Wednesday, January 7, 2009

Kicking off the New Year

Here's a few worthwhile articles to kick off the New Year while I continue to work on the post about inflation and deflation.

"The Crisis in 10 Points"

This article provides a concise summary of many of the significant the events and policies which led to the 2007-2008 financial crisis. In his first three points, Robert Stewart sets the context by outlining some of the interventionist policies which began in 1913.. (Intervention didn't begin in 1913--that had been going on since the first Congress-- but interventionist policies ramped up during the Progressive Era of the early 20th century.)

One very key action was the establishment of the Federal Reserve The central banking system of the Fed enabled a marked expansion of the money supply and the subsequent debasement of the dollar. This was followed eventually by Keynesian arguments claiming free markets don't work and what we need instead is government debt and spending to help us consume our way out of recessions.

The next six points look at factors which significantly contributed to our current struggles. These include: living beyond our means; viewing houses as a way to make and/or spend more money; government actions which encouraged riskier borrowing and lending, which then led to risky attempts to hedge the risky borrowing and lending, all of which came crashing down like a strand of dominoes when housing prices quit going up. Near the end, Stewart poses a poignant (even if in hindsight) question: Why was it that "no one in authority (regulators, risk managers, senior bank executives, credit-rating agencies, investment analysts) asked the key question, namely, how on earth was it possible in the long-term to make profits by lending money to people whose chances of paying it back were practically nil?" He concludes by pointing out the now hopefully obvious: "A financial system built on debt and excessive leverage was a financial system built on sand."

An essential economic task is to judge just when leverage is “excessive.” Central to understanding the current crisis is to understand how manipulating the money supply distorts the price signals upon which we are dependent to make precisely that judgment. This leads me to my next recommendation.

Understanding the Austrian Business Cycle

For a easy, quick introduction to the effects of inflationary monetary policy on creating booms, bubbles and busts, I recommend Whatever Happened to Penny Candy. Although written to introduce Junior High students to the economic concepts of investment cycles, velocity, business cycles, recessions, inflation, the demand for money and more, it is surprisingly accurate in its explanations.

For those already familiar with those concepts, I recommend a recent EconTalk podcast with Pete Boettke on The Austrian Perspective on Business Cycles and Monetary Policy. He makes many of the same points as in Penny Candy but in more depth and aimed at a more economically sophisticated audience. Both Boettke and Maybury make the point that new money enters the economy at a particular point, thus raising prices and profits at the point of entry. This monetary demand is mistaken to be a real demand and leads to an imbalance in the allocation of resources, some of which end up as illiquid investments which can not instantaneously shift when they are inevitably discovered to be nonprofitable. In addition, artificially low interest rates send false signals on the true state of savings and the ability to handle risk. The pyramiding of debt and risk, along with the creation of moral hazard though implicit and explicit government guarantees encourages even greater risk taking and the creation of complex investment derivatives. Accountability and calculability are lost as assets are distanced from market forces and market discipline.

Toward the end of the podcast, Roberts points out that the Austrian theory is not taken seriously by mainstream economists and askes “Why?” Boettke ties to answer this and then provides a brief summary of how a Keynesian approach would attempt to explain recent events. The discussion provides a useful description of these conflicting points of view, but not a detailed rebuttal or defense.

Balancing Theory and Experience

Understanding our current economic situation has two major aspects, both of which are important but which must not be confused. The first aspect is to understand the underlying economic forces operating to cause booms and busts in general. The other aspect is identifying what specific manifestations these forces took in this particular boom and bust. Both are important because although the specifics help us empirically validate economic principles, without the correct theoretical explanations, we will be helpless in preventing future repetitions. The next few recommendations are aimed at improving our understanding of the specific details of this particular business cycle.

The Role of Adjustable Mortgage Rates

An often over looked contributor to the sequence of the bursting of the housing bubble is the role of adjustable rate mortgages. You can find a worthwhile analysis of this inadequately appreciated factor in Anatomy of a Train Wreck by Stan Leibowicz.
ARM’s did not cause the housing bubble but had an important role in the construction of the credit-expansion house of cards, as well as providing a trigger for its collapse. (I recommended this article before in a previous post, along with a few others, but as this point was not included in Stewart’s “10 Points”, I wanted to mention it again.)

