AIG in Hindsight

That is the title of a new NBER working paper by Robert McDonald and Anna Paulson (ungated versions). They conclude,

Much of the discussion about the crisis has focused on liquidity versus solvency. The two cannot always be disentangled, but an examination of the performance of AIG’s underlying real estate securities indicates that AIG’s problems were not purely about liquidity. The assets represented in both Maiden Lane vehicles have experienced write-downs that disprove the claim that they are money-good. While it may seem obvious with the benefit of hindsight that not all of these securities would make their scheduled interest and principal payments in every state of the world, the belief that they could not suffer solvency problems and that any price decline would be temporary and due to illiquidity was an important factor in their creation and purchase.

My random comments:

1. This is valuable work. I am really glad to see a retrospective audit of this important bailout.

2. I view the conclusion as saying that this truly was a bailout. The Fed was not acting as a hedge fund of last resort, buying temporarily undervalued assets that otherwise were just fine.

3. This also throws Gary Gorton under the bus. Gorton said that AIG’s problems were collateral calls, meaning illiquidity rather than insolvency. Note that Gorton is not included in the list of references, at least in the ungated version. Note also that the authors write that AIG’s problems were both liquidity and solvency.

4. Bob McDonald and I shared an apartment our first year as MIT grad students. He has written a treatise on derivatives.

Regulators and the Socialist Calculation Problem

My latest essay is on Engineering the Financial Crisis, by Jeffrey Friedman and Wladimir Kraus. I think that their book demonstrates that regulation falls victim to the socialist calculation problem.

Centralizing risk assessment through regulatory risk weights and rating agency designations has several weaknesses. Local knowledge, such as detailed understanding of individual mortgages, is overlooked. At a macro level, regulators’ judgment of housing market prospects were no better than those of leading market participants. Moreover, regulators imposed a uniformity of risk judgment, rather than allowing different assessments to emerge in the market.

The Banking Crisis and the Real Economy

How important was the financial crisis as a causal factor in the economic slump? Apparently, Brad DeLong and Dean Baker disagree. Baker wrote,

The $8 trillion in equity created by the housing bubble made homeowners feel wealthier. They consumed based on this wealth, believing that it would be there for them to draw on for their children’s education, their own retirement or for other needs.

When the bubble burst, homeowners cut back their consumption since this wealth no longer existed. However contrary to what you often read in the paper, consumption is not currently low, it is actually quite high when compared with any time except the years of the stock and housing bubbles.

DeLong replies,

in the absence of the financial crisis, the Federal Reserve’s lowering interest rates as consumption spending fell in response to the decline in home equity would have pushed down the value of the dollar and made further hikes in business investment a profitable proposition and so directed the additional household savings thus generated into even stronger booms in exports and business investment: in the absence of the financial crisis, what was in store for the U.S. was not a long, deep depression but, rather, a shallow recession plus a pronounced sectoral rotation.

Pointer from Mark Thoma. Conventional economics did not have a story of how stress in the financial sector could cause problems in the real economy. Even now, that view comes across as a just-so story. Baker argues that one does not need such a story, but DeLong says that we do need it.

I would note that if the financial crisis did not matter, then the bailouts, including interest payments on reserves, were simply transfers to bank shareholders. The more conventional view is that the bailouts prevented a horrible depression. So, the way I see it, the conventional view went from saying that the financial sector is nothing special to saying that you need to invoke specialness of the financial sector to explain how bad the recession was (Baker argues the opposite) and, moreover, the recession would have been even worse without the bailouts.

From a PSST perspective, I think that one must allow that it is possible that credit plays a big role in sustaining patterns of trade, and there may be something special about the financial sector. However, my own inclination is to see the financial sector as of 2007 as overgrown and to view the bailouts as making no contribution to the process of creating new patterns of specialization and trade.

The Age of Creative Ambiguity

Tyler Cowen writes,

File under “The End of Creative Ambiguity.” That file is growing larger all the time.

What is Creative Ambiguity? I would define it as the attempt by policy makers to ignore trade-offs and to deny the need to make hard choices. Consider the Fed’s balance sheet. One hard choice might be to sell its gigantic portfolio of bonds and mortgage-backed securities. That would depress the prices of those assets and make it harder for the government to borrow and to provide mortgage loans. The other hard choice might be to provide whatever support is necessary to enable the government to borrow and to provide mortgage loans, even if it means printing enough money to risk hyperinflation. Creative ambiguity means convincing investors that neither hard choice will be necessary. Perhaps that is even true.

