I have read a couple of good articles recently which touch on the issues of economics, markets, and society more broadly. In particular, what does economic analysis have to say for how society functions and how it should function? What are markets, and what does economics truly say about them, and how does that compare to the popularized slogans that we hear so often? How does the implementation of markets fit in with other societal goals that we want to achieve? Here are the articles that I have read recently and that I will address, to the best of my ability, point-by-point:
"What Fannie Mae and Freddie Mac Tell Us About Free Markets" - Harvard Business Review Editor's Blog
"Economics Does Not Lie" - City Journal
Wednesday, July 30, 2008
More Articles on Housing, and Fannie and Freddie
- McCain on Fannie Mae and Freddie Mac, courtesy of Lawrence Kudlow. I couldn't agree more.
- The dangers and consequences of the government directing industries and telling businesses what to do: here and here.
- An alternative view on government-sponsored enterprises.
This last line is highly deceptive: "Seventy-six years after it was created by a president whose administration was hostile to government intervention in markets, the FHLB stands as an enduring and (so far) effective example of socialism among capitalists." Quite to the contrary, the structure of the FHLB is far different from that of Fannie Mae and Freddie Mac, and far less socialistic. First of all, because its customers are also its members, the FHLB has a strong disincentive from acquiring an irresponsible amount of risk, which is precisely why it has "high standards." To see why the FHLB has yet to fail, note that "advances are heavily collateralized—the market value of mortgage collateral typically covers 125 to 170 percent of the advance. This protection explains why the FHLB System has never lost a penny on an advance." Still, the FHLB is not entirely without controversy, and it too likely encourages too much risk-taking on the behalf of its members, but the potential for problems is far less than for Fannie Mae and Freddie Mac. See the next article for a more in-depth explanation.
- Everything you could possibly want to know about GSE's, particularly Fannie Mae, Freddie Mac, and the FHLB.
I especially like this paragraph from the last article:
"The housing GSEs and their many advocates in the financial sector, in Congress and across the country argue that the housing GSEs have yet to cost taxpayers a nickel. They also note that stand-alone ratings of housing-GSE debt, that is, the bond ratings Moody’s and Standard & Poor would award absent implicit federal-government backing, are quite high. Finally, supporters point to the millions of Americans whose dream of home ownership became a reality due to housing-GSE activity. Because this reality is so vivid to most taxpayers, the downside of Fannie Mae, Freddie Mac and the FHLBanks is easy to overlook. An informed judgment about the proper scope of housing-GSE activity must take into account the potential costs of misdirected subsidies and financial instability."
Hmm, the GSEs have yet to cost taxpayers a nickel? A lot has changed since July 2004, and we should be wiser from it. There is no "wishing away" of risk simply by shifting it onto the taxpayer. We see now that because of Fannie Mae and Freddie Mac, we have had far too much irresponsible investment in housing at the expense of the stability of the financial markets.
- The dangers and consequences of the government directing industries and telling businesses what to do: here and here.
- An alternative view on government-sponsored enterprises.
This last line is highly deceptive: "Seventy-six years after it was created by a president whose administration was hostile to government intervention in markets, the FHLB stands as an enduring and (so far) effective example of socialism among capitalists." Quite to the contrary, the structure of the FHLB is far different from that of Fannie Mae and Freddie Mac, and far less socialistic. First of all, because its customers are also its members, the FHLB has a strong disincentive from acquiring an irresponsible amount of risk, which is precisely why it has "high standards." To see why the FHLB has yet to fail, note that "advances are heavily collateralized—the market value of mortgage collateral typically covers 125 to 170 percent of the advance. This protection explains why the FHLB System has never lost a penny on an advance." Still, the FHLB is not entirely without controversy, and it too likely encourages too much risk-taking on the behalf of its members, but the potential for problems is far less than for Fannie Mae and Freddie Mac. See the next article for a more in-depth explanation.
- Everything you could possibly want to know about GSE's, particularly Fannie Mae, Freddie Mac, and the FHLB.
I especially like this paragraph from the last article:
"The housing GSEs and their many advocates in the financial sector, in Congress and across the country argue that the housing GSEs have yet to cost taxpayers a nickel. They also note that stand-alone ratings of housing-GSE debt, that is, the bond ratings Moody’s and Standard & Poor would award absent implicit federal-government backing, are quite high. Finally, supporters point to the millions of Americans whose dream of home ownership became a reality due to housing-GSE activity. Because this reality is so vivid to most taxpayers, the downside of Fannie Mae, Freddie Mac and the FHLBanks is easy to overlook. An informed judgment about the proper scope of housing-GSE activity must take into account the potential costs of misdirected subsidies and financial instability."
