« February 2008 | Main | April 2008 »
Posts from March 2008
March 31, 2008
Are Bernanke-Paulson Puts Net Wealth?
Are Bernanke-Paulson Puts Net Wealth?
Somebody really should write a paper with that title next month.
Barry Eichengreen volunteers me...
Brad DeLong http://www.j-bradford-delong.net http://delong.typepad.com brad.delong@gmail.com 925 708 0467
"Economists set themselves too easy, too useless a task when in
tempestuous seasons they say only that when the storm is long-past the
sea will be flat again"
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.
I Find Myself Unable to Disagree...
How could anyone possibly disagree with this, from Paul Graham?
How to Disagree: The web is turning writing into a conversation.... Many who respond to something disagree with it.... Agreeing tends to motivate people less than disagreeing. And when you agree there's less to say.... The result is there's a lot more disagreeing going on, especially measured by the word....
If we're all going to be disagreeing more, we should be careful to do it well... here's an attempt at a disagreement hierarchy:
DH0. Name-calling.... DH1. Ad Hominem.... DH2. Responding to Tone.... DH3. Contradiction.... DH4. Counterargument.... DH5. Refutation.... DH6. Refuting the Central Point....
Truly refuting something requires one to refute its central point, or at least one of them. And that means one has to commit explicitly to what the central point is. So a truly effective refutation would look like:
The author's main point seems to be x. As he says:
quotation
But this is wrong for the following reasons...
The quotation you point out as mistaken need not be the actual statement of the author's main point. It's enough to refute something it depends upon.
What It Means
Now we have a way of classifying forms of disagreement... while DH levels don't set a lower bound on the convincingness of a reply, they do set an upper bound. A DH6 response might be unconvincing, but a DH2 or lower response is always unconvincing.
The most obvious advantage of classifying the forms of disagreement is that it will help people to evaluate what they read. In particular, it will help them to see through intellectually dishonest arguments.... By giving names to the different forms of disagreement, we give critical readers a pin for popping such balloons.
Such labels may help writers too. Most intellectual dishonesty is unintentional....
But the greatest benefit of disagreeing well is not just that it will make conversations better, but that it will make the people who have them happier. If you study conversations, you find there is a lot more meanness down in DH1 than up in DH6. You don't have to be mean when you have a real point to make. In fact, you don't want to. If you have something real to say, being mean just gets in the way.
If moving up the disagreement hierarchy makes people less mean, that will make most of them happier. Most people don't really enjoy being mean; they do it because they can't help it.
David Sirota on the Clinton Campaign
He meditates on this graph:
The Clinton Firewall -- In These Times: The Race Chasm may sound like a conventional discussion of the black-white divide, but it is one of the least-discussed geographic, demographic and political dynamics driving the contest between Clinton and Obama... you are left with 33 elections that best represent how the black-white split has impacted the campaign... when you chart Obama's margin of victory or defeat against the percentage of African-Americans living in that state, a striking U trend emerges. That precipitous dip in Obama's performance in states with a big-but-not-huge African-American population is the Race Chasm--and that chasm is no coincidence.
On the left of the graph, among the states with the smallest black population, Obama has destroyed Clinton. With the candidates differing little on issues, this trend is likely due, in part, to the fact that black-white racial politics are all but non-existent in nearly totally white states.... On the right of the graph among the states with the largest black populations, Obama has also crushed Clinton.... "in the Democratic primary the black vote is so huge [in these states], it can overwhelm the white vote," says Thomas Schaller, a political science professor at the University of Maryland--Baltimore. That black vote has gone primarily to Obama, helping him win these states by big margins.
It is in the chasm where Clinton has consistently defeated Obama. These are geographically diverse states from Ohio to Oklahoma to Massachusetts where racial politics is very much a part of the political culture, but where the black vote is too small to offset a white vote racially motivated by the Clinton campaign's coded messages and tactics. The chasm exists in the cluster of states whose population is above 6 percent and below 17 percent black, and Clinton has won most of them by beating Obama handily among white working-class voters...
Econ 101b: March 31, 2008 Lecture: Markets for "Lemons"
Notes: Lecture Audio. Adverse Selection in Lending Markets.
Readings:
- George A. Akerlof (Aug. 1970). "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism". Quarterly Journal of Economics 84 (3): 488–500 http://links.jstor.org/sici?sici=0033-5533%28197008%2984%3A3%3C488%3ATMF%22QU%3E2.0.CO%3B2-6
- J. Bradford DeLong, "Dealing with Adverse Selection in the Mortgage Market"
- Mark Thoma, "Adverse Selection, Loan Defaults, and Credit Rationing"
- J. Bradford DeLong, Comment on Lawrence Summers, "Safeguarding America's Economy from Adverse Consequences of Financial Crisis"
March 30, 2008
Dealing with Adverse Selection in the Mortgage Market
Suppose that a bank calculates that the net value of the mortgage to the bank as a fraction of its principal is equal to four years' interest minus the chance of default:
π = 4r - d
And suppose that the homeowners and homebuyers who come to the bank have a chance of default which is:
d = 15% + 20r2
Then bank profits expected from a typical homeowner and home buyer are:
π = 4r - 20r2 - 15%
Which means that a bank can make profits as long as:
5% ≤ r ≤ 15%
And if there are a bunch of competitive banks, and if homeowners can comparison shop, competition will push the interest rate down to 5% and a bit more. And the observed default probability will be 20%.
Now suppose that there is bad economic news: the default probability rises by 5% to:
d = 20% + 20r2
Then, the way I have rigged this scenario, interest rates rise to 10%: no bank can make money charging less than 10%, given the new, higher default probability--and the observed default probability will rise not by 5% but by 20%, to 40%. The big increase in default, you see, comes not from the bad economic news but from the fact that a lot of people who could still make their mortgage payments at the old interest rate cannot make them at the new one.
And if the default probability rises even more, to:
d = 21% + 20r2
then the market collapses. There is no interest rate at which any bank--even a monopoly bank--wishes to be in this business. No loans are made at all.
Suppose that at this stage the government steps in. "We," the government says, "are going to cap your default losses at 20%." Then banks look at the situation and once again discover that it is profitable to make loans at any interest rate above 5%. Competition chases the market interest rate back down to 5% again. There is a problem--at a 5% interest rate default losses are not 20% but rather 26%--and so the government has to kick in money. But maybe a 26% default rate with the government having to kick in some money is better than a 40% default rate from a cultural, sociological, political, and in the presence of aggregate demand externalities economic point of view. And surely it is better than a complete collapse of the mortgage market.
That is the logic behind Frank, Dodd-Obama, the Barr-Tyson plan being pushed by Hillary Rodham Clinton, and the other variants: that when the major cause of large-scale defaults is not the fecklessness of the borrowers but rather the fact that the market equilibrium has high interest rates that are themselves both the consequence and cause of high default rates, that the government has a market-making role to play by providing guarantees. This seems to me to be a good logic.
