Yet More DeLong Smackdown Watch: Yves Smith Raises Objection (3) to Dealing with the Financial Crisis

Larry Summers's believes (and I agree) that we can likely resolve the financial crisis by (a) using regulatory authority to induce banks and not-banks to recapitalize (thus raising their demand for risky assets) and (b) having the government fund its own or GSE's purchase of mortgages or having the government guarantee mortgages (thus reducing the supply to the private market of risky assets):

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and so returning us to a good near-full-employment financial-markiet equilibrium.

Yves Smith disagrees, and in an attempted refutation raises what I call Objection (3): "It can't work, it won't work--at least not in the long run":

naked capitalism: Lessons from Japan Versus Wishful US Prescriptions (Summers/De Long Edition): Let's say that, in the end, the banks will have to get a public injection of funds. What might be some implications? First is that all these measures to shore up markets are a very indirect, inefficient, and therefore costly was to try to finesse the real problem, that a lot of institutions are or shortly will be insolvent. That says we should quit propping up the mortgage market... deal with the damage to families frontally rather than by trying to prop up home prices... the government has no reason to be shy about nationalizing institutions, and that means wiping out the equity holders before any funds are injected. Yet people like Summers seem remarkably loath to even voice that idea, as if it were somehow anticapitalist. Huh? What is anti-capitalist is privatizing gains and socializing losses....

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....

Note that [Summers] acknowledges that the government cannot keep asset prices from declining to their fundamental value but does not consider the implications. Even more bizarrely, he dances around the role of Freddie and Fannie, on the one hand arguing that they should be lenders of the "first, last, and every resort" (um, that means they are serving a public purpose) yet will not address the need to nationalize them. What gives? Similarly, he makes a motherhood statement that if banks get help from the government they should anticipate that that costs arecattached. But this is a charged area where details are far more helpful than platitudes...

Yves Smith is standing on the shoulders--well, not so much standing on the shoulders as walking in the footprints--or giants, specifically Karl Marx and Friedrich Engels, who wrote in 1850:

Reviews from Neue Rheinische Zeitung Revue: The years 1843-5 were years of industrial and commercial prosperity.... As is always the case, prosperity very rapidly encouraged speculation... [which] occurs... when overproduction is already in full swing... provides overproduction with temporary market outlets... precipitating the outbreak of the crisis and increasing its force.... When the Bank of England keeps its interest rates down in times of prosperity... capitalists with investments in loan capital thus see their income reduced by a third... under pressure to look for more profitable capital investments. Overproduction gives rise to numerous new projects, and the success of a few of them is sufficient to attract a whole mass of capital in the same direction, until gradually the bubble becomes general...

And, they say, the economy's problems cannot be cured by mere government financial manipulation:

The crisis itself first breaks out in the area of speculation; only later does it hit production. What appears to the superficial observer to be the cause of the crisis is not overproduction but excess speculation, but this is itself only a symptom of overproduction. The subsequent disruption of production does not appear as a consequence of its own previous exuberance but merely as a setback caused by the collapse of speculation...

That's Smith's argument: that Larry Summers and I neglect the implications of the fact that "the government cannot keep asset prices from declining to their fundamental value." How sound is it?

The fundamental value of any risky asset--housing, say--depends on (a) per-period value or profit, (b) the time profile of safe interest rates, (c) the quantity of risky assets that the private financial sector must bear, (d) the amount of risk associated with each tranche of risky assets, and (e) the risk-bearing capacity of the private market. All of things are things that can be high or low--and that the government can affect:

• A competent government that keeps the economy near full employment boosts future profits and values; an incompetent government that fails to stem an economic collapse into depression diminishes them.
• Similarly, a competent government that keeps asset prices from being pushed into fire-sale territory by irrational pessimistic panic diminishes the amount of risk associated with each tranche of risky assets.
• The Federal Reserve controls the time profile of safe interest rates. No argument.
• The government can buy up or guarantee risky assets, thus diminishing the quantity that the private market must hold--unless you adopt some hyper-Barrovian pose and are willing to maintain that Bernanke-Paulson puts are not net wealth.
• The risk-bearing capacity of the private market can be extended via financial regulation that diminishes the chance that a relatively uninformed investor is being victimized by someone with inside information, and widens the pool of investors willing to bear risk.

