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Not unexpectedly, there has been a sufficient amount of crowing from the left about the need for more financial regulation in light of the credit crunch. Their reasoning seems to encompass little more than the idea that deregulation or underregulation was the source of our current problems (which makes even less sense when you consider that there is no significant repeal in mortgage or lending laws to my knowlege).

This essay, however, directly refutes that idea:

The most striking fact about the ongoing financial mayhem is that it is concentrated not in lightly regulated hedge funds but in more heavily regulated commercial and investment banks. It is banks that created subprime mortgage securities. It is banks that mispriced them. And it is banks that filled their own coffers with this toxic paper, losing hundreds of billions of dollars. A somewhat breathless March 31Financial Times article proclaimed the closing of the worst month for hedge funds since the collapse of the infamous Long Term Capital Management in 1998. But the average fund tracked by the Chicago-based firm Hedge Fund Research declined by a mere 2.4 percent in March, bringing the cumulative fall for the first quarter of 2008 to 2.7 percent. By contrast, the bank-heavy financial services component of the S&P 500 fell 12.3 percent in the first quarter.

Hedge funds, for the most part, have weathered the storm remarkably well.

Simply put, if underregulation was the problem we would logically see worse performance from hedge funds than investment banks seeing that hedge funds are relatively unregulated financial vehicles.

While I blame the present problem on years of overly exuberant credit expansion by the Fed, I think it is an economic mystery why loose credit disproportionately funded a bubble in the mortgage market versus any other area of the economy (in the same way that it is mysterious why technology was overextended in the late ’90s). Put simply, we do not know why the mortgage markets bore the brunt of the Fed’s policy, but hopefully we can at least be resolved to do two things: a) not let the central banks devalue our money to the extent they have been doing this decade and b) avoid government bail-outs participants in these financial markets, which will create the same incentives to make bad investments that cause the problem in the first place.

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One of the reasons Steven Landsburg, a professor of economics from the University of Rochester, is one of my favorite economists around today is because he writes articles like the one he wrote this week called, The Case for Foreclosures. Here is part of his explanation:

I predict with great confidence that when I say that foreclosures create new homeowners, a sizable chunk of my readers will scoff that “the people who can afford them would have been able to afford nice homes anyway.” I could use economics to explain why those readers are mistaken (a glut of homes on the market leads to falling prices, etc.), but that’s unnecessarily complicated. All it takes is the simple observation that there cannot be more homeowners than there are homes, and if one home becomes vacant, then there can be one new homeowner. Call it the law of conservation of homes.

Its nothing more than a logical consequence of the price system that as people cannot pay their mortgages and demand goes down, prices will also go down to compensate and reestablish equilibrium in the housing market. The alternative, such as a freeze in foreclosures or interest rates as proposed by Hilary Clinton, could not change the fact that many residents cannot afford to pay their mortgages under the presently readjusted, the peril of which would be that more lenders would go bankrupt and less lenders would be able to initiate new mortgages for buyers looking to purchase homes on the market at reduced market prices.

Indeed it is contrarian to encourage foreclosures, but that’s not exactly what Landsburg is doing; Landsburg is, in reality, encouraging market forces and the price system as a means of achieving the optimal outcome in a below-average situation and warning against the unintended and unseen consequences of manipulating those natural forces. Indeed, much of my blogging on economics aspires to have the same effect whereby it defeats anti-market conventional wisdom by enumerating all the possibly hidden or misunderstood effects of anti-market policies.

Hahvahd professor Greg Mankiw also pointed out that it should come as no surprise that such an economist would be making a case for something as indefensible and callous as home foreclosure, considering he has also praised Ebenezer Scrooge. Of course this too sounds unfathomable considering the way the very name has become a household admonishment on any individual accused of selfishness.

In this whole world, there is nobody more generous than the miser—the man who could deplete the world’s resources but chooses not to. The only difference between miserliness and philanthropy is that the philanthropist serves a favored few while the miser spreads his largess far and wide.

