Why Didn't We Stop the Market's Chain of Events?

Calculated Risk issues an invitation:

Calculated Risk: Hoocoodanode?: Earlier today, I saw Greg "Bush economist" Mankiw was a little touchy about a Krugman blog comment. My reaction was that Mankiw has some explaining to do. A key embarrassment for the economics profession in general, and Bush economists Greg Mankiw and Eddie Lazear in particular, is how they missed the biggest economic story of our times.... This was a typical response from the right (this is from a post by Professor Arnold Kling) in August 2006:

Apparently, the echo chamber of left-wing macro pundits has pronounced a recession to be imminent. For example, Nouriel Roubini writes, "Given the recent flow of dismal economic indicators, I now believe that the odds of a U.S. recession by year end have increased from 50% to 70%." For these pundits, the most dismal indicator is that we have a Republican Administration. They have been gloomy for six years now...

Sure Roubini was early (I thought so at the time), but show me someone who has been more right! And this brings me to Krugman's column: Lest We Forget

... Why did so many observers dismiss the obvious signs of a housing bubble, even though the 1990s dot-com bubble was fresh in our memories? Why did so many people insist that our financial system was “resilient,” as Alan Greenspan put it, when in 1998 the collapse of a single hedge fund, Long-Term Capital Management, temporarily paralyzed credit markets around the world? Why did almost everyone believe in the omnipotence of the Federal Reserve when its counterpart, the Bank of Japan, spent a decade trying and failing to jump-start a stalled economy?

One answer to these questions is that nobody likes a party pooper.... There’s also another reason the economic policy establishment failed to see the current crisis coming. The crises of the 1990s and the early years of this decade should have been seen as dire omens, as intimations of still worse troubles to come. But everyone was too busy celebrating our success in getting through those crises to notice...

[I]n addition to looking forward, I think certain economists need to do some serious soul searching. Instead of leaving it to us to guess why their analysis was so flawed, I believe the time has come for Mankiw, Kling and many other economists to write a post titled "Why I was wrong".

Let me say what things I was "expecting," in the sense of anticipating that it was they were both likely enough and serious enough that public policymakers should be paying significant attention to guarding the risks that it would create:

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

or:

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

I was not expecting (2) plus:

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

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

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

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

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

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

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

We could have interrupted this chain that has gotten us here at any of a number of places. And I still am trying to figure out why we did not.

Comments

[ferguson:]

"We could have interrupted that has gotten us here at any of a number of places. And I am still trying to figure out why we did not."

The question assumes that life is essentially a rational process, that sufficient information is always available to all participants so that they can make rational judgments based on the information available, and that the consequence of past and current events is (if not perfect) at least highly predictable.

In fact, it appears to me that none of these assumptions is correct. Rationality is a vital treasure, but is no more than a thin veneer that overlays the struggle for life. Bill Clinton is a good example. George W. Bush is a good example of the abandonment of that veneer. Barack Obama gives every indication that he represents its restoration. Never-theless, it remains a veneer and, until, it is clearly established that rationality is in the ascendancy rather than decline, there will be great uncertainty about the future.

The lack of information upon which to make rational judgments is obvious. Those who were in the best position to understand what was going on (Henry Paulson and Ben Bernanke et al) continually told us that the sub prime mortgage problem would be "contained." And few people in the investment world had an interest in revealing to their customers the extent of the potential problems. They were all making too much money. Why kill the goose that layed the golden egg. The few who did smell a rat (John Paulson) were content to just make money or were hushed up (Peter Schiff, Nuriel Roubini).

When we judge what the future is going to be like, it would be nice to think that we could make rational judgments free of past experience. But, it would also be terrifying. To preserve sanity, we must assume that the future will be pretty much like the past. And "the past" no longer means 1,000 or even 100 years ago. Egged on by CNBC, MSNBC et al it means at most what happened last year or even last quarter. And, wince everyone was making a lot of money, why should we expect anything different?

If both Richard Rubin and Phil Gramm abandon both common sense and history in order to embrace deregulation, rationality is clearly not in charge and the financial system is a train wreck in the making.

The assumption of rationality is not sufficient to prevent it from happening. We need regulation that understands the irrational nature of things.

2008 Nov 30 10:15 AM

[ferguson:]

I have reread my above comment and realized that I could have said the same thing in fewer words by just noting that:

"The assumption of rationality behind the question raised is undermined by the fact that neither greed nor fear can be governed by rationality and that, consequently, the question does not apply to the world that drives markets. We need regulation that understands that greed and fear are what drives markets, not rationality."