Here is Alan Blinder on this issue:
How to Cast a Mortgage Lifeline?: THE financial markets are downright scary. And it seems unlikely that we can extricate ourselves from the current series of rolling financial crises without improving the situation in three related markets: those for houses, mortgages and securities based on mortgages. In a previous column for Sunday Business, I advocated one possible approach: creating a modern version of the Home Owners' Loan Corporation.... How would it work in practice? Let's concentrate on six major design issues:
STRUCTURE The original HOLC bought mortgages outright. But Representative Barney Frank, the Massachusetts Democrat, and Senator Christopher J. Dodd, Democrat of Connecticut, the chairmen of the two banking committees of Congress... would use a beefed-up Federal Housing Administration to guarantee new mortgages -- issued, say, by banks -- instead of buying up old ones. The effects would be much the same: old, unaffordable mortgages would be replaced by new, affordable ones; and the government would then assume the risk of default. But in the Frank-Dodd proposal, the federal government would be a big insurer rather than a big bank. Because the approach actually has a chance of becoming law, let's adopt its structure.
BAILOUTS The Frank-Dodd plan for a Super F.H.A. is intended to make a bad situation better. But it must not be too generous in shielding people and businesses from the consequences of their own bad decisions -- both for economic reasons (to minimize moral hazard) and for political reasons (to gain voter support)... existing mortgages would be bought below face value, forcing investors to, as they say in the trade, "take a haircut"... [and] the proposal would make homeowners relinquish part of any price appreciation on their houses for as long as their Super F.H.A. mortgages remain in effect....
LEGAL SAFE HARBOR The Super F.H.A. would have to deal with legal complexities.... Servicers are petrified of lawsuits if they sell individual mortgages... at a loss.... Congress must pass legislation shielding servicers from legal liability when (as now) market conditions depress prices....
SETTING PRICES The HOLC bought pre-existing mortgages at a discount. The Super F.H.A. would use government guarantees to induce private businesses to do so. In either case, we need prices for the old mortgages.... My suggestion is that the Super F.H.A. categorize the mortgages it might refinance into, say, "high," "medium," and "low" qualities... adjust those prices according to whether mortgage owners rush in to sell (meaning that the prices were set too high) or stay away (meaning that the prices were set too low)....
SUNSET Emergency measures must not outlast emergencies....
ELIGIBILITY AND SCALE How large should the mop-up operation be? Mr. Frank and Mr. Dodd are thinking about one million to two million mortgages, but they understand that a larger number might be necessary to stem the downward spiral....
The urgency of creating something like the HOLC or a Super F.H.A. has grown, not shrunk, since I wrote my previous column.... [T]he Frank-Dodd proposal... offers a smart approach to a knotty set of problems.... Their design is not flawless. But do you know of any perfect solutions? It deserves our support.
Figures:
Hoisted from Comments: Bank Capitalization
Hoisted from Comments: Tom R asks:
Grasping Reality with Both Hands: Economist Brad DeLong's Fair, Balanced, and Reality-Based Semi-Daily Journal: There is one thing I don't understand in all this. If financial institutions are undercapitalized, i.e lack liquid assets, but are in all other regards viable, why don't owners of liquid capital (read W Buffett) buy them and hold the assets until the income stream makes them whole with nice profits to boot.. Of course I know that there are times when this does not happen, i.e. now, but what does this say about the capitalist system? Can we stipulate that capitalism in inherently flawed? Is the flaw behavioral? (We have nothing to fear but fear itself?)
The way Larry Summers puts it is roughly as follows:
At the level of each individual bank, each individual bank that finds itself overleveraged is more-or-less indifferent between whether it solves that overleverage problem by raising more capital or by shrinking the volume of loans it makes and the amount of bonds it holds. But all the rest of us would much, much rather that the banks as a whole raise capital rather than cut back on their assets.
There is a Keynesian aggregate demand externality roaming about here...
Mark Thoma: Adverse Selection, Loan Defaults, and Credit Rationing
Maybe I will use Mark Thoma's model in lecture tomorrow morning:
Economist's View: Adverse Selection, Loan Defaults, and Credit Rationing: What is the source of foreclosures, interest rate resets or falling prices? In this post, I said:
It's easy to explain how interest rate resets could increase foreclosure rates since the monthly housing payment will change as a result of the reset, but why do falling prices cause increased foreclosures? Falling prices don't change monthly payments, so why do more people default?
The post then explains how falling prices can increase defaults and Richard Green provides academic work supporting the mechanism.
But falling prices and interest rate resets are not mutually exclusive explanations for rising foreclosure rates, both could be at work, and Brad DeLong presents a model that explains how, through adverse selection, rising interest rates can cause increases in defaults.
The purpose of this post is to further illuminate Brad's discussion and to explain how the adverse selection mechanism operates.
To do so, rather than try to impress all of you by building my own model, I'll avoid reinventing the wheel and will instead base this discussion on a version of the Stiglitz and Weiss (1981) model presented in Carl Walsh's Monetary Theory and Policy text (so full credit should be given to those authors). The presentation is mathematical, but along the way I will try to provide the intuitive underpinnings, so hopefully the points will be clear even if the mathematics is not.
The basic point of the model is to illustrate two things. First, how an increase in the interest rate can increase defaults. This is the main point. Second, how equilibrium credit rationing can occur, i.e. how financial markets can settle on an equilibrium where there are buyers willing to take out loans at the going interest rate, but nobody willing to lend them money at that rate, and the excess demand for loans is not resolved through rising interest rates.
I should add that there are other mechanisms that can be used to explain these results, moral hazard and monitoring cost models for example (e.g., as interest rates increase, borrowers are induced to take on more risk in moral hazard models, and the increased risk taken on by borrowers increases defaults) so this should not be considered exhaustive.
The Model:
1. The model contains a single type of lender, and different types of borrowers. The lender's expected return on loans is a function of the interest rate and the probability of repayment. The probability of repayment will vary across individuals.
2. Borrowers come in two types:
Type g: this type repays loans with probability qg
Type b: this type repays loans with probability qbIt is assumed that qg > qb, so that the good borrowers (g types) are more likely to repay than the bad borrowers (b types).
3. If lenders can observe the type of borrower they are lending to, they will charge each a different interest rate to reflect differences in risk, and the market will clear without credit rationing. It will be fully efficient.
4. For example, we'll assume the supply of credit is perfectly elastic (the supply curve for credit is horizontal):
Assuming risk neutral lenders, and that they lend to a large number of borrowers (so the law of large numbers applies), the lender will charge r/qg to the good borrowers, and r/qb to the bad borrowers and will realize an expected return of r for each group (i.e., the lender receives r/q with probability q so the expected return is q(r/q)=r). There is no credit rationing, the lender simply charges risky borrowers more than good borrowers to compensate for the extra risk.
