"investigating how human psychological limits lead to bad private-sector contract design that then magnifies psychological biases."

Brad DeLong at Cato:

"Think of it this way: two years ago we lived in a world in which the wealth of global owners of capital was some $80 trillion — that was the market value of all of their property rights to dividends and contract rights to interest, rent, royalties, options, and bonuses. Now over time the wealth of global capital fluctuates, and it fluctuates for five reasons:

1. Savings and Investment: Savings that are transformed into investment add to the productive physical — and organizational, and technological, and intellectual — capital stock of the world. This is the first and in the long run the most important source of fluctuations — in this case, growth — in global capital wealth. ( WHAT ABOUT INVESTMENTS IN HOUSING? )
2. News: Good and bad news about resource constraints, technological opportunities, and political arrangements raise or lower expectations of the cash that is going to flow to those with property and contract rights to the fruits of capital in the future. Such news drives changes in expectations that are a second source of fluctuations in global capital wealth. ( WHAT ABOUT OIL CONCERNS? )
3. Default Discount: Not all the deeds and contracts will turn out to be worth what they promise or indeed even the paper that they are written on. Fluctuations in the degree to which future payments will fall short of present commitments are a third source of fluctuations in global capital wealth.
4. Liquidity Discount: The cash flowing to capital arrives in the present rather than the future, and people prefer — to varying degrees at different times — the bird in the hand to the one in the bush that will arrive in hand next year. Fluctuations in this liquidity discount are yet a fourth source of fluctuations in global capital wealth.
5. Risk Discount: Even holding constant the expected value and the date at which the cash will arrive, people prefer certainty to uncertainty. A risky cash flow with both upside and downside is worth less than a certain cash flow by an amount that depends on global risk tolerance. Fluctuations in global risk tolerance are the fifth and final source of fluctuations in global capital wealth.

In the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion. Savings has not fallen through the floor. We have had little or no bad news about resource constraints, technological opportunities, or political arrangements. Thus (1) and (2) have not been operating. The action has all been in (3), (4), and (5).

As far as (3) is concerned, the recognition that a lot of people are not going to pay their mortgages and thus that a lot of holders of CDOs, MBSs, and counterparties, creditors, and shareholders of financial institutions with mortgage-related assets has increased the default discount by $2 trillion. And the fact that the financial crisis has brought on a recession has further increased the default discount — bond coupons that won’t be paid and stock dividends that won’t live up to firm promises — by a further $4 trillion. So we have a $6 trillion increase in the magnitude of (3) the default discount. The problem is that we have a $20 trillion decline in market values."

That leaves $14 trillion. Where are these figures from?

"The problem is made bigger by the fact that for (4), the Federal Reserve, the European Central Bank, and the Bank of England have flooded the market with massive amounts of high-quality liquid claims on governments’ treasuries, and so have reduced the liquidity discount — not increased it — by an amount that I estimate to be roughly $3 trillion. Thus (3) and (4) together can only account for a $3 trillion decrease in market value. The rest of that decline in the value of global capital — all $17 trillion of it — thus comes by arithmetic from (5): a rise in the risk discount. There has been a massive crash in the risk tolerance of the globe’s investors."

Okay. $17 trillion from 5.

"Thus we have an impulse — a $2 trillion increase in the default discount from the problems in the mortgage market — but the thing deserving attention is the extraordinary financial accelerator that amplified $2 trillion in actual on-the-ground losses in terms of mortgage payments that will not be made into an extra $17 trillion of lost value because global investors now want to hold less risky portfolios than they wanted two years ago."

This makes sense to me given the magnitude of the fear and aversion to risk, and accompanying flight to safety. It must be enormous.

"From my standpoint, the puzzle is multiplied by the fact that we economists have what we regard as pretty good theories about (4) and (5), and yet those theories do not seem to work at all. As far as the liquidity discount (4) is concerned as long as we love our children as ourselves (and most of us do) and as long as we have access to and can credibly pledge collateral for financial transactions (and we can) the magnitude of the liquidity discount should be roughly equal to the technologically and organizationally driven rate of labor productivity growth divided by the intertemporal elasticity of substitution. The technologically and organizationally driven rate of labor productivity growth is a fairly steady 2 percent per year. The intertemporal elasticity of substitution is in the range from 1/2 to 1. The liquidity premium should be in the range of 2% to 4% per year in real terms — and no central bank should be able to drop it to 2% per year by a few open-market operations: big moves in the liquidity premium should require big moves in expected future growth rates of consumption. Perhaps in the old days — back when banknotes and demand deposits backed fractionally by gold or central-bank reserves were the only liquid stores of value, the only means of payment, the only mediums of exchange, or the even older days when the king’s picture on a disc of gold was it, and when the torturers of the Mint and the Tower were standing by — things were different and credit expansion via the use of the seigniorage power could have greater effects. But today the ability of central banks to swing the liquidity discount as they have in the past year and a half is a mystery."