However, if the Fed’s hard choices are to be avoided, then at some point the government must get its fiscal house in order. That is where the real creative ambiguity comes in. See Lenders and Spenders.

Should the CBO Use Dynamic Scoring?

John Cochrane writes,

Greg Mankiw has a nice op-ed on dynamic scoring

The issue: When the congressional budget office “scores” legislation, figuring out how much it will raise or lower tax revenue and spending, it has been using “static” scoring. For example, it assumes that a tax cut has no effect on GDP, even if the whole point of the tax cut is to raise GDP.

My thoughts.

1. I am against dynamic scoring. Dynamic scoring means using an economic model. I think that politicians and the press give too much credence to economic models as it is. Even static scoring requires some modeling, but the modeling has more to do with spreadsheet arithmetic as opposed to claiming to be able to predict economic behavior.

2. To the extent that the CBO has to predict economic behavior, I think it should present several scenarios, as opposed to a point estimate or a range. Cochrane says it well:

It’s a fact, we don’t know the elasticities, multipliers, and mechanisms that well. So stop pretending. Stop producing only a single number, accurate to three decimals. Instead, present a range of scenarios spanning the range of reasonable uncertainty about responses.

Responding to another point from Cochrane, Mankiw writes,

you need to specify how the government is going to satisfy its present-value budget constraint. You might be tempted to ask the model what happens if the government cuts taxes and never does anything else. But you won’t get very far. The model will tell you that the government has to do something else eventually, and it won’t tell you what will happen if the government tries to do something impossible.

What I hear Greg saying is that to properly do dynamic scoring, you would need to include a model of future policy responses. That is a point well taken, but I am not sure that I would restrict those policy responses to be only doing things that are possible. Policy makers are doing impossible (that is, unsustainable) things now. The challenge is to predict the outcome of undertaking unsustainable policies until you cannot do so any more.

Of course, the traditional “static” scoring does not solve the problem of how to predict the outcome of unsustainable policies, either.

The Harm of Government Debt

Tyler Cowen writes,

I worry that the general decline of discretionary government spending may make politics less stable (but also more interesting, not necessarily in a good way). When there is plenty of spending to bicker about, politics revolves around that question, which is relatively harmless. When all the spending is tied up, we move closer to the battlefield of symbolic goods, bringing us back to “less stable and more interesting.” If that is a cause, this trend is likely to spread.

For a longer essay on the way that government borrowing creates political friction, see my essay Lenders and Spenders.

Economists and Greece: Finish the Sentence

Greece will achieve economic success when ____.

My inclination is to feel as unable to complete the sentence as I was the similar sentence about peace in the Middle East. Yet Simon Wren-Lewis writes,

To be able to say intelligent stuff about what is going on at the moment (which you would hope an economics education would enable you to do), you need to know quite a lot of economic theory. A lot of macro of course, but quite a bit of finance, and also at least some game theory. . .And if you want to get into all those ‘reforms’ imposed by the Troika, you need a lot of micro.

Pointer from Mark Thoma.

To be fair, Wren-Lewis is saying that knowledge of these topics is necessary in order to offer opinions on Greece. He is not claiming that it is sufficient to finish the sentence.

I just want to emphasize the extent of our ignorance here. Somebody with legitimate training in mainstream economics could easily argue that the best thing for Greece right now would be to get off the Euro. After all, many mainstream economists, perhaps a majority, would say that it was a mistake for Greece to go on the Euro in the first place. Still, there are many other mainstream economists who would argue that it would be better for Greece to remain in the Euro.

As for supply-side reforms, the economic analysis is the easy part. The hard part is dealing with the historical and cultural baggage of the country.

If you forced me to take my best shot at addressing the historical and cultural baggage, I would be inclined to fill in the sentence with “some time after the government runs out of other people’s money.” But there are many economists who would disagree.

In any case, my prediction is that this will not happen soon. Again, I think that the route by which German money gets to the Greek government will be opaque and circuitous for face-saving reasons, but I expect such an outcome. Note: I gather that Tyler Cowen assesses the situation differently. I think we agree that it is possible to claim a symbolic win and take a substantive loss, we just disagree as to which party is most likely to end up doing that.

