either agents made implausible assessments of future risk/return tradeoffs, or were engaged in "looting" the system by exploiting implicit guarantees

The Spigot Theory is attacked by Menzie Chinn on Econbrowser:

"A New Meme: Blame It on Beijing (and Seoul, and Riyadh...)

Perhaps I'm overstating it, but I think this is the abridged version of the Bush Administration's perspective on how we got into the financial mess we find ourselves in. You might ask why I focus on the ideas of the outgoing government. Well, it's because I'm confident that this will be a thesis pushed by some commentators eager to absolve previous policymakers of blame( I AGREE. IT'S AN ATTEMPT TO SHIFT BLAME. ) [1]. And indeed (as Mish points out), this view has apparently adherents in high places.

But let me let the the Economic Report of the President [large pdf] (Chapter 2) speak for itself:

• The roots of the current global financial crisis began in the late 1990s. A rapid increase in saving by developing countries (sometimes called the "global saving glut") resulted in a large influx of capital to the United States and other industrialized countries, driving down the return on safe assets. The relatively low yield on safe assets likely encouraged( THAT'S ALL IT WAS ) investors to look for higher yields from riskier assets, whose yields also went down. What turned out to be an underpricing of risk across a number of markets (housing, commercial real estate, and leveraged buyouts, among others) in the United States and abroad, and an uncertainty about how this risk was distributed throughout the global financial system, set the stage for subsequent financial distress.
• The influx of inexpensive capital helped finance a housing boom. House prices appreciated rapidly earlier in this decade, and building increased to well-above historic levels. Eventually, house prices began to decline with this glut in housing supply.
• Considerable innovations in housing finance—the growth of subprime mortgages and the expansion of the market for assets backed by mortgages—helped fuel the housing boom. Those innovations were often beneficial, helping to make home ownership more affordable and accessible, but excesses set the stage for later losses.
• The declining value of mortgage-related assets has had a disproportionate effect on the financial sector because a large fraction of mortgage-related assets are held by banks, investment banks, and other highly levered financial institutions. The combination of leverage (the use of borrowed funds) and, in particular, a reliance on short-term funding made these institutions (both in the United States and abroad) vulnerable to large mortgage losses.
• Vulnerable institutions failed, and others nearly failed. The remaining institutions pulled back from extending credit to each other( A CALLING RUN ), and interbank lending rates increased to unprecedented levels. The effects of the crisis were most visible in the financial sector, but the impact and consequences of the crisis are being felt by households, businesses, and governments throughout the world.
• ...

There is greater detail in the section titled: "Origins of the Crisis", subheading "The Global Saving Glut":

...

As this influx of capital became available to fund investments, interest rates fell broadly. The return on safe assets was notably low: the 10-year Treasury rate ranged from only 3.1 percent to 5.3 percent from 2003 to 2007, whereas the average rate over the preceding 40 years was 7.5 percent. While to some extent the low rates reflected relatively benign inflation risk, the rate on risky assets was even lower relative to its historical average: the rate on a 10-year BAA investment-grade (medium-quality) bond ranged from only 5.6 percent to 7.5 percent from 2003 to 2007, whereas the average over the preceding 40 years was 9.3 percent. The net effect was a dramatic narrowing of credit spreads. A credit spread measures the difference between the yield on a risky asset, such as a corporate bond, and the yield on a riskless asset, such as a Treasury bond, with a similar maturity. Risky assets pay a premium for a number of reasons, including liquidity risk (the risk that it will be difficult to sell at an expected price in a timely manner) and default risk (the risk that a borrower will be unable to make timely principal and interest payments).

Thinking in terms of systems of supply and demand is a very useful disciplining device. And here I think resorting to this framework, even allowing for distortions in the markets, can be useful, for it reminds one that the outcome (current account balances or the mirror image, financial account balances, and interest rates) are the equilibrium outcome of supply and demand for saving. (A related, but distinct, perspective is Brad Setser's creditors/debtors story.)

I'll admit that it's plausible to think of an exogenous shift in excess saving (decrease in investment demand in East Asia, increase in corporate and household saving in China, etc.) as resulting in increased US borrowing from abroad. This is indeed a variant of the Bernanke "saving glut" thesis. The Bernanke focus is on the "depth and sophistication" of the US capital markets.

Well, I think this last point leads us to my critique. Was it really sophisticated capital markets in the US, or a mania in which either agents( YES ) made implausible assessments of future risk/return tradeoffs, or were engaged in "looting"( YES ) the system by exploiting implicit guarantees( YES ) and building up contingent liabilities for the taxpayers( YES ), that sucked in capital from the rest of the world.( YOU'VE GOT IT )

Three years ago, I'd surely have a difficult time convincing people that US capital markets weren't completely self-regulating and self-correcting. Maybe it's time to revisit the "saving glut" hypothesis, and say that perhaps capital "sucked" into America, rather than "pushed" into America.

Even if one were to say that the excess saving from East Asia -- and the oil exporters as we enter 2005-08 -- drove( HELPED ) the bubble (and I'm willing to admit that there is something to the argument that global imbalances exacerbated domestic imbalances, especially related to the housing sector), I have two big caveats.

The argument that the saving glut led to low interest rates is not unambiguously accepted. [2], [3], [4], [5] [6] [7]. Consider Wright's work [pdf] on how the conundrum can be explained without resort to a central role for international factors (although he allows for some; see also this post). Also consider the correlation between low interest rates and the US current account. Below is a graph from a post two years ago.

Figure 1: The Net Export to GDP ratio and the ten year constant maturity yield (end of quarter) yield minus the ten year ahead (median) expected CPI inflation rate. Source: FRED II and Philadelphia Fed.

