton Friedman, of “A Monetary History of the United States, 1867 to 1960”

Taylor on the Crisis

If I could only recommend one economist to read on the current financial crisis, I would choose John Taylor. His latest paper details the causes of the financial crisis as well as the subsequent policy responses (and failures). Here are some highlights:

  • He presents evidence that the Federal Reserve significantly deviated from its historical behavior (the Taylor Rule), which created the boom-bust scenario in housing.
  • He presents counter-factual evidence through the use of simulation that suggests the housing boom would have been avoided had the federal funds rate not deviated from the Taylor rule.
  • He rejects the global savings glut hypothesis.
  • The behavior of other central banks similarly deviated from the Taylor rule and those with the largest deviations also had the largest housing booms.
  • There is a connection between excessive monetary policy and risk-taking.
  • The subprime mortgage market exacerbated the problem.
  • The financial crisis was (is) not a liquidity problem, but rather a counter-party risk problem.
  • There is a strong correlation between the sharp cuts in the federal funds rate and the price of oil.
  • Credit spreads increased in the aftermath of the announcement of the TARP. (Taylor blames this on the uncertainty surrounding the vague discretionary power of the Fed/Treasury in implementing the plan.)
  • From his conclusion:

    “In this paper I have provided empirical evidence that government actions and interventions caused, prolonged, and worsened the financial crisis. They caused it by deviating from historical precedents and principles for setting interest rates, which had worked well for 20 years. They prolonged it by misdiagnosing the problems in the bank credit markets and thereby responding inappropriately by focusing on liquidity rather than risk. They made it worse by providing support for certain financial institutions and their creditors but not others in an ad hoc way without a clear and understandable framework. While other factors were certainly at play, these government actions should be first on the list of answers to the question of what went wrong.”

I am teaching Money and Banking again this semester and this paper will undoubtedly be required reading.

Here is a non-gated link to the paper.

Is There a Credit Crunch?

Hale Stewart has purportedly written a blog post (reprinted in a bit lengthier form by our friend Barry Ritholtz) in which he refutes the piece by Chari, Christiano, and Kehoe entitled, “Facts and Myths about the Financial Crisis of 2008“. These authors conclude that the following are myths:

1. Bank lending to non…nancial corporations and individuals has declined sharply.
2. Interbank lending is essentially nonexistent.
3. Commercial paper issuance by non…nancial corporations has declined sharply, and rates have risen to unprecedented levels.
4. Banks play a large role in channeling funds from savers to borrowers.

Stewart, however, counters:

In fact, a careful reading of each Beige Book from the last year along with a reading of the Federal Reserve’s survey of senior loan officers indicates a drop in loan demand along with a tightening of lending standards throughout the year.

Further he reproduces the following graph of outstanding commercial bank credit:

He then forms two conclusions:

1.) The latest recession is the only recession where total credit outstanding has leveled off for an extended period. (The first recession in the 1980s saw a contraction but only after total credit increased). While it didn’t decrease it also didn’t increase. Compare this to the previous 6 recessions when lending increased at least slightly throughout the recession. In other words, the leveling off of credit creation is a story in and of itself.

2.) In order for the US economy to grow it must have a continual supply of new credit. A leveling off is just as hazardous as a decline.

The conclusions are not supported by the data. To look at the aggregate level of bank lending is misleading. In other words, we are interested in the fluctuations of bank lending, not the aggregate level. There are a variety of factors that cause the upward trend in bank lending since 1973 including the upward trends of GDP, the money supply, and a multitude of others. Further, consider the percentage change from the previous year in bank credit:
fredgraphfile
The percentage change in bank credit actually seems quite consistent with previous recessions. Further, it is important to note that despite claims by Stewart that credit has leveled off, the percentage change from a year ago is still positive and actually more so that during previous recessions. (It is also important to note that this “leveling off” similarly disappears when the time series is expressed in natural logarithmic form to correct for the growth over time in the variance of the data.)

Stewart further attempts to argue that attempts to explain the expansion of bank lending are given by a recent paper by authors at the Boston Fed:

The Bank of Boston adds other extremely credible explanations for the lack of decline in lending. They note that in a credit crunch companies rely more on their existing lines of credit as other sources of funds (the stock market, commercial paper and new lines of credit) dry up. In addition, banks are unable to securitize loans in the current environment and are therefore forced to keep more loans on their books, thereby increasing lending.

This, however, entirely misses the point. As Casey Mulligan has pointed out with regards to this very study:

The new study does not dispute the increase, but notes its composition: bank customers were drawing on previously established credit lines. While the additional evidence provided is quite useful, please remember that I had already suspected as much. More important, this point about composition in no way refutes the fundamental claim that banks are still lending to many types of customers.

Finally, Stewart concludes that the reason that this debate is even occurring is because (1) the TARP has been a disaster, and (2) there is an anti-Wall Street mood right now. Number (1) is clearly correct, but (2) has little bearing on my opinion nor the opinions of serious economists.

Here are some facts:

1.) The percentage changes from the previous year on a multitude of measures of credit have declined, BUT remain positive.

2.) The decline in percentage increases in credit is consistent and not necessarily as bad as during previous recessions. (See graphs presented here.)