Hmm, the GSEs have yet to cost taxpayers a nickel? A lot has changed since July 2004, and we should be wiser from it. There is no "wishing away" of risk simply by shifting it onto the taxpayer. We see now that because of Fannie Mae and Freddie Mac, we have had far too much irresponsible investment in housing at the expense of the stability of the financial markets.
Government Bail-Outs: How I see things
First, let me make the case that someone could make for the government to be willing to give bail-outs:
The government can and should act as an insurer against systemic risk and uncertainty to the economy. In particular, not only should the government provide assistance during times of natural disasters, but it should be willing to "bail out" certain financial institutions during times of financial panic. The argument here is familiar: some institutions are "too big to fail." If one of these institutions fails, then the resulting loss of liquidity and general panic (perhaps because that failure would signal to other market participants that some underlying economic condition is substantially worse than previously thought) would cause people to flee from their medium and long-term financial commitments, thereby putting a great strain on all other financial institutions. In essence, the failure of such a large institution can cause people to fear that other institutions are likely to fail, which becomes a self-fulfilling prophecy as people run to get their money.
*If* the government is to have this role as insurer, then the risk is that financial institutions will make excessively risky and poor investments so that when those investments work in their favor, they profit, and when the investments flop, taxpayers share the losses. This is the common moral hazard problem. If you insure someone against a risky event whose probability of occurring can be affected by the person's actions, then the person is less disinclined to take those actions, thereby making the risky event more likely to occur.
The "solution": if the government is willing to bail-out financial institutions, then it must regulate them properly to reduce moral hazard. Most importantly, the government must insist on complete transparency in the institution's dealings, so that investors can accurately gauge the level of risk that the institution is taking on. In addition, the government should probably insist on reasonably tight capital requirements (such as in the case of banks, which must retain on hand a certain percentage of deposits) to prevent excessive leverage.
What I personally prefer:
There are several disadvantages to having the government bail out individual private companies. First of all, unless there are explicit contracts between the federal government and any institution that it is willing to bail-out (basically, insurance contracts), then we have a two-pronged nightmare: 1) The government, being in principle willing to bail-out any firm that is "too big to fail," deems it necessary to heavily regulate the entire financial industry, and perhaps other industries, in order to prevent the moral hazard problem discussed above. Of course, in doing so it is inevitable that the regulation would be inefficient, politically tainted, and would reduce innovation and productivity in those industries, and 2) Big firms still manage to make investments that are unsound or excessively risky in nature while simultaneously being unable to make certain sound investments due to clumsy regulation, thereby spreading excessive risk onto the average investor along with sub-par performance. All of this leads me to oppose these sorts of government bail-outs.
Here is what we should do instead (subject to me learning more in the future)...
1) The government should require a drastic increase in transparency in our financial markets. The current asymmetries of information between investor, lender, and borrower are, in my opinion, the primary cause of the current credit crisis. In the mortgage market, many people were allowed to purchase homes without proof of income, and then their mortgages were repurchased by a Bear Stearns or Fannie Mae, bundled with other mortgages, and sold to third party investors. Normally, the initial bank would face the consequences of not knowing the buyer's private information about his or her ability to make payments on the loan. However, when the bank can then sell the mortgage to an unaccountable and huge government-sponsored enterprise like Fannie Mae, which has little incentive to manage risk since it knows that it is "too big to fail," the bank can shift the risk onto the eventual third-party investor who has no real idea just how much risk is inherent in many of the mortgages he just purchased (and, for that matter, does not really care since he too knows that Fannie Mae is too big to fail).
2) The government should cut loose Fannie Mae and Freddie Mac, and it should aggressively seek to ensure that our financial markets are as close to "perfectly competitive" as they can get. In essence, the government should do what it can to prevent, or at least minimize, the very existence of firms that are "too big to fail." The health and stability of our financial institution should not rely on a handful of firms, and instead of having firms that are "too big to fail," we should have firms that are "too little to matter." In principle, this does not actually mean that most financial firms would be small. Far from it. It simply means that the government should do what it can to lower barriers to entry into the financial industry, should reform and aggressively prosecute its antitrust laws, and should allow the process of creative destruction, unimpeded by monopoly or manipulation, to do its work.