But, thinking again about exogeneity, why were funds flowing to the US. Some of it was low national saving. And why was that saving low? Because we were piling tax cuts upon tax cuts (admittedly I'm sounding like a broken record here: [8] [9]). But then add to this question why did the oil exporters start building up current account surpluses of enormous magnitudes? Because demand for oil rose in China, and the US (some observers conveniently ignore the US and focus on China, but it was adding substantial amounts of incremental demand up to 2005 or so). But some of that Chinese demand for oil was "derived demand", driven by US consumption of Chinese made goods.

So, while I won't say that the idea of saving flows coming from East Asia had some role in the financial crisis we're now undergoing [is completely without content grammar corrected 11:15 Pacific 1/22]], I'd say one has to think about how those flows came about, as much as how big they are. We don't usually think of the rest-of-the-world driving macroeconomic events in the US (here's my take: [10]), and I still don't think it's time to start.

Figure 2: Trade balance to GDP ratio (blue) and trade balance ex. oil imports to GDP ratio (red). NBER defined recessions shaded gray. Sources: BEA/Census trade release for November, Macroeconomic Advisers [xls] (release of 15 January 2009), NBER, and author's calculations.

By the way, I am disagreeing slightly with Brad Setser's take on this subject, although I think it is more a point of emphasis than substance. My reading of his post is that excess saving from East Asia and oil exporters enabled( I AGREE ) (my phrase, not his) the US housing boom, and the search for yield. I think that's somewhat different from the ERP thesis."

This is basically my view.

" the China-trade-imbalance argument has gotten enough traction within China that suddenly the debate seems to have erupted into the spotlight"

More on China from Michael Pettis:

"As deficit( SPENDER ) countries contract, can surplus( SAVER ) countries be far behind? January 10th, 2009 by Michael | Filed under Fiscal debt and deficits, Hot money, Labor and unemployment, Policy.

The US loses the most jobs since 1945, the Financial Times headline blared out yesterday. According to the article:

The US economy lost more than half a million jobs in December for the second month running, figures showed on Friday, making 2008 the worst year for job losses since 1945 and intensifying pressure on Congress to pass a fiscal stimulus. The number of jobs lost during the year reached 2.6m, while the unemployment rate – 4.4 per cent before the credit crisis – jumped to 7.2 per cent in December, its highest level in 16 years.

Yesterday’s Telegraph was not a whole lot warmer on the subject of Europe. It had an article entitled “Europe’s economy contracts at rates not seen since 1930s,” which started off with:

German exports and industrial orders have both plunged at the steepest rate since modern records began and Spain’s unemployment has surged above three million, capping one of the most disastrous days for Europe’s economy since the Second World War.

It is pretty obvious that consumption in trade deficits countries is adjusting at a breakneck pace( A PROACTIVITY RUN ) – “adjusting” being a word often used by economist’s to mean “the party’s over”. The rising savings rate required by households to repair tattered balance sheets has not just meant an equivalent decline in consumption, since this rise is occurring so quickly that income is declining. The total drop in consumption is, and will continue to be, severe.

With consumption declining so quickly, and fiscal spending so far unable to keep pace, what does this do for countries exporting excess production? In some trade surplus countries – i.e. Germany – the predictions some of us had been making about the “second stage” in the crisis, in which trade surplus countries get hit with deeper and longer-lasting adjustments, seem already to be coming true. Exports are collapsing, and with no increase in domestic demand to compensate, it is pretty hard to imagine how businesses are going to cope( FORGIVE DEBT ).

For all the attempts by the government to keep confidence up, Chinese businesses, not surprisingly, are worried. Yesterday’s South China Morning Post had the following article:

Business confidence in the mainland plunged in the final three months of this year to an eight-year low as the mounting effects of the financial crisis weighed on exports and industrial output, an official survey showed on Friday. The business confidence index fell 29.2 points in the fourth quarter to 94.6, the National Bureau of Statistics said. That is the lowest reading since the start of 2001, the earliest date for which official figures are available.

Hardest hit were manufacturers, hurt by shrivelling demand in the United States and Europe and a weakening domestic property sector. Their sub-index plummeted 32.1 points from the third quarter to 87.2. That reading is in line with two purchasing managers’ surveys published earlier this month, which showed a continued contraction in the sector, as well as economists’ expectations that exports shrank more quickly in December.

The debate locally about what caused the trouble and what to do about it (and not incidentally, who to blame) continues strong, and recently two things seem to have been added to the stew. One, the China-trade-imbalance argument has gotten enough traction within China that suddenly the debate seems to have erupted into the spotlight. A number of local analysts, especially critics of both the left and the right, have been arguing that Chinese monetary and fiscal policies may have been part of the root cause of the imbalances that led to the crisis.( I DON'T ACCEPT THESE EXPLANATIONS )

Regular blog readers know that I won’t find this argument at all surprising, but local policymakers are inordinately sensitive to being blamed for anything, and the official position is that China is simply an innocent bystander in a problem wholly concocted and hatched elsewhere. However an increasing number of Chinese economists and academics seem to be challenging that position, so much so that the People’s Daily posted a rather angry editorial three days ago titled “U.S. blame game cannot change facts of financial crisis.” The article blasts Paulson and Bernanke for saying that “a failure to address the rise of emerging markets and resulting imbalances was partly to blame for the global financial crisis,” and concludes:

Imbalances in global trade and investment did have a role in the crisis but were not at the root of the problem. Loose supervision that helped pump excessive dollars into circulation was the root cause. When a morally upright person is mired in difficulties, he or she will engage in introspection rather than shift responsibility. China has moved to cope with the problem with a stream of measures and so have other large world economies.

It is not time to play a blame game. Regulators in the United States might not want to miss the chance that they failed to seize before the crisis, when property companies, investment banks and insurance companies juggled various financial products and Wall Street “elites” snatched tens of millions out of the bubble.( THESE ARE SIMPLY NECESSARY CONDITIONS, NOT THE CAUSES OR EXPLANATIONS OF OUR CRISIS )

It is hard to argue with these conclusions, but a cynic might wonder if any of the participants in the crisis would be considered, by this argument, “morally upright.”( TRUE )

The second thing we seem to be hearing a lot of is concerning capital flows and whether or not China is experiencing hot money outflows. We are all still trying to figure out what is happening to capital flows and to the composition of reserve accumulation (or is it reserve dissipation?). In a recent note, Logan Wright of Stone & McCarthy tries to back out the things we know to get some sense of what is happening to capital flows.

He concluded in an email to me that was attached to his research report that “outflows of around $100-150 billion for the quarter seem within the realm of possibility, but we won’t know anything until we see the data,” but was at pains to establish that he is only guessing. His guesses would be easier to dismiss if a SAFE official hadn’t made a rather surprising announcement four days ago. According to Bloomberg:

China faces a threat of “abnormal” cross-border capital flow because of global financial tumult, the country’s foreign exchange regulator said Tuesday.

I accidentally erased the article and can’t get it back, so I can’t quote much more from it, but I do remember finding the whole thing a little odd. There was no clear explanation of what was “abnormal”, but all the evidence suggests that money flows are not behaving as well as we would want them to. Other interesting official commentary last week included the following, from an article in Tuesday’s South China Morning Post:

The mainland’s financial position will be difficult in the year ahead as revenues fall and spending surges, Minister of Finance Xie Xuren warned yesterday. Painting the most sombre picture of the government’s finances in years, Mr Xie said that shrinking corporate profits caused by rapidly slowing economic growth, as well as tax cuts, would lead to a drop in revenue, while government measures to boost growth would add to spending.

“[It] will be a very difficult year,” Mr Xie told an annual national meeting on fiscal affairs in Beijing. “The problem of unbalanced income and expenditure will be prominent in 2009.” His warning came as an official revealed that the mainland’s giant state-owned enterprises had reported a rare decline in profits last year. “Profits of state-owned enterprises directly under the central government fell about 30 per cent year on year in 2008 to 700 billion yuan [HK$800 billion],” said Huang Shuhe , vice-chairman of the State-owned Assets Supervision and Administration Commission

Some of my older readers will remember last year when I argued that something a lot of analysts saw as a real strength – the huge surge in China’s fiscal revenues, which left the fiscal account more or less in balance – was, in my debt-trader-influenced pessimist’s eyes actually a real problem. If the fiscal account stayed in rough balance with fiscal revenues soaring by 30% a year, it seemed to me that any discrepancy between the rate of revenue growth and expense growth could lead to a sudden unexpected rise in the fiscal deficit, especially since in a downturn the pressure for revenues to decline and for expenses to rise would be unbearable.

The probability geek in me instinctively worries about very rapidly changing numbers, even when they are good, because there is a lot more room for things to go very bad. From what Mr. Xie is saying, the worry was on the mark. The growth rate of fiscal revenues and fiscal expenses have already sharply diverged, and this is even before the big spending plans have been put into place. The article goes on to say:

Ha Jiming , chief economist at China International Capital Corp, said the weakening financial position would cast doubt on the government’s much-vaunted economic stimulus package. The measures, including the 4 trillion yuan stimulus package and tax cuts, are to stem a rapid slowdown in economic growth, by boosting public spending and private consumption.

It claims that economists “expect the mainland will have a budget shortfall this year, with the deficit between 500 billion and 800 billion yuan.” I am nowhere near smart enough to predict what the deficit will be, but I am happy to bet anyone it will be a lot more than the current predictions.

Finally one last comment about recent interesting, and even surprising, government statements, is about a report last week in Laiowang, a Xinhua publication. According to an article on the topic in South China’s Morning Post:

The mainland faces surging protests and riots this year as rising unemployment stokes discontent among migrant workers and university graduates, a state-run magazine said in a blunt warning about unrest in this sensitive year. The unusually stark report was in this week’s Liaowang [Outlook] magazine, issued by Xinhua news agency, which laid out the hazards facing the mainland and ruling Communist Party as growth falters during the global economic crisis.

“Without doubt, now we’re entering a peak period for mass incidents,” a senior Xinhua reporter, Huang Huo, told the magazine, using the official euphemism for riots and protests. “In this year, Chinese society may face even more conflicts and clashes that will test even more the governing abilities of all levels of the party and government.”( A REAL WORRY )

This report has been so widely discussed that I don’t have a whole lot to add to it.

My last comments are about two recently published pieces. On yesterday’s Economists Forum on the Financial Times website Martin Wolf published my short version of a longer article also published today in Far Eastern Economic Review on the global balance of payments and the US-Chinese adjustments.

Tags: Logan Wright, US jobs"

"I am convinced however – perhaps a little monomaniacally – that excess liquidity is sufficient and doubt the ability of regulators to prevent bubbles

From Michael Pettis:

"The fun part – assigning blame
January 7th, 2009 by Michael | Filed under Balance sheets, Global liquidity, Policy.
The piece I wrote for YaleGlobalOnline, which I mentioned in my last entry, was published today, and is called “US and China Must Tame Imbalances Together.” In the article I try to argue that the roots of the current financial imbalance – or, more accurately, of the latest and strongest stage of the current financial imbalance ( THE SAVER COUNTRY/SPENDER COUNTRY SYMBIOSIS ) – are buried in the trade and capital relationship between, primarily, China and the US. It is very important, I argue here and elsewhere, that the US and Europe do everything possible to help what could otherwise be a very difficult adjustment for China( IT WILL BE VERY HARD FOR THEM TO SAY GOODBYE TO THIS SYMBIOSIS. ). The editor’s summary of the piece is:

With surging liquidity and massive trade imbalances, no one should have been surprised by the global economic crisis, because as finance professor of Peking University Michael Pettis explains, this has been the historical pattern. Pettis details the history of the crisis, starting in 1980s, when US policy encouraged( WITH GUARANTEES, YES. NOT THE INTEREST RATES THEMSELVES. ) securitization of mortgages, converting illiquid assets into highly liquid investments; US households shifted money into homes( THIS HAS TO DO WITH MANY FACTORS, INCLUDING RETIREMENT PLANS AND RENT TO OWNERSHIP PRICES. ) rather than savings accounts( WHICH DON'T GO UP MUCH, ESPECIALLY IF YOU HAVE TO PAY RENT. ), and housing prices climbed; China, enjoying a trade surplus, collected US dollars and invested in US assets. A self-reinforcing cycle led( THEY CHOSE. ) US consumers to buy more, Chinese factories to produce more, banks in both countries to lend more, and the bubbles burst in late 2008. US adjustment is more rapid than China’s, which could lead to a new set of problems. Pettis warns that replacing US household consumption with US government consumption will only perpetuate the imbalances( WHICH IS WHAT CHINA WANTS ), and he urges the two nations to act responsibly, coordinating fiscal and monetary policies to ease US overconsumption and Chinese overproduction.( THIS CAN'T BE DONE UNTIL THE CALLING RUN ENDS. )

The argument I am making here is also part of a spirited discussion among a group of China scholars who communicate regularly on China-related themes. At the heart of the discussion is an argument over the monetary and policy mistakes made by the major players in permitting or even encouraging the credit bubble of the past decade. Although at its worst these kinds of discussions can quickly degenerate into a fruitless who-to-blame invective (”It is all the fault of Chinese polices” versus “It is all the fault of the US failures”), at its best – and the discussion has generally been quite good – it is a real attempt to understand the roots of the current crisis and the still-unclear ways in which it may continue to unfold.

I am not allowed to publish or publicize any of the comments among this group since the moderator wants to encourage completely open discussion, but I can say that one of the participants wondered about the sequence of events and questioned my claim that crises are always caused as a result of periods of excess liquidity ( A TAUTOLOGY. IT'S THE WORD "EXCESS" THAT MAKES IT ONE, SINCE THE EXCESS IS DETERMINED AFTER THE FACT. IT'S A USELESS EXPLANATION. ), and that it is difficult for regulators to prevent excessive( THIS HAS TWO MEANINGS, ONE OF WHICH IS USELESS. "EXCESSIVE" CAN MEAN "AGAINST INVESTING RULES", WHICH IS USEFUL, OR IT CAN SIMPLY MEAN"DETERMINED TO HAVE BEEN SO AFTER THE FACT", WHICH IS OBVIOUS, AND USELESS. ) risk-taking when the financial system is forced to accommodate excess liquidity. I think that this is an interesting enough discussion, and very relevant to China, to repeat the argument and my response.

My friend argues that although he agrees excess liquidity is a necessary condition( I'M FINE WITH THIS ) for credit bubbles, it is not at all clear to him that it is a sufficient condition. Besides excess liquidity, he argues, we need misguided regulatory policies to create a bubble and a subsequent financial collapse. In his view, the Fed was primarily responsible for the crisis because of its failure to regulate the financial system with sufficient rigor, and given the expansion of liquidity, it was only a question of time before that failure would lead to crisis.( A MECHANISTIC EXPLANATION AND USELESS. A HUMAN AGENCY EXPLANATION FOCUSES ON INTENTIONALITY AND PRESUPPOSITIONS. IT IS THE ONLY EXPLANATION OF THIS CRISIS. THE SPIGOT THEORY IS USELESS. )

In my response I argued that it is hard to say if excess liquidity growth is both necessary and sufficient condition for crisis since we would need an objective way to measure excess liquidity growth( EXCEPT AFTER THE FACT ), and that is extremely difficult, at best. The late Frank Fernandez, while chief economist of the Securities Industry Association, spent years trying to do so, but always complained that the financial system was too good at developing new and unexpected ways to expand money.( HE WAS CORRECT. )

I am convinced however – perhaps a little monomaniacally – that excess liquidity is sufficient and I doubt the ability of regulators to prevent bubbles. Part of my skepticism about whether or not a robust regulatory framework can truly prevent credit bubbles is theoretical, and part of it is empirical, with the latter resting on two personal experiences. First, in my reading on financial history and current events there has clearly been tremendous improvement over the past 300 years and more in our understanding of financial risks, the functioning of the financial system, the sophistication of our regulatory institutions, and monetary policy, but absolutely no concomitant reduction in the incidence of credit bubbles. ( ARE HUMAN BEINGS STILL INVOLVED SIR? )

Quite the contrary, and if good regulation prevented crises, why wouldn’t we have seen evidence of gradual improvement in the number and viciousness of crises? Second, as a former smart-ass banker/trader I am too respectful of the enormous ability of the market to game any system that can be put into place( I AGREE ). Regulators simply cannot outplay the market, and when too much liquidity leads( IT DOESN'T DO ANY SUCH THING. THERE ARE INCENTIVES AND DISINCENTIVES TO EVERY HUMAN ACTION, OTHERWISE IT'S NOT AN ACTION. THE VIEW OF HUMAN AGANCY HERE PROPOUNDED IS PURELY MECHANISTIC AND FALSE. ) to an increase in risk appetite, the financial system will find a way to take on more risk that might be healthy. As I argue in my piece, “When any part of the financial system is constrained from taking on risk, the market simply evades these constraints in one of three ways: It innovates around them, it generates or develops new and unregulated parts of the financial system, or it conceals regulatory violations.” ( I AGREE COMPLETELY HERE, WHICH IS WHY I DON'T BLAME THE REGULATIONS OR MATH MODElS OR INVESTMENTS VEHICLES. OTHER WAYS TO LOWER CAPITAL REQUIREMENTS WOULD HAVE BEEN FOUND. )

