Monthly Archives: October 2013

Greenspan and the Housing Bubble

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Scott Sumner writes,

I really don’t care whether money was about right during 2005-06, or slightly too easy. Either way it wasn’t at all unusual compared to earlier periods of our history. Indeed during most of my life policy was far more expansionary during cyclical expansions than 2002-06.

John Taylor and some libertarian/Austrian economists judget Alan Greenspan as guilty for greatly exacerbating the housing bubble by keeping interest rates too low for too long. Scott Sumner exonerates Greenspan. I do, too, although for a very different reason. Sumner’s argument is that nominal GDP was not so far out of line. That is a fair point.

I would say that I find the strength of the link that Taylor finds between the Fed Funds rate and the housing market to be implausibly strong. The interest rates faced by borrowers are determined in the bond market, and the Fed’s influence there tend to be weak.

The other argument comes from the left, where it is suggested that Greenspan’s benign view of the markets blinded him to the excesses in credit creation that were fueling the bubble. In hindsight, this argument is compelling. Knowing what we know now, we can say that the Fed should have questioned the AAA ratings of securities backed by sub-prime loans, stress-tested banks on their exposure to a decline in house prices, and yelled “Danger!” about the collapse of credit standards at Freddie Mac and Fannie Mae. However, back when it mattered, in 2005 and 2006, not even the Bakers and the Shillers and the Krugmans who were talking about a housing bubble were recommending those actions.

Land Price Appreciation and Consumption

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David Altig writes,

why should there be a “wealth effect” at all? If the price of my house falls and I suffer a capital loss, I do in fact feel less wealthy. But all potential buyers of my house just gained the opportunity to obtain my house at a lower price. For them, the implied wealth gain is the same as my loss. If buyers and sellers essentially behave the same way, why should there be a large impact on consumption?

This was the crux of his blog post, although he later crossed it out because a colleague suggested it was oversimplified. Pointer from Mark Thoma.

Some comments:

1. When land prices rise, we are looking for asymmetries between the behavior of the winners from higher land prices (home owners) and the losers from higher land prices (non-owners). Conversely, when land prices fall, the winners are non-owners and the losers are owners. If the winners and losers behave symmetrically, then the effect on overall consumption should not be large.

2. As Altig points out, it could be that access to credit behaves asymmetrically. Owners experience large swings in access to credit to finance consumption via home-equity extractions, while non-owners do not experience such swings.

3. There may be a Shillerian channel, based on expectations of house price changes. That is, the effect of past changes in house prices is symmetric. However, as prices rise, owners tend to be people with high expectations for future price increases. They expect their wealth to rise, and they spend some of these anticipated gains. If non-owners had similar expectations of rising land prices and were symmetrically concerned about future increases in their living costs as a result, then they would save more. But they are not symmetrically concerned.

4. If we get out of the AS-AD framework and into the PSST framework, a broad-based land-price bubble might be less distorting than an uneven land-price bubble. A broad-based bubble creates too many real estate agents, mortgage loan officers, and homebuilders. An uneven bubble causes all sorts of ancillary businesses to locate differently. Entrepreneurs open restaurants and high-end shopping centers in booming areas*, and then when the bubble bursts they are stuck with bad investments.

*But why are they not closing such businesses in lagging areas?

Jeffrey Friedman on Voter Ignorance

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He writes,

the libertarian conclusion does not follow from the rational ignorance premise. Rational ignorance theory blames public ignorance on the low incentive to become a well-informed voter. Raise the incentives and you solve the problem. One way to raise the incentives would be to make government far more powerful than it now is, so that everyone had a much higher stake in electoral outcomes. Another solution would be to turn state power over to highly knowledgeable experts who would be fired or even fined if their policies didn’t work.

Yet another solution was suggested by Bryan Caplan: pay voters to become informed.

While voter ignorance is a problem for fans of democracy, it is not an insurmountable problem. Elite hubris is the killer. Yes, voters think they know more than they do about public policy. But elites also think that they know more than they do. And it is the elites who end up more dangerous. Read Jeffrey Friedman’s whole essay.

Ideology and Macroeconomics

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Scott Sumner writes,

I am amazed by how many proponents of fiscal policy don’t understand that it’s symmetrical. Fiscal policy doesn’t mean more government; it means more government during recessions and less government during booms, with no overall change in the average level of government. Anyone who doesn’t even get to that level of understanding, who doesn’t think in terms of policy regimes, is simply not part of the serious conversation.

I agree with the first two sentences, but not with the last.

Yes, in theory, there should be economists who, as they argued for more stimulus in 2009, should at the same time have been arguing for entitlement reform or other reductions in future spending. Other things equal, the bigger debt that we have accumulated over the past five years would make a non-ideological macroeconomist want to propose tighter fiscal policy somewhere down the road.

But “nonideological” and macroeconomics are nearly oxymorons. Name a prominent economist who believes that fiscal expansion is important during recessions and who also is to the right of the median economist on issues like school choice or taxing the rich or the usefulness of regulation. Or try to name a prominent economist who is to the left of the median economist on those issues and who does not believe that fiscal expansion is important.

I know that I was more to the left generally 30 years ago, and I was a confirmed Keynesian. I am more to the right today, and I am a skeptic of Keynesianism.

I do not think that being on the left (right) on other issues necessarily causes you to be a supporter (skeptic) of Keynesianism. However, I do think that people try to avoid affiliative dissonance and cognitive dissonance.

Cognitive dissonance is an issue because if your general view is that market failures are small and difficult for government to correct, then it is hard to fit Keynesianism in with that belief. If your general view is that market failures are significant and require government intervention, then it is hard to fit the skepticism toward Keynesianism in with that belief.

Affiliative dissonance is my own expression. It just means that if the people with whom you feel an affinity on issues W, X, and Y take a position on issue Z with which you disagree, that makes you uncomfortable. Other things equal, this will make it easier to get you to change your mind on issue Z.

We know from Daniel Kahneman (and others) that we are good at rationalizing opinions that may be arrived at on the basis of intuition. I am not saying that therefore we will never find truth in macroeconomics. What I am saying is that if you close your ears every time you detect someone’s ideology embedded in what they say about macroeconomics, then you will not hear anything.

Some Important Principles of Economics

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What would I consider to be some important principles of economics that I want my students to walk away with?

1. Market processes promote long-term growth. The market processes of specialization, exploiting comparative advantage, and creative destruction have benefits that are widely dispersed in the long run. These processes impose short-term costs on those who have invested in physical and human capital made obsolete.

2. Competition is a regulatory mechanism. For example, the ability of a business to exploit consumers or workers is attenuated by competitive forces. Businesses do not like competition. They lobby for policies that stifle competition. Often, such lobbying is successful. Competition is far from perfect as a regulatory mechanism. It is possible to be too optimistic about how well it can work. It is also possible to be too optimistic about the prospects for fixing the flaws in markets using government regulation.

3. Human cooperation is difficult to achieve. The conditions under which large organizations can operate without internal friction are never satisfied. Aligning incentives is more difficult in the real world than it might appear to be in the abstract.

4. Economists need two hands. The conditions under which markets will produce optimal outcomes are never satisfied. The conditions under which a government official can act as an omniscient, benevolent central planner are never satisfied.

Two Types of Confidence

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Watch this video of Robert Shiller from a few years ago.

Source here. Pointer from Tyler Cowen.

Shiller’s body language, speaking style, and content suggest discomfort. He is like a kid (and of course he has very boyish looks for someone in his 60s) talking about why he never gets picked by the other kids to play in team games at recess.

And yet, when I showed the video to my students, one of them reacted by saying that Shiller seemed arrogant. And I think there is something to that, as well.

Contrast the confidence of Stanley Fischer, the voice of authority. Fischer knows that when he speaks, respectable macroeconomists stand with him. Over the years, he had make-or-break power over the careers of most of them.

Shiller has a different type of confidence. His is the confidence of the boy who sees the naked emperor. He has found what he is pretty sure are fundamental flaws with the mainstream world view.

So, there is establishment confidence. That is the confidence that you have the establishment with you, agreeing with your world view and respecting your power. Then there is outsider confidence, the confidence that you have in your ideas and a belief that it is better to be a low-status person with good ideas than a high-status person with mainstream ideas that are not as good.

It is easy for me to see Timothy Geithner not wanting to have Shiller in the room. Geithner has establishment confidence, which is threatened by outsider confidence.

Having said that, I myself am not heavily influenced by Shiller’s ideas. In finance, I like Frydman and Goldberg’s critique of rational-expectations modeling. In particular, different people are bound to have different information and different models. In macro, I am inclined toward a Schumpeterian story of difficult adjustment to changes in productivity in different sectors. However, if you want tell an aggregate-demand story, then I am with Shiller that “animal spirits” sounds like a better place to start than the Euler equation of a single representative consumer/worker.

Why Public Choice Matters

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Reihan Salam writes,

And so Gyourko calls for replacing the FHA with a subsidized savings program aimed at helping low-income borrowers accumulate a 10 percent down payment, a policy he describes as preferable for a number of reasons…

2. Focusing on borrowers helps ensure that benefits will flow to the intended beneficiaries rather than realtors and homebuilders.

From a public choice perspective, the realtors and the homebuilders are the intended beneficiaries. People with modest incomes are what Thomas Sowell calls the mascots for the policy. The housing lobby isn’t going to come out and say that they engaged in rent-seeking. They tell you that if you abolish FHA, you will be depriving people of the American Dream™.

Quality, Features, and Schedule

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From the book Lost Moon, retitled Apollo 13 after the movie was made:

Apollo was downright dangerous. Earlier in the development and testing of the craft, the nozzle of the ship’s giant engine…shattered like a teacup when engineers tried to fire it. During a splashdown test, the heat shield of the craft had split open, causing the command module to sink like a $35 million anvil to the bottom of a factory test pool. The environmental control system had already logged 200 individual failures the spacecraft as a whole had accumulated roughly 20,000.

In January 1967, one of the first Apollo spacecraft caught fire during an on-the-ground test, killing astronauts Gus Grissom, Ed White, and Roger Chaffee. At that point, NASA decided that quality was more important than schedule and they overhauled the Apollo project (although they still managed a moon landing 2-1/2 years later).

In some ways, the rollout of the Obamacare web site is reminiscent of this. The hurried schedule appears to have hurt quality. The rational thing to do now would be to let the schedule slip and resolve the quality issues.

Speaking of which, here is one recent report.

Recent changes have made the exchanges easier to use, but they still require clearing the computer’s cache several times, stopping a pop-up blocker, talking to people via Web chat who suggest waiting until the server is not busy, opening links in new windows and clicking on every available possibility on a page in the hopes of not receiving an error message. With those changes, it took one hour to navigate the HealthCare.gov enrollment process Wednesday.

Those steps shouldn’t be necessary, experts said.

Neither was the last sentence.

The Tea Party

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William Galston has some facts.

Many frustrated liberals, and not a few pundits, think that people who share these beliefs must be downscale and poorly educated. The New York Times survey found the opposite. Only 26% of tea-party supporters regard themselves as working class, versus 34% of the general population; 50% identify as middle class (versus 40% nationally); and 15% consider themselves upper-middle class (versus 10% nationally). Twenty-three percent are college graduates, and an additional 14% have postgraduate training, versus 15% and 10%, respectively, for the overall population. Conversely, only 29% of tea-party supporters have just a high-school education or less, versus 47% for all adults.

Although some tea-party supporters are libertarian, most are not. The Public Religion Research Institute found that fully 47% regard themselves as members of the Christian right, and 55% believe that America is a Christian nation today—not just in the past. On hot-button social issues such as abortion and same-sex marriage, tea partiers are aligned with social conservatives. Seventy-one percent of tea-party supporters regard themselves as conservatives.

Galston also has delivers some insinuations and assumptions. In particular, he assumes that the the Tea Party movement is some sort of dysfunctional emotional reaction and that the establishment is correct on the fundamental policy issues.

It is possible that this view is correct. However, the probability is not zero that the establishment view on the budget (spend more now; the future will take care of itself, or brilliant health care technocrats will take care of it, or something) is more dangerous than the view of the Tea Party. In fact, the establishment strikes me as suffering from a dysfunctional emotional reaction every time the topic of future budget commitments is brought up.

Conflict of Interest in Mortgage Lending and the Role of Regulation

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I received some pushback on this post. This is a response.

