I currently teach several sections per year of economics for MBA students. My MBA students are a joy to teach: they are energetic, curious, engaged, and motivated. (And even better, they laugh at my jokes. Most of the time.)
But this term, even before the first midterm exam, there has been some sotto voce grumbling.
Why is he messing around with indifference curves when financial history is being made? When the World As We Know It is Ending?
I know. I'm finally interested in economics and want to learn what's going on, but Newmark's doing . . . other stuff.
My defense, which I plan to offer my students this week, is two-fold:
1. My university has a fine finance faculty--the MBAs will take at least one course in finance--and it seems both proper and efficient to let those folks discuss the issue.
2. It's too early. A lot of what we--economists as well as everybody else--think we know about the current trouble could change depending on what happens in the months and years to come.
But perhaps those are cop-outs. And there is one economics-related aspect of the mess that I am intensely interested in, even if I'm far from the best person to address it.
There will be a huge fight, just as there was about the Great Depression, over whether the current mess was caused by "free markets". The sneering and jeering have already begun: "The Free Market: A False Idol After All?" (Peter S. Goodman, NY Times); "Americans May Be Losing Faith in Free Markets" (Peter G. Gosselin, LA Times); "Capitalism's Reality Check" (E. J. Dionne, Washington Post).
It is hard to overstate how important the outcome of this fight will be for public policy in the United States and throughout the world. And while, as noted, it's early, let me declare my bias: by instinct, training, and experience, I believe free markets work well the vast majority of the time. To coin a phrase, based on one from one of my favorite authors, Ernest Hemingway, "Markets are a fine thing, and worth fighting for."
[Digressive rant: by "free market" I mean the institution as understood by scholars from Adam Smith to Milton Friedman and beyond, not the grotesque caricature offered by some people today.
Don't free markets require at least some laws to operate?
Wouldn't markets utterly collapse without government rules and regulations?
Financial markets in particular have always required a huge amount of regulation to operate. Where's your "free market" now, Monkey Boy?!
Answer: yes, markets usually require some laws and some government. Confidence in free markets does not imply a preference for anarchy. The question, as always, is how many laws and what kinds, and how much government and what kind. Are we clear, now?]
So here are more than two dozen links that I'll use for a projected 15-minute talk to my MBA students that primarily relate to that issue. They advance what seems like sound reasons why, at the very least, government has been heavily involved in creating the problem. I've made no attempt to be complete or "fair". These are just links that I think are interesting or useful or both. They may not even be the best links I've seen recently; they're just ones I could gather quickly on a Sunday morning when I should be doing other things.
Some government-related causes
1. "Anatomy of a Train Wreck: Causes of the Mortgage Meltdown" (Stan Liebowitz). Concise summary (John R. Lott, Jr.).
The federal government has pursued the objective of "increasing homeownership" for a long time. Pursuit of that objective really picked up steam in 1992 after a study by researchers at the Boston Fed supposedly found systematic discrimination by mortgage lenders. But the study was flawed, and the pursuit of the objective was largely misguided. Poorly-chosen government, actions helped cause, therefore, the vast increase in mortgage lending to people who turned out to have trouble repaying, lending that sparked the problem.
2. "The Subprime Mortgage Market Collapse: A Primer on the Causes and Possible Solutions" (Ronald D. Utt).
There would have been less interest in making houses "affordable" if they hadn't been so freakin' expensive in places. Why were they? Amidst much other detail on the history and causes of our current problem, Utt states (pp. 14-15) that local land-use regulations helped propel house prices higher.
3. "Time to Break Up the Credit Rating Cartel" (Mike "Mish" Shedlock).
4. "The subprime turmoil: What’s old, what’s new, and what’s next" (Charles W. Calomiris).
Not only were a lot of lousy mortgages written, they were securitized and "tranches" of the securities were rated investment grade by Standard & Poor's and Moody's. Some of those ratings turned out to be grossly wrong. Why did the ratings agencies fail? Shedlock points to a 1975 SEC mandate that debt be rated by a Nationally Recognized Statistical Rating Organization. The effect, he argues, was to constrain competition in the ratings market and to distort the incentives of the ratings agencies. (Note that Arnold Kling disagrees that that was a cause.) Calomiris points to distorted incentives caused by the Basel I and II capital requirements and to 2005 and 2006 actions by the Congress and the SEC that encouraged ratings inflation.
5. "The Mark to Market Fiasco" (Terence Corcoran, Financial Post).