That leaves me a hard-core Minskyite on financial instability, and it is Minsky who creates the theoretical basis for my skepticism. According to Minsky it is not possible even in theory to eliminate financial instability because the very mechanisms used to control one form of instability will cause changes in the financial system (all those smart-ass bankers/traders) that will create new forms of instability( TRUE ). The whole purpose of a financial system is to intermediate risk, and when risk appetites change( I AGREE, BUT I DISAGREE ABOUT THE CAUSES OF THIS CHANGE. ), the financial system will find a way to accommodate that change, whether or not regulators are comfortable with the change.( TRUE )


That doesn’t mean regulations( I DIFFERENTIATE BETWEEN REGULATION AND SUPERVISION. I BELIEVE THAT WE NEED SUPERVISION, WHICH DOESN'T FOCUS ON RULES BUT METHODS AND GOALS. )) are a waste of time. On the contrary, they are extremely important in the proper functioning of the financial system, but we need to be clear where they matter and where they don’t. As I see it, the purpose of the regulatory framework is:


1) To create a financial system that in “normal” times optimizes the ability of the system to allocate capital cheaply and efficiently. This is where issues of transparency, corporate governance, agency problems and information asymmetry matter.( TRUE )

2) To eliminate balance sheet feedback mechanisms that are automatically pro-cyclical and, to the extent possible, create fiscal and balance sheet stabilizers. These don’t eliminate bubbles and crises, but they do reduce the impact and weaken the transmission mechanism into the real economy. ( TRUE )

To bring this back to China, it is for these reasons that I am more skeptical than most about the recent financial reforms in China. As I see it, the financial system here is replete with balance sheet pro-cyclicality, which the government has not directly addressed (in fact many of their interventions increase the risk) and so China runs the risk of a big, “unexpected” jump in volatility when things turn bad.

The strongest element of counter-cyclicality in China is probably government ownership and control of the banks, but even this is counter-cyclical only up to a point, beyond which it becomes massively pro-cyclical –for example if problems in the banking system ever threaten government credit, which is why I have always advised anyone who will listen that the government should be very sparing in its willingness implicitly or explicitly to guarantee credit risk( I DISAGREE. IT NEEDS TO BE A LOLR TO STOP A CALLING RUN. WHAT ARE NEEDED ARE BAGEHOT'S PRINCIPLES, WHICH WILL KEEP A CALLING RUN FROM OCCURRING. ). Government control of the banks can prevent banks from behaving in ways that exacerbate a downturn, and usually this is a good thing, but in a very severe downturn – like that which Japan experienced after 1990 – the attempt to control banking activity can actually backfire if it leads to a surge in government debt that threatens government credibility( THIS IS WRONG. THE AMOUNT IS A PROBLEM, BUT THAT'S DIFFERENT THAN THE NEED FOR THE GOVERNMENT TO BE A LOLR. ). This loss of government credibility happened in Japan (yet) but it has happened in a number of other cases.

This is basically why I think the liquidity creation generated by the Chinese recycling of the US trade deficit would have led to crisis anyway, even if there had been stronger regulation within the US financial markets( I AGREE ). And, by the way, although I share in the general horror about the huge breaches in our regulatory framework, I also remember that during the enormous petrodollar recycling in the 1970s, the US regulatory framework was much more robust, regulated, rigid and constrained then it is now, but that didn’t prevent excess risk-taking. The only impact of regulatory constraints was that extremely foolish behavior – massive loans to countries that had no chance in hell ever to repay – still occurred among American banks (to such an extent that by the time I joined the market in 1987 only one – JP Morgan – of the top ten US banks was not insolvent) but they occurred outside the regulatory constraint. For all the regulatory prudence the risky behavior simply migrated ( THIS IS WHAT WILL HAPPEN. TO SOME EXTENT, IT DID THIS TIME. )to London, where international banks were not as strictly regulated by their home countries.

The real fault of the Fed in the current crisis, in my opinion, was not to foresee that this unsustainable system would eventually come to a breathtaking close, and to prepare the stabilizers that would have prevented the decimation of the US financial system and its brutal transmission into the real economy. In fact every time they intervened to prevent the system from clearing, they increased the accumulation of balance sheet mismatches( TRUE. BUT, COME ON, THE BUSH ADMINISTRATION IS THE MAIN CULPRIT HERE. ). The regulators did have a role( COLLUSION ), but it was not to prevent the crisis but rather to mitigate( WORSEN ) its impact. In my opinion the Fed could not have prevented the crisis except by engineering a recession in the US to counteract strong mercantilist policies in Asia, and that is perhaps a lot to ask( IMPOSSIBLE. I HAD A BAD FEELING THAT THIS IS WHERE HE WAS GOING. RECESSION ON A THEORY. SURE, LET'S STOP PEOPLE DOING WELL ON A THEORY. ).

One last thing about the joy of assigning blame, I have read and re-read several times Charles McKay’s Extraordinary Popular delusions and the Madness of Crowds and thought I should post the following selection from his chapter on the South Sea Bubble – after the bubble collapsed brining ruin in its wake:

The state of matters all over the country was so alarming, that George I shortened his intended stay in Hanover, and returned in all haste to England. He arrived on the 11th of November, and parliament was summoned to meet on the 8th of December. In the mean time, public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the Legislature upon the South-Sea directors, who, by their fraudulent( FRAUD. DO YOU SEE THAT? FRAUD. ) practices, had brought the nation to the brink of ruin. Nobody seemed to imagine that the nation itself was as culpable as the South-Sea company. Nobody blamed the credulity and avarice of the people,—the degrading lust of gain, which had swallowed up every nobler quality in the national character, or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned. The people were a simple, honest, hard-working people, ruined by a gang of robbers, who were to be hanged, drawn, and quartered without mercy.( WELL, THIS IS TRUE. GULLIBILITY ISN'T A CRIME. FRAUD IS. )