5. Now assume the lender cannot observe the different types of borrowers. What we will now show is that as the interest rate, r, increases, the fraction of bad borrowers in the loan applicant pool also increases, so the probability of default goes up.
That is the main point - when interest rates rises, the good borrowers drop out (this is the adverse selection mechanism, the good borrowers self-select out of the pool leaving a greater fraction of risky borrowers in the market).
But we can also get equilibrium credit rationing with this as well. Here's how. As r increases, the return to the lender goes up, so an increase in r increases profit. But, as we will show, the increase in r also causes the fraction of bad borrowers to go up and this increases the default rate and lowers profit. So, the net effect of an increase in r on profit depends upon which of these two effects is stronger, the increase in profit from charging a higher interest rate, or the decrease in profit from higher defaults.
To get rationing, what we have to show is that as r increases, initially profits go up since the higher price effect dominates the increase in defaults. But there comes a point in the lender's profit function where any further increase in r is not profitable, the loss from defaults increasing is larger than the profit increase from the higher interest rate, so the lender won't raise the interest rate even if there is an excess demand for loans at the current r being charged in the marketplace.
This is the credit rationing. Even if there is excess demand for loans, the lender will not raise r above the critical value of r, call it r*, where profit begins falling.
Let's show this mathematically.
6. Let g be the fraction of good borrowers among all borrowers. In order to earn an expected return of r, the lender charges borrowers (which cannot be distinguished and hence face the identical loan rate) r1 such that:
gqgr1 + (1-g)qbr1 = r = expected return if lender charges r1 to all types.
The lender should charge:
r1 = r/[gqg + (1-g)qb]
7. Using this strategy, the lender will thus earn r if borrowers are chosen (walk through the doors of the bank) randomly. But they don't show up randomly, so this is not the end of the story.
Notice that r/qg < r1< r/qb. Good borrowers are paying too much, and bad borrowers are paying too little. Thus, good borrowers are more likely to drop out of the market, and the fraction of good borrowers will diminish over time increasing average default rates (perhaps because they are good borrowers they can find other, cheaper ways to finance investment) .
This is a classic lemons problem and it will lead to market failure, a failure that, in this case, expresses itself as equilibrium credit rationing.
8. Now let's change the model slightly to illustrate rationing. Loans are characterized by more than just the interest rate, and here we will characterize loans by three parameters, the interest rate lenders charge on loans, r1, the size of the loan L, and the required collateral on the loan, C.
9. The probability that a loan is repaid depends upon the return yielded by the borrower's risky project. Let a particular project yield a return of R. Then the lender will be repaid if
L(1 + r1) < R + C
That is, the lender is repaid if the value of the loan is less that what the borrower has to give up in default (the lender gets to claim any return, R, that the borrower made on the project plus the value of the collateral). This just says that the borrower repays when losses are smaller from doing so.
10. Now suppose that the return, R, is risky:
Return R = R1+x with probability 1/2
Return R = R1-x with probability 1/2Then the expected return is R1, and the variance of returns is x2. As x increases, there is a mean-preserving spread in the distribution, i.e. risk goes up, but the expected return is not changed.
11. Next, to limit the outcomes to the ones we are interested in, assume that
R1-x < (1+r1)L - C
This means that the borrower will always choose to default when a bad outcome is drawn (-x), and will always repay when there is a good outcome (+x).
12. Thus, under a good outcome the borrower earns
R1+x - (1+r1)L
(this is the return on project minus the cost of the loan) and under a bad outcome, the borrower loses -C, i.e. loses the collateral on the loan.
13. Then the borrower's expected profit is
EπB = (1/2)[R1+x - (1+r1)L] + (1/2)[-C]
[The superscript means borrower]. That is, the borrower gets the good outcome shown in the first set of brackets 1/2 the time, and the bad outcome of -C shown in the second set of brackets the other half of the time.
14. Define x*(r,L,C) ≡ (1+r1)L - C - R1. That is, x* is the value of x such that EπB > 0 whenever x > x*, and EπB < 0 whenever x < x*. It's the point where profit turns negative.
Another way to say the same thing is that, with x* defined in this way, EπB = (1/2)(x-x*). x* gives the level of risk (how big the bad outcome must be, i.e. the size of x) where it becomes worthwhile for the borrower to walk away from the loan and default.
15. Notice that x* is increasing in r1. This means that as r1 increases, those with smaller x values drop out (i.e. those facing less risk), but the riskier borrowers (those with larger x values) remain in the pool. The mix of borrowers changes toward riskier borrowers and defaults will increase.
16. What about the lender? The lender's expected profit is
EπL = (1/2)[(1+r1)L] + (1/2)[C+R1-x] - (1+r)L
The first term is the return in the good state, the second is the return in the bad state (both happen with probability 1/2), and the third term is the opportunity cost of the funds it lends out (so the return is r, not r1, since the opportunity cost is the market return, r).
That is, the lender receives a fixed amount in the good state, (1+r1)L, but as x increases, the lender does increasingly worse in the bad state where it receives C+R1-x (i.e. as x increases, profit falls). This means that EπL is decreasing is the level of risk, x.
17. Now, let there be two groups of borrowers . Good borrowers are low risk (have small x values), bad borrowers are high risk (have large x values). Designate the x-values for each group as xg and xb, where xg < xb.
From the condition that EπB = (1/2)(x-x*), if r1 is low enough,
xg < xb < x*(r, L, C)
In this case, all loans are repaid, and all loans are profitable. If each type of lender is equally likely to be in the market, then expected profit for the lender is
EπL = (1/2)[(1+r1)L+C+R1] - (1/4)[xg + xb] - (1+r)L
This is increasing in r1.
18. But, as r1 increases, we will eventually reach the point where xg = x*(r, L, C) and the good types drop out of the market and stop borrowing (this is adverse selection at work). In this case, expected profit falls to
EπL = (1/2)[(1+r1)L+C+R1] - (1/2)[xb] - (1+r)L
Thus, EπL falls discretely when xg = x*, i.e. profit falls discretely when r1 increases and reaches
r1 = (1/L)[xg - C + R1] - 1
since this is the point where low risk types exit the market (the discrete jump comes from having two groups - with a continuum of risky borrowers, the discrete jump would be replaced by a maximum profit point, i.e. a single-peaked profit function).
19. We can show this graphically:
For loan rates between 0 and r1, no loans are profitable and none will be made. For loan rates between r1 and r*, both types of borrowers are in the market, and all loans are profitable (and profit is increasing in r).
For loan rates between r* and r2, loans are unprofitable, so no loans would be made. For loan rates above r2, loans are profitable, but only the risky group will be in the market.