Attempting to fix a previous alleged debacle of the market , the collapse of Enron, and strongly encouraged by Congress, the FASB adopted "mark to market" rules. Which are probably fine, ordinarily. But what about during extraordinary times, when there is little or no trading, and "market price" is difficult to determine? Might not the rules add gasoline to the fire? Corcoran relates that a number of central bankers warned of potentially serious problems. (Art DeVany agrees the rules contributed to the problem; Daniel Gross sharply disagrees.)
No surprise: people respond to incentives.
". . . regulation and/or accounting rules are the most fertile breeding ground for derivatives and synthetic or packaged securities. Regulations and accounting rule-inspired transactions describe the bulk of the well known derivative-related blow-ups of the last two decades. Proscriptive regulation and the derivative trade have a symbiotic relationship. . . .
"Complicated rules encourage complex transactions that seek to conceal or re-shape their true nature. Regulated entities create demand for complex derivatives that substitute proscribed risks for admitted risks. If a new risk is identified and prohibited, the market starts inventing instruments that get around it. There is no end to this process. Regulators have always had this perversely symbiotic relationship with Wall Street. . . .
"Regulations that focus on complete disclosure are much more effective than those that attempt to dictate behavior, and they impose less of a burden on the regulated entity."
7. "Too Few Regulations? No, Just Ineffective Ones" (Tyler Cowen).
Like the piece above, Cowen argues that regulations, themselves, induce a lot of problems. He also notes that "it's not obvious that the less regulated financial sector performed any worse than the highly regulated housing and bank mortgage lending sectors, including, of course, the government-sponsored mortgage agencies."
Not a cause: repeal of Glass-Steagall
8. "Glass Steagall: The Real History" (Alex Tabarrok).
9. "Clear as Glass-Steagall" (Megan McArdle).
The repeal of Glass-Steagall, which separated investment banking and commercial banking, did not play a role. McArdle concludes:
"If Glass-Steagall's repeal had meaningfully contributed to this crisis, we should see the failures concentrated among megabanks where speculation put deposits at risk. Instead we see the exact opposite: the failures are among either commercial banks with no significant investment arm (Washington Mutual, Countrywide), or standalone investment banks. It is the diversified financial institutions that are riding to the rescue."
A warning to fans of excessively big government: what became of Fannie Mae and Freddie Mac
10. "Andrew Cuomo and Fannie and Freddie" (Wayne Barrett, Village Voice[!])
11. "Fannie Mae and the Vast Bipartisan Conspiracy" (Jack Shafer).
12. "How Washington Failed to Rein in Fannie, Freddie" (Binyamin Applebaum and others, Washington Post).
13. "Where Was Senator Dodd?" (Al Hubbard and Noam Neusner).
14. "Freddie Mac and Fannie Mae: An Exit Strategy for the Taxpayer" (Arnold Kling).
Even if--and it seems like a big "if" now--the federal government should have encouraged home ownership, and even if--ditto--Fannie Mae and Freddie Mac were the appropriate means to do so, the two agencies were deeply corrupted by politics. There are many more articles I could have linked to that make the same point. The problems were well-known, but Congress and the agencies simply wouldn't correct them. A fine example of "public choice".
15. Anatole Kaletsky, London Times.
And the government may have converted a problem into the imminent threat of a meltdown by fixing, way overdue, Fannie Mae and Freddie Mac.
“What triggered this change was the US Government's ‘rescue’ of the Fannie Mae and Freddie Mac mortgage companies. This rescue was actually more of an expropriation.”
What is to be done?
16. "Welcome to History" (Jim Manzi).
I like Manzi's conclusion: there are terrible potential problems with past and current government bailouts, as well as with the likely future ones. But sometimes ideology has to be set aside, and we must pick, reluctantly, a bad action over an even worse result.
"Against all of this we have one huge consideration. If investors lose confidence in the safety of money market funds, mutual funds, demand deposit accounts and the other storehouses of value in the modern economy, we would have a problem that would make somewhat higher taxes and moral hazard seem like child’s play. Trust me — you do not want to experience a full-scale bank run in contemporary America."
17. "Why Paulson is Wrong" (Luigi Zingales).
18. "Hindsight regulation" (Megan McArdle).
19. "Modern Financial Systemic Risk: A Primer" (Arnold Kling).
20. "The Real Impact of the Plan" (Michael Mandel).
That said, Zingales--Robert C. McCormack Professor of Entrepreneurship and Finance at the U. of Chicago Business School--sharply criticizes what's brewing. The other pieces also look at potential problems. Smith points to a really scary-sounding part of the current proposal.
22. The Subprime Solution (Robert J. Shiller).
I've only read the summary. But it's probably worth reading because it seems as though Shiller has been right about a lot recently.
Finally, we should laugh, at least a little
Number 1. Lender of Last Resort: Oprah.
UPDATE: ten additional links are in a later post.