What, then, is this "fundamental value" to which asset prices must decline if government policy can have effects--profound effects on nearly each of the factors on which fundamental value depends?

The Marx-Engels-Hayek-Smith line of argument does attempt a parry. It says that the root problem is overproduction--that we have too many houses. Attempts to change fundamentals will mean that those who build more houses will continue to earn more profits, and so we will have more and more and more houses, and we will have an even greater overproduction crisis some time in the future. So we must make sure that housing prices are so low that nobody builds another house for a long time to come, and that is the only way to minimize the misery coming out of the collapse of the housing bubble.

I have never been able to make this "overproduction" argument maske sense. If the government provides a subsidy--like a mortgage insurance subsidy--then we will indeed have more of whatever the government subsidizes, but there is no reason to think that this is in any way a big problem or an unsustainable situation. It may well be a waste of the government's money to provide the subsidy: taxpayers might rather endure a housing crash and a depression than be forking out extra taxes to pay mortgage guarantees. That's an empirical and a cost-benefit issue.

Smith's problem, to my mind, is that he appeals to slogans:

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....

without ever specifying what the costs and benefits of alternative policy paths are. John Maynard Keynes would say that a policy aimed at maintaining full employment via monetary policies that support asset prices and fiscal policies that directly stimulate demand can work, and do work, and that opposition to them is ultimately based not o pragmatic practicalities but on the memory of too many Anglican preachers denouncing the Mammon of Unrighteousness:

While some part of the investment which was going on in the world at large was doubtless ill judged and unfruitful, there can, I think, be no doubt that the world was enormously enriched by the constructions of the quinquennium from 1925 to 1929; its wealth increased in these five years by as much as in any other ten or twenty years of its history....

Doubtless, as was inevitable in a period of such rapid changes, the rate of growth of some individual commodities [over 1924-1929] could not always be in just the appropriate relation to that of others. But... [a] few more quinquennia of equal activity might, indeed, have brought us near to the economic Eldorado where all our reasonable economic needs would be satisfied.... It seems an extraordinary imbecility that this wonderful outburst of productive energy [over 1924-1929] should be the prelude to impoverishment and depression. Some austere and puritanical souls regard it both as an inevitable and a desirable nemesis on so much overexpansion, as they call it; a nemesis on man's speculative spirit. It would, they feel, be a victory for the mammon of unrighteousness if so much prosperity was not subsequently balanced by universal bankruptcy. We need, they say, what they politely call a 'prolonged liquidation' to put us right. The liquidation, they tell us, is not yet complete. But in time it will be. And when sufficient time has elapsed for the completion of the liquidation, all will be well with us again.

I do not take this view. I find the explanation of [depressions, i.e.] the current business losses, of the reduction in output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment. I see no hope of a recovery except in a revival of the high level of investment. And I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity...

I'm with Keynes.

Comments

[Neal]

Fafblog returns!!!!!!!!!!!!!!!

"While the cops're distracted we'll sneak out with a coupla billion of our closest friends an punch out the sun in the guard tower," says me. "Then we can go back an bust the rest out an topple the ancien régime!"
"The triumphant cry of revolution will call out through the streets: Vive Fáfnir! Vive Gibléts!" says Giblets. "Radical Fafbloggists will demand a new era of Fafno-Gibletsian rule over the cosmos, and none will be able to stand in their way!"
"At least till they figure out we're not there," says me, "'cause we'll already have slipped out the back door into the new universe."
"But will it be any better than the old universe?" says Giblets.
"Well it can't be any worse," says me.

[Iván]

What Yves is getting at is that the value of housing had become (and remains even with the modest drops) completely detached from what you classify as (a) - which amount to equivalent rents. Thus boosting future profits does not boost future values until equilibrium is reached.

[Neal]

The fundamental value of a tulip lies in its beauty. The rise in the price of tulips had nothing to do with a proportionate increase in beauty or the utlity of beauty, it rather had everything to do with the possiblity that tomorrow someone would pay more for the tulip, yet unseen in the buld.

