Tuesday, February 09, 2016

Punish who?

Historians still argue about the causes of the Great Depression. Arguments like that will also go on re the Great Recession. Nevertheless, pundits and politicians (and and the NY Times editorial page, among others) complain, for example, that "no one went to jail." See here that "America got fleeced and no one was punished."

Who should go to jail? What do we know?  The pre-conditions for forest fires accumulate over many years; an unpredicted spark then sets off the fire. Likewise, at least ten political-economy events interacted to form a “perfect storm” -- the best descriptor we have until these are sorted out

 1. Federal Reserve policy. In the years 2001-2006, the Fed kept short-term interest rates too low too long (in the post-dot.com bust fear of deflation -- even during 4% GDP growth). Low interest fanned a speculative bubble in real estate. This was followed by typical over-reaction when the Fed tightening in 2005.
2     2. Local land use policies.  The housing price bubble was magnified by (varying) state, local development restrictions; these made local housing supply less elastic (many local “bubbles”) and further boosted home prices.
3     3.  Federal housing policy.  Since at least 1968 (GNMA loan guarantees), it has been national policy to promote home ownership. Policy makers promoted home ownership -- and pushed debt (and speculation). More recently, 20% down payments were no longer required; underwriting standards were steadily loosened. Over-leveraged households were encouraged.
4     4,  Many new savers around the world. World’s middle class grew by 2-billion+ in recent years (“Burgeoning bourgeoisie” Economist,Feb 14, 2009). There was a new large international demand for developed-country (mainly U.S.) assets which prompted a huge asset inflow to the U.S. Banks easily over-leveraged. 
4    5. Advances in finance. Securitization made it possible to tap into more money available for mortgage lending.More risk-spreading; international pools of capital made available (advantage of gains and losses spread far and wide). But loan originators did less to screen out high-risk borrowers. Regulators did equally poor job assessing sub-prime loans packaged with good loans in a single financial security 

6     6 Moral hazard. Previous bail-outs encouraged risk-taking and over-leveraging; profit-loss system requires possibility of loss. Public choice economics explains bail-outs; corporate bondholders/creditors less vigilant if 100-cents-to-the-dollar bail-outs are expected -- 100-cents-to-the-dollar bail-outs became public debt
            7. Too few SEC-sanctioned bond ratings groups. Call it oligopoly. Competition would have been better.  Many inflated bond (including mortgage-backed securities) ratings.  Risk-averse pension fund by-laws require a certain allocation of the portfolio to be AAA -- by one of big-three ratings agencies.  Regulators require less capital held -- if against AAA-rated government bonds; greater leverage allowed if AAA-rated mortgage-backed security.
       8. Normal due diligence by auditors and regulators overwhelmed. There never were “unfettered free markets.” Where/when/how would we get better regulators? Financial innovation usually outpaces regulators capabilities.
       9. Panic policies (start with Dodd-Frank) and panic messages from policy makers. Robert Higgs might say these prompted extraordinary “regime uncertainty”.

       10.  More bad Fed policy. Post-2008, member banks were paid interest on their excess reserves at the Fed. This bailed out many banks – and also reduced their lending.

So, who should go to jail? Best not to ask the politicians who had a hand in all but one or two my top ten.


Central bankers, now including Janet Yellen, are talking about or actually doing negative interest rates. We hear that there are three kinds of macro-economic policy: fiscal policy, monetary policy, economic reform (which can include tax code reform). The first two have apparently failed to deliver real growth. The third remains the much discussed but seemingly untouchable "third rail".


The problem with policy.  Found this at MR.