Wednesday, September 24, 2008

Solving the financial crisis in a world of two-handed economists

There is a story, possibly apocryphal, that President Harry Truman once had a meeting during the course of which he asked questions of several economists, one of whom would respond by saying "On the one hand," and giving one view, followed by another who would say, "On the other hand" and giving the alternative view. A frustrated Truman, upon leaving the meeting, told an aid, "Next time, get me economists with only one hand."

The story comes to mind in the current national discussion over the financial crisis. The vast majority of Americans understand little about it, and so are consigned to being spectators in a see-saw spectacle in which those who they thought should know such things disagree.

Although many Americans are concerned about the current situation on Wall Street, most of them can do little more than scratch their heads. They simply have no way to determine how bad the problem is, let alone what the solution might be. If they were only economists, they think, they would know what to do. But then they watch the economists, and the awful truth dawns on them: even if they were economists, they wouldn't know what to do.

As it turns out, the people who they are trusting with solving this problem don't seem to know themselves, whether or not they think they do. "Nobody involved in the bailout proposal," says Arnold Kling of EconLog, "has sufficient knowledge of mortgage credit risk." Great. Of course we could ask whether even the people who say nobody knows know enough to know that nobody knows.

Such is the state of our collective ignorance.

Even former Fed Chairman Alan Greenspan, one whose mere utterance caused the markets would rise or fall, said he didn't see it coming.

How bad is the problem? According to Ben Bernanke last Tuesday, a recession could ensue unless the Bush administration's bailout plan is passed. Yet Allan Meltzer, a historian of central banking, says that the problem is not as bad as it is being portrayed:
I've listened to governments tell me for 40 years that there was a crisis and the world was going to fall apart if we didn't do this or that. But there have been a few cases where they weren't able to do that.
And let's not ask the question why Bernanke, who warns of an imminent recession if his plan is not passed, doesn't agree with those who think we've been in a recession for some time now.
Now we know why, as one wag has observed, if you took all the economists in the world and laid them end to end, they still couldn't reach a conclusion.

And if you thought there was confusion in regard to the problem, wait till you see the confusion in regard to the solution. So if everyone is confused, including the people who aren't supposed to be, what should we do?

Was there anyone among all the hordes of economists arguing with each other who actually wasn't confused? Were there any economists out there who were so lacking in confusion that they saw this coming? Are there people out there who actually warned us about this?

And this leads me to my proposed solution. First, forget about the economic experts who were blindsided by the mortgage crisis. Ignore them. Pretend they don't exist. If they offer a solution, listen to them politely, and then forget about them. Secondly, find out who, among all the people who are supposed to know what they are talking about, saw this coming first. Honor them, exalt them, ensconce them in plush offices with large salaries, and give them the first word on what to do about it.

Are there such people?

Tyler Cowen, at Marginal Revolution, claims Lawrence Sterne addresses the problem in his 18th century work Tristram Shandy, and he's right, but let's not get carried away.

Here is Mark Thornton, writing in June of 2004. See if this doesn't sound prophetic:
Given the government's encouragement of lax lending practices, home prices could crash, bankruptcies would increase, and financial companies, including the government-sponsored mortgage companies, might require another taxpayer bailout.
"Who is Mark Thornton," you ask? You've never seen his talking head on television, you say? Thornton is one of a number of economists of the Austrian School of Economists. Although the names don't mean much to the general public, early 20th century figures such as Ludwig von Mises and Freidrich Hayek are at least familiar to those of us who have bothered to study economics. The late Murray Rothbart, a political journalist who died several years ago, is perhaps better known. But the best known adherent of the Austrian school is Ron Paul, who ran for Republican nomination this year, and who people like John McCain sneered at.

In fact, here is Paul, speaking to Congress in 2002:
Ironically, by transferring the risk of a widespread mortgage default, the government increases the likelihood of a painful crash in the housing market. This is because the special privileges of Fannie, Freddie, and HLBB have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions. As a result, capital is diverted from its most productive use into housing...

However, despite the long-term damage to the economy inflicted by the government’s interference in the housing market, the government’s policies of diverting capital to other uses creates a short-term boom in housing. Like all artificially-created bubbles, the boom in housing prices cannot last forever. When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged over-investment in housing.