I think that this is possible:

"big moves in the liquidity premium should require big moves in expected future growth rates of consumption."

"Things are even worse as far as the risk discount is concerned. Our models predict that in normal times, with the ability to diversify portfolios that exists today, the risk discount on assets like corporate equities should be around 1% per year. It is more like 5% per year in normal times — and more like 10% per year today. And our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level but that has led to ten times the total losses in financial wealth of the impulse."

I think that it's understandable, but doesn't make sense. That's what a Human Agency Explanation can afford you.

"Thus my dissatisfaction with Larry White’s piece: he talks only about the impulse, while it is the propagation mechanism — the financial accelerator — that is the important part of the story. $2 trillion shocks to global wealth do, after all, happen every several years, every time there is a recession or a big rise in the prices of natural resources. But financial distress of the magnitude we see today happens once a century. Since the Bank of England developed its lender of last resort doctrine in the 1830s, we have only had two episodes this bad: the Great Depression and today."

This is a fair point. It's weird, by any standard.

"Moreover, I do not think that Larry White has gotten the part of the story that he does cover right. I am not convinced of his account of the origins of the trouble in the housing finance market. Larry White blames government subsidies: the implicit government guarantee offered to FNMA and FHLMC, the explicit guarantee to the FHA, the requirements of the CRA, and the subsidy to borrowers provided by the Federal Reserve’s credit expansion — i.e., its open-market operations that bought Treasury bills for cash."

I think that it is the guarantees, but not for the reasons White does. However, DeLong is correct, these subsidies are a small part of the problem.

"From the start of 2002 to the start of 2006 the Federal Reserve bought $200 billion in Treasury bills for cash. This $200 billion reduction in outstanding bonds and increase in cash surely did lead to an increase in demand for private bonds. But recall the magnitudes here. We have $2 trillion of losses on $8 trillion in face value of mortgages that ex post should not have been made. Are we supposed to believe that $200 billion of open-market purchases by the Fed drives private agents into making $8 trillion of privately unprofitable loans? Not likely. I can see how monetary contraction can make previously profitable loans unprofitable. But I see no way that this amount of monetary expansion can force private agents to make that amount of unprofitable loans. The magnitudes just do not match."

I agree. It's a Mechanistic Explanation. It won't add up.

"The requirements of the CRA also appear to me to be a red herring. Larry White writes that those who blame the crisis on greed are wrong because “greed… is always around” and you cannot explain a variable result by a constant cause “just as one can’t explain a cluster of airplane crashes by citing gravity.” I say that the same is true of the CRA. It has been around in more-or-less its current form for a generation."

I agree.

"FHA, FNMA, and FHLMC make up the last of the actors to whom Larry White attributes the impulse — the $8 trillion in unwise mortgage loans made over the past five years. Once again the problem is that they have been around for a while. White tried to deal with this by saying that the GSEs changed their policies by cutting severely on down payment requirements — and that the private-sector mortgage lenders had no choice but to match them."

I don't accept this explanation. These incentives are just that. They cannot excuse stupid and fraudulent lending. That sort of explanation is Mechanistic as well. They do not explain the magnitude of what happened.

"This claim provokes two immediate reactions. First, as your mother says: “If Freddie jumps off a cliff is that a good reason for you to follow him?” The answer to your mother’s question is: “No.” Just because GSEs are leading the market in making stupid money-losing loans did not force private financial companies to follow them and so lose their money too."

I completely agree.

"Second, Freddie and Fannie and FHA were not the first to jump off the cliff. They lost huge amounts of market share in the mid 2000s. We don’t have a crisis which started when private mortgage lenders losing market share cut back on the quality of the loans they were willing to make. We have a crisis which started when private mortgage lenders cut back on the quality of the loans they were willing to make and so gained market share. The sequence is the opposite of what would have happened if White were correct."

It's not the Freddie/Fannie problem that is the main culprit.

"Moreover, if ill-judged loans by the GSEs were the problem, we would expect to see a crisis in which FNMA and FHLMC failed first — which they did not, their troubles coming back in the line well after the Countrywides and the Bear Sternses. And we would expect the failure of FNMA and FHLMC to take the form of them leaking cash as the number of mortgage payments they received crashed with defaults and consequent foreclosures. Instead Fannie and Freddie are still cash-flow positive — as long as they can borrow at nearly the Treasury rate. Fannie and Freddie crashed not because their revenues collapsed but because their borrowing costs ballooned. At it looks right now as though government ownership of 80 percent of Fannie and Freddie will bring money into the Treasury over the next five years."