George Selgin on Calomiris and Haber

He reviews their book Fragile by Design.

the observed interdependence of states and banks isn’t as deep-seated and inescapable as Calomiris and Haber claim. Consequently, keeping bankers and governments from getting too cozy with one another isn’t quite so difficult as they suppose.

Later, Selgin writes,

they seem unaware of the adverse effects of the “bond-deposit” provisions included in misnamed state “free banking” laws. These provisions allowed banks to issue notes only after tendering eligible securities to state authorities for the ostensive purpose of securing the notes’ holders from loss. Calomiris and Haber (p. 169) note that, by making their own bonds eligible for this purpose, states were able to force banks to lend to them “in exchange for their right to operate.” Still they fail to point out that some states force-fed their banks, not “high-grade” bonds (ibid.) but junk ones, and that it was this practice, rather than unit banking, that was the main cause of bank failures during the so-called “free banking” era

…In Canada, in contrast, banks’ almost unrestricted ability to issue notes
contributed to the banking system’s stability no less than banks’ branch networks did.

You may also wish to read my review of the book.

I Disagree with Brad DeLong

He writes,

Martin Wolf’s The Shifts and the Shocks; and my friend, patron, teacher, and (until the last reshuffle) office neighbor Barry Eichengreen ‘s Hall of Mirrors. Read and grasp the messages of both of these, and you are in the top 0.001% of the world in terms of understanding what has happened to us–and what the likely scenarios are for what comes next.

Pointer from Mark Thoma.

These are ultra-Keynesian treatments of the financial crisis and its aftermath. The all-purpose causal variable is a glut of savings and a dearth of government spending.

I cannot prove that this view is wrong. However, I am more convinced by Jeffrey Friedman and Wladimir Kraus, Engineering the Financial Crisis. The easiest way to summarize the book is that (with a nod to a different Kraus) risk-based capital regulations were the disease that they purported to cure.

The Friedman-Kraus story is one in which regulators suffer from the socialist calculation problem. With risk-based capital regulations, regulators determined the relative prices of various investments for banks. The prices that regulators set for risk told banks to behave as if senior tranches from mortgage-backed securities were much safer than ordinary loans, including low-risk mortgage loans held by the bank. The banks in turn used these regulated prices to guide their decisions.

In 2001, the regulators outsourced the specific risk calculations to three rating agencies–Moody’s, S&P, and Fitch. This set off a wave of securitized mortgage finance based on calculations that proved to be wrong.

Friedman and Kraus challenge the basic mindset not only of DeLong but of 99 percent of all economists. That mindset is that the socialist calculation problem, if it matters at all, only matters for full-on socialists, not for regulators in an otherwise capitalist system. In the conventional view, regulators can fail for ideological reasons, or because they are manipulated by special interests. But Friedman and Kraus offer a different thesis. When information discovery is vital, regulators, like socialist planners, are doomed to fail because they are unable to mimic the market’s groping, evolutionary approach to learning.

In Friedrich von Hayek’s Nobel Lecture, The Pretence of Knowledge, he concludes,

The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society–a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.

What Friedman and Kraus claim is that well-intended but now well-informed bank regulations were the destroyer, not of an entire civilization, but of a financial system. Like Hayek, they offer a profound critique of mainstream thinking. Like Hayek, they are sadly likely to be ignored.

529: Popular != Good Policy

Peter Suderman writes,

this episode and the swift bipartisan opposition it generated is so revealing, not only about the short term political instincts of the Obama administration, but about the longer term political and policy dynamics of sustaining the welfare state.

He is writing about President Obama’s proposal to tax savings from “529 plans” for college saving, which the Administration has since backed away from. I read Suderman as saying that the larger point is that when it comes to unsustainable fiscal policy, we have met the enemy and he is us. My comments:

1. Re-read Lenders and Spenders. Government debt inevitably leads to political strife.

2. 529 plans are regressive. Nearly all of the benefit flows to people with high incomes.

3. 529 plans are yet another enabler for colleges to boost tuitions.

4. 529 plans subsidize affluent people for doing what they would have done anyway–send their kids to exclusive, high-priced colleges.

529 plans are terrible public policy. Instead of demagogically criticizing the Administration’s proposal to tax them, I would say let’s get rid of them altogether.