Tuesday, April 21, 2009

Solow Reviews Posner

Robert Solow is one of my favorite economists even though he's a liberal and I'm not, and he helped focus a lot of attention on aggregate production functions, a monumental distraction (the Solow Growth Model). Reifying technology as a parameter with an exogenous growth process, and capital as a number K, is about as useful as telling me I should judge my daughter's welfare by her height and weight.

But he has loads of common sense, and as he does not have an opinion on everything like other Nobelists--or at least does not feel compelled to tell us his opinion on everything--his opinions have a lot more weight. Like myself, he finds most nonfiction not just imperfect, but plain wrong, consistent with Sturgeon's Law (that 90% of everything is crap). In contrast, Tyler Cowen's reviews seems to assume a 10% crap base rate, but he reads books much differently than I do.

Anyway, Posner's book A Failure of Capitalism goes over the latest financial crisis, and Solow rips it a new binding. But Solow makes some statements that were clearly too good to check:

In the past, 10-to-1 leverage would have been about par for a bank. More recently, during the housing bubble that preceded the current crisis, many large financial institutions, including now-defunct investment banks such as Bear Stearns and Lehman Brothers, reached for 30-to-1 leverage, sometimes even more.

This canard is not made more plausible by repition. Bear Stearns had 34-to-1 leverage in 1989, 35 in 1992, 37 in 1997, and 33 in 2007. Lehman has a similar story, with leverage well above 30 throughout the 1990s. It seems high because he is conflating investment banks with traditional banks, which generally have leverage ratios around 12-to-1, and those have not changed much over the past 15 years. So the increase in leverage is because of an apples to oranges comparison. This fact is simply not true, unless you define leverage using notional derivative amounts, but there one would have to offset derivatives, