Financial Pneumonia (Mark Thoma & Scott Sumner)

[Bloggingheads]

[claymisher]

This is the econ diavlog everybody has been asking for!

[Markos]

I like this.
I just wish I could understand it much better than I do.

[Markos]

I hope these two do more bloggingheads tv.

[a Duoist]

When did either of these economists, between 2003-07, point out the terrible hazards being assembled in the housing sector of the American economy? Which of them became infamous for standing up to Mr. Barney Frank, pointing out the certain exploding results of Fannie and Fred hitting leverage in their capitalizations of 300 to one?

Monday morning quarterbacks. How non-illuminating.

These guys don't sound like they are economic forecasters. They appear to only study the economy after-the-fact. Unless they were doing some government or private work on the side, they probably weren't trying to predict the future at the time.

However, there probably were economic forecasters who were telling their bosses the sky was going to fall, but they are not the decision makers in the corporate world; the corporate officers and board of directors are. Many corporate leaders probably didn't listen very closely to what some of their economists were probably telling them.

[Stapler Malone]

Thanks to both these new 'heads.

I'm usually reeling in confusion when BhTV has these chewy econ-vlogs, but both Scott and Mark managed to keep it comprehensible to a layman like me. I think the Quantitative Easing section marked the first time I've got my arms around what that means (with an assist from Wiki).

Come back soon now, y'hear!

[x9#z6]

Great analogy by Mark Thoma. Let's consider his example further. Each car, if it functions properly, is worth $20,000. Like Mark says, some unknown number of cars are total trash and are worth $0. There is 1000 cars in total.

Nobody knows for sure how many are trash but the guess from market wizards is 700. Therefore, to buy the lot, investors will pay $6,000 per car. However, the banks claim (hope!) that only 200 cars are trash and therefore, they won't sell for less then $16,000 per car. So what is Geitner's plan. In a nutshell the government bridges this difference by saying to investors, if you put in just $3,000 per car we'll cover the other $13,000 and when you sell we'll split the difference. So how does everyone make out if the market is right and 700 are trash and the investors sell for $6,000:

investors=push; banks=+$10,000; government=-$10,000

Big win for the banks and big loss for us. Ok, what if the banks are right and only 200 cars are trash and the investors sell for $16,000:

investors=+$5,000; banks=push; government=-$5,000

Big win for investors and another big loss for us. See a pattern here. Heads we lose and tails we lose. There's another name for this plan it's called theft.

[rfrobison]

You may well be right, but what's the alternative, realistically speaking? Let the bankers keep sitting on their hands while the economy strangles for lack of credit? That doesn't seem like a very good option either.

[bjkeefe]

Very informative diavlog. Thanks to Scott and Mark.

Scott's idea at the very end of the diavlog about deposit insurance actually increasing risk was a new thought to me. As he said, we're not going to go away with those programs anytime soon, but I did like the idea that new regulations try to emulate, for bankers, this sense of working without a net, with the hope that it would make them more prudent.

Somehow, we've got to figure out some ways to make people in the financial services industries have some real skin in the game.

[rfrobison]

Originally Posted by bjkeefe

Very informative diavlog. Thanks to Scott and Mark.

Scott's idea at the very end of the diavlog about deposit insurance actually increasing risk was a new thought to me. As he said, we're not going to go away with those programs anytime soon, but I did like the idea that new regulations try to emulate, for bankers, this sense of working without a net, with the hope that it would make them more prudent.

Somehow, we've got to figure out some ways to make people in the financial services industries have some real skin in the game.

This is the essence of the "moral hazard" dilemma that economists refer to. The textbook example is that of fire insurance: If you know your house is fully insured you may be inclined to take risks you might otherwise avoid, making a house fire more likely.

One idea doing the rounds is to make some significant portion of executive pay contingent on, say, five-year performance benchmarks rather than the next quarter or next year. Compensation could come in the form of vested stock, for example, cashable after five years.