Thus, credit rationing is possible at equilibrium. If loan demand is robust, lenders will increase r until it hits r*. At r*, there can be excess demand, but lenders will not raise the loan rate unless demand is so strong that rates can be profitably increased all the way to r2. Thus, if demand is strong enough to produce excess demand at r1, but not strong enough to push rates all the way to r2 or above, there will be credit rationing at equilibrium.
Conclude briefly:
We have shown two things. First, when the interest rate increases, adverse selection mechanisms can cause good borrowers to drop out of the loan pool increasing the riskiness of the average borrower. This increases default. Thus, this shows how an increase in the interest rate can increase default rates.
[Note: I wouldn't apply this model directly to mortgage markets as is, interest rate resets would be modeled a little bit differently, but the basic mechanism would be the same and is well illustrated by this and Brad DeLong's example.]
Second, the adverse selection mechanism can explain the presence of equilibrium credit rationing. There are other explanations too, e.g. moral hazard and monitoring cost models can explain equilibrium credit rationing, so there are other ways to get this result.
Safeguarding America's Economy from Adverse Consequences of Financial Crisis
Larry Summers hopes that the current financial crisis has passed its peak:
Steps that can safeguard America's economy: Neither US financial institutions nor the economy are likely to suffer from a lack of central bank liquidity provision. New lending facilities are coming along almost weekly, the safety net has been expanded to include non-bank primary dealers, the Fed has demonstrated a willingness to take on directly the most problematic parts of Bear Stearns' balance sheet, and the Fed funds rate has been reduced by 200 basis points within 7 weeks.... [P]rocesses are in motion that may lead to new demands for more than $1,000bn in mortgages, directly or indirectly. Recent regulatory actions will enable Federal Home Loan Banks along with Fannie Mae and Freddie Mac (the government-sponsored enterprises) to purchase more than an additional $300bn in mortgage-backed securities... legislation to reduce foreclosures being pushed by Senator Christopher Dodd and Representative Barney Frank could result in the federal government purchasing or providing guarantees that enable the purchase of several hundred billion dollars worth of mortgages.
The confidence engendered by all of this has led to some normalisation in credit markets.... For the first time since last August, I believe it is not unreasonable to hope that in the US, at least, the financial crisis will remain in remission.... Just as cascading liquidations have contributed to a vicious cycle of both real and financial contraction, it is possible that recovery can be a virtuous circle in which improved financial and real economic performance are mutually reinforcing.
Wise policymakers hope for the best but plan for the worst... markets continue to price in significant probabilities of default for even the most apparently strong financial institution... the federal government is bearing credit risk in extraordinary ways through its implicit guarantee to the GSEs, the lending activities of the Fed and the general backstop it is providing to the financial system... a priority for financial policy has to be increases in the level of capital held by financial institutions....
The policy approach should start with the GSEs.... It is appropriate at a time of crisis in the mortgage markets that they become, as their regulator put it last week, the "lender of first, last and every resort."... It is not appropriate that their shareholders' "heads I win, tails you lose" bet with the taxpayer be expanded for this purpose... their regulator... should insist that they stop paying dividends and raise capital promptly and substantially as they expand their lending....
Because they do not have a similar public mission and are operated with more financial rigour and closer regulation, the situation is somewhat different with respect to other financial institutions.
As part of its dialogue with financial institutions, the Fed should push for further efforts to raise capital... destigmatise cutting dividends or raising equity. The idea of linking access to Fed credit and measures to attract capital should also be explored. At a time when much is being given to financial institution shareholders and management, action to help the economy and protect the taxpayer should be expected in return.
What is the analysis that underlies this argument?
Start with a version of Bernanke-Gertler: financial intermediaries can operate in one of two modes: well-capitalized or poorly-capitalized. When financial intermediaries are well-capitalized, they themselves have little problem borrowing on a large scale and serving as conduits for the flow of funds between savers and investors. Thus market demand for risky financial assets is relatively high:
And, given the (fixed in the short run) supply of risky financial assets like mortgages and private-sector bonds, the prices of such financial assets are relatively high as well--which gives businesses an incentive to expand their capital stocks and thus put people to work in the investment-goods industries:
But there is another mode of operation: if financial intermediaries are poorly-capitalized they themselves will have great problems borrowing--savers will fear the moral hazard problems that arise when those who manage their money don't themselves have a large stake in the game, and a financial intermediary without a large equity cushion leads savers to ask the American question "if you're so smart, why aren't you rich?" and shy away. So if financial intermediaries are poorly-capitalized, supply and demand looks very different:
with low demand for financial assets, a low equilibrium price of financial assets--and no incentive for businesses to expand their capital stocks, and mass unemployment, and depression.
The kicker is that large declines in the prices of financial assets--a panic--can switch financial markets from one mode to the other, because their is a large range over which declining prices do sufficient damage to financial intermediaries' capital and reputation to cause the demand curve to slope the wrong way--in what I was taught to call the "Krugman Backwards-S" demand curve:
which produces two stable equilibrium--a good, high-price, high-investment, full-employment one, and a bad, low-price, low investment depression one. The task of central banking is to keep the financial markets and the economy at the good equilibrium, and keep it from jumping to the bad one.
Now let's jump back in time to 2001-2002. It is the aftermath of the collapse of the tech boom and of 911. The Federal Reserve has lowered interest rates to try to forestall deflation and keep the economy near full employment. By lowering interest rates it made safe assets less attractive, and thus pushed demand for risky assets outward--raising the prices of (which is the same thing as lowering the interest rates of) risky financial assets:
The outward push became larger because of two additional factors: Asia's policy of low-currency valuation and thus of providing interest-rate subsidies to America's borrowers, and relaxed lending standards coupled with real estate exuberance. In an environment in which any newly-created financial asset could be sold for a high price, construction companies undertook to build lots more houses--and thus pushed the supply of financial assets out to the right between 2002 and 2006 as all of these new houses--3 million more than trend construction--needed mortgages:
Now comes 2007 an end to irrational exuberance and a little bit of bad macroeconomic news pushes demand for financial assets back to the left. At first--last summer--the Federal Reserve thinks that its job is simply to maintain confidence, to keep the economy at the good equilibrium by making everybody understand that the Fed was not going to let the economy get to the bad, depression equilibrium. But over the fall it became clear that such "Panic Stage I" policy wasn't going to be enough:
Providing liquidity to the market in order to maintain confidence--following Bagehot's rule of lending freely at a penalty rate to organizations that could offer collateral that would be acceptable in normal times--wasn't going to be enough to avoid a depression because it was no longer a matter of maintaining confidence that banks and other financial intermediaries were and would remain well-capitalized. Why wasn't it enough? Because they weren't well capitalized.
So over the winter the Federal Reserve moved on to "Panic Stage II" policy: fight the possibility of deflation and depression by doing what they did in 2002, and lowering safe interest rates in order to boost private-sector demand for risky assets. And that gets us to today, where the Federal Reserve has done almost all that it can do in the way of reducing interest rates on safe assets, and yet financial markets are still not calmed, are still not confident that the good equilibrium exists.