This was the almost unanimous feeling of the country. The two Houses of Parliament were not more reasonable. Before the guilt of the South-Sea directors was known, punishment was the only cry. The king, in his speech from the throne, expressed his hope that they would remember that all their prudence, temper, and resolution were necessary to find out and apply the proper remedy for their misfortunes. In the debate on the answer to the address, several speakers indulged in the most violent invectives against the directors of the South-Sea project. The Lord Molesworth was particularly vehement. “It had been said by some, that there was no law to punish the directors of the South-Sea company, who were justly looked upon as the authors of the present misfortunes of the state. In his opinion they ought upon this occasion to follow the example of the ancient Romans, who, having no law against parricide, because their legislators supposed no son could be so unnaturally wicked as to embrue his hands in his father’s blood, made a law to punish this heinous crime as soon as it was committed. They adjudged the guilty wretch to be sown in a sack, and thrown alive into the Tiber. He looked upon the contrivers and executors of the villanous South-Sea scheme as the parricides of their country, and should be satisfied to see them tied in like manner in sacks, and thrown into the Thames.” Other members spoke with as much want of temper and discretion.

Mr. Walpole was more moderate. He recommended that their first care should be to restore public credit. “If the city of London were on fire, all wise men would aid in extinguishing the flames, and preventing the spread of the conflagration before they inquired after the incendiaries. Public credit had received a dangerous wound, and lay bleeding, and they ought to apply a speedy remedy to it. It was time enough to punish the assassin afterwards.” On the 9th of December an address, in answer to his majesty’s speech, was agreed upon, after an amendment, which was carried without a division, that words should be added expressive of the determination of the house not only to seek a remedy for the national distresses, but to punish the authors of them.

Robert Walpole, for those who don’t remember, was the brilliant (if not always scrupulous) statesman – effectively Britain’s first Prime Minister, although the title hadn’t yet been invented – who had been more or less pushed out of favor for speaking strongly and often against the South Sea scheme and warning of its consequences. After the collapse, he was called back to London to clean up the mess – predictable, right? Perhaps because he had been so widely reviled for speaking against the South Sea scheme, he was not fully sympathetic to the claims that the whole thing had been a scam foisted on innocent people by evildoers. He was perfectly happy to avoid the whole orgy of blame and deal with the actual consequences, but needless to say blaming the schemers was always likely to be a lot more satisfying than acknowledging that an awful lot of people participated a little too willingly in the whole thing. Walpole was famously a realist – when there were sufficient incentives for foolishness and fraud, he didn’t doubt that even the nicest people would act stupidly or dishonestly."

I'm puzzled by this. If this view is correct, why is fraud a crime? I believe in blame. One thing is for sure, and that is the fact that not punishing crime is an incentive for more of it.As for the last sentence, it is patently false. Walpole was less a realist than a misanthropist. Thankfully, throughout history, we've have many great people who have turned down great incentives and done the right thing. A Human Agency Explanation assigns blame for committing crimes, and endeavors to investigate and prosecute them. Excusing crime by blaming the victims or saying that we are all possible criminals is useless at preventing anything. Rather, it's a trumpet call for crime. No wonder we're in this mess.

"how do we explain an increase in optimism? "

Here's another take by Lawrence H. White on Casey Mulligan's notion of Optimism causing the Housing Bubble:

"If I understand him rightly, I don’t much disagree with Professor Mulligan. We agree that Federal Reserve policy acted to promote the housing price boom by lowering real interest rates. The difficult question is: what share of the boom can we attribute to monetary policy, and what share to other independent sources? Applying Professor Mulligan’s way of computing the impact of lower real interest rates alone on the present discounted values of houses, correct anticipation in 2002 of real T-bill rates — which were about to go 200 basis points lower for the next three years — can account for only around a six percent rise in house prices. Thus the milder-discounting effect by itself accounts for only a fraction of the actual run-up in prices observed, assuming correct anticipations. The present-value calculation is straightforward.

We can get a bit more impact out of lower interest rates by noting that the lowering of mortgage lending standards implied an even larger drop in risk-adjusted mortgage rates than in risk-free Treasury rates. Market participants did not have any clear basis in historical time series for anticipating that this drop would reverse itself soon.

Still, I agree that the joint hypothesis “real interest rate anticipations were correct and they alone fully explain the rise in house prices” is untenable. Of course, we already knew that anticipations of house prices could not have been correct, given that nobody would pay $300,000 for a house in 2006 that he knew would be worth only $200,000 two years later. "

I agree with this. No Spigot Theory.

"Professor Mulligan reasonably proposes to attribute the bulk of the rise in house prices to some kind of ex-post-mistaken (but not necessarily irrationally exuberant) anticipations, offering the hypothesis that “it was optimism that raised housing prices, not much of anything tangible during the boom. Whether it was optimism about future interest rates, future tastes, or future technology is more of a quibble.” Optimism about “tastes” here includes optimism about the future growth of demand in particular local housing markets. Something like that would seem to be required to explain why the house price boom was so highly concentrated in a few states. We can’t explain such concentration by appealing only to optimism about technology or national economic policy variables.

An appeal to optimism, of course, doesn’t really explain events but simply gives us a reframed question: how do we explain an increase in optimism? I suggest that optimism (regarding whatever) during this period was not independent of the rising rate of aggregate nominal income growth that was being fueled by Fed policy. Expansionary monetary policy may have (at least cyclically) effects on relative prices and real variables, like the real demand for houses, through income channels, not only through its effect on the real interest rate. I anticipate, and agree, with Professor Mulligan’s likely response that more needs to be done to quantify these other effects."