There is a narrative of the housing bubble/crash which tries to fit it into a neat oppressor-oppressed model. Greedy banks exploited naive borrowers in an era of libertarian deregulation. Emotionally, it as a satisfying story. Analytically, it is not. Here is why.

There are conflicts of interest between borrowers and mortgage originators, and there are conflicts between originators and investors. The financial crisis was created by the latter, not the former.

The main conflict of interest between borrowers and originators is that it is almost always in the interest of the mortgage originator to induce the borrower to pay an excessive fee and/or interest rate.

In my view, this conflict was not much of a factor in the housing crisis. The vast majority of the defaults were the result of the collapse of house prices, not the cost of mortgage loans.

Nonetheless, I have spent a lot of time thinking about this conflict and how to deal with it, because it bothers me that the most vulnerable people are the ones who are most likely to get ripped off. I do not think that market competition works very well to protect consumers, because a sophisticated lender can make it appear that he is offering the most competitive rate and then turn around and rip off the consumer. I do not think that letter-of-law regulation works very well, because you can never close all of the loopholes.

One possibility would be reputation systems. If an entity like Consumer Reports were to rate lenders and loan offerings, and enough consumers use that entity, then bad actors would be driven out of the lending market. Unfortunately, the most vulnerable consumers do not use these sorts of consumer rating services, so I do not think that solution will work.

The other possibility is principles-based regulation. Audit firms to ensure that their products, policies, procedures, and internal incentives are designed not to exploit vulnerable consumers.

The oppressor-oppressed narrative has lenders giving loans to borrowers when the lenders should know better but the naive borrower does not realize that he or she should not be getting the loan. Some comments on this.

1. Lenders are not omniscient. They make mistakes. A Type I error is making a loan that you think will be repaid, and it turns out to default. A Type II error is turning down a loan that would have been repaid. Until 2007, the main oppressor-oppressed narrative was that lenders were making Type II errors, particularly with respect to minorities. That is, the evil lenders were turning down too many good borrowers. When the crisis hit, the oppressor-oppressed narrative suddenly became the opposite. Lenders supposedly forced loans on unwitting borrowers who could not pay them, and we need to regulate lenders to make sure this never happens again. That is, originators deliberately committed Type I errors.

2. Under the old-fashioned originate-to-hold model, there is never an incentive for lenders to make loans that will not be repaid. You lose money on those loans. In this model, the bank pays its loan origination staff not on sheer volume, but on quality decisions, including rejecting loans as warranted.

3. On the other hand, with securitization, the originator’s idea of a good loan is any loan that can be sold to an investor, without regard to whether it can be repaid. When you deny a loan application, you cannot possibly make money on it. If you approve the loan and it cannot be repaid, that is someone else’s problem. This is primarily a conflict of interest between originators and investors, not between borrowers and lenders. At Freddie Mac, this conflict of interest occupied us constantly. Trying to keep originators from funneling bad loans to us drove enormous amounts of our staff time, business functions, policies, procedures, and contractual arrangements.

4. One of the illustrations of the conflict between originators and investors is that loan applications often include fraud and misrepresentation. The most common examples include over-stating the borrower’s income and/or lying about whether the borrower is going to occupy the home. Income misrepresentation is often initiated by the originator, trying to “help” the borrower get a loan. Occupancy fraud, on the other hand, is almost always initiated by the borrower. It can be hard for the originator to prevent this fraud, because it only becomes clear after the loan has been sold that the borrower never intended to occupy the home and instead is a speculator.

Taking all this together, I do not find the story of deregulation leading to the housing crisis to be very compelling. The main conflict of interest that caused the problem was the conflict between originators and investors. Basically, originators were able to foist bad loans on investors. This is not a case of the rich and sophisticated taking advantage of the poor and naive. On the contrary, the typical originator is a low-class guy working for a poorly-capitalized company in a highly competitive business. The typical investor is a sophisticated money manager.

Regulation was part of the problem, not part of the solution. The regulators’ perverse risk-based capital requirements encouraged the risk-laundering AAA-rated tranche business. And their attack on Type II errors prior to the crisis was at worst a major cause of the crisis and at best spectacularly poorly timed.