In many ways his approbation of the miser is not only a approbation of the classical principles of savings and thrift, but also a rebuke of consumptionist-Keynsian thought. Either way, it is particularly brilliant in the tradition of “pop economics,” which dates back to Fredric Bastiat and Henry Hazlitt, for looking at “that which is seen, and that which is unseen.”

Today, popular economics has reached its apex, namely in the fame of the book Freakonomics. But what most don’t recall is that in modern times, before there was Steven Levitt–or anyone else for that matter–there was Steven Landsburg who wrote The Armchair Economist written in the late ’80s with a greater emphasis on logic, incentives, and larger economic trends, compared with Levitt’s nuanced microeconomic empiricism.

Finally, I found this video of Professor Landsburg on John Gibson’s Fox News show from a couple of years ago. He was brought on to talk about trade and a rising protectionist inclination among the American people, and in the face of those sentiments he makes the case that protectionism is xenophobic, irrational, and not dissimilar to racism. The exchange is heated but Landsburg sufficiently owns Gibson on his own show. And with trade and NAFTA emerging as a leading issue in this campaign cycle, the video is particularly relevant.

You can watch it by clicking the link directly below:

Lire le reste de cet article »

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In front of a House committee on Wednesday Ben Bernake claimed that lagging growth is the central bank’s chief concern.

This means only one thing: that the Federal Reserve will cut rates again in the relatively near future. His claim that growth is the chief concern also indicates that climbing inflation and the falling dollar are of secondary concern. The reality of both economic slowdown and climbing prices are beginning to revive worries of impending stagflation, which could be revealing itself for the first time since the 1970s and early 80s. The dilemma for Bernake is balancing these two inverse herrings. At this point, if he is indicating that he will cut rates to bolster short-term growth he is willingly accepting more inflation and a weaker dollar.

Yet there is still another side-effect that the fed is accepting: the stifling of long-term growth. This never gets talked about much on the news or by economically illiterate congressmen, but for the simple fact that more rate cuts encourage consumption at the cost of savings, we will be capital accumulation for usage of our economic resources in the short term. Its a simple matter of distorting time prefferances.

Additionally, unanswered is how rate cuts will actually revive the economy’s real capacity to produce and grow. While easier money encourages more spending, and thus creates the image of more growth by boosting aggregate demand in the immediate, it does not actually represent a real or sustainable spike in productivity. If rate cuts did boost real output then there would be no reason for the Fed to stop at 3%, they would just keep cutting and cutting the FFR down to 1% or less, and then keep it there. But the fact is that loose banking policy does little more than increase the money supply–which is the reason we are presently seeing more inflation–not wealth, contrary to the Keynsian and Mercantalist doctrines which apparently survive still today.

Another issue rarely addressed is the possibility of reinflating any bubbles in the economy by repeated rate cuts. Recall the slowdown in ‘01/’02 and how the Fed aggressively debased interest rates all the way to one percent by 2003. One of the consequences of the absurdly low rates was that investors that went bust in the tech bubble of the late nineties were to an extent bailed out by easy money and thus a standard of incentives were set which said that ‘even if you make bad investments, you will not be made to bear the full burden of your decision-making.’ Today, we may be seeing the deja vous in the housing market.

Henry Hazlitt once said, “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.” Currently, I think many in the public eye are not acting as “good economists” by this measure. Even many economist have jumped on the fiscal/monetary stimulus bandwagon without enumerating all the costs and benefits of those policies. Until and unless many more Americans, economists, and policymakers start heeding Hazlitt’s advice, we should all become accustom to the patters of moderate booms and busts that we have witnessed in recent history.

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Tonight, the Senate passed a slightly moderated version of the compromise stimulus bill settled on by the White House and the House of Representatives 81-16. The bill was immediately rushed back to the House, where Speaker Pelosi got it passed rapidly. Senate Democrats’ version of a stimulus bill fell flat earlier after being fillibustered by Republicans and coming one vote short of qualifying for an up-or-down vote on the floor.