2008 Nov 30 10:28 AM

[axelrod608:]

? Ever notice how irrational and dysfunctional behavior gets at a party where the drinks are free and unlimited ? Same thing happens when money and credit are easy, cheap and unlimited.

The people who were supposed to be our "leaders" weren't bright enough to figure out that all the gobbledegook coming out of Alan "Bubbles" Greenspin's mouth was, indeed, gobbledegook, not intelligent discourse.

Easy unlimited credit is a nice concept right up to the point where it has to be paid back. And, as Capt. Jack used to say when the last line was fastened, "Done reached".

2008 Nov 30 10:41 AM

[swaps:]

The ruling elites in economics and business generally put too much faith in the Federal Reserve Bank, which has replaced G-d. It is the dispenser of prosperity. It is the angry god who then raises interest rates to put people out of work, close down businesses and "kill inflation."

That latter comment though may be the key. Since the Federal Reserve Bank was created out of thin air in 1913 the value of a dollar has fallen to a nickle. A 95 percent drop in purchasing power.

With such relentless ongoing inflation constantly underway it was logical for all of us to assume the costs of housing would grow to the sky. We were like Pavlovian's dog, mentally conditioned.

Everyone should know that when the pundits on business tv praise the Fed as an inflation fighter they are speaking in code.

What happened was that the relentless inflation of the Fed ran head first into globalism, which has been working - through outsourced jobs, massive inflows of cheap labor and a general deconstruction of U. S. productive labor - to bring the U. S. wage structure down from its peak because a more level playing field is required for globalism.

Of course the people behind the Fed are globalists too. Its just that they were too stupid to get the big picture of what they were doing.

The result was massive deflationary holes in the all the major controlling puppeteer banks. The huge bailouts have attempted to fill these holes.

But the deflation of wages meant that workers could not keep up with what they were expected to pay for fuel, food or...homes.

The economists did not see this coming. Because they have been mesmerized into Fed fans.

Instead of constantly arguing whether the Fed should artificially manipulate the world by creating money out of thin air - and charging us and the government interest to boot - the argument should have been how quickly can The Fed be put out of business along with the racketeers who are part of it.

2008 Nov 30 03:50 PM

[Terry Mock:]

From Sustainable Land Development International November Newsletter
On Election Day: Balance in Contentious Times
www.sldi.org/newServic...

In what surely will be noted as one of the most remarkable stretches in history, we have had a collapse in the housing market, which triggered a meltdown in our financial systems, which has now created a slowdown in economies around the world -- all in short order. With all these financial woes weighing on investor confidence, I couldn’t help thinking of what President Thomas Jefferson said in 1802:

“I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all their property until their children will wake up homeless on the continent their fathers conquered.”

Fast forward to 2008, specifically to former Fed Chairman Alan Greenspan’s recent testimony to a House Oversight Committee hearing on the roles and responsibilities of federal regulators in the current financial crisis. He acknowledged to the hostile panel of questioners that the crisis exposed flaws in his thinking about the working of the free market system, telling the Committee that his belief that the banks would be more prudent in their lending practices because of the need to protect their shareholders had been proven wrong by the crisis.

This “once-in-a-century credit tsunami” has come to a head just weeks before the electorate goes to the polls to pick both local candidates for office and a new U.S. President. Whichever party wins will make history as well. The barrage of extraordinary events makes for fascinating times and presents a rare opportunity for strategic long term investment, according to seasoned experts such as Warren Buffett. But politically, it can be treacherous sledding, as personal angst and partisan fervor are unleashed full blast. In his Farewell Address, George Washington was particularly adamant in warning the nation that this “spirit of party” was “not to be encouraged” because it was - “A fire not to be quenched, it demands a uniform vigilance to prevent its bursting into a flame, lest, instead of warming, it should consume.”

T. Boone Pickens, Al Gore and the Sierra Club are creating strange bedfellows and setting an example of non-partisan collaboration by discussing the combination of domestic wind power and natural gas in an aggressive US domestic energy plan. In a related effort to provide a bridge from the current inefficient, carbon-heavy electric grid toward more sustainable development, SLDI-member HBH Gas Systems is partnering with land developers nationwide to provide central community propane gas systems - bringing clean-burning gas fuel to communities where it was otherwise not available.

Innovative collaboration is the answer. See the featured article at the above URL on the SLDI Pilot Sustainable Land Development Best Practices Model.

Your participation and comments are welcome.

Terry Mock
Executive Director
Sustainable Land Development International
SLDI.org
SLDTonline.com
SURmag.com

Promoting land development worldwide that balances the needs of people, planet & profit - for today and future generations.

2008 Nov 30 06:38 PM