Perhaps the Federal Reserve can stave off the day of reckoning by purchasing GSE debt and pumping liquidity into the housing market, but this cannot hold off the inevitable drop in the housing market forever. In fact, postponing the necessary but painful market corrections will only deepen the inevitable fall. The more people invested in the market, the greater the effects across the economy when the bubble bursts.
This if fully 4-5 years before Alan Greenspan says he saw the light at the end of the tunnel and realized it was an oncoming train.

Now I will admit that I have always considered people who support Ron Paul as a little cultish in their devotion. Among these I count several members of my immediate family (Don't tell them I wrote this, or I will be accosted with a thousand "I told you so"s). And, in fact, many of the Austrian School are not entirely pleased with Paul.

But the fact is that if you roll back the tape, it becomes very apparent that Paul and the Austrian economists have been warning us about this very thing happening for several years now.

So if the Austrian School knew enough about the situation six years ago to know what was coming, what do they say we should do now? Are they for a bailout, or against it? Here is Paul, writing at CNN.com:

The solution to the problem is to end government meddling in the market. Government intervention leads to distortions in the market, and government reacts to each distortion by enacting new laws and regulations, which create their own distortions, and so on ad infinitum.

It is time this process is put to an end. But the government cannot just sit back idly and let the bust occur. It must actively roll back stifling laws and regulations that allowed the boom to form in the first place.

The government must divorce itself of the albatross of Fannie and Freddie, balance and drastically decrease the size of the federal budget, and reduce onerous regulations on banks and credit unions that lead to structural rigidity in the financial sector.

The people who knew enough to see the problem coming think the solution is not for the government to lay hands on the financial system, but for the government to get its hands off it.

Are there people who will scoff at the idea of the government backing off instead of bailing out? Sure there are. And to them I say, you go and predict an economic crisis six years before it happens, and then come talk to me.

4 comments:

Anonymous said...

With so many economists predicting so many different scenarios, the odds that some will be correct is almost 100%. Does that mean they knew what they were talking about? Not necessarily.

jah

Lee said...

Chalk all this up to:

1. Do-good liberalism run amok. The presumption was that, if black homeownership lagged behind whites, it was therefore because of the racism of the mortgage lenders. It couldn't have possibly been that mortgage lenders were impartially assessing the risks. So through a series of increasing threats, mortgage lenders were forced to relax their requirements and make a percentage of their loans to people previously judged to be unqualified.

2. Wall Street greed. Once lenders figured out they could make money under the new rules, they went nuts. Which was fine in an "up" market. The market turned to "down" and now the assets don't cover the liabilities. Ooops.

3. Congressional knee-jerk responses. Mark-to-market accounting is insane. Sarbanes-Oxley is stifling the economy, making it too expensive for companies to go public. If you make it too hard for entrepreneurs to get something going, they will take their money and go home. All in response to "corporate excesses". Congressmen make decisions based on how good it makes them look. They look good ruining the economy, and they look good fixing what they ruined. That's okay. I don't mind paying $700 billion if Nancy Pelosi got to preen for fifteen minutes. Worth every penny.

4. Government-sponsored enterprise, such as Fanny Mae and Freddie Mac. Political incentives rule the day. Unsurprisingly, both companies are heavy Democratic contributors. Privatizing profits and publicly-shared losses are not my idea of capitalism at its best.

Thomas said...

Jah, I'd say that when the Austrian school predicts the great depression, the depression of 1937, the events of the 70's, this meltdown, etc, etc (and that's just in this country) they're not randomly guessing. Especially when they're not only saying what will happen, but why.

David said...

Sometimes if you are too close to the details nothing makes sense. We and the economists all need to take a step back to see the problem. I agree any action the government takes to help ease the financial crisis will only treat the symptoms, not the cause.
The problem is rooted deep in our egoistic nature. A quote from Michael Laitman expands this better than I can and also proposes solutions :-

“At the foundation of human behaviour, driving all economic and social systems, is the ego, which always prefers the narrow personal interests of investors and stockholders, over the common good of the public. The pursuit of wealth, honour and control at the expense of others are the top priority for company owners.”