The Senate passed the House’s $150 billion bill, and tacked on an additional $18 billion in spending for those not paying income taxes but earning at least $3,000, as well as Social Security recipients and wounded veterans. Harry Reid alas’ decided to accept the original bill–which primarily features rebates for those earning less than $150,000/year and business tax credits–after vowing to stand for his bill whose price tag stood around $204 billion. The failed Democrat’s bill included bolstered unemployment insurance, heating subsidies for the poor, and incentives for investment in renewable energies, coal, and home building (because higher prices and more demand for energy, not to mention more home construction, are exactly what our economy needs right now).

All of the 16 who voted against the bill in the Senate were Republicans. They included such spending hawks as Tom Coburn (OK), Jim DeMint (SC), and Bob Corker (TN), the last of whom opined that Congress had just done the equivolent of throw $150 billion “into a mud puddle.” Wise words from the junior Senator from Tennessee. Unfortunately, John McCain apparently was never graced with Corker’s bout of wisdom, as the presumptive GOP nominee returned to the Hill on Thursday to vote for the muddled spending. Of course this is disappointing to see from the AZ Senator who has lauded himself as a great deficit hawk and budget cutter. On top of that, I have never–in any speech or debate–heard him explain what he believed on stimulus, nor even enumerate what his opinion was up until this point.

Hillary Clinton (in addition to Barack Obama) flew back just for the first vote. On the trail, Clinton has offered her own stimulus plan which has baffled me for its economic irrationality for some time now. It includes a provision to freeze rates on adjustable rate mortgages (of which there are currently 11 million in America) for the next five years. Here is a solid article from two prominent economists demonstrating the would-be consequences of such price fixing.

Despite the Federal Reserve cutting its federal funds rate substantially in recent months (from 5.25% all the way to 3% already), European central banks have been resolved in keeping their rates generally steady to combat inflation and avoid reinflating any credit bubble. Just today the Bank of England cut its rate by .25% but indicated that is unlikely to trim it any more, while the European Central Bank has yet to ease rates at all (announcing tonight that it would continue to keep them steady). Jean-Claue Trichet, the President of the ECB, made the case that the fundamentals of the European economy are strong and that inflation, which is currently above 3% and will probably remain above 2% for some time, is a more daunting worry.

More importantly, he noted that M3 growth remained fervent, as did borrowing by non-financial businesses, reaching highs in December 2007. The scary thing is that Europe is not having the same credit problems as we do, as Trichet noted, yet we are the ones debasing interest rates to the potential end of reinflating existing financial imbalances. The current mess we are witnessing is little more than the consequence of the Fed doing the exact same thing that it is doing now, when it lowered the federal funds rate all the way to 1% in 2003 in order to respond to the same type of economic slowdown. Even worse, the downturn in ‘01/’02 was less related to credit woes, so this time by loosening credit we are putting fire to even more flamable substances. Nevertheless, Trichet was wise to note that there is only so much we know–only so much data available to paint a realistic picture of the economy–and that “further data and analysis will be required in order to obtain a more complete picture of the impact of the financial market developments on banks’ balance sheets, financing conditions and money and credit growth.”

The ECB President’s speech also brings me back to the topic of fiscal stimulus, as he used some of his time to rebuke the idea of government spending to boost the economy saying:

With respect to fiscal policies, a discretionary fiscal loosening in EU countries should be avoided. There is ample evidence that activist fiscal policies were not effective in stabilising European economies but rather led to sustained increases in the ratios of government expenditure and debt to GDP. Allowing the free operation of automatic stabilisers in countries with strong fiscal positions and safeguarding the long-term sustainability of public finances are the best contributions that fiscal policy can make to macroeconomic stability.

It looks like American officials from Bush to Bernake could take use some advice from the Frenchman, who is right on the money when it comes to warning about intervention to encourage more economic spending. Add him to the coalition against fiscal stimulus.