3) The government should still in some capacity be lender of last resort. There are two main reasons for this. In the first case, the government as LLR can reduce the occurrence of what are called "sunspot equilibria." A sunspot equilibrium is where people in the economy have a belief that something will happen, react accordingly, and by reacting in that way actually cause the event to happen, even if it would not have otherwise occurred. A bank panic is a standard example of this. People fear, for whatever reason, that their bank will fail, so they run to the bank to withdraw their money, which in turn causes the bank to fail. If the government can credibly insure people against the risk of bank failure, then people will not run on the bank if they hear that it may fail, thereby making it less likely for the bank to actually fail. However, if the government is to do this, then it should also institute regulations to avoid the moral hazard problem that was previously discussed. According to economist Ricardo Caballero, "ex-ante policy recommendations typically center on prudential risk management. For example, in many analyses there are externalities present that drive a wedge between private and social incentives to insure against a financial crisis episode. Then, ex-ante regulations to reduce leverage, increase liquidity ratios, or tighten capital requirements are beneficial."
The second main reason for the government to be lender of last resort is to deal with economic situations of great uncertainty which are of a nature not previously seen. In these situations, people do not have any prior experiences or adequate models to reference, and are therefore more likely to react as if they are in a "worst-case scenario."
Once again, according to Caballero,
"an important dimension of the crisis is that there is uncertainty about outcomes. Agents cannot refer to history to understand how a crisis will unfold because the historical record may not span the event space. In such a case it is unclear whether any entity, either private or public, can arrive at the appropriate ex-ante risk management strategy, calling into question the feasibility of these policy recommendations. Instead, in our uncertainty model, the most beneficial ex-ante actions are ones which help to reduce the extent of uncertainty should a crisis occur. In some cases, this may simply involve making common knowledge information that is known to subsets of market participants – for example, making common knowledge the portfolio positions of the major players in a market."
To read Ricardo Caballero's paper titled "Collective Risk Management in a Flight to Quality Episode," go here.
The government can and should act as an insurer against systemic risk and uncertainty to the economy. In particular, not only should the government provide assistance during times of natural disasters, but it should be willing to "bail out" certain financial institutions during times of financial panic. The argument here is familiar: some institutions are "too big to fail." If one of these institutions fails, then the resulting loss of liquidity and general panic (perhaps because that failure would signal to other market participants that some underlying economic condition is substantially worse than previously thought) would cause people to flee from their medium and long-term financial commitments, thereby putting a great strain on all other financial institutions. In essence, the failure of such a large institution can cause people to fear that other institutions are likely to fail, which becomes a self-fulfilling prophecy as people run to get their money.
*If* the government is to have this role as insurer, then the risk is that financial institutions will make excessively risky and poor investments so that when those investments work in their favor, they profit, and when the investments flop, taxpayers share the losses. This is the common moral hazard problem. If you insure someone against a risky event whose probability of occurring can be affected by the person's actions, then the person is less disinclined to take those actions, thereby making the risky event more likely to occur.
The "solution": if the government is willing to bail-out financial institutions, then it must regulate them properly to reduce moral hazard. Most importantly, the government must insist on complete transparency in the institution's dealings, so that investors can accurately gauge the level of risk that the institution is taking on. In addition, the government should probably insist on reasonably tight capital requirements (such as in the case of banks, which must retain on hand a certain percentage of deposits) to prevent excessive leverage.
What I personally prefer:
There are several disadvantages to having the government bail out individual private companies. First of all, unless there are explicit contracts between the federal government and any institution that it is willing to bail-out (basically, insurance contracts), then we have a two-pronged nightmare: 1) The government, being in principle willing to bail-out any firm that is "too big to fail," deems it necessary to heavily regulate the entire financial industry, and perhaps other industries, in order to prevent the moral hazard problem discussed above. Of course, in doing so it is inevitable that the regulation would be inefficient, politically tainted, and would reduce innovation and productivity in those industries, and 2) Big firms still manage to make investments that are unsound or excessively risky in nature while simultaneously being unable to make certain sound investments due to clumsy regulation, thereby spreading excessive risk onto the average investor along with sub-par performance. All of this leads me to oppose these sorts of government bail-outs.
Here is what we should do instead (subject to me learning more in the future)...
1) The government should require a drastic increase in transparency in our financial markets. The current asymmetries of information between investor, lender, and borrower are, in my opinion, the primary cause of the current credit crisis. In the mortgage market, many people were allowed to purchase homes without proof of income, and then their mortgages were repurchased by a Bear Stearns or Fannie Mae, bundled with other mortgages, and sold to third party investors. Normally, the initial bank would face the consequences of not knowing the buyer's private information about his or her ability to make payments on the loan. However, when the bank can then sell the mortgage to an unaccountable and huge government-sponsored enterprise like Fannie Mae, which has little incentive to manage risk since it knows that it is "too big to fail," the bank can shift the risk onto the eventual third-party investor who has no real idea just how much risk is inherent in many of the mortgages he just purchased (and, for that matter, does not really care since he too knows that Fannie Mae is too big to fail).
