Post-Meltdown After-Action Report: The Housing Market, the Tasks of the Fed and the Treasury, and Economists' Reputational Bets
Paul Krugman comments on Dean Baker's ire:
The few, the proud, the ignored: Dean Baker is mad at Robert Rubin for suggesting that "few, if any" people saw the financial meltdown coming.
I'd say that there are two levels to this. First, a lot of people -- including Dean, me, Calculated Risk, and others -- saw that there was a huge housing bubble. It remains amazing that so many alleged experts failed to see the obvious.
What's going on now, however, is beyond that: the "financial accelerator," with deleveraging causing a credit crunch that forces further deleveraging, and now threatens to produce a sort of pancake collapse of the whole system, was not, I think, so widely foreseen. Certainly Nouriel Roubini was on the right track; I can claim to have described something quite a lot like what's now happening, though I covered myself by making it a slightly jokey scenario rather than a straight prediction. But in Rubin's defense, I don't think many people saw how much the system itself would break down.
In the larger sense, though, Dean is right. Even now, those who saw the risks are somewhat marginalized in public discussion, while those who airily dismissed all the warnings are still treated as men of good judgment.
I would prefer to make some finer distinctions. During much of the 2000s, the housing boom was generated by six factors:
- Interest rates artificially pushed down by the Federal Reserve to try to rotate from high-tech to construction as a leading sector, and so avoid a recession.
- Closely related, interest rates artificially pushed down by the Federal Reserve to try to stem incipient deflation, and so avoid a depression.
- Lower spreads than in the past on long-term mortgages out of confidence that the Fed does have and will keep inflation licked.
- The filling-up of America so that you can no longer build a detached single-family house within half-an-hour's driving time of the interesting places people want to be, and the consequent rise both in current location premia and expected future location premia.
- Interest rates artificially pushed down by foreigners seeking political risk insurance--both private (i.e., get your money into a Citigroup account certain to be safe) and public (i.e., keeping the renminbi low and U.S. imports high in order to avoid unemployment in the streets of Shanghai.
- A speculative housing bubble leading to a crash.
Of these six factors, (1) through (4) seemed at the time and still seem to me perfectly appropriate at the time--we should have had house price rises and a housing construction boom in the 2000s; it was macroeconomically appropriate for us to do so. (5) and (6) were much more worrisome, and many people (including me) did worry about them at the time. But what we worriers mostly worried about was (5), "global imbalances". It seemed to be the dog, and (6) seemed to be the tail--we could see how a collapse of the dollar driven by the end of what is called the Bretton Woods II configuration of the global economy could bring about a housing crash and a large-scale financial crisis. The chain of events that has actually taken place--a housing crash and a large-scale financial crisis without a dollar collapse--seemed to me ex ante and still seems to me a low-probability leaf on the outcomes tree. As I asked last August, "who had imagined that the people most naked to subprime mortgage risk were the analytically and quantitatively-sophisticated hedge funds of America?"
I also think that Paul gets the emphasis wrong when he writes:
What's going on now, however, is... the "financial accelerator," with deleveraging causing a credit crunch that forces further deleveraging, and now threatens to produce a sort of pancake collapse.... Certainly Nouriel Roubini was on the right track.... But in Rubin's defense, I don't think many people saw how much the system itself would break down...
I would say that many people expected some degree of deleveraging and a flight to safety, but did not regard it as a significant problem: the Federal Reserve exists to supply safe assets to the financial system whenever it does get panicked, and the only danger seemed to be if markets concluded that the dollar was no longer safe and so were demanding assets the Federal Reserve could not supply. The reason that East Asian central banks could not handle 1997-98--indeed, the reason that the Austrian and British central banks could not handle 1931--was that their currencies were no longer regarded as safe. This hasn't happened.
Yet we are still in significant trouble. Why? Especially "why" because nothing terribly bad has happened to the real economy: unemployment has not risen much, production and incomes have not fallen, wildfires have not annihilated all the houses of California's Riverside County driving their inhabitants into Bushvilles in the arroyos of the California desert--normally we would require that something bad have happened to the real economy before the financial side is in such a state.