The fundamental value in the house lies with its ability to shelter from the elements. The rise in the price of houses, similar to tulips, had much to do with the possiblity of that tommorow someone would pay more for the house.

Up to 40% of the houses were second homes (or third or fouth, etc., etc.). I read an article recently where there was a statement that many of these homes were in the same metropolitan area as the first house, putting the lie to the idea of them being a "vacation" home.

The overbuilding, oversupply, and over-finishing of the house market came when the house passed from the orginal purpose of shelter to being an investment vehicle. Houses were built and bought in lieu of other investments, because "house prices will never go down". I wonder if the meme was also "tulip bulbs will never go down"? The reconception of a house as a path to wealth was new and a complete change from historical understanding of what a house was.

For most recent purchasers of houses the decision was not based on rational need governed by realistic assessment of long-term ability to pay--it was based on a minimum investment in a bet on an over-sized over-priced house that could be sold for more in a few years.

The long-term goal of ultimately owning a property where you could live out the rest of your life was lost. The idea of paying down the mortgage and increasing equity in the property was unimportant. People entered into mortgages that would legally obligate them to pay crippling amounts of money well into their retirement years. This all was the result of the change of the house from a home into an investment vehicle.

As a result, too many houses were built. As a result, too many expensive houses were built. As a result, house prices rose. As a result, developers and builders developed and built. And like all dynamic processes, the production overshot demand--far too many were produced to be absorbed by the market, especially when the market hit the pocket-book limit of the purchasers. This is the same with Frisbees, YoYos Beanie Babies, etc..--supply follows demands, with the frenzy of the demand sparking frenzy in the suppliers.

Ultimate, it is the pocket-book limit that is the problem. Should the banks keep making loans to people who can't repay them at their current income levels? Should GSE's subsidize the purchase of homes that are 15 times the median income of the population? Should the government maintain a ZIRP so that people can continue to pay their mortgages?

The issue for the government then is to figure out a sustaianable route to wage growth in an increasingly competitive world--not to try to pump more air into a patched balloon that burst. Real-estate inflation was a very effective means of goosing an already faltering economy but it is not a sustainable model for the future. After all how many houses do you need? How many square feet do you need?

[Dean Baker]

Wow, the only way to keep the U.S. economy from having a long and deep recession (depression?) is by trying to sustain a housing bubble indefinitely?

[I wouldn't say "indefinitely..." I would say "make housing price declines long enough and slow enough that we don't get mass unemployment while we rotate construction out and tradeables manufacturing into its position of leading sector..."]

How long ago was it when the leading economists all told us that sustained periods of departure from full employment were relics of the past, that the economy was self-correcting, or that a little tweak from the Fed could quickly bring the economy to full employment?

[Milton Friedman may have characterized stabilizing monetary policy as 'tweaking', but I don't know anybody else who did--and everybody else said that monetary policy might not be enough...]

Oh, whatever happened to the good old days?

[I don't think they ever were...]

In all seriousness, if we really accept the DeLong hypothesis, that the only way to prevent prolonged stagnation is a policy of indefinite bubble preservation, then there are massive implications for income distribution that us Marxist types would like to explore.

[Yep...]

[Sean Matthews]

> I'm with Keynes.

Last time this discussion came up, I seem to remember that Paul was with Keynes, and you were having difficulty letting go of your inner Hayek.

What changed?

[anon]

any perspective?

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[ottnott]

Brad lost me at "The fundamental value of any risky asset--housing, say".

Housing is not a risky asset. Housing is a place where people live.

Risky is buying more home than you can afford, at a time when home prices are already far above historical norms, using massive leverage in the form of 100% financing, at terms that require continued appreciation and continued low interest rates in order to avoid default within a few years.

Risky is lending money to buyers in the situation above, while trying to spend as little money and time as possible to vet the buyer and the appraised value of the home, relying heavily on shortcuts like indepentdent, commission-driven mortgage brokers to bring in customers and on the misapplication of FICO scores to determine the default risk of a loan.