Also of interest is NYU Prof of Econ, Will Easterly’s critique of Bill Gates’ concept of “creative capitalism,” which the Microsoft founder spoke in favor of in his speech at the World Economic forum in Davos. In response to Gates, who argued that self-interest and the profit motive do nothing for the poor and that foreign aid and a sense of social responsibility are necessary to improve the plight of the world’s poor, Easterly makes the case that charity does little to lift poor peoples out of perpetual poverty. His rebuttal is in line with his book, The White Man’s Burden, as he argues that indeed self-interest and unfettered capitalism makes the whole world better off in the long run because it is most productive and creates the best incentives for third-world nations to build an economic system through a sense of individualism and self-reliance.

Finally, on a happier note, the writer’s strike appears to be over. A deal has been reached between corporate media and the writer’s guild, according to ex-Disney CEO Michael Eisner.

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In a surprise move this morning, the Federal Reserve cut the federal funds rate by .75%, from 4.25% to 3.5%, which is the largest single day adjustment by the Fed in years.

The move came amidst growing US recession worries, and a severe drop in Asian and European markets on Monday and Tuesday.

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From his Economic View column in the NYT, Tyler Cowen writes:

There has been plenty of talk about “predatory lending,” but “predatory borrowing” may have been the bigger problem. As much as 70 percent of recent early payment defaults had fraudulent misrepresentations on their original loan applications, according to one recent study. The research was done by BasePoint Analytics, which helps banks and lenders identify fraudulent transactions; the study looked at more than three million loans from 1997 to 2006, with a majority from 2005 to 2006. Applications with misrepresentations were also five times as likely to go into default.

This fact, however, falls upon the deaf ears of the Democrats, all of who touched upon the issue in Tuesday’s Nevada debate:

Edwards said, “We need a national law cracking down on predatory and payday lenders that are taking advantage of our most vulnerable families.”

Clinton argued that, “…because of the way the interest rates are going up, and many of the fraudulent and predatory practices that got people into them in the first place…” we need to extend credit and loosen bankrupcy laws for those in trouble.

Obama agreed, “Hillary’s exactly right, but we’ve got to modify some of the fraudulent practices, predatory lending practices.”

It sounds wonderful to the economically illiterate, but this season’s buzzword–“predatory” lending–does not so much as pass the smell test. The fact is that the phenominan–if you can call it that–is easily explained by the price system. If the price of credit goes down, and lenders have access to a greater supply of funds then demand from consumers goes up as they are able to borrow more then they previously could. With more credit, consumers are able to buy higher end goods, which they otherwise wouldn’t have access to–such as homes–and the price for those goods grows.

In reality, neither the lenders nor borrowers were “predatory.” Each demanded more credit as credit became cheaper. Unfortunately for both, the credit bubble burst and they are suffering the consequences of unsustainable financing. But the fact remains, it makes no sense to call either party “predatory” considering they both got screwed. And I believe that is the point that Professor Cowen would ultimately make.

In the same column, Cown spoke on lethal cold fronts:

Spells of extreme cold kill over 27,000 Americans each year, or about 700 people each very cold day. Heat waves may receive more publicity, but it turns out that cold periods — days with an average temperature below 30 degrees —have more significant and longer-lasting effects on human mortality. More people die in cold periods than in homicides.

Extreme cold brings cardiovascular stress as human bodies struggle to adjust to the temperature; many of the deaths in these periods come through heart attacks. Heat waves tend to kill people who were already weakened and would have died soon anyway; cold periods bring additional people to the verge of death.

When retired people move to a warmer state, their life expectancy rises dramatically. In fact, 8 to 15 percent of the increase in American life expectancy over the last 30 years comes from people moving to warmer climates, according to research done by two economics professors, Olivier Deschenes at the University of California, Santa Barbara, and Enrico Moretti, at the University of California, Berkeley.

Much is made of how a warming trend could hurt us, but, not only do I assume that those are under the most severe of scenarios, not much is made of if and how warming can help. Not only do many more humans die from the cold than from the heat, but productivity also flurishes when it is warmer. For instance estimates generally hover around the consensus that warming and greater CO2 has contributed to a 15% growth in crop yields since 1950.