What do we do now? That is the subject of Larry Summers's column. We do two things. First, we have the Federal government reduce the supply of risky financial assets by having the government buy or guarantee (thus making the assets no longer risky, you see) or support the purchase of mortgages (and other things) and so push the private financial-sector supply of financial assets to the left. Second, we have the Federal government "encourage" the financial sector to recapitalize itself, thus pushing the supply up and to the right, like so:
And so pushing up the prices and reducing the interest rates charged on financial assets, making the good equilibrium reappear, and keeping us out of depression, like so:
That, in a nutshell with simple graphs, is what Larry is saying, with the addition that he thinks that we now have in motion enough policy moves to resolve the crisis and save the world economy from depression. But there are four additional points that don't fit easily on the graphs. We need to make sure that we also:
- do smart things to try to keep this from happening again
- assign blame and try as hard as we can--without causing a depression--to make sure that those who bear responsibility don't make out like bandits by looting the Treasury as this is accomplished.
- make sure that others--even if they are still largely innocent bystanders at the moment--do not earn unjustified windfall fortunes in the process.
- make sure that the upward-and-to-the-right orange-arrow movement of the supply curve does in fact take place: make sure that financial intermediaries that survive and profit because of government intervention become not just part of the problem but part of the solution: that because "much is being given to financial institution shareholders and management, [it is only fair that much] action to help the economy and protect the taxpayer... be expected in return."
Now there are three objections to this analysis and this plan of action, roughly: (1) it's immoral, (2) it's unfair, and (3) it can't work in the long run. To expand a bit:
- It's immoral because people have a right to be treated like adults--which means that they have a right not to be rescued by the government from the consequences of their bad judgment, and we are violating that right.
- It's unfair because feckless greedy financiers who caused the problem ought to lose money and aren't-or aren't losing enough money--and because feckless greedy imprudent thriftless borrowers who caused the problem ought to lose money and aren't--or aren't losing enough money.
- It won't work--at least not in the long run.
I dismiss objection (1). It is made, mostly, by those who speak for the Princes of Wall Street. Note that the Princes of Wall Street themselves are not opposed to what the Federal Reserve and the Treasury and the congress doing--anything, anything at all that promises to raise asset prices is something that each of the Princes of Wall Street would trade at least one of their organs of generation for. But those who speak for the Princes of Wall Street--well, they really believed that the Princes earned their fortunes by virtue of their virtue--their intelligence, their nerve, their skill, and their willingness to run great risks for great rewards. The idea that there is a public safety net to catch the Princes when they all fall off the tightrope at once--that they are not actually rugged Randite individualists running great risks--that they are people in the right place at the right time with enough low animal cunning to cover themselves with glue and then step outside at 57th and Park or on Canary Wharf as the money blows by so that a bunch of the money sticks to them--well, this strikes those who speak for the Princes of Wall Street on the editorial page of the Wall Street Journal or in Investors' Business Daily as a betrayal of the moral order.
The response to objection (1) is that the people who make it need to grow up. There is no more a John Galt or a Jane Galt than there is a Santa Clause. There are no Randites in a financial crisis--or no even quarter-sane Randites. The fact that there is a safety net in a financial crisis is something that has been obvious to everything with a spinal column for at least a century and a half--that's what central banks are for, for Jeebus's sake! The Princes of Wall Street did not earn their fortunes by virtue of their virtue, their intelligence, their nerve, their skill, and their willingness to run great risks, et cetera, et cetera, low animal cunning, glue, money sticks as it blows by.
Later on we can talk about the corollary to the refutation of objective (1)--the fact that the existence of a safety net for the rich since 1844 makes it an obvious matter of simple justice that there be a safety net for the poor and the middle class as well, and that Harvard University would have been better served if it had taken Robert Nozick's slot away from the philosophy department so that he would not write Anarchy, State, and Utopia and given it to the economics or the history department. But that's for later, and for the present it's important to make sure that people who argue for tax cuts for the rich or for welfare-state program cutbacks for the poor or for more slots for libertarian political philosophers in elite universities should not be allowed to disrupt the formulation of public policy when there is serious busienss to be done.
The response to objection (2) is "tough." Yes, it is important to design the elements of the rescue package in such a way as to give as few windfalls as possible to the undeserving feckless, greedy, imprudent, thriftless, et cetera. But as Federal Reserve vice chair Don Kohn says, it is bad public policy to hold the jobs of tens of millions hostage in an attempt to teach a few feckless financiers (or even somewhat more thriftless borrowers) even a much-deserved lesson.
Objection (3) is intellectually more interesting and substantive. But that will have to wait for the next lecture.
Hondas and Toyotas vs. Fords and Chevys
Matthew Yglesias writes:
Matthew Yglesias: Reliability: Asked how to choose a good mechanic, Tyler Cowen responds that you should buy a Honda or a Toyota and you probably won't need a mechanic to do anything beyond the super-routine. I've never owned a car, but in second-hand anecdotal terms that definitely seems to be the case -- folks who own Hondas or Toyotas, even pretty cheap ones, rarely have problems whereas American cars are plagued with reliability issues. This often strikes me as an under-analyzed element in the saga of American deindustrialization; maybe it's not even true that American durable goods are far less reliable than Japanese brands, but it's certainly what a lot of people think.
Well, we've bought two Hondas (Acuras, actually), one Toyota, one Subaru, one Volvo, one Ford, and one Chevy.
The Toyota is still too new to have a view, but so far no problems at all...
The Hondas have been wonderful...
The Subaru had one mysterious problem that went away when we did the 30K service 5K early, and has not returned...
The Volvo was unpleasant--but not because of the Swedes. The dealership in Arlington VA had installed a remote entry/alarm that fouled up the elecrical system somehow...
As for the Ford and the Chevy, our experience--well, it would take not just money but guns and lawyers as well to induce us to buy another one.
Department of "Huh"?
Shannon Brownlee writes:
Let's Stop Running Scared: I have no plans to monitor my cholesterol, undoubtedly to my doctor's consternation. Why bother? I'm already watching my weight, exercising regularly and eating a healthful diet, and I don't want to take medications that offer little if any protection against heart attacks for people whose only risk factor is elevated cholesterol...
Ummm.... As I understand it, if a woman in her 50s has cholesterol of 250-40 as opposed to 150-60 (total-HDL) and no other risk factors, her ten-year risk of heart attack is higher by one percentage point.
Avoiding a heart attack seems to me to be worth at least $100K. Reducing the chance of a heart attack by one percentage point seems to me to be worth $1K over ten years--or worth spending $100 a year.
