It is so obvious that I am puzzled why no-one is talking about it. If so many House members voted against the plan so as not to run afoul of their local constituents, it must be the case that those constituents are not feeling the crisis in their pocketbook (yet), that they are not nearly as panicked about the situation as most economists are, that they are simply unconvinced that drastic measures are called for--or some combination thereof. A corollary is that Washington, New York, and the economist community collectively have not been able to tell a convincing story about how badly all this will turn out to be for Main Street. All the talk about the credit crunch and collapse in retirement savings remains apparently too abstract for most people.
It is possible that the person on the street knows something that most economists don't. Perhaps the crisis will remain largely a financial one and the real economy will be spared the worst. Casey Mulligan thinks the people are right and the economists wrong, and he makes a number of good arguments. But I am afraid a full blown financial crisis presents a different situation from the kind of historical episodes Mulligan's evidence draws on. In any case, if Congress fails to reverse itself soon, we will have the opportunity to test this theory.
How do you feel about taking this particular gamble? I am not sure I feel good about it.
The New York Times has a fantastic account of how a small unit at AIG, employing just a few hundred people, managed to decimate the entire company through its issuance of hundreds of billions of credit default swaps on CDOs. It was all supposed to be a safe way of making money, while generating tremendous income for the company and the unit's employees, the latter of which received an average of more than $1 million a year. As the unit's chief says, in reassuring investors, “It is hard to get this message across, but these [credit default swaps] are very much handpicked.”
The whole story clarifies for me a number of things: the pattern of human decision-making that led to AIG's downfall, the link between subprime mortgages and AIG's fortunes, and on a wider scale, the relationship between financial innovation and the growing inequality in earnings in recent years.
... while trying to save the economy? Lucian Bebchuk offers some ideas, including this:
Suppose that the economy has illiquid mortgage assets with a face value of $1,000 billion, and that the Treasury believes that the introduction of buyers armed with $100 billion could bring the necessary liquidity to this market. The Treasury could divide the $100 billion into, say, 20 funds of $5 billion and place each fund under a manager verified to have no conflicting interests. Each manager could be promised a fee equal to, say, 5% of the profit its fund generates – that is, the excess of the fund’s final value down the road over the $5 billion of initial investment. The competition among these 20 funds would prevent the price paid for the mortgage assets from falling below fair value, and the fund managers’ profit incentives would prevent the price from exceeding fair value.
Our Center for International Development launched its new Empowerment Lab with a conference yesterday, and one of the most interesting new social entrepreneurship initiatives I learned about is something called MyC4.com. This is a web-based platform that allows you to look up a list of African entrepreneurs who need funding for their projects (described briefly on the site) and to offer them loans. You bid a certain interest rate, which is accepted as long as it is below the maximum the entrepreneur is willing to accept and as long as others have not bid below you. You can lend as little as 5 euros. The average interest rate accepted is 12.8 percent per year, and I am told that the rate of default has been so far in the low single digits.
So here is a chance to make money while you contribute to Africa's development.
Bono and Jeff Sachs have the tough job of convincing the U.S. and other rich nations to cough up real money for the world's poor during these financially uncertain times, and they chronicle their travails--encounters with Carla Bruni and all--here.
Whichever way the Paulson plan goes, it is clear that we are in for a period of heavily regulated finance. The questions are: what type of regulations and how heavily will they be administered?
Many commentators have argued that the problem is not one of inadequate or insufficient regulation and that returning to pre-1980s style heavy-handed regulation would be one of the worst mistakes we could make. According to this line of argument, sapping financial innovation would be very costly.
If so, these advocates owe us a bit more detail about the demonstrable benefits of financial innovation. What I would love to hear are some examples such financial innovation—not of any kind, but of the kind that has left a large enough footprint over some kind of economic outcomes we really care about. What are some of the ways in which financial innovation has made our lives measurably and unambiguously better?
If I had asked this question a little over a year ago, I suppose I would have been hearing a lot about how collateralized debt obligations and structured finance have allowed millions of people to purchase homes that they would not have been able to afford otherwise. Sorry, but you will have to come up with some other examples now.
I was just about ready to write off the repeal of Glass-Steagall as one of the instigators of the current mess, based on arguments made and linked to here, when I came across Barry Eichengreen's newest Project Syndicate piece. Now Barry is a great economist, with the rare historical perspective on international capital markets (the paperback version of his Globalizing Capital arrived on my desk just today). He has what I think is a new argument:
In the United States, there were two key decisions. The first, in the 1970’s, deregulated commissions paid to stockbrokers. The second, in the 1990’s, removed the Glass-Steagall Act’s restrictions on mixing commercial and investment banking. In the days of fixed commissions, investment banks could make a comfortable living booking stock trades. Deregulation meant competition and thinner margins. Elimination of Glass-Steagall then allowed commercial banks to encroach on the investment banks’ other traditional preserves.
In response, investment banks branched into new businesses like originating and distributing complex derivative securities. They borrowed money and put it to work to sustain their profitability. This gave rise to the first causes of the crisis: the originate-and-distribute model of securitization and the extensive use of leverage.
So the culprit, according to Barry, was too much competition in financial markets, which led to excessive risk-taking and leverage. (The second set of culprits Barry discusses relates to global current-account imbalances.)
Barry makes it clear that he thinks the deregulation of the 1970s and 1990s were sensible things at the time, and that they did reduce costs of intermediation. It was, he thinks, a case of unintended consequences.
The financial crisis that has developed around subprime mortgages is so so astounding in so many different ways that, like many others I suppose, I am still having difficulty getting my mind around it. The whole thing is a big surprise for me. I would have been pretty ready to assert, as late as 6 months ago, that financial crises of this magnitude had become solely a developing-country phenomenon and that rich countries had developed the regulatory and other mechanisms that would prevent them from getting into such a mess. Yes, there would be smaller scale hiccups, such as the S&Ls or LTCM, but you certainly couldn't have a meltdown a la East Asia 1997-98 or Mexico 1994 in an economy such as the U.S.
Now we know that I would have been wrong. What is happening in the U.S. is no different from what took place in Thailand in 1997 or in Argentina in 1999, with the entire financial sector going belly-up. The only thing that remains to be seen is whether the costs to the real economy will be as high too. The rough rule of thumb for emerging markets is that banking crises are associated with an output loss of around 10% (see here for example). The best estimate we have at present is that U.S. real GDP will take a hit of something like 3.6% over the next couple of years. This is a fraction of the loss experienced in a typical emerging market crash--but of course this particular estimate may also prove to be wildly optimistic.
But here is what I would love to know. What is the single thing that, had it not happened or happened differently, would have prevented this crisis from turning into the meltdown it has? In other words, what is it that has allowed a regular credit cycle to metamorpose into a systemic crash? Here are some of the culprits we regularly see mentioned:
A bubble in the housing market
The originate-to-distribute model of mortgage lending
Lack of transparency in structured finance and mortgage-backed securities
Lack of regulation of derivatives
Poor credit-rating practices
Fannie Mae and Freddie Mac straying from their original mandates
Implicit government guarantees for Fannie and Freddie
Lack of regulation of hedge funds and private equity
Inadequate capital requirements for financial intermediaries
The too rapid or generous extension of Fed credit to non-banks
The rescue of Bear Stearns
The failure to rescue Lehman
I am sure you can add a few more to the list.
What I am asking is this: which one of these items--individually or taken in groups--was both necessary and sufficient to bring us to our current impasse, where the government has little choice but to take over all mortgage-related assets off the books of private financial institutions? If you answer "all of the above," you are not being helpful at all.