2) The government should cut loose Fannie Mae and Freddie Mac, and it should aggressively seek to ensure that our financial markets are as close to "perfectly competitive" as they can get. In essence, the government should do what it can to prevent, or at least minimize, the very existence of firms that are "too big to fail." The health and stability of our financial institution should not rely on a handful of firms, and instead of having firms that are "too big to fail," we should have firms that are "too little to matter." In principle, this does not actually mean that most financial firms would be small. Far from it. It simply means that the government should do what it can to lower barriers to entry into the financial industry, should reform and aggressively prosecute its antitrust laws, and should allow the process of creative destruction, unimpeded by monopoly or manipulation, to do its work.
3) The government should still in some capacity be lender of last resort. There are two main reasons for this. In the first case, the government as LLR can reduce the occurrence of what are called "sunspot equilibria." A sunspot equilibrium is where people in the economy have a belief that something will happen, react accordingly, and by reacting in that way actually cause the event to happen, even if it would not have otherwise occurred. A bank panic is a standard example of this. People fear, for whatever reason, that their bank will fail, so they run to the bank to withdraw their money, which in turn causes the bank to fail. If the government can credibly insure people against the risk of bank failure, then people will not run on the bank if they hear that it may fail, thereby making it less likely for the bank to actually fail. However, if the government is to do this, then it should also institute regulations to avoid the moral hazard problem that was previously discussed. According to economist Ricardo Caballero, "ex-ante policy recommendations typically center on prudential risk management. For example, in many analyses there are externalities present that drive a wedge between private and social incentives to insure against a financial crisis episode. Then, ex-ante regulations to reduce leverage, increase liquidity ratios, or tighten capital requirements are beneficial."
The second main reason for the government to be lender of last resort is to deal with economic situations of great uncertainty which are of a nature not previously seen. In these situations, people do not have any prior experiences or adequate models to reference, and are therefore more likely to react as if they are in a "worst-case scenario."
Once again, according to Caballero,
"an important dimension of the crisis is that there is uncertainty about outcomes. Agents cannot refer to history to understand how a crisis will unfold because the historical record may not span the event space. In such a case it is unclear whether any entity, either private or public, can arrive at the appropriate ex-ante risk management strategy, calling into question the feasibility of these policy recommendations. Instead, in our uncertainty model, the most beneficial ex-ante actions are ones which help to reduce the extent of uncertainty should a crisis occur. In some cases, this may simply involve making common knowledge information that is known to subsets of market participants – for example, making common knowledge the portfolio positions of the major players in a market."
To read Ricardo Caballero's paper titled "Collective Risk Management in a Flight to Quality Episode," go here.
Tuesday, July 29, 2008
Fannie, Freddie, and the Government as Risk-Manager
I will first start off by mentioning that I am not (at least not yet) an expert on these issues, so my thoughts are subject to change as my knowledge grows on the subject. As a result of my lack of expertise, you may want read this, this, and this first. Here are my favorite excerpts:
From Joseph Stiglitz (who I normally disagree with):
"Much has been made in recent years of private/public partnerships. The US government is about to embark on another example of such a partnership, in which the private sector takes the profits and the public sector bears the risk. The proposed bailout of Fannie Mae and Freddie Mac entails the socialisation of risk – with all the long-term adverse implications for moral hazard – from an administration supposedly committed to free-market principles.
Defenders of the bail-out argue that these institutions are too big to be allowed to fail. If that is the case, the government had a responsibility to regulate them so that they would not fail. No insurance company would provide fire insurance without demanding adequate sprinklers; none would leave it to “self-regulation”. But that is what we have done with the financial system."
From Dick Armey:
"Actions by Fannie and Freddie management and their regulators this year precipitated the current crisis. Under pressure from the Democrat-controlled Congress, the Bush administration lifted Fannie and Freddie's portfolio caps in February and reduced their capital reserve requirements in March. In this year's stimulus bill, Congress went further and nearly doubled the size of the loans that Fannie and Freddie can purchase or guarantee.
As a result of this reckless expansion, the government-sponsored enterprises (GSEs) now touch nearly 70% of all new mortgages. At the same time, they are insolvent by most measures. The ostensible purpose of Fannie and Freddie is to provide liquidity to America's housing markets. In practice, they are the source of systemic risk and instability in a time of need."