Understanding Money and Markets

Marketplace Senior Editor Paddy Hirsch has a series of “Whiteboard” mini-lectures explaining some of the unfamiliar market and monetary terms which have become part of today’s news reports and editorials. Here’s a list of some of the more helpful explanations. (Caveat: Although the terms themselves are well explained, many of the ways that Hirsch interprets their connection to the larger economic is flawed.)

13. Crisis explainer: Uncorking CDOs

14. Untangling credit default swaps

16. Getting naked in short selling

17. Margin calls and the financial market’s decline

18. Over-the-counter, over the top

19. How credit cards become asset-backed bonds

21. Leveraging and deleveraging

22. A look inside hedge funds

23. Quantitative easing
(For another view about the need to get banks lending, check out this WSJ article.)


LB said...

Thanks for the list of resources, Beth. I think I'll start with Penny Candy (which looks remarkably like the "Easy Reader" series) and if I can understand that, I'll move onward.

Michael Labeit said...

I too find that the Austrian school offers the best explanations for economic phenomena. It is their special emphasis on deduction that allows them to conclude propositions that empiricist economists could never conclude. I suspect that this is the primary reason why Austrian economic theory is neglected. Though I don't believe economics is purely deductive as some Austrians assert, a great deal of it is.

Anonymous said...

Yes, thanks, Beth. I'll make what use I can of your resources.

Your comment at the opening grabbed my attention. Intervention from the first congress shouldn't be surprising. Our leaders have been and are men of action, and their intention is to act on our society. As far as I can tell, the Austrian school calls for leaders to abstain from leading or acting on economic issues. That is anathema to the personalities that seek public office. Moreover, when things start to go wrong, the governed expect the governing to do something. Ans so they do.

Regarding previous discussions about loans and assistance to the Detroit auto industry, the valid question of where do we draw the line was raised. First, I do believe that Detroit should have gone bankrupt thirty years ago, and that they should be allowed to go bankrupt, except for the further deterioration of the economy owing to the loss of at least 3 million jobs, at this juncture. If saving them now will allow our economy to recover to the extent that letting the American auto industry go bankrupt would not hasten the destruction of our economy then I'm for helping them.

Now, about the question of where to draw the line, the answer is provided with a twist of good humor by none other than Larry Flint. I'll draw my line somewhere before we get to a $5 billion bailout of the porn industry. My question is, 'is he serious, or is his the extreme argument to the contrary designed to prove your point?' You have to appreciate the humor and audacity!


Beth said...

Dear Anonymous1,

On government and economics:
I think it helpful to separate leadership and action.

I think it is possible to lead without acting. The leaders I admire most use their ability to alter the choices and actions of others through rational persuasion. Contrary to desiring abstinence from this type of leadership, I would encourage and celebrate it!

I am grateful for a constitution which limits actions by government that violate individual rights. (I do not mean to imply you would disagree with that in general, although we most likely disagree on just what constitutes an individual right.) Proper government action, I view it, is limited to the protection of individual rights. In the realm of economic matters, that would include protection of property rights, enforcement of contracts, and assuring equality before the law. So it is not action in and of itself that is the problem.

You are so right in pointing out that when things go wrong, the current expectation is for government to do something. It is with that expectation that politicians are currently elected to office. This is what the state of thought about the proper role of government in our lives has produced. This situation has developed within a mostly-free system—and although I disagree with the conclusion of today’s majority, I am grateful I live in a country that allows me to disagree openly and to do my best to persuade others of my points of view.

On drawing the line:
So who gets to draw the line and why? If banks, why not the auto industry? If the auto industry, why not some other industry? When and how do we quit propping up past mistakes? If I had confidence that bailing out Detroit’s Big 3 would really be the last government bailout ever, I would chalk it up to experience and move on. But there is no indication that is the case.

The other thing to consider is that without government bailouts, there would be private “bailouts”—even if only through bankruptcy, or selling at a significant loss. I fear that the arguments in favor of government bailouts based on “too big to fail” (thus failure leads to a collapse of the economy) are analyzing the situation too narrowly and need to expand their analysis to the whole economy over the long run.

Welcome to the new year!