Saturday, November 29, 2008

Here's a first glimpse at what the economics and finance professions did wrong to give us the current financial and economic collapse

Brad Delong has responded to a challenge by Calculated Risk to economists to determine what they did wrong that led us to the current financial collapse and the resulting economic downturn. His post is illuminating, and the comments to his post are absolutely fascinating. Here is Brad DeLong's post:
Let me say what things I was "expecting," in the sense of anticipating that it was they were both likely enough and serious enough that public policymakers should be paying significant attention to guarding the risks that it would create:

(1) A collapse of the dollar produced by a panic flight by investors who recognized the long-term consequences of the U.S. trade deficit.


(2) A fall back of housing prices halfway from their peak to pre-2000 normal price-rental ratios.

I was not expecting (2) plus:

(3) the discovery that banks and mortgage companies had made no provision for how the loans they made would be renegotiated or serviced in the event of a housing-price downturn.

(4) the discovery that the rating agencies had failed in their assessment of lower-tail risk to make the standard analytical judgment: that when things get really bad all correlations go to one.

(5) the fact that highly-leveraged banks working on the originate-and-distribute model of mortgage securitization had originated but had not distributed: that they had held on to much too much of the risks that they were supposed to find other people to handle.

(6) the panic flight from all risky assets--not just mortgages--upon the discovery of the problems in the mortgage market.

(7) the engagement in regulatory arbitrage which had left major banks even more highly leveraged than I had thought possible.

(8) the failure of highly-leveraged financial institutions to have backup plans for recapitalization in place in the case of a major financial crisis.

(9) the Bush administration's sticking to a private-sector solution for the crisis for months after it had become clear that such a solution was no longer viable.

We could have interrupted this chain that has gotten us here at any of a number of places. And I still am trying to figure out why we did not.
The comments on Brad's article are even more illuminating than his mea culpa. Here are some of my favorites:
The fundamental problem of the political economy of the U.S. and, to a lesser extent, other industrialize countries is excessive inequality. If the haves get too big a share, they won't be able to find an adequate return on their wealth by putting their money in productive investments because the market for new goods and services won't be big enough. Hence there will be an endless succession of speculative bubbles as all that money drives up the price of one class of assets after another. Under these circumstances, economists, like technocrats everywhere, will attempt to find specific technical explanations for each crisis because the underlying issue involves unpleasant politics. The blindness of the geeks is not irrational. After all, there has been no real prospect of doing what needed to be done, i.e. changing the tax and labor policies that promote inequality. Recall that Clinton took a huge political hit for slightly increasing the tax rate on the highest brackets, even though the official justification of the increase was controlling the deficit, not increasing income redistribution.

The prospect of a new depression has changed the politics of income distribution so that it may be possible to understand what's happened and even do something about it, at least until things calm down. O well, what's left to say except "sweet are the uses of adversity," or, if you prefer Heraclitus to Shakespeare, "every cow is driven to pasture by a blow."

Posted by: Jim Harrison | November 29, 2008 at 09:44 AM
This is what I have been getting at when I have written of the importance of well-paid middle class consumers. The size of the economy is primarily based on the degree of consumption, not investment. Investment will always follow growth in consumption, and investment funds can be created by the banks. Investment funds not created by middle class savings means excess social inequality and a resulting long term weakness in the economy. That makes government supply-side policies nothing more than a pay-ff to wealthy political donors. That's a payoff that will ultimately lead to economic problems when it takes over the government policy-making machinery as has happened since the Reagan Revolution has been rolling through our society.
Like others, I saw a good number of things coming (I was short homebuilders by spring/summer 2006; I was short FRE by winter), but I did not predict the full denouement. My first surprise was not the failure of all concerned to consider a housing-price downturn (just looking at the model results told you that), not the abject failure of the NSROs (who have always superciliously minted money by telling investors soothing lies couched in grade-school math), nor that banks had not distributed enough housing exposure (they were buying in in 2003-2006, not selling out), and certainly not panic when it all became clear.

However, the surprise point for me (and, alas, the reason I left so freaking much money on the table when I covered my shorts much, much too early) was the response to a broken buck in the money markets and WaMu's seizure in the loan markets. I assumed that money-market investors would simply and accurately have reevaluated those funds with an eye towards risk instead of yield first (Reserve had amazing yields and had siphoned up vast assets with them; you knew they were taking risks), but they put runs on funds instead. I assumed the bond market would simply mark up spreads to compensate for the real chance of being wiped out by a bad loan book, but it simply stopped lending to banks instead.

Those were mistakes I could have avoided going in. I was wrong, and had every chance not to be. The lesson I draw for my little trading accounts is not to assume I know what other market participants will do in a novel environment.

Posted by: wcw | November 29, 2008 at 10:29 AM
Banks and finance institutions in modern capitalism are two contradictory things: profit making institutions who take risks and maximize their returns, and collectively the financial system of the economy, where we don't want systemic risk. The periodic financial crises (Third World debt, S and Ls, Long-Term Capital, now this) come when everybody starts to copy the "innovation" and everybody (including various Nobel economists) say that it is different this time, and the risks are under control due to clever market adaptations. Then the collapse, and the taking on of the bad assets by taxpayers. ... Risk taking banks and financial institutions overshoot, and as they make money, everyone else copies them, hence the systemic quality. Regulators have to anticipate that and work accordingly, and be supported politically. Career regulators, especially in the U.S., cannot by themselves fight off the massive lobbying and political expenditure by these firms and industries. Otherwise, we'll just keep getting a series of these down the road, and then everyone can say "Oh gosh, how did this happen?"