More on Creative Destruction
I will continue to postpone any discussion of how we might approach the big issue of economic risk and security, but here is an excerpt from The New Palgrave (and in particular from Ricardo Caballero):
"Creative destruction refers to the incessant product and process innovation mechanism by which new production units replace outdated ones. This restructuring process permeates major aspects of macroeconomic performance, not only long-run growth but also economic fluctuations, structural adjustment and the functioning of factor markets. Over the long run, the process of creative destruction accounts for over 50 per cent of productivity growth. At business cycle frequency, restructuring typically declines during recessions, and this add a significant cost to downturns. Obstacles to the process of creative destruction can have severe short- and long-run macroeconomic consequences."
"Creative destruction refers to the incessant product and process innovation mechanism by which new production units replace outdated ones. This restructuring process permeates major aspects of macroeconomic performance, not only long-run growth but also economic fluctuations, structural adjustment and the functioning of factor markets. Over the long run, the process of creative destruction accounts for over 50 per cent of productivity growth. At business cycle frequency, restructuring typically declines during recessions, and this add a significant cost to downturns. Obstacles to the process of creative destruction can have severe short- and long-run macroeconomic consequences."
Thursday, July 17, 2008
Creative Destruction or Destructive Creation?
Nobody likes to lose their job, especially politicians. Particularly in the midst of our current economic difficulties, people worry about the impact that international trade, globalization, and competition can have on their economic security. I don't fault them for that. Politicians in the US and elsewhere often attempt to address that fear by making it more difficult to fire employees (such as in France, where the termination process can take more than 6 months and requires permission from a court), by restricting the ability of new firms to enter into an industry (either directly by adding layers of regulations and hurdles or indirectly by subsidizing incumbent firms), by restricting foreign access to markets, by making it more difficult for companies to sell their products, or by restricting entry into new occupations (such as by imposing licensure requirements).
In some occasions, these requirements appear reasonable. After all, who wouldn't want the assurance that the FDA provides when it checks the safety and efficacy of a new drug? However, in many instances, these particular attempts to increase economic security, particularly by restricting market entry or making it difficult to hire/fire employees, cause far more economic damage with little to no gain in economic security.
In short, we hurt ourselves by implementing these policies because doing so stops the vital process of creative destruction. We cannot expect new innovation as long as we shelter inefficient firms from competition or put up roadblocks that prevent companies from creating the most dynamic labor forces that they can. Does this mean we have to throw away economic security? No. I'll address that issue later. However, we cannot provide that security by pretending the forces that cause it are somehow bad or unnecessary.
Thursday, July 10, 2008
Four More Years?
Even though the 2008 Presidential campaign has been going on for a couple years now, and the general election campaign has been going on for over a month, we still have little to no true political discourse.Obama's motto: John McCain = Bush III. That's it! Debate over. Rather than contest the issues, Obama would prefer to link McCain (inaccurately in many ways) to Bush, talk about hope and change, and have the public vote for someone whose positions on the issues they know very little about.
For all that Obama speaks of change, what new, innovative policies is he even proposing?
Windfall profits tax: yes, maybe if we re-institute the failed (led to decreased production and higher imports from the Middle East) 1970s-era tax on profits, "Big, Scary Oil" (which "controls" only 5% of world oil supplies) will increase investment, research and development, production, and lower prices! Or, better yet, the government can nationalize the industry and emulate the other areas of the world which are paragons of energy production efficiency (Russia, OPEC, Venezuela).
Higher income taxes: "The rich must pay their fair share!" Of course, in Obama's world, a rich person's fair share is twice as big as everybody else's. Sure, there are wealthy people who evade taxes, and they do so by exploiting needlessly complex tax loopholes which exist because of our abuse of using taxes to enact social engineering. Even so, the rich pay a greater share of the tax burden even than their share of the economic pie. What else is lost in this discussion? Lowering tax *rates* is about increasing incentives for businesses, entrepreneurs, workers, and investors to engage in productive activity, ie innovation, the creation of wealth, and the starting of new enterprises. Hike taxes, crush incentives, lose jobs, shutter businesses. Maybe that can be Obama's motto.
I could go on and on, whether about education policy, or health care policy, or judicial philosophy, or foreign policy. I don't want to get across the wrong message, though. This isn't about demonizing Obama. Not everything Obama says is nonsense. Isn't it a bit convenient when somebody makes the argument that one political party is always right while the other one is always wrong? What we need, though, is a debate not based on slander, false associations, and obfuscation. Bush-Carter '08!
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