I won't even go into the risk levels further down the chain where the mortgages have been blanched and tranched and leveraged and otherwise financially "innovatized" into an opaque godknowswhat that is still supposed to be a good investment after 6 layers of innovators have taken a cut for their hard work on the transformation.

There is no large excess of housing. Housing is simply overpriced. It makes no sense to try and keep them overpriced. Prices have been falling and will continue to fall, but there is little danger of "fire sale prices" except in local areas that see large declines in employment. Unlike a share of AOL, say, a home has a relatively steady and lasting value based on the demand for shelter.

Because there is relatively little danger of the asset prices overshooting significantly on the downside, the government need not take on the role of reducing the amount of risky housing assets (i.e. homes and mortgages) that the private market must hold.

[maynardGkeynes]

Marx would agree completely with Summers on bailing out homeowners. Are they not the the lumpen proletariat of our age?

[matt wilbert]

Setting the thermostat in my house affects the temperature. If I set it to 65 or 70 or 75 degrees F, the temperature stays right around there. But strangely, if I set it to 100 degrees F in the winter, or 30 degrees F in the summer, it doesn't stay near 100 or 30.

There is no reason to think that the tools being discussed have the power being attributed to them.

[a]

IMHO Yves is correct. "The fundamental value of any risky asset--housing, say--depends on (a) per-period value or profit, (b) the time profile of safe interest rates, (c) the quantity of risky assets that the private financial sector must bear, (d) the amount of risk associated with each tranche of risky assets, and (e) the risk-bearing capacity of the private market." Sure it depends on all that, but it does not just depend on that. Any graph of (housing price/income) shows that housing prices wrt income have completely overshot, and this shows the problem is not with nominal housing prices, but real housing prices. One can inflate and hold up nominal housing prices, but real housing prices will decline. The government can do many things, but it cannot sustain an unstainable situation.

Calling his argument "Marx-Engels-Hayek-Smith" strikes me as a bit of a cheap shot.

[vt codger]

If you have colleagues in the physical sciences whose judgment you respect, you might want to talk this over with them. They may have some thoughts on dealing with systems with multiple stable states, representational tools, pitfalls, and the wisdom of deliberately trying to operate an economy in something other than its "ground state" if that is, in fact, what you are suggesting. On another note, has it occurred to you and Dr Krugman that the next version of the Laffer curve will almost surely be S shaped? You're probably in for four decades of babbling about how eliminating all taxes, restoring chattel slavery, and direct subsidies to the wealthy will switch to economy to a new state of perpetual prosperity.

[Jodie]

Why does everybody claim that housing is overpriced? Relative to many other assets housing doesn't seem that overpriced.

Try: Oil, Gold, Corn, Stocks, Foreign currencies.

Even postage rates have gone up as much as housing in the past 10 years.

Maybe US wages, the most lagging of indicators, are underpriced.

[Just a yob journalist]

Here's the shorter De Long: Let's inflate the hell out of the currency so that we avoid a depression.

Brad is right that the Fed can drop interest rates to ultra low levels and that Washington can print tons of extra money to buy up distressed securities. But do both and an epic wave of inflation results.

At first glance that's not so bad. Heck, inflation will make homes more affordable. But I'm still not sure inflation can avoid a depression. I suspect the success of the strategy depend upon foreigners. If they start raising the interest rates they demand for buying US Treasuries the game's up.

(Of course, Washington could keep a lid on inflation by not printing currency to buy distressed securities. It could buy them out of general tax revenue. Somehow, though, I think it's politically impossible to bail out bankers with taxpayers' cash. And even if were possible, all you're really doing is transferring the pain back to the private sector in more diffuse fashion.)

[zinc]

"The fundamental value of any risky asset--housing, say--depends on (a) per-period value or profit"

Observing housing profit over the last few periods sure suggests somebody thinks the fundamental value is a whole lot lower.

[PeeDee]

Yep, I'm still with Yves here.

Brad is talking about the government just assigning an arbitrary value to an asset in an effort to make us "feel" rich. Why not guarantee the price of beanie babies? Serves the same purpose. Simply buy up outstanding beanie babies and guarantee loans on beanie babies until they are worth $500k each. Think of how richer we'd all (on average) be! At least with Beanie Babies there is no annoying fundamental value like rental yield that keeps dragging prices back to earth.