Thus it seems to me that including a cholesterol test in your every-two-years blood screening and adding a pill to your morning vitamins if the cholesterol numbers are going south in a serious way--even with no other cardiac risk factors--is a good idea.
What am I missing?
The Iceman Cometh...
Daniel Davies points us to:
'Iceman' Wrestles Shark To Save Shipmates |Sky News|World News: An Icelandic fishing captain, known as "the Iceman", wrestled and killed a 300kg shark to stop it attacking his crew, according to witnesses. Captain Sigurdur Petursson was on a beach in Kuummiit, east Greenland, watching his crew processing a catch when he saw the shark swimming towards his men. The skipper of the trawler Erik the Red, ran into the shallow water and grabbed the shark by its tail with his bare hands. He dragged it off to dry land and killed it with his knife...
And comments:
D-squared Digest -- FOR bigger pies and shorter hours and AGAINST more or less everything else: Let it further be resolved: Bear vs Shark (ie, who would win in a fight between a bear and a shark if the fight was staged in a pool of water deep enough for the shark to manouevre, but shallow enough for the bear to be able to stand up) is apparently a subject of controversy among the violence-loving, animal-hating, crap-talking community. I can settle this one. Bear, by a mile. The shark gets one good bite, maximum, and then gets mullered. Proof. Sigurdur Petursson is by all accounts a reet hard bastard, even by the standards of Icelandic trawlermen, but he is not as strong as a bear.
Yeah. But a bear's claws and fangs aren't as sharp and long as a knife, either...
March 29, 2008
Hedge Fund Schadenfreude...
Louise Armitstead of the Torygraph:
Hedge fund legends hit by financial crisis: Soon the Griffins boasted a dining-room chandelier by glass artist Deborah Thomas, two installations by potter-sculptor Edmund de Waal (including a complete room of more than 600 porcelain vessels), and an architectural version of a Morandi painting.... Tisbury, a $2.7bn (£1.35bn) event-driven fund... Griffin... archetypal hedge fund manager: aggressive, arrogant and nearly always right.... The latest bite of the credit crunch has caught Griffin offguard... down 8 per cent in the first two months of the year.... Hamstrung by the lack of liquidity... new terms with his prime brokers, beg for patience from investors and offered his business for sale to bigger rivals, including GLG Partners....
Peloton Partners, the award-winning fund run by ex-Goldman Sachs star Ron Beller, imploded. Focus Capital, another EuroHedge fund of the year, wound up days later... Carlyle Capital Corporation.... John Meriwether, the man behind the collapse a decade ago of Long Term Capital Market... JWM Partners is struggling with losses of 28 per cent this month.... "This is just beginning. Somewhere been 40 and 100 hedge funds will liquidate shortly. It's a bloodbath and it will get worse."
Already investors are showing their fury. One said: "I thought volatility was what hedge funds lived for? Making money, or at least preserving cash, during volatile times is certainly what we pay them for. They have been poncing around during the good times and are now found wanting at the first sign of trouble. It's a debacle out there.".... Hedge funds have been blamed for all market woes from the implosion of Bear Stearns three weeks ago, the collapse of HBOS's share price days later and now the weaknesses of the entire Icelandic economy....
Just a few months ago these were the best brains in finance. Now they are being exposed as average fund managers at best, and potential market manipulators at worse. How many more pretenders are there out there and how much more chaos will their demise bring to the rest of the markets?... Scrambling to cope with the next stage of the credit crunch, bank bosses ordered their prime brokerage and repo departments to comb through their books again and slash risk exposure. Lending lines have been cut, just as the funds needed them most to cope with the volatility.... While hedge funds have traditionally used two or three times leverage in their funds, this figure has been multiplied to eight or nine times in many cases - and even more in some. One prime broker said: "Hedge funds have had it easy. Every man in a pink Cadillac has been able to raise money, start a fund and do really well. Frankly, those who have taken the biggest risks have come off best because markets have been so extraordinarily kind."...
The leverage that magnified gains in the rising markets has had the same impact on the way down. Weaker funds were the first victims.... Beller... often boasted that Peloton was sailing close to the wind. "I once asked Beller how he would cope if the market suddenly turned and he was forced to mark to market. He said he'd be in trouble but that would never happen." Focus Capital... EuroHedge industry award... returning more than 100 per cent in 2006. O'Brien and Bubb told investors that they had been the victims of the credit crunch and short selling.... Endeavour Capital, run by former Salomon Smith Barney fixed-income traders... 27 per cent of the value of the $3bn fund had been wiped out... 18 times leveraged.... Platinum Grove, the $5.5bn New York-based hedge fund set up by former Long Term Capital Management co-founder Myron Scholes, fell 7 per cent... London Diversified had lost between 4 per cent and 5 per cent... founders, led by David Gorton, famously took £55m in management fees... in 2004...
What's really going on? What's going on is that perhaps $6T of mortgages with a duration of a decade that had been priced at a 1% per year chance of default (with a 1/3 value haircut in the event of default) are now being priced at a 4% per year chance of default. That's a loss of $600B in market value--and if your share of that $600B is greater than your capital, or is thought to be greater than your capital and so impedes your operations, you are gone.
But truth be told it is a zero-sum game--not a real destruction of wealth. The real rates at which cash flows of constant risk are being discounted haven't changed much: there hasn't been a big redistribution of wealth between the present and the future. What has happened was that a bunch of people believed that the default risk was 1% when it was actually 2% and reported gains of $200B (of which they took 2-and-20 on the hedge fund slice, perhaps $20B, for themselves), and that now a bunch of people believe that the default risk is 4% when it is actually still 2% (unless, of course, the assembled central banks of the world fail and unemployment heads rapidly upward). So in aggregate hedge fund partners have gained $20B, hedge fund investors have paid$20B to their money managers for the privilege of losing another $200B that they never had, and there are $400B of transitory paper losses that will turn into real losses for those overleveraged and caught by the credit crunch and so forced into fire sales, and into real gains for those with steel nerves and liquidity.
Unless, of course, Ben Bernanke and company fail to contain the crisis, and we wind up in a severe depression. But then we would have much, much bigger things to worry about than $600B of missing paper mortgage value. 4 years x 3 percent excess unemployment x Okun's Law coefficient of 2 x $13T economy means a $3.1T cumulative Okun gap in lost real wages, salaries, and profits. That's the thing to worry about.
Comment Moderation Strategies
Barry Ritholtz points us to the owl-like Teresa Nielsen Hayden::
The Big Picture: My own policies are clearly stated here, but I like the description of how to get your comments banned over at boingboing:
Q. What's likely to land me in your bad graces? A. Since you've asked, here's a nowhere-near-exhaustive list... http://www.boingboing.net/2008/03/27/boing-boings-moderat.html
Washington Post Death Spiral Watch
The Washington Post, for no reason anybody can explain to me, gives airtime to James Carville so Carville can explain that he was right to call Bill Richardson a "Judas" because Bill Richardson was obligated not to endorse Barack Obama:
I was a little-known political consultant until Bill Clinton made me. When he came upon hard times, I felt it my duty -- whatever my personal misgivings -- to stick by him. At the very least, I would have stayed silent. And maybe that's my problem with what Bill Richardson did. Silence on his part would have spoken loudly enough...