I'm not qualified to say whether that would help align incentives with sounder financial conduct, but intuitively it makes sense to me.

[bjkeefe]

Originally Posted by rfrobison

This is the essence of the "moral hazard" dilemma that economists refer to. The textbook example is that of fire insurance: If you know your house is fully insured you may be inclined to take risks you might otherwise avoid, making a house fire more likely.

One idea doing the rounds is to make some significant portion of executive pay contingent on, say, five-year performance benchmarks rather than the next quarter or next year. Compensation could come in the form of vested stock, for example, cashable after five years.

I'm not qualified to say whether that would help align incentives with sounder financial conduct, but intuitively it makes sense to me.

I've heard the long-term/vested option, too, and like you, it sounds good to me based on mostly intuition. I'd also like to see some sort of mechanism that makes them suffer some of the losses, and for people who trade stocks, I'd like to see removal of incentives to churn.

I also still fail to see why capital gains can't be taxes the same as regular income, maybe with a few very narrowly defined exceptions to keep people from getting killed when they sell their primary domicile, say, but that's another fight.

[ledocs]

This does look interesting. I don't have time to pay as much attention to it as it requires right now, so I'll try to weigh in in about a week. They sure weren't talking down to us laypeople.

I'll just say one thing that I noticed about the U. Oregon guy's intro. He went through a litany of real estate professionals who had no incentive to put the breaks on the bubble. And there he is absolutely right, of course. But what he may not realize is that there is no *theoretical* mechanism for appraisers to put the breaks on a bubble. The whole idea of appraisal is just to report what the market is doing. Making the call on whether appreciation is reaching bubble proportions is "above the pay grade" of appraisers. I was a professional appraiser of commercial real estate. The whole profession is a theoretical joke, as far as I am concerned, and this fact played a minor role in my early retirement. But anyway, there need to be people with political power, guts, and both theoretical and practical acumen to put the breaks on a bubble, because investors won't do it, since the greater fool theory seems to work until the music stops, and appraisers won't do it, *because they can't,* they have no power, they are compromised by their sources of revenues, and, most importantly, they can't do it because appraisal "theory" does not allow it. My guess is that this fellow does not realize this, but it's a very important point that contributed heavily to the market failure, because people have the crazy idea that appraisers are in a position to halt a bubble. They are not. What could work is to have people with power look at price appreciation with a critical eye and then have mechanisms in place to do something about it, when it is getting out of hand, things like requiring higher equity ratios for purchases in a market that has appreciated by more than, say, six percent, for some number of consecutive years. This would stop a bubble in its tracks. It would be just like raising margin requirements, which is what many think Greenspan should have done to slow down the stock market bubble.

[bjkeefe]

Originally Posted by ledocs

... there is no *theoretical* mechanism for appraisers to put the breaks on a bubble. ...

Interesting post, ledocs. Thanks.

I'd add to your proposals of ways to implement brakes for real estate bubbles threatening to grow to dangerous sizes this: revamp the tax structure so that flipping houses is not a privileged way to make money. As I understand it, profit from selling a house is considered a capital gain (not regular income), and unlike the way it used to be, people can now make these protected gains early and often, on sales not involving their primary residences.

Seems to me if there were less incentive to try to get rich quick by buying and selling houses as fast as one could while the market is perceived to be climbing, we'd remove some of the impetus that pushes it to unnatural heights.

[bkjazfan]

I didn't understand a word they said. Having never taken a class in business and economiocs doesn't help. I have read a bunch of material on econ but this conversation along with practically everything Megan McArdle says (splitting up a mansion) goes right over my head.

What I do know is the usual: 50% drop in S & P, unemployment going up, taxes and prices doing the same in California, and fairly well versed on the de-industrialization taking place and how it effects many industries, the auto being the prime example of that now.

What bothers me for being a person raised in the 50's and 60's is the price of everything now compared to then. My dad made hardly any money but we had a small tract home with a family of 5. Also, the choices to spend money on was so limited for a youngster as it isn't now.