This wisdom regarding warming is certainly unconventional, but it is worth discussing openly. I believe the reason we never hear about it is that global warming skepticism is strongly condemned by the mainstream.

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News this week was released indicating that the unemployment rate surpassed 5%. This along with $100/barrel oil, a very weak dollar, and growing inflation (here and here) are probably the consequences of the Federal Reserve cutting interest rates to the extent they have in the face of the credit crunch.

I surmise that this policy is probably creating more problems in the long run although it may calm the nerves of Wall Street in the immediate. Credit problems were the perril of loose credit, so it makes little sense to keep credit too loose in response.

Its sounds good, politically, to encourage the stimulation of investment with new money. However, economic laws still apply and by lowering interest rates against market forces we will reduce the incentive to save and essentially cause a shortage of investment capital.

Once again, there is a disparity between popular opinion and reality.

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In a House hearing Congressman Ron Paul took issue with the basic logic of the Federal Reserve as well as this Fed’s recent cuts in interest rates in an Austrian inspired manner. Given, the Chaimen did not have much time to respond but I was surprised with how inadequate his response was in the time given. There were two main questions posed to Bernanke: a) what justifies the Federal Reserve’s inflationary nature (given, it this was somewhat a loaded issue) and b) why cut interest rates assuming that the current problem is provoked by an inflationary monetary policy.

To the first issue, Bernanke gave a weak one sentence answer regarding how the Fed is just doing the job that the Congress authorized them to do. His answer escapes the entire issue of what justifies that authorization in the first place. To the second issue the Chairman only alluded to how the Fed must factor both inflation and employment to achieve an optimal balance. Basically, it was clear that the two men were not on the same page. The exchange illuminated the simple differences in how mainstream economists and radical ones (Austrians for instance) see the subject.

Here is the video:

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Economist George Reisman, author of one of the most comprehensive defenses of capitalism to my knowledge, concurs with my conclusions on the roots of the credit crunch. Reisman explains articulates the issue very well on his blog:

The situation today is essentially similar to all previous episodes of the boom-bust business cycle launched by credit expansion. The only difference is that in this case, the credit expansion fed an expanded demand for housing and, at the same time, most of the additional capital funds created by the credit expansion were invested in housing. Now that the demand for housing has fallen, as the result of the slowdown of the credit expansion, much of the additional capital funds invested in housing has turned out to be malinvestments. In most previous instances, credit expansion fed an additional demand for capital goods, notably plant and equipment, and most of the additional capital funds created by credit expansion were invested in the production of capital goods. When the credit expansion slowed, the demand for capital goods fell and much of the additional capital funds invested in their production turned out to be malinvestments.

In all instances of credit expansion what is present is the introduction into the economic system of a mass of capital funds that so long as it is present has the appearance of real wealth and capital and provides the basis for sharply increased buying and selling and a corresponding rise in asset prices. Unfortunately, once the credit expansion that creates these capital funds slows, the basis of the profitability of the funds previously created by the credit expansion is withdrawn. This is because those funds are invested in lines dependent for their profitability on a demand that only the continuation of the credit expansion can provide.

I recommend reading the whole thing.

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After about a week of standing firm and not pump priming amidst the credit crunch as well as pleas from many investors to do so, Fed Chairman Ben Bernake injected the market with extra “liquidity” through Open Market Operations and a cut in the Discount Rate. Here is what the WSJ editorialized about the decision:

Financial markets were roiled again yesterday, with the Federal Reserve and other central banks stepping in to bolster liquidity in the wake of the subprime credit seizure. Serving as lender of last resort in these conditions is the proper function of central banks. But going further–with an emergency rate cut, as some in the market seem to be anticipating or hoping for–carries the risk of introducing even greater moral hazard into the financial system.