We are in such a state because:
- Quantitatively- and analytically-sophisticated Wall Street teams greatly overestimated their capability to assess and manage risk.
- Institutions greatly overestimated the extent to which the QaASWSTs were assessing risk as opposed to simply writing out-of-the-money puts they could not value and claiming they had lots of alpha.
- Investors greatly overestimated the extent to which institutions understood what their teams were doing.
And now we have something significantly worse than a financial-accelerator-deleveraging creating a credit crunch. What such an episode would look like was well-analyzed by Paul Krugman last Monday with this graph:
On which Paul commented:
[A] lot of securities are held by market players who have leveraged themselves up. When prices fall beyond a certain point, they get calls from Mr. Margin, and have to sell off some of their holdings to meet those calls. The result can be a stretch of the demand curve that’s sloped the “wrong way”: falling prices actually reduce demand.... In this case, there are two [stable] equilibria, H and L.... And this introduces the possibility of self-fulfilling panic: if something spooks the market, you can get a “systemic margin call” that causes the whole financial market to go to L, and causes a big, unnecessary price decline.... Fed policy seems to be based on the view that if only they can restore confidence — with extra liquidity to the banks, Fed fund rate cuts, whatever — they can get us out of L and back to H. That’s the LTCM model: Rubin and Greenspan met a crisis with a rate cut and a show of confidence, and the whole thing went away...
I would add that Greenspan and Rubin did a third thing in the 1998 LTCM crisis: rate cuts, yes; shows of confidence, yes; but also following the Bagehot rule of lending freely on collateral that would be thought good in normal times in order to (a) provide the market with the liquid, safe assets it is suddenly demanding, and (b) provide those who want to make large bets that the economy will in fact make its way back to the good "H" equilibrium with the resources they need to make such bets.
Deleveraging and the financial accelerator are things the Federal Reserve can deal with through its normal (or at least its not too abnormal) tools and procedures. That, indeed, was Greenspan's bet over 2003-2006: confident that the Fed did have the tools to deal with a credit crunch should it come, the Greenspan Fed thought that it was better to keep the economy near full employment via a housing boom than to diminish the risk of a future bubble collapse and credit crunch by destroying the jobs of millions of Americans.
The problem now, however, is deeper than simply "financial accelerator and credit crunch." As Paul was diagnosing it only last Monday, we now seem to be in a situation in which supply and demand for mortgage-backed securities looks like this:
As Paul wrote last Monday:
[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. Maybe the underlying losses in housing and elsewhere are sufficiently large... [that] 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...
That appears to be our problem right now.
But I would like to amend Paul Krugman's analysis by referring to the analysis of Alan Blinder down the hall from Paul in the Princeton Economics Department (actually, I think Paul Krugman's office is at the WooWoo). Alan looks back at the Depression-era Home Owner's Loan Corporation. If the U.S. government has a vehicle to buy up (at a discount from face value) and then manage home loans that look shaky, and if it can set the price of such loans, it might be able to do so in a way that not only rescues the financial system but makes money for the taxpayer. Suppose that the Feds set a price P at which they will buy up shaky loans like so:
and then buy up those loans offered at that price, taking them out of the market and thus out of private sector supply:
And then push the economy back to the good equilibrium, making money for the Treasury in the process:
If I were working for the Treasury right now, I would be saying: make this happen on Monday. There isn't time to set up a new bureaucrtacy--a HOLC, which is what Alan Blinder wanted to do as of three weeks ago. So use an existing bureaucracy: Fannie Mae. If I were Treasury Secretary Hank Paulson, I would spend the weekend building a legislative vehicle to introduce Monday morning on an emergency basis to give Fannie Mae the resources and the mission to undertake this mortgage rescue operation, and I think Fannie Mae is the right institution for the task: why does it have its government-sponsored status and guarantee if not to be used for purposes like these at times like these?
And if I were Ben Bernanke and Tim Geithner, I would be spending this weekend thinking about how to first thing Monday morning punish bear speculators on Bear Stearns, Lehman, and others by pushing their CDS spreads back to more normal levels. It seems to me that people on Wall Street need to be taught that betting that the Fed will not intervene to stabilize or that its interventions to stabilize will be unsuccessful is an unhealthy thing to do.