DeLong Smackdown Watch: Yves Smith on the Financial Crisis

Yves Smith:

naked capitalism: Lessons from Japan Versus Wishful US Prescriptions (Summers/De Long Edition): Finally, there is a longish post by Brad De Long on Summer's article, in which he uses as point of departure a simple construct first posted by Paul Krugman (admittedly, De Long pushed around this model in an earlier post at some length). Krugman posited that there might be an S-shaped demand curve (supply is vertical, since at any point in time there is a fixed amount of securities). He further reasoned that there was a high-priced equilibrium, and a low-priced one that could be induced by panic, and the Fed was trying to get back to the high equilibrium (for reasons of space, I did not replicate his so-called cartoons, but you can see them at his post). But he concluded:

But at this point a series of rate cuts and other stuff just hasn't done the trick -- which suggests that maybe there isn't a high-price equilibrium out there at all.....And in that case, the Fed can't rescue the financial markets. All it -- and the feds in general -- can do is to try to limit the effects of financial crisis on the rest of the economy.

Yet De Long blithely ignores the conclusion that Krugman reached, and by implication, so does Summers.

What about "bubble" don't you understand? That high priced equilibrium was not stable, it was created by unsustainable leverage. Per Herbert Stein, "That which is unsustainable will not be sustained." It is neither good economics nor good policy to try to keep an asset bubble aloft.

First, Paul's claim that "the Fed can't rescue the financial markets" if the good equilibrium in the Backwards-S model has disappeared like so:

is not complete. The Fed can't rescue the financial markets through Bagehot rule policies that provide a firehose of liquidity at a penalty rate. Such Bagehot-rule policies work only with a Stage I financial crisis, when the Backwards-S diagram looks like this:

Second, I do not ignore the claim that, as Yves Smith puts it: "What about 'bubble' don't you understand? That high priced equilibrium was not stable, it was created by unsustainable leverage. Per Herbert Stein, 'That which is unsustainable will not be sustained.' It is neither good economics nor good policy to try to keep an asset bubble aloft..."

I explicitly write:

Objection (3) is intellectually more interesting and substantive. But that will have to wait for the next lecture.

Yves Smith is making a version of Objective (3). And I do have an answer to it. But, to quote Gandalf the White, "I have no time!" I do hope to make some more time soon, however.

Comments

[MobiusKlein]

I have a proof regarding Objection (3) - but it's too large to fit into the margins here.

(Just give us a hint!)

[andrew]

Brad,

Very glad you responded to this, am looking forward to seeing the argument. Whether I'll be convinced or not remains to be seen, but viva la discussion.

[christofay]

The question, is it possible to inflate back to bubble era prices in overly complicated & leveraged financial products?

[christofay]

Also pay attention to the next post at Naked Capitalism, "Selling Fads to Investors Backfires."

There is another question relating to financialization, the more the innovative finance sphere tail wags the dog, the smaller the dog becomes and the larger the tail grows.

[g]

"supply is vertical, since at any point in time there is a fixed amount of securities"

Is this true? It seems to me that the use of derivatives and insurances and mortgage securitization during the past few years have increased the supply of securities (broadly defined) in response to a demand.

[christofay]

"Supply is vertical," that's for the sake of argument.

Supply of derivatives has increased exponentially in the Greenspan/Bush era. We still have problems saying it is a credit bubble.

The capability to increase supply is unlimited between the Federal Reserve and innovative finance sphere.

Between the popping of the bubble and the ability to lengthen the spool of product is causing the trouble to find a floor in prices

We need an honest (or a dishonest but effective) guardian of the Social Security trust before Washington decides to fund the bail out with Social Security overpayments. Appointing Volcker that guardian with real powers of a czar might be stabilizing.

What are the dangers of letting innovative financial sphere institutions fall?

[christofay]

I have the answer to what's behind curtain # 3.

The banks paper assets are the equivalent of "no copper, only pvc."

[Matt]

Wow, this is like an essay contest.

Here is how I do it.
The housing market consists of a flow of housing units, in which the market process governs the spectral output of the flow.

The flow consists of arrivals, each one a pair, value and transaction. Generally, when the housing flow has known variations, then there are gains to be made by removing the variations with inventory management (all things linear). So, we expect that efficiency drives the housing flow toward a white noise gaussian stochastic process. It is a time varying signal, like like electricity, with random variations that remain unpredicted.

Now, when the housing flow is modeled cyclic, then we have a two force model, transaction*value such that at the cycle peak, transaction count goes to a minimum and value is at it highest, and in mid cycle, transaction count is highest and value minimum. The total wealth of a market would be (value**2)*(Transaction**2)/dt**2 integrated over the integration period of the economy.

What is the restoring force? The market always drives the flow back toward its gaussian white noise, baring non-linearity. That the market overshoots, we know, because the integrations times are finite. Two things determine instability, if your model is square integrable, and quantized.

So, when we push, deliberately, in procyclical fashion, the mechanism is thus: We move, by some externality, a market to a new standard lot size to minimize variations. Then, the externality is relaxed, and the time to readjust lot sizes lags. Is this the ultimate mechanism for instability? Probably, though I cannot prove that. But if the market restores the optimum flow, and retooling the inventory chain is a lag, the requirements for cyclic behavior is there.

[Robert Waldmann]

I don't have time either, but I suspect that your point principally is that the FED can print all the money it wants and no one seems to object if they find new uses for it.

Why with a bit of minor reform, they can pay everyone's mortgage, and everyone will be happy. No more mortgages no more mortgage bonds no worries except, perhaps a spot of inflation.

That which can not be sustained, can be liquidated by a fool or a central banker.

They will have plenty of time to think of new uses for money if the Bush administration manages to remove their "power to regulate the day-to-day affairs of banks" under the new Bush administration financial regulation reform plan which was originally a deregulation plan.

http://www.washingtonpost.com/wp-dyn/content/article/2008/03/31/AR2008033102356.html?hpid=topnews

[GA]

To add to the points above regarding leverage etc... it strikes me that the leveraged state on the Krugman curve (upper part of the S) should be not only above but off to the right, as leverage and quantity of supply seem to be a couple for the current crisis. This would change the subsequent analysis of the chart.

[dilbert dogbert]

Christofay at 4:52,
Sorry can't help it: Toothpaste meets Tube.
Ths S curvie Supply curve is very interesting!! Maybe it needs a new name like the Marylin Monroe Supply Curve or the Janyne Mansfield Supply Curve (Dolly Parton??).
Please forgive me one more time.

[Maurice Lanselle]

Okay, you have no time...but what bets would we be placing if we were as scient as you?

Bravo for recycling the graphs. Every little bit helps to save the planet and to promote the potential persistence of life of some form.