There seems good reason to believe that their was such an overabundance and overly magnified aspect of Wishful Thinking in this current situation. However, for the explanation, we need to understand the presuppositions, assumptions, and context of this explosion of Wishful Thinking. I believe that a lot of it comes down to an overestimation of what government can do, and simply thinking of the actors in this drama as free market adherents misses the true nature and assumptions of their belief system, which includes plenty of government intervention when it's in their interest.

"The sooner prices are allowed to naturally fall to normal, post-bubble levels, and the sooner that houses become affordable"

I said that there were people who felt that the Fed's plan to help people buy houses was a mistake. Declan McCullagh on CBS News is one of them:

"In reality, more government intervention will do more harm than good. The sooner prices are allowed to naturally fall to normal, post-bubble levels, and the sooner that houses become affordable, the sooner the economy can heal itself and start growing instead of contracting.

By way of analogy, imagine a reprise of the Dutch tulip mania of 1637. Say the price of tulip bulbs has grown handsomely in the last few years, and impressive fortunes were made by early speculators.

Bidding wars erupt, with the winners hoping to resell them the bulbs at a handsome profit months or years later. Cable TV hosts proclaim that a golden age of prosperity has dawned. Prized bulbs change hands for $1 million each, and skeptics are reviled as doomsayers.

Eventually this boom leads to a bust, as new buyers become scarce, and the price of tulip bulbs suffers a dizzying fall down to $10 each. Speculators complain to Congress. Politicians pledge to use tax dollars to purchase bulbs for $1,000 or $10,000, invoking phrases like "stability" and "liquidity crisis," or offering taxpayer-backed loan guarantees to speculators.

This would sound silly for tulips, but it's close to what's happening for houses. All this will do is slow -- and not arrest -- the process of prices falling. Not even the president of the United States can veto the laws of supply and demand.

It's difficult to convince someone to buy a tulip bulb (or house) today if he thinks the price will be a lot lower in a year. Worse, government spending diverts funds away from productive purposes, including investment, education, and infrastructure. "

In general, I agree with this. But, there's one problem with this comment. It assumes that the people buying houses now won't be able to make their payments going forward. But what if they can? What if the problem isn't that current home purchasers are going to get into trouble, and banks aren't lending to them because of that. Rather, many people who can clearly afford the houses they are going to buy are being turned down because of the situation of the banks, which is being locked into a shell-shocked aversion to risk, and using money to clean up their books? How would you know?

"By usual metrics, such as the ratio of prices to incomes, the ratio of rents to mortgages, and the ratio of current prices to expected ones, some areas of the country still look pretty bubbly.

In the decade ending August 2008, according to S&P Case-Shiller data, house prices in New York metropolitan area leaped by 2.2 times, though incomes grew only modestly. The Washington, D.C. area experienced a 2.1-fold jump -- while non-bubbly areas like Cleveland saw an increase of a mere 1.17 times, which is consistent with incomes and inflation.

The median family income in Allentown, Penn. is $46,400, and the median home price is $125,000, meaning houses tend to cost 2.7x the median income. Compare that to San Francisco, where homes consume a whopping 11.6x the median annual salary. "

What if the usual metrics are wrong? They are failing to figure in demographic changes, regulation changes, wealthier people moving and concentrating in new areas where they drive up the prices,etc.? The real world metric is simply whether or not people can afford their houses. Is that metric written in stone?

"Robert Shiller, who teaches economics at Yale University, has calculated that housing prices have remained remarkably constant from 1890 through 1998, rising only 13 percent when adjusted for inflation -- through world wars, the automobile, and the rise of the two-income family. When the dot-com bubble burst, money flowed into real estate, encouraged by the Federal Reserve cutting interest rates more than prudence allowed. "

The Spigot Theory again. What does "more than prudence allowed" mean? Let's say it made it easier to fund a mortgage. Did that automatically lead to irrational and asinine lending practices?
What's the connection between low interests rates and fraud and stupidity? Is there a law for that? I'm trying to understand this phenomenon in a way that explains the way actual human beings act. Oh my God, interest rates are low, let's throw caution to the wind.

"Which brings us back to a taxpayer-funded "rescue" of homeowners. It's true that many people who bought homes in the last decade acted responsibly, made sizable down payments, and purchased a house within their means; they owe more than they paid through no fault of their own.

On the other hand, many people were speculators, fibbing about their income, lying about their assets, and treating their house as an ATM to finance cruises and flat screen TVs. Many banks were in on the game, knowingly placing people in homes they couldn't afford. Even if a bailout is justified, Washington is in no position to determine who's deserving and not. Any bailout punishes renters and Americans who were fiscally responsible by taxing them to benefit those who weren't.

Prices in some areas need to fall, and the market needs to return to normal. Eventually it will. All Washington can do is prolong the pain. "

Is a mortgage deduction taxpayer funded? My problem with this analysis is that it assumes a model of the economy to be the real economy, which has recently been proven to be a less than perfect mode of analysis. At any point in time, there are all kinds of competing incentives and disincentives moving people's decisions this way and that. It might well be that the government will, to some degree, "prop up" home prices in some theoretical model sort of way. But, on the other hand, if the people buying the houses today can afford to buy them and do, then the prices were not artificially propped up, and, even if they were or are, if people can and do freely purchase them, then the market worked. The market only fails if a significant number of people default, since there will always be some defaults. Does he really believe that new buyers, in this market, are radically prone to default?

Do I support the Fed's actions? Not really, no. But I understand what they're trying to do, and am not so sure that it can't work because of a theory I hold, however dearly.

Of course, I'm talking about houses. What works for tulips, I haven't a clue.

"a sense that unhealthy things were going on in the U.S. housing market": And It's Not Mold

Michael Lewis with a post that got a lot of attention on Portfolio:

"At the end of 2004, Eisman, Moses, and Daniel shared a sense that unhealthy things were going on in the U.S. housing market: Lots of firms were lending money to people who shouldn’t have been borrowing it. They thought Alan Greenspan’s decision after the internet bust to lower interest rates to 1 percent was a travesty that would lead to some terrible day of reckoning. Neither of these insights was entirely original. Ivy Zelman, at the time the housing-market analyst at Credit Suisse, had seen the bubble forming very early on. There’s a simple measure of sanity in housing prices: the ratio of median home price to income."

Poor loans. Spigot Theory, useless.

"By the spring of 2005, FrontPoint was fairly convinced that something was very screwed up not merely in a handful of companies but in the financial underpinnings of the entire U.S. mortgage market.

"Unhealthy things". "Screwed up". Don't blind me with science.

"But the scarcity of truly crappy subprime-mortgage bonds no longer mattered. The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.

The arrangement bore the same relation to actual finance as fantasy football bears to the N.F.L. Eisman was perplexed in particular about why Wall Street firms would be coming to him and asking him to sell short. “What Lippman did, to his credit, was he came around several times to me and said, ‘Short this market,’ ” Eisman says. “In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’ ”

I've already used the football and betting analysis in my losing debate with Derivative Dribble.

"More generally, the subprime market tapped a tranche of the American public that did not typically have anything to do with Wall Street. Lenders were making loans to people who, based on their credit ratings, were less creditworthy than 71 percent of the population."

Poor loans. Over and over.

"In retrospect, pretty much all of the riskiest subprime-backed bonds were worth betting against; they would all one day be worth zero. But at the time Eisman began to do it, in the fall of 2006, that wasn’t clear."

This is called regret. It doesn't occur only in finance.

"The funny thing, looking back on it, is how long it took for even someone who predicted the disaster to grasp its root causes. "

Highly comical. If someone predicts something but not for the right reasons, it's called a lucky guess. It certainly doesn't qualify as prescience.

"But he couldn’t figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. “I didn’t understand how they were turning all this garbage into gold,” he says."

It's called alchemy. Even Newton believed in it.

"Eisman, Daniel, and Moses then flew out to Las Vegas for an even bigger subprime conference."

Next time fly to Bakersfield. You'll get more done.

“Would you say that 5 percent is a probability or a possibility?” Eisman asked.

A probability, said the C.E.O., and he continued his speech. "

Pardon me? This is just a confusion of words.

"That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them."

Poor loans.

"The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs."

Sorry, if done right, these can be useful for determining the likelihood of default. It's not the product. I wouldn't do it, but I'll use the info.

“We have a simple thesis,” Eisman explained. “There is going to be a calamity, and whenever there is a calamity, Merrill is there.”

Is this a priori or what?

"There was only one thing that bothered Eisman, and it continued to trouble him as late as May 2007."

He's a hell of a lucky guy. I'm troubled but hundreds of things daily.

“The thing we couldn’t figure out is: It’s so obvious. Why hasn’t everyone else figured out that the machine is done?”

Strangely, he's Heideggarian.

“When I read it, I thought, Oh my God. This is like owning a gold mine. When I read that, I was the only guy in the equity world who almost had an orgasm.”

I wouldn't brag about almost. It's not terribly satisfying.

"Outside it was gorgeous, the blue sky reaching down through the tall buildings and warming the soul. "

This sounds like my Fuld parody.

Let's end it here. Too much pathos, not enough satire.

Hedge Funds In Trouble: Weather Words Being Used

Via Bloomberg, Hedge Funds aren't hedged enough it seems:

``October was the perfect storm for liquidity drying up, especially in the credit markets,'' said Gary Vaughan-Smith, co-founder of London-based SilverStreet Capital LLP, which has $600 million invested in hedge funds for its clients. ``We are through the worst and the turmoil should be gone by the end of November.''

While hedge funds have held up better than actively managed mutual funds or index-based investments, losses in 2008 are almost certain to be the biggest on record. U.S. global equity mutual funds fell by an average of 39 percent in the first 10 months of the year, according to data compiled by Bloomberg. The Standard & Poor's 500 Index was down 34 percent. The hedge-fund industry's only unprofitable year was 2002, when the HFRI index shed 1.45 percent and the S&P 500 tumbled 23 percent."

Oh my God, I forgot the Weather Words Rule. If people start using weather disaster words to describe the situation, it's really bad. 40% you say. See, that's not good.

``I don't think the hedge fund model is broken,'' said Jaeson Dubrovay, head of the $19 billion hedge-fund group at Cambridge, Massachusetts-based consulting firm NEPC LLC. ``We just need to loosen the credit spigots to get the system working again. We don't anticipate that they will be loosened in any way like they were before.''

Hedge funds are private, largely unregulated pools of capital whose managers can buy or sell any assets, bet on falling as well as rising asset prices and participate substantially in profits from money invested. They typically charge fees of 2 percent of assets and 20 percent of investment profits."

Dear Lord, now the Spigot Theory. Remember, once you turn it on, it can be stopped until there's a bubble. Okay, I see. This time we'll man the tap better.

"Hedge funds run by Jeffrey Gendell and John Burbank III posted their worst monthly losses in October. Peter Thiel gave back gains made earlier in the year. Nobel-prize winner Myron Scholes froze his biggest fund.

The managers, like many in the $1.7 trillion hedge-fund industry, were caught in a downdraft of market declines, client redemptions, demands from lenders for more collateral and forced asset sales that accelerated after Lehman Brothers Holdings Inc. collapsed in mid-September."

Downdraft you say. Is that a weather word? I might be wrong about this, but in weather analysis, we have what is called forecasting. It determines whether or not, depending on how accurate it is, you get caught in a downdraft. Maybe we should hire weather forecasters as our financial advisers. Could it hurt?