The only way to fundamentally support home prices is to raise rents. The only way to manage that is to increase real incomes. The only way to manage that is to increase GDP per capita. The only way to manage that is to increase productivity. There is the rub.

The alternative is to hold nominal debts fixed and inflate the hell out of everything else - a la Beanie Babies.

[RC]

Jodie,

You are confusing Home ownership with housing. Home prices are bubbling, housing is not. Take a look at local rents compared with home prices and what do you see? They do not agree on the value of the home. Why would a home owner lose more money owning a home that renter pays for renting that home?

Barring speculative appreciation of home prices when a renter's sunk cost of renting are less than that of a home owner than the home owner has lost. I could then rent and take the sunk cost advantage combine that with the money not put toward home equity and be ahead of the homeowner. I could have my cake(rent a home) and eat it too(bank the equity equivalent).

[john c. halasz]

O.K. Cross-posted from Yves' place, and the long-winded first paragraph needs to be broken up and reparagraphed, but still I'm amazed at the good professor's obtuseness. What has he been looking at lo these past 7 years? And there is a difference between recognizing malinvestment and overaccummulation as endemic issues and arguing that there are means for possibly compensating for them, rather than denying the problems involved, and conflating the difference. It seems to me that putting together the pieces of the puzzle and pursuing any productive debate about resolving the oncoming crises requires basic clarity about that difference.

The fact that DeLong comes up with a "Marx-Hayek" school should tell you something about his confusions and fantasies, as well as, his sophistical polemical positioning. But saying that he can make no basic sense of malinvestment and overaccumulation is quite astonishing coming from a highly credentialed economist. It's really basic production economics. In order for anything to be exchanged, it must first be produced, (yes, that's Adam Smith). And the production system of an economy must be vertically integrated in correct ratios, regardless of whether that occurs through market exchanges between firms or through infracorporate transfers at administered prices, and intersectorally balanced, since different industries produce inputs for each other long before they produce final consumption outputs, if the production system is to be reproduced, let alone expanded, in its output. That bottlenecks and imbalances should occur in the overall production process is hardly surprising, since it is by no means fore-ordained, and subject to varying macroeconomic conditions, and techical changes in processes and products that raise the level of productivity, (though, note, not necessarily in a balanced way through the production system), and alter, refine and diversify distributable, consumable output. But, ultimately, all increases in real distributable surpluses, i.e. profits, flowing to financial assets as legal-claims on the distribution of those increases in productive surpluses, derive from the realization of real capital investment in the organization of production processes through revenue derived from the sale of output. Now the real distributable, consumable surplus product, real "wealth", consists in the total product minus that portion of the product that is consumed or used up in the process of its production, (though that would include services and symbolic artefacts, as well as, more-or-less physical goods), and it is divided up and distributed between profits and wages in a inversely proportional relation, a simplification of empirical revenue streams, but basically true. (The using up of raw materials, depreciation of capital stocks and subsistence wage are all subtracted from the total product to get the surplus product). If the wage rate is too high the replacement and/or improvement of capital stocks is impaired and the economic system can not reproduce, let alone expand. If the rate of profit is too high, then there will be a shortfall in real effective aggregate demand, hence over-production, excess capacity, and underconsumption, which will devalorize capital stocks, lower profits and lead to a contraction of the production system. In principle, there would be a sweet spot in the distribution between wages and profits, labor and capital, that would optimize the production of output and the balance of the whole system, but due to constantly changing technical conditions of production, that optimum itself constantly is changing through macroeconomic cycles of economic conditions. The role of the financial economy is simply to intermediate between firms and households in maintaining the "virtuous" cycles of growth in the real rpoductive economy, under constantly changing conditions and economic and technical ratios. But note that increases in productivity, while increasing potentially the real distributable surplus product, which can raise wages for remaining workers, in the short-to-medium-run, increase unemployment of workers, which must be redeployed elsewhere, and eliminate outmoded techniques and sectors, which requires that new sectors much ultimately be formed. And, on the other hand, profits must be reinvested to produce further profits, else there will be an overaccumulation of profits competing against other profits, a deterioration in the rate of profit, and a decline in the value of financial assets, (as the price goes up through increased competitive demand, the yield goes down), together with a devalorization of real capital stocks, which decreases the incentive toward new real investment and threatens a disaggregation of the production system with mass unemployment and further declines in aggregate demand. That is a capital realization crisis in the real productive economy through overaccumulation of capital and excess productive capacity. Such a crisis can be deferred through an increasing financialization of the real economy, in which debt-financed consumption and increased demand for financial assets to prop up their prices, increases claims on future output, but unless new avenues and sectors for real capital investment and employment are discovered in the process, that merely results in an increasing stock of fictional capital, that is, financial assets whose nominal "value" increasingly exceeds the real productive capacities of extant capital stocks and their replacement costs and the revenues to be realized therefrom, and only encourages increasing financial rent-seeking activities, as "profits" are minted from profits, without attachment to costs of production in the real economy. Ultimately such stocks of fictitious capital must be destroyed to rebalance the production system and to reestablish viable ratios between wages and profits that can sustain its further growth. But that's not a pleasant prospect, in the meanwhile.