Another sore spot is the middle class job base becoming more scarce. For example, what is a middle aged, out of work, former blue collar worker suppose to do? Retrain for what? Not only that but as a teen I never had a problem finding a job now I don't think that is the case.

John

[rfrobison]

Originally Posted by bjkeefe

Interesting post, ledocs. Thanks.

I'd add to your proposals of ways to implement brakes for real estate bubbles threatening to grow to dangerous sizes this: revamp the tax structure so that flipping houses is not a privileged way to make money. As I understand it, profit from selling a house is considered a capital gain (not regular income), and unlike the way it used to be, people can now make these protected gains early and often, on sales not involving their primary residences.

Seems to me if there were less incentive to try to get rich quick by buying and selling houses as fast as one could while the market is perceived to be climbing, we'd remove some of the impetus that pushes it to unnatural heights.

Interesting you should mention capital gains on housing. There was an op-ed in the Wall Street Journal yesterday http://online.wsj.com/article/SB123897612802791281.html that cites the exemption of capital gains on housing up to $500,000 in 1997 as a contributing factor in the bubble. That may need to be revisited. I would go further and say the mortgage interest deduction should probably be phased out as well (Though that's no silver bullet. The Economist pointed out in a recent article that Britain has no such deduction and that didn't stop a bubble from forming there.)

[bjkeefe]

Originally Posted by rfrobison

... Though that's no silver bullet. ...

No, there never will be one. As long as we have anything resembling free markets, there will be booms and busts, if the past four centuries are anything to go by.

[Gravy]

It is ridiculous to assume that it is impossible to know which cars on the lots aren't in working order. This is a myth spread by banks and bond investors. These assets are very well defined, but they are complex. But their complexity is no higher today than it was when they were created and then purchased. The current owners of these assets know perfectly well how they are performing and have all the necessary macro data to give rational ranges on their future expected performance. But they are holding out with the hope (expectation?) that the Obama plan - let's stop kidding ourselves that Sec. Geithner calls the shots, please - will come along to recapitalize them by the magic of overpaying. So it is incredibly convenient for them to encourage the view that a real market cannot develop since the assets are too hard to understand, since selling it for what they are worth is anathema to them. Hence the need for the government (you and me, by the way) to come in with the "deep pockets" and different "risk profiles". In otherwords, we will be dumb enough to protect Obama's peeps in the banking and bond communties.

[graz]

Originally Posted by Gravy

It is ridiculous to assume that it is impossible to know which cars on the lots aren't in working order. This is a myth spread by banks and bond investors. These assets are very well defined, but they are complex. But their complexity is no higher today than it was when they were created and then purchased. The current owners of these assets know perfectly well how they are performing and have all the necessary macro data to give rational ranges on their future expected performance. But they are holding out with the hope (expectation?) that the Obama plan - let's stop kidding ourselves that Sec. Geithner calls the shots, please - will come along to recapitalize them by the magic of overpaying. So it is incredibly convenient for them to encourage the view that a real market cannot develop since the assets are too hard to understand, since selling it for what they are worth is anathema to them. Hence the need for the government (you and me, by the way) to come in with the "deep pockets" and different "risk profiles". In otherwords, we will be dumb enough to protect Obama's peeps in the banking and bond communties.

It seems we will be paying either way. If we don't overpay with the largesse to the banks and bond holders, with the goal of increasing liquidity... then we have to face that they are insolvent, which will require Nationalization and fire sale on the fragments. Is there a definitive case for the second way to be more cost effective or less painful to the taxpayers?

thanks to mark for the excellent geitner plan explanation

Very informative. To hear two economists express doubts about their ability to predict the future was refreshing. Right now there are too many prophets of doom and too many Dr Panglosses ready to proclaim this the best of all possible worlds.

There is an old Arab saying I recently came across in an article by a British economist that says it all: “All who claim to see the future are lying, even if by chance they are later proved right.”