There was a problem with the implicit, actually explicit guarantees, that did cause problems for this particular program. But it's a small part of our crisis. Let's move on from this issue.

"So why does Larry White’s diagnosis of what is going on differ so much from mine? I think that what is going on is a characteristic weakness of the Austrian tradition: the baseline assumption that all evils must have their origin in some form of government misregulation. If government could be drowned in the bathtub, then an Eden in which people indulged in their natural propensity to truck, barter, and exchange would emerge. And this automatically rules out what I regard as the most likely and fruitful road to walk down to understand this financial crisis: the road that starts from investigating how human psychological limits lead to bad private-sector contract design that then magnifies psychological biases."

This is what I call a Human Agency Explanation. Excellent.

"I am not happy with the state of such explanations — they seem to involve, at the moment, a great deal of handwaving. But in my judgment it is less handwaving than required to make the case that our current financial crisis is the result of our abandonment of a proper gold standard and our embrace of fractional-reserve banking and government-sponsored mortgage lending enterprises."

Those explanations are Mechanistic, and will get you into a pickle, not out of one. This was an excellent post from DeLong. I listed a few questions I'd like answered, but, otherwise, a great job.

Plan B Is We're Screwed

ChumpChanger gets the picture:

"The consensus wisdom emerging about the Big 3 automakers is "Let 'em fail." There are some awfully good arguments for this. Yes, what's happening with the automakers is their own fault, the consequence of decades of bad decisions. Yes, to extend the bailout beyond the financial industry invites every ailing business in the country to run to the bailout trough. Yes, the shock therapy of bankruptcy may be the only way to make the US auto industry viable in the long run.

But what other choice is there? This is not a rhetorical question. I really don't know. It's easy to say that we should let them fail. But if John Dingell stares down at you (and I've sat in the audience when Dingell's stared down from his elevated perch--trust me, you can go many years without seeing a stare as blood curdling as his) and asks what your plan is for all the autoworkers who are going to be displaced, what's your answer? It seems to me that at the moment we have none. And anyone who says we should just let the industry go bankrupt and let it sort and downsize itself out had better have some answer to this.

PS: If you want to get some historical perspective on the dialogue here, check out A Step Toward Feudalism: The Chrysler Bailout, a paper from back in 1980 that the Cato Institute has put online (points to them for not just throwing out the sillier stuff when they were digitizing the archive). We bailed out Chrysler and the nation survived -- though it did mean years of listening to Lee Iacocca's turnaround story. "

Well, you and Cato both have a point, because that's how the world works. On the one hand, we aren't the USSR, on the other hand, government intervention leads to more government intervention. In the case of Chrysler, the terms should have at least been more onerous, including a vow of silence from Iacocca, even though I don't believe in vows for myself.

So, in this case, you're right again. There's no Plan B for any of this, because everyone's been working under a system of implicit and explicit government guarantees, based partly on the past government interventions. We're in a huge bind because of this, and are having to intervene to attempt to lessen an outright panic against risk.

On the other hand, Cato is right. We need to get out of this government guaranteed system, or at least radically alter it, because those guarantees made this outcome more likely.

So, you're both correct again, because that's the way the world works.

"The new fusionism may well be fiscally conservative and socially tolerant "

Ilya Shapiro with a nice point on Cato:

"Indeed, this Tuesday’s election probably saw the highest-ever percentage of libertarians — depending on how you count them – vote for the Democratic presidential candidate (at least in the modern era, with the possible exception of the Nixon years). This despite that Democratic candidate being commonly seen as the most statist major-party candidate in history."

Makes sense to me.

"But this type of discussion may be beside the point; libertarian-conservative (in the sense of socially conservative, economically squishy) fusionism may have run its course, a relic of the Cold War. The new fusionism may well be fiscally conservative and socially tolerant (not necessarily liberal, just not wanting government to do anything about the way people live their private lives), including folks who might call themselves conservative cosmopolitans, crunchy cons, South Park conservatives, or indeed libertarians. Or they might eschew labels altogether but are sick of the rot coming from (or to) Washington. In other words: Purple America."

Goodbye Conservative/ GOP - libertarian fusion. Welcome to my world. Come on in.

"“but if the intention was to attract back high value Australian workers who have temporarily moved to Hong Kong or Singapore, it may not be enough.”