It’s worth recalling in this connection that the root cause of this credit correction was the Federal Reserve’s willingness to keep money too easy for too long. The federal funds rate was probably negative in real terms for close to two years between 2003 and 2005. This led to a misallocation of capital into real estate and certain mortgage instruments that is currently being worked off. For the Fed to take its eye off the price-stability ball now in response to short-term market gyrations would only compound the original policy mistake.

I couldn’t agree more. The recent boom in the housing as well as stock markets can, to a significant extent, be explained by the Fed induced monetary expansion which inevitably created a great demand for borrowing money. Now, borrowing money is natural economic phenomena, however, it must be understood that the borrowing cannot just occur, but rather it need be supported by proportionate amount of savings. Thus, for the economy as a whole, the demanded amount of loanable funds need be compensated by an equilibrated amount of savings, otherwise there will be a shortage of funds. In this way–like in any other market–supply and demand work together to find the correct price level.

(Back to the story) What appears to be happening currently is that the Federal Reserve kept the effective price of borrowing money too low and alas’ the market is realizing that there is actually a shortage of loanable funds. As I have pointed out before there is just not a sufficient amount of savings in our economy to justify low level of interest rates that we have been experiencing and we experience still today. The effect of the situation is an ”overinvestment” by businesses and individuals in lines of production that are essentially too expensive and too risky to be financed by the actual supply of savings–which is lower than the low interest rates led us to believe.

The peril of Fed policies are currently being experienced now. The current “credit crunch” is the reallocation of funds which includes the liquidation of many investments; it is also the source of the downward tumble of the markets. Nevertheless, the credit crunch is necessary and vital for the economy. Although at first glance it may appear to be the root of the problem, it is indeed the remedy to our economic imbalance. The deflationary pressure is nothing more than the market readjusting its price level towards equilibrium so that the relation between savings and investment do not continue to yield the same insolvencies.

The late economist Murray Rothbard explains the theory of this phenomenon very well:

In sum, businessmen were misled by bank credit inflation to invest too much
in higher-order capital goods, which could only be prosperously sustained
through lower time preferences and greater savings and investment; as soon
as the inflation permeates to the mass of the people, the old
consumption-investment proportion is reestablished, and business
investments in the higher orders are seen to have been wasteful.[8]
Businessmen were led to this error by the credit expansion and its
tampering with the free-market rate of interest.

He continues by explaining the significance of the ”boom” as well as the “bust” periods:

The “boom,” then, is actually a period of wasteful misinvestment. It is the
time when errors are made, due to bank credit’s tampering with the free
market. The “crisis” arrives when the consumers come to reestablish their
desired proportions. The “depression” is actually the process by which the
economy adjusts to the wastes and errors of the boom, and reestablishes
efficient service of consumer desires. The adjustment process consists in
rapid liquidation of the wasteful investments…In short, and this is a highly
important point to grasp, the depression is the “recovery” process, and the
end of the depression heralds the return to normal, and to optimum
efficiency. The depression, then, far from being an evil scourge, is the
necessary and beneficial return of the economy to normal after the
distortions imposed by the boom. The boom, then, requires a “bust.”

Of course, it would be very difficult for Rothbard to describe the present turbulence in 2007 since he died in 1995. The excerpt is from his book America’s Great Depression in which applies the Austrian theory that monetary policy is the prime cause of fluxuations in the business cycle to explain the cause of the Great Depression. Certainly, the peril of fiat money as experienced in the 1930s is far greater than what is happening today but the fact remains that when a governmental body is the dictator of an economy’s credit imbalances are likely to proceed.

It is a mistake that Bernake’s Fed is now moving to loosen credit at the same time that the market is moving in the opposite direction. In the grand scheme of things, they have not acted very radically so far, but their actions nevertheless will have consequences. The central bank should not cut the interest rate when they meet next on September 18 as many inversters hope they will. Perhaps the residual of the Fed induced bubble as well as the Feds inflationary crisis management will be small, however I assume that our credit problems are not yet solved and that we could witness a minor economic downturn within the next two years.

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