Friday, March 1, 2013

Limited clairvoyance

The current approach to financial and banking regulation relies a lot on the idea that our now-wise regulators, armed with new powers and the tens of thousands of pages of Dodd-Frank regulations, really will see trouble around the corner next time and do something about it. If only they had more power back then....And of course even conventional macro policy chat revolves around wise heads of the Fed, IMF, ECB, and so on spotting "global imbalances," pricking "bubbles," "coordinating policies" and otherwise guiding the ships of state.

In this context, a lovely little piece at "The American" AEI's online magazine, caught my eye, Alex Pollock's "The housing Bubble and the Limits of Human Knowledge"

An excerpt:
Consider the lessons of the following 10 quotations:

1. About whether Fannie and Freddie’s debt was backed by the government: “There is no guarantee. There’s no explicit guarantee. There’s no implicit guarantee. There’s no wink-and-nod guarantee. Invest and you’re on your own.” — Barney Frank, senior Democratic congressman, notable Fannie supporter, later chairman of the House Financial Services Committee

It would be difficult to imagine a statement more wrong.

2. “We do not believe there is any government guarantee, and we go out of our way to say there is not a government guarantee.” — John Snow, Republican and secretary of the Treasury

Saying it did not make it so, unfortunately.

3. “The facts are that Fannie and Freddie are in sound situations.” — Christopher Dodd, senior Democratic senator, prominent Fannie supporter, chairman of the Senate Banking Committee

Pronounced two months before Fannie and Freddie collapsed.

4. “We have no plans to insert money into either of those two institutions [Fannie and Freddie].” — Henry Paulson, Republican and secretary of the Treasury

Stated one month before the Treasury started inserting money into Fannie and Freddie.

Ordinary Americans are being taxed so that foreign and domestic bondholders get back every penny they lent Fannie and Freddie.

5. “Home prices could recede. A sharp decline, the consequences of a bursting bubble, however, seems most unlikely.” — Alan Greenspan, chairman of the Federal Reserve Board

The common wisdom of the bubble years. At the time of this statement in 2003, the Fed was in the process of dramatically reducing short-term interest rates and stimulating house-price increases.

6. “Global economic risks [have] declined.” — International Monetary Fund

Observed four months before the international financial panic started in August 2007.

7. “More than 99 percent of all insured institutions met or exceeded the requirements of the highest regulatory capital standards.” — Federal Deposit Insurance Corporation

This statement was made in the second quarter of 2006, at the peak of the housing bubble. More than 400 such institutions later failed and others were bailed out in the ensuing bust. The FDIC failed its own required capital ratio, reporting negative net worth.

8. “The risk to the government from a potential default on GSE [Fannie and Freddie] debt is effectively zero.” — Joseph Stiglitz, Nobel Prize–winning economist, Peter Orszag, a future White House budget director, and Jonathan Orszag

Conclusion after considering “millions of potential future scenarios” — but obviously not the scenario which then actually happened.

9. "'Not only didn’t we see it coming,' but once the crisis started, central bankers 'had trouble' understanding what was happening." — Remarks by Donald Kohn, vice chairman of the Federal Reserve Board

A candid statement of the truth.

10. Finally: “Libenter homines id quod volunt credunt.” That is: “People easily believe that which they want to believe.” — Julius Caesar

Nothing has changed in this respect since Caesar’s day, and his dictum applies to government officials, central bankers, economists, and experts — just as it does to you and me.


  1. "When it comes to the United States federal government, people do seem willing to lend us an infinite amount of money. … Our debt is so big and so many people own it that it’s preposterous to think that they would stop selling us more." -- Michael Bloomberg, 3/1/2013

    Uh oh.The USA as been declared TBTF. BOHICA

    And someone please explain to Hizzoner that they don't "sell" us our debt. How did this guy get to be so rich? Was it one of those Forrest Gump things?

  2. After the "London Whale" incident Jamie Dimon made a statement that JPM had not understood the risks of the transactions they had engaged in.