Interesting news from Cato:

"When rates become too high, it is now increasingly easy for productive resources - including labor - to escape across national borders. This is leading politicians, even in places such as France and Germany, to lower top tax rates. In our new book, Global Tax Revolution, Chris Edwards and I explain how this process of tax competition is an amazing liberalizing force in the world economy. But for those of you who inexplicably don’t want to buy our book, this excerpt from a report in Tax-news.com provides ample evidence:

Top personal income tax rates around the world have fallen by an average of 2.5% in the past six years, as governments strive to balance their need for revenue with the impact of increasing global labor mobility, a new study from KPMG International has found. Worldwide, top personal tax rates have fallen from an average of 31.3% in 2003 to 28.8% in 2008. "

And:

“We do not foresee a time when personal income taxes will fall so far that they become irrelevant to people moving from country to country. But it is entirely possible that the relative level of indirect taxes will begin to play a much greater part in people’s decisions on where in the world to go for work,” Garnon concluded."

This is precisely why I don't fear governments getting bigger in the long run. This is a long term and irreversible change. Not no government, but smaller government. Also, this crisis will lead to less moral hazard in the future. The numbers are way too large for a repeat.

A Map Of Our Current Crisis

A map of our current crisis:

A) The rise in home prices:

Randal O'Toole on Cato:

"The credit crisis has led to numerous calls for bigger government. Yet the truth is that big government not only let the crisis happen, it caused it.

This truth is obscured by most accounts of the crisis. “I have a four-step view of the financial crisis,” says Paul Krugman. “1. The bursting of the housing bubble.”

William Kristol agrees. His account of the crisis begins, “A huge speculative housing bubble has collapsed.” “The root of the problem lies in this housing correction,” said Secretary of the Treasury Henry Paulson."

So it all started with the bubble. But what caused the bubble? The answer is clear: excessive land-use regulation. Yet while many talk about re-regulating banks and other financial firms, hardly anyone is talking about deregulating land."

B) The amount of money looking for investments:

This American Life Episode Transcript
Program #355
The Giant Pool of Money

"Alex Blumberg: The thing that got me interested in all this was something called a
NINA loan. Back when the housing crisis was still a housing bubble. A guy on the
phone told me that a NINA loan stands for No Income, No Asset, as in, someone will
lend you a bunch of money without first checking if you have any income or any
assets. And it was an official, loan product. Like, you could walk into a mortgage
broker’s office and they would say, well, we can give you a 30 year fixed rate, or we
could put you in a NINA. He said there were lots of loans like this, where the bank
didn’t actually check your income, which I found confusing. It turns out even the
people who got them found them confusing."

And:

"The real roots of the crisis lie in a flawed response to China. Starting in the 1990s, the flood of cheap products from China kept global inflation low, allowing central banks to operate relatively loose monetary policies. But the flip side of China's export surplus was that China had a capital surplus, too. Chinese savings sloshed into asset markets 'round the world, driving up the price of everything from Florida condos to Latin American stocks.

That gave central bankers a choice: Should they carry on targeting regular consumer inflation, which Chinese exports had pushed down, or should they restrain asset inflation, which Chinese savings had pushed upward? Alan Greenspan's Fed chose to stand aside as asset prices rose; it preferred to deal with bubbles after they popped by cutting interest rates rather than by preventing those bubbles from inflating. After the dot-com bubble, this clean-up-later policy worked fine. With the real estate bubble, it has proved disastrous."

C) Who said these investments were good:

"An Expert-Induced Bubble

The nasty role of ratings agencies in the busted housing market

David M. Levy and Sandra J. Peart | September 30, 2008

"Those who made the ratings became like expert witnesses in court, seeing things the way their clients, the firms holding the securities and offering them for sale to you and me, wanted things to be seen. The problem was that shoppers, like a jury, did not have the ability to average out different pieces of testimony to help remove the bias. As long as experts were trusted and the market didn't know the difference between unbiased and biased estimates, the trick worked marvelously. The collapse followed suddenly as we have all come to understand that the ratings were miserably biased."

And:

"When, in 2006, the roof began to fall in, Wall Street was in a quandary. It held outsize volumes of triple-A-rated mortgage-backed securities (MBSs). That they were not, in fact, triple-A, had become painfully obvious. Curious analysts consulted the financial statements of the top mortgage dealers, including Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley, for clarification.

Readers, however, found no clarification and no foreshadowing of the troubles to come. Neither in Bear's year-end 2006 report (10K, in Securities and Exchange Commission jargon) nor in its March 31, 2007, quarterly filing was there a meaningful word of warning about the sagging prices of the MBSs that did so much to pull Bear down. Those seeking to learn Merrill's exposure to the mortgage contraptions called collateralized debt obligations, or CDOs, were similarly stymied. Although Merrill was to write off $23 billion worth of CDOs in 2007, the phrase "collateralized debt obligation" did not appear once in its 2006 10K.