I think that Stewart and I are fundamentally in agreement with regards to the fact that there is a financial crisis. Any time that you have hundreds of firms failing within one single industry, financial stocks that are a mere fraction of their previous value, and an industry that has experienced over $1 trillion dollars in losses, it would be wrong to conclude that this is not an industry in the midst of a crisis. However, it does not follow from the fact that we are in the midst of a financial crisis that we are necessarily in the midst of a credit crisis.

The Government, Housing, and The Crisis

It is time to weigh in on some important topics with respect to the current financial crisis. First, I think it needs to be noted that the crisis has already had many stages, each of which likely need to be discussed individually. They can loosely be classified as follows:

1.) The housing bubble (or “How we got here…”)

2.) The bursting of the housing bubble, the increased perception of risk, the fall of Bear Stearns, and the expansion of Federal Reserve power (sorry I couldn’t make this pithy).

3.) Financial market mayhem.

4.) The Hank Paulson Variety Show. (My thoughts here and here.)

Over at Cato Unbound the crisis is being debated by the likes of Lawrence White, Brad DeLong, and Casey Mulligan. Each makes particularly intriguing points, but the main point that I would like to address is in regards to the stages of the crisis. We seem to have gotten to the point where everyone is talking past one another because each is talking about a separate stage of the crisis. For example, White’s essay clearly outlines the incentives put forth by the government that contributed to the housing boom. DeLong, however, counters that White is not addressing the important issue and that he even gets the one he is discussing wrong. I think that there are elements of each of their essays that are correct, but I do not agree with DeLong that they are mutually exclusive.

White is largely concerned with stage 1 listed above. His essay (helps) explain the cause of the housing bubble, but is quite vague on the impact of the economic shock created by its collapse. DeLong is primarily concerned with stages 2 and 3, or in other words the impact of the economic shock. Further, he asserts that government intervention and monetary policy explain little about the shock.

Let’s take this point-by-point. First with regard to monetary policy. DeLong asks:

Are we supposed to believe that $200 billion of open-market purchases by the Fed drives private agents into making $8 trillion of privately unprofitable loans?

This is somewhat misleading. As our friend David Beckworth points out,

The absolute dollar size of the [open market purchase], however, is not important. What is important is whether these increases in liquidity were excessive relative to the demand for them. One only needs to look at the negative real federal funds rate that persisted over this period to see that these injections were excessive.

I think that Beckworth hits the nail on the head here. These injections were clearly excessive as is evident from White’s chart in his Cato policy paper, in which he compares the actual federal funds rate to that which would be predicted by the Taylor Rule. Further, recent research has shown that low interest rates cause banks to lower their lending standards. These would seem to suggest that monetary policy played in important role in causing the economic shock.

This brings us to the second point in this discussion: did government intervention cause the housing bubble? I believe that the answer is both yes and no. I am on record in saying that Fannie and Freddie (see here and here) did not cause the crisis. In fact, if you read Stephen Cecchetti’s excellent discussion of the early part of the crisis, you will notice that private securitization of mortgage debt was growing much faster than that of the GSEs in the early part of this decade. Nonetheless, I believe that government policy did play a minor role in creating the housing boom (as I will discuss below).

As previously mentioned, monetary policy seems to have played a crucial role in the financial crisis. However, the fact that monetary policy stoked the fire says little about why all of this money flowed into housing. I think that there are two main culprits: (A) Securitization, and (B) Government policy; the former being a necessary condition for the latter to have a meaningful impact. Allow me to explain.

In private conversations with our friend Barry Ritholtz about these matters, he has challenged me to explain why the Community Reinvestment Act (CRA) did not create a boom (or crisis) from 1977 to 2002. This is a fair point and one that I think few (if any) have failed to address. What changed in recent years is that (i) the CRA received some teeth in 1995, (ii) the Federal Reserve lowered interest rates to historic lows for an extended period of time, and (iii) the increased use of private securitization. Ultimately, I think that (ii) and (iii) are the most important both in creating the economic shock and that (i) played a minor role in that the other two factors facilitated the compliance with government policy.

When government regulation is created, there is an immediate incentive to circumvent the regulation. However, the use of securitization essentially made it easier for banks to comply with CRA (by buying securitized mortgages that complied or by issuing the mortgages themselves and selling them off as part of an ABS in the future). Thus far all we have is lower bound estimates of the impact of the CRA on subprime loans, but this lower bound is decidedly not zero. As the link above indicates, a recent Fed study indicated that only about 8% of subprime loans can be correctly tied to the CRA. Nevertheless, as Lawrence White points out in that post, this ignores potential “demonstration” effects. In other words, once banks who are not required to comply with the CRA discover that other banks are making these loans somewhat successfully, they might be more inclined to enter the market to compete directly with these firms (this might explain why 75% of troubled mortgages originate from firms that are not required to comply with the CRA). In any event, however, it is unlikely that the percentage of subprime that originated directly as a result of CRA exceeds 20% and therefore must be deemed a relatively small factor.

To summarize, I believe that monetary policy and the increased use of securitization are to blame for the creation of the economic shock and the subsequent chaos in its aftermath. Nonetheless, I think that government policy does play a minor role in explaining the creation of the shock.