Posted by: macheath | November 29, 2008 at 10:54 AM
Macheath's comment lays out the inherent conflict between bankers and regulators. Bankers make their money by exploiting risks in the economy. Regulators exist to eliminate the major risks in the overall economic system and to prevent bankers from creating systemic level risks. This is the conflict. When the regulators are doing their job, the bankers are frequently blocked from making the money they wish to. But when bankers start making money and other bankers copy them, then the copied actions of individual bankers becomes increased systemic risk which the regulators are there to prevent. Or as the old line goes, the regulators are there to watch the party and when it gets going good, their job is to take away the punch bowl.

The problem is that wealthy individuals then use the inherent political power of large amounts of money to stop regulators from doing their jobs. It really doesn't cost very much to buy one or two key powerful legislators like Phil Gramm.

That becomes especially true when the bankers have one of the two American political parties which has made an art of running against government regulators as the Republicans have done since the Reagan reign. It is this conflict between bankers and regulators that is at the core of the Republican free market fundamentalism.
Isn't this a case of experts being confused because they are lost in the arcane details. From a relatively uninformed macro point of view, it was clear that an unsustainable debt buildup was occurring. It should have also been obvious that a lot of the debt was backed up by an unsustainable increase in asset prices. Yet it was assumed that the overall system could absorb the unwinding of these unsustainables without major damage. I have to admit that, like wcw I was somewhat taken in by the expert opinion. Because I gave it some weight, my flight from the equity & debt markets was far too timid -really just a minor readjustment of asset allocation, when a wholesale retreat would have been in order.

Posted by: bigTom | November 29, 2008 at 11:08 AM
The problems with the ratings agencies were pretty clear to all by 2002 (and I believe were discussed extensively in the comments section of this blog), but "when a mans income depends on his not understanding something" came into play and the finance and politco-economic worlds closed ranks to shut up anyone who tried to point out the leaks in the dike.

All of Wall Street since 1995 has essentially been one big ball of conflict of interest at a level that would get any $30k/year junior purchasing agent fired in a heartbeat, but anyone who tried to point that out was brutalized (and I suspect if they had any connections to the Street or the Treasury they and/or their institutions were threatened). Read the comments from the "professional finance people" here, on Crooked Timber, and in Drum's comments section: they are still in vicious counterattacking denial mode. Our job as taxpayers is to shut up and send our paychecks to Uncle Sam so that Wall Street salaries can continue uninterrupted.


Posted by: Cranky Observer | November 29, 2008 at 12:34 PM
I'm just an investor who became overall defensive too early while shorting specific asset classes such as real estate and mortgage lenders (some of that worked out just fine later). It was clear we were in a bubble but, in the end, the magnitude of its consequences was simply shocking and I was not nearly defensive enough; in 20-20 hindsight 90% in T-bills with 10% in double short market ETF's like SDS would have been about right WRT risk-adjusted return.

Excluding movement conservatives incapable of appropriately assessing the dangers for ideological reasons and those deepest in sell-side servitude who wouldn't tell the truth even if they knew it, I'm guessing the only economists making reasonably accurate predictions were heterodoxic (students of Minsky or those grounded in complexity and systems theory perhaps) with strong proponents of neoclassical framework(s) missing the boat by the widest margins and everyone else winding up more or less in between.

I believe it was Nikki Giovanni who said, mistakes are a fact of life, it is the response to error that counts: It will be interesting to see how the field of economics responds to the empirical challenge this 'mistake' represents to say nothing of the continuing monetary and fiscal policy responses by government since that has vitally important consequences for all of us: I would certainly feel better though if some of those who predicted this debacle were on that new advisory council along with Paul Volcker; don't think any of Obama's economic transition team were among those who 'saw this coming' were they?

Posted by: RW | November 29, 2008 at 12:56 PM
Don't feel so bad, Delong. Few can overcome the indoctrination that is required for an advanced economics degree and the never-ending reindoctrination that is required of the professional economist. This indoctrination requires one to ignore the real world and focus instead on very pretty, if fictional, models. This tunnel-vision allows one to suspend common-sense and write elegant papers set in fairytale lands in service to existing wealth and power.

The fully indoctrinated economist sees bubbles as the this time it's different/forever happy times of new paradigms, increasing inequality as a rising tide lifting all boats and financial swindles as desired innovation.

Look at Robert Rubin and his economist offspring Larry Summers. Two people who really really eff'd up and yet they are held in high regard. Why? Because the profession can not allow those orthodox to doctrine to be shown to be really really wrong. Once the foundations are shown to be made of sh*t, the whole rotten edifice could fall in a heartbeat.

Ask yourselves, if the majority economics profession not only didn't see this train wreck coming but instead justified the train's direction, then aren't they part of the problem?

Posted by: Paul Yarbles | November 29, 2008 at 01:07 PM
Paul Yarbles recognizes what almost anyone exposed to academic Economis knows - it is primarily brainwashing in the existing financial system. After such brainwashing it is difficult for most people to accept objections to the existing
the fact that there seems to be a missing item in the list, the high degree of leverage and entanglement among the various higher order derivatives, which is why we had the financial collapse that needed the recapitalizaton. Ever since Geithner's Hong Kong speech of Sept. 2006, which I have mentioned here previously more than once, this should have been high on any financial market watcher's list of things to worry about.

BTW, I think the people at the Fed were worrying about it. Most fail to remember how quickly the Fed responded in August, 2007 with their innovative response. They were not as taken by surprise as Brad and so many others.

Posted by: Barkley Rosser | November 29, 2008 at 01:45 PM
There is a lot of insight in this post and its comments.

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