Bill Richardson served in the U.S. House of Representatives from 1983-1997, was U.N. Ambassador from 1997-1998, Secretary of Energy from 1998-2001, and has been governor of New Mexico since 2003.
Why oh why can't we have a better press corps?
Four years, Washington Post, four years.
Making False Advertising True
Nick Barrowman gave his weblog a somewhat deceptive name:
So he tries to recover:
Collapsing Worldwide Credit Volumes
From Paul Davies of the FT:
FT.com / Home UK / UK - Credit crunch leaves mark on all debt market areas: Global debt issuance collapsed in the first quarter as the credit crunch took its toll on new deals in all sectors from structured finance and riskier high-yield bonds and loans right up to sturdy investment-grade corporate debt, according to new data.
Total debt market volumes were $1,030bn in the first quarter, a 48 per cent drop compared with the same quarter a year ago, while total syndicated loan market volumes were $599.bn, a 47 per cent drop versus the same period last year, according to Dealogic, the data provider.
The numbers illustrate how the withdrawal of liquidity from the world's debt markets in the wake of the turmoil that began in the US mortgage markets has affected everything from the safest corporate borrower to the most risky private equity backed leveraged buy-out deal.
March 28, 2008
links for 2008-03-29
-
You'd think installing the guy and having 150,000 troops there to underwrite his government would at least buy American forces a heads up. You'd be wrong.
New York Times Death Spiral Watch
Outsourced to Matthew Yglesias, who reads Erica Goode so the rest of us can escape uninjured:
Matthew Yglesias (March 28, 2008) - Know Your Enemy (Foreign Policy): New York Times: "Mr. Bush also accused Iran of arming, training and financing the militias fighting against the Iraqi forces." Would it have killed the Times to point out that Iran is also arming, training, and financing the militias fighting alongside the Iraqi forces? After all, the government of Iran has extremely cordial relations with the government of Iraq and our main militia allies in Iraq were literally created in Iran by the Iranian Revolutionary Guard. This context certainly seems relevant.
Meanwhile, is there any real precedent for the sort of repeated misstating the identity of the enemy that we've seen from the Bush administration? Recall that it took years for the administration to grudgingly acknowledge the existence of a non-AQI Sunni Arab insurgency even though this insurgency had long been the US military's primary adversary. But now we're supposed to believe that everyone we and our Iranian-backed allies fight are Iranian. Sure.
Why oh why can't we have a better press corps?
John McCain and Hillary Rodham Clinton Fail the Commander in Chief Test
Matthew Yglesias writes:
Matthew Yglesias: Northern Ireland: Here's a nice rundown of the Clinton campaign's Northern Ireland mumbo-jumbo. I think what her husband's administration did there was a very legitimate achievement and very much highlights some of the shortcomings of the George W. Bush approach which has no comparable examples of constructive U.S. engagement in the troubles of the world. It also highlights John McCain's catastrophically poor understanding of foreign affairs as, at the time, he denounced the Northern Ireland initiative as a sellout of a key U.S. ally doomed to failure.
So it's not a bad issue for Clinton to raise, in its way. But she wants to raise it as an example of her personal foreign policy chops and the evidence just isn't there. It's normal for a new president to have little direct foreign policy experience, and either Clinton or Obama would fit that bill. But Clinton seems determined to pretend she's some kind of seasoned hand that she isn't.
The Singularity Will Be Blogged...
I think they are getting ready for the Economics Department spring skit party. Whatever they are.
Ben Mathis-Lilley tried to warn me. But did I listen? No!
Do Two Recent Novels About China Obscure the Looming Robot Threat? Yes: The Times review of Alex Berenson’s The Ghost War gave us déjà vu. The novel depicts an imagined war between China and the United States triggered by an idealistic but scheming Communist Party official. It seemed familiar because it reminded us of the other book the Times reviewed recently whose plot is driven by Chinese chicanery, Colin Harrison’s The Finder. In Harrison’s novel, a Chinese immigrant poses as a janitorial worker in midtown in order to steal corporate secrets for her brother’s firm in Shanghai.
Frankly, this threatening-Chinese theme worries us. Not for political reasons; neither book is said to be jingoistic. Rather, it’s because we’re concerned that “the coming war against the Chinese” is going to replace “the coming war against the machines” as our leading fictional-future-war trope.
The inevitable apocalyptic battle against machines has long been a fruitful topic in books (Philip K. Dick, Isaac Asimov), film (The Terminator, The Matrix), and shit-shooting bar discussions. (We personally believe that simple machines pose an underrated threat; how are we going to lift and move heavy objects when the automaton rocket-blasting helicopters, appealing to intra-machine solidarity, convince levers and pulleys to turn against us?) And this business with the Chinese is a dangerous distraction — a second front, if you will, in a time when America doesn’t have the resources to fight two imaginary future wars at once. In fact, we suspect “Alex Berenson” and “Colin Harrison” are actually Undercover Models AB-246 and CH-391, robotic novelist-simulating fifth-columnists.
In summary, the Times book section is actively working toward a future in which humans are kept alive only so robots can imprison them in cages and harvest their fingernails, which they use to make decorative chess pieces. Need more proof? The Times has resolutely refused to review How to Build a Robot Army, by Daniel Wilson, Ph.D., which — if not solving the problem of an eventual robot uprising — does at least offer humans guidance in co-opting the violent tendencies of robots for our own purposes. Review this worthy book, New York Times, and then we can talk about "balanced coverage" and "not letting our robot masters drive the agenda."
Please share this information with everyone you know. —Ben Mathis-Lilley
The Fed's New Tools
From Barry Ritholtz:
The Big Picture: Now, you can track all of these programs via the Federal Reserve Bank of New York. They published a handy guide counting all the ways you can engage in Moral Hazard borrow from the nation's lender of last resort.
These Five were created since August:
- Term Securities Lending Facility (TSLF), announced March 11, allowing securities dealers to get Treasurys at auction for 28 days
- Primary Dealer Credit Facility (PDCF), announced March 16, for securities firms to receive overnight loans
- Term Auction Facility (TAF), announced December 12, for banks to get funds at auction without the discount window stigma
- Single-Tranche OMO (Open Market Operation) program, announced March 7, allowing securities dealers to get 28-day funds
- Term Discount Window Program (TDWP?), announced August 17, extending the length of discount-window loans to 90 days...