  3. OK. But how would you explain the fact that after imposing strict regulations on banks following the Great Depression we did not have any financial crises until 1980s when Congress started to dismantle those regulations?

  4. Gotta love those right-wing think tanks! They keep repeating things like: "It's all the governments fault!" and "The experts are all wrong". The conclusion, of course, is that we should get rid of all regulations and let the free market work it's magic. But...

    How do they explain that most of the MBS issuances in 2005 and 2006 were private - not GSE?
    How do they explain that Texas - with stricter mortgage regulations - avoided the bubble?
    What about guys like Krugman, Shiller and Bill McBride that were warning of a bubble but were largely ignored by the free market media - which gets much of it's advertising revenue from the Real Estate industry?

    I also like how they ignore context, and cherry pick quotes. For example, that quote from Stiglitz about a low risk of GSE default was from 2002. Back then we had never had a nationwide housing bubble. If you look at the entire study, it was based on historical data - which didn't include a bubble. Here is another quote from that study:

    "Secondly, and more broadly, Fannie Mae and Freddie Mac would likely require government assistance only in a severe housing market downturn."

    Since the study was published before the bubble, it's a little disingenuous to use it as proof that he was wrong. Here is what Stiglitz said in 2005 regarding Greenspan:

    "Lower interest rates worked, but not so much because they boosted investment, but because they led households to refinance their mortgages, and fueled a bubble in housing prices."

    Only a right-wing think tank can prove a liberal economist was wrong... when he was right.

    1. Thank you for a beautiful demonstration of observation #10. Only a paranoid liberal could read an article quoting both Republicans and Democrats and conclude it was an attack on liberals. As further evidence of paranoia and reading with eyes wide shut you take an article about cognitive bias and somehow construe it as an article denouncing government regulation.

      Your defense of Stiglitz is either uninformed or disingenuous. Orzag and Stieglitz wrote that paper for Fannie Mae and probably for a fat fee. Here's what they said: “the expected cost to the government of providing an explicit government guarantee on $1 trillion in GSE debt is just $2 million.” Did that turn out to be true? Stieglitz's flip-flop on the issue during the days of the Occupy movement is documented history and has been the subject if much discussion.

      Only a lunatic - no matter what political or economic persuasion - could go off the tracks in such spectacular fashion.

  5. The policymakers favor a strong dollar. Is it true or do we want to believe it?

    1. Watch what they do, not what they say.

    2. We should emulate the "strong yen" policy that the Japanese Central Bank has so effectively pursued over the last 20 years.

      Or how about the "strong euro" policy of the ECB currently?

      Advocating a "strong dollar" is an intellectual cop-out that avoids economic analysis.

      Christy Romer does a good job debunking the simplistic notion of a "strong dollar" here:

  6. I'd question whether the Fed was really the driving force behind interest rates in the 2000s (pre crisis). The Fed's share of the Treasury market was about 16% in 2000, peaked at 20% in 2002, and then fell pretty much in a straight line back to 16% in 2007.

    Meanwhile, the Treasury market share of foreign governments went from 20% in 2000 to 40% in 2007. While there may be an issue of endogeneity, arguably much of the foreign government purchases were driven by economic policy rather than concern over investment returns (China being a prime example).

    Daniel Thornton at the SF Fed has done some interesting research in this area, and his conclusion is that the Fed is (at least pre crisis) in the business of smoothing short term interest rates between equilibria, rather than controlling them, a point Greenspan appears to agree with in his autobiography.

    Do you think there is validity to this?

    1. Justin,

      The federal reserve (pre-crisis) primarily focused on short term interest rates. Long term interest rates (those that affect mortgages) are handled by a combination of market activity and government activity. Beginning during the Clinton administration and continuing through the Bush administration, the US Treasury actively sought to shorten the average duration of its outstanding debt. For a period during the Bush administration, the Treasury went so far as to suspend the sale of 30 year bonds.


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