Because there was often no market for these idiosyncratic securities, Wall Street did not have to value them at market prices. Rather, it marked them "to model." That is, it assigned them prices at which they would trade, according to one mathematical construct or another, if they could trade. Of course, these mathematical constructs tended to cast things in a cheerful, management-approved way. Only later did a telltale plunge in the value of traded mortgage indices open the eyes of the market to the full extent of the troubles.

Prices can be unwelcome pieces of information."

D) Who insured the investments as good:

"Credit Default Swaps: Yes, You Have to Think About Them

Brian Doherty | October 3, 2008, 7:16pm

"If my theory is correct, then the credit default swap protection is somewhat of a delusion....It is too late to undo the delusion. In the aggregate, markets under-estimated the risk of the bonds they were buying. The risk premium needs to adjust upward. That upward adjustment is not a credit squeeze--it's a return to reality" Arnold Kling

And:

"Before your eyes glaze over, Michael Greenberger, a law professor at the University of Maryland and a former director of trading and markets for the Commodities Futures Trading Commission, says they are much simpler than they sound. "A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails," he explains.

"It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated," Greenberger adds.

"So anybody who was nervous about buying these mortgage-backed securities, these CDOs, they would be sold a credit default swap as sort of an insurance policy?" Kroft asks.

"A credit default swap was available to them, marketed to them as a risk-saving device for buying a risky financial instrument," Greenberger says.

But he says there was a big problem. "The problem was that if it were insurance, or called what it really is, the person who sold the policy would have to have capital reserves to be able to pay in the case the insurance was called upon or triggered. But because it was a swap, and not insurance, there was no requirement that adequate capital reserves be put to the side."

"Now, who was selling these credit default swaps?" Kroft asks.

"Bear Sterns was selling them, Lehman Brothers was selling them, AIG was selling them. You know, the names we hear that are in trouble, Citigroup was selling them," Greenberger says."

E) Why accounting problems contributed:

"Prophets of Accountancy: Tyler Cowen: Marginal Revolution

"Here is Franklin Allen and Elena Carletti, circa 2006:

When liquidity plays an important role as in times of financial crisis, asset prices in some markets may reflect the amount of liquidity available in the market rather than the future earning power of the asset. Mark-to-market accounting is not a desirable way to assess the solvency of a financial institution in such circumstances. We show that a shock in the insurance sector can cause the current value of banks’ assets to be less than the current value of their liabilities so the banks are insolvent. In contrast, if historic cost accounting is used, banks are allowed to continue and can meet all their future liabilities. Mark-to-market accounting can thus lead to contagion where none would occur with historic cost accounting."

What Caused The Rise In Home Prices?

On Obsidian Wings, I got into a discussion of housing prices. I realized that I assumed a different cause for the rise in home values than my interlocutor. Here's Randal O'Toole on Cato:

"Though everyone knows that the deflation of the housing bubble is what caused the financial meltdown, few have associated the bubble itself with land-use regulation. Back in 2005, Paul Krugman observed that the bubble was caused by excessive land-use regulation. Yet nowhere in his current writings does he suggest that we deregulate land to prevent such bubbles from happening again. Such suggestions have come only from the Cato Institute, Heritage Foundation, and a few other think tanks.

We know that if the regulation is left in place, housing will bubble again — California and Hawaii housing has bubbled and crashed three times since the 1970s. We also know, from research by Harvard economist Edward Glaeser, that each successive bubble makes housing more unaffordable than ever before — and thus leaves the economy more vulnerable to the inevitable deflation. This is because when prices decline, they only fall about a third of their increase, relative to “normal” housing, before bottoming out.

Thus, median California housing was twice median family incomes in 1960, four times in 1980, five times in 1990, and eight times in 2006. In the next bubble, it will probably be at least ten times. This means homeownership rates will decline (as it has declined in California since 1960), small business formation (which relies on the equity in the business owners’ homes for capital) will decline, and education will decline (children of families that own their homes do better in school than children of families who rent)...

Instead of such laws, states that have regulated their land and housing should deregulate them. Congress should treat land-use regulations as restrictions on interstate mobility, and deny federal housing and transportation funds to states that impose such rules. Otherwise, hard as it may be to imagine, the consequences of the next housing bubble will be even worse than this one."

That's why I don't assume that housing prices will remain low for the indefinite future, as some commentators do.

However, the question of the advisability of mortgages made to finance the buying of these houses in this bubble is a separate question.