March 27, 2008
Abu Muqawama: Why We Oppose the Sadrities
It is as good an explanation as any:
abu muqawama: A Town Called Malice (Updated): Update III: Why, some wonder, is the U.S. closer to the Iran-backed ISCI and Badr Brigades than it is with the Sadrites? Why does this make sense? Two Baghdad political veterans have ruefully pointed out to Abu Muqawama that while Sadr has more popular support, the ISCI crowd have something more valuable: they speak English. One former State Department veteran with whom Abu Muqawama spoke a few months ago pointed out that former Iraq honcho Meghan O'Sullivan was particularly vulnerable to falling under the sway of those politicians who didn't just speak in that confusing gutteral language where they write from right to left in co-joined letters. Ergo: they speak English, so they must be our friends! Hoo-ray, democracy!
Impeach George W. Bush. Impeach him now.
A Bulletin on Baghdad and Basra from the Times of London
James Hilder writes:
Areas of Baghdad fall to militias as Iraqi Army falters in Basra: Iraq's Prime Minister was staring into the abyss today after his operation to crush militia strongholds in Basra stalled, members of his own security forces defected and district after district of his own capital fell to Shia militia gunmen. With the threat of a civil war looming in the south, Nouri al-Maliki's police chief in Basra narrowly escaped assassination in the crucial port city, while in Baghdad, the spokesman for the Iraqi side of the US military surge was kidnapped by gunmen and his house burnt to the ground.
Saboteurs also blew up one of Iraq's two main oil pipelines from Basra, cutting at least a third of the exports from the city which provides 80 per cent of government revenue, a clear sign that the militias -- who siphon significant sums off the oil smuggling trade -- would not stop at mere insurrection.
In Baghdad, thick black smoke hung over the city centre tonight and gunfire echoed across the city. The most secure area of the capital, Karrada, was placed under curfew amid fears the Mahdi Army of Hojetoleslam Moqtada al-Sadr could launch an assault on the residence of Abdelaziz al-Hakim, the head of a powerful rival Shia governing party. While the Mahdi Army has not officially renounced its six-month ceasefire, which has been a key component in the recent security gains, on the ground its fighters were chasing police and soldiers from their positions across Baghdad. Rockets from Sadr City slammed into the governmental Green Zone compound in the city centre, killing one person and wounding several more.
Mr al-Maliki has gambled everything on the success of Operation Saulat al-Fursan, or Charge of the Knights, to sweep illegal militias out of Basra. It has targeted neighbourhoods where the Mahdi Army dominates, prompting intense fighting with mortars, rocket-grenades and machineguns in the narrow, fetid alleyways of Basra. In Baghdad, the Mahdi Army took over neighbourhood after neighbourhood, some amid heavy fighting, others without firing a shot. In New Baghdad, militiamen simply ordered the police to leave their checkpoints: the officers complied en masse and the guerrillas stepped out of the shadows to take over their checkpoints.
In Jihad, a mixed Sunni and Shia area of west Baghdad that had been one of the worst battlefields of Iraq’s dirty sectarian war in 2006, Mahdi units moved in and residents started moving out to avoid the lethal crossfire that erupted. One witness saw Iraqi Shia policemen rip off their uniform shirts and run for shelter with local Sunni neighbourhood patrols, most of them made up of former insurgents wooed by the US military into fighting al-Qaeda. In Baghdad, thousands of people marched in demonstrations in Shia areas demanding an end to the Basra operation, burning effigies of Mr al-Maliki, whom they branded a new dictator, and carrying coffins with his image on it.
From his field headquarters inside Basra city, the Prime Minister vowed to press on with his attack, which he said was not targeting the Mahdi Army in particular but all lawless gangs. "We have come to Basra at the invitation of the civilians to do our national duty and protect them from the gangs who have terrified them and stolen the national wealth," he said. "We promise to face the criminals and gunmen and we will never back off from our promise." Supporters of Hojetoleslam al-Sadr, the rebellious cleric who formed the sprawling, 60,000-strong militia five years ago, have accused the Prime Minister of trying to wipe out the powerful Sadrists as a political force before provincial elections in October.
Residents of Basra complained that water and electricity had been turned off in the three main areas besieged by the Iraqi Army, which has an entire division deployed for the battle. They also said that they were running low on food an unable to evacuate their wounded. Estimates of the death toll in Basra reached as high as 200, with hundreds more wounded. “The battle is not easy without coalition support,” lamented one Basra resident, who had worked as a translator for the British forces. “The police in Basra are useless and helping the Mahdi Army. The militia are hiding among the civilians. This country will never be safe, I want to leave for ever. I don’t know how to get out of this hell.”
One man was shot in the leg while trying to fix the rooftop water tank on his house but feared he would be taken for a militiaman if he tried to reach a hospital. Officials said that more than 200 militiamen had surrendered after the Government issued a three-day deadline to give themselves up. While residents in Basra said that the army appeared to be making little headway against the militia bastions, a British Army spokesman based at nearby Basra airport said progress was being made. “The Iraqi Army are rebalancing across the city, consolidating their positions, resupplying and preparing for future operations,” said Major Tom Holloway. “They made considerable progress, although not total progress by any stretch of the imagination.”
With fighting flaring across the Shia south, the police chief of Kut — where Mahdi fighters had seized large parts of the town, 110 miles southeast of Baghdad — said his men had killed 40 militiamen while losing four officers. "The security forces launched an operation at around midnight to take back areas under the control of Shiite gunmen," Abdul Hanin al-Amara said. While US and British military officials have been at pains to distance themselves from the push against the deadly militias, President Bush praised the high-risk strategy of tackling militias that a politically weak Mr al-Maliki had been forced to court in the past. "Prime Minister Maliki's bold decision, and it was a bold decision, to go after the illegal groups in Basra shows his leadership and his commitment to enforce the law in an even-handed manner," Mr Bush said. "It also shows the progress the Iraqi security forces have made during the surge"...
Barack Obama, Historian and Hamiltonian
Mark Kleiman writes:
The Reality-Based Community: Barack Obama, Historian and Hamiltonian: Putting the substance aside for one moment, Obama's Cooper Union speech on the economy illustrates two points about his thinking that haven't been widely remarked on: 1. When he considers issues he tends to start out by thinking historically, and by starting with the period around the framing of the Constitution. This is a very unusual impulse among American office-seekers. 2. He identifies strongly with Hamilton as against Jefferson. In particular, he uses Hamiltonian interventionism to demonstrate that laisser-faire was not among the founding doctrines of the nation. Since Jefferson remains among the household idols of the Democratic Party, that's a fairly bold thing to do.
The same themes come through in The Audacity of Hope.
The Regulation of the Mixed Economy in Action
Both the highly-intelligent Martin Wolf and the highly-intelligent David Wessel, I think, overstate the importance of what has happened in financial markets this month. Both of them--very smart as they are--talk as if there has been a big shift: an end to laissez-faire in financial marke