The upshot is that issues of malinvestment and overaccumulation are endemic to industrial capitalism, though in varying degrees through economic cycles and technical development, and are not simply to be wished away though some technocratic wizardry manipulating nominal prices. I'm just gobsmacked that DeLong could claim not to understand such basics through abstracting out from them through a theory of macro-economic general equilibrium which is, er, speculative at best. (Similarly, I'm struck how much effort conventional neo-classical academic economists expend on determining and touting "financial efficiency" with respect to, say, relatively small differences in inflation rates, while ignoring the transition costs of large imbalances in the production system). Granted, in this age of financial and industrial globalization, it's no longer possible to speak in terms of a model of "an economy", but that's all the more to the point, since the global CA imbalances are glaring, as are the misallocative effects of them in terms of fictive housing values and wage stagnation. What DeLong feels entitled to ignore in his modelling defies belief.

In fairness to Delong, if I grasped his point, he is modelling a specific point: that under certain conditions, lenders will not further offer mortgage loans, regardless of how high the interest rate would go in response to excess demand for loans. It's in that context that he proposes that the government needs to back-stop loans, not to prop up asset values, but to correct for market failure in the market for mortgage loans, which might be required to facilitate housing transactions and thus housing price adjustments. But that would be beyond the capacity of the FED and would require the fiscal capacities of the overall government. And there are definite costs to be associated with increasing the fiscal indebtedness of the U.S. government/economy. I'm one that believes housing prices need to come down to affordable levels and basically the sooner the better, but fiscal intervention might be required to maintain the liquidity of that process, provided it doesn't prop up excessive house prices, nor swallow the losses of financial institutions. As well as reforming BK law, (so that the asset-inflated complacency of the middle class would get its comeupance without total ruin), I like Dean Baker's proposal of allow the option of converting foreclosures into rentals, which might help to mitigate the worst social effects of the housing meltdown without interfering in price adjustments much, (which would otherwise overshoot anyway, which would be a kind of inefficiency), which probably would require a federal fiscal backstop, with the government as landlord-of-last-resort, without bailing out the rent-seeking follies of the finance sector. I'm unclear on the exact legal and administrative means by which such a program could be instituted, but at least there the costs of increased fiscal endebtedness are counterbalanced with a real good, without impeding unduly price adjustments.

[John Drake]

Can the government really eliminate risk, or does it simply transfer it? Delong wants to hand off the hot potato basket to the federal government. Is this really a good idea? What then? A borrower who can't meet his loan obligation still can't meet his loan obligation. When the borrower defaults do you simply forgive the loan? Someone with a $60,000 yearly income can't afford to service a $500,000 loan, and most likely he never will. Why must he be bailed out? Likely such a borrower had no skin in the game. He simply goes back to being a renter. He never was an owner in the first place. It was all a pretend game anyway. Does DeLong think the taxpayers who can meet their obligations want to pay for those who can't? Don't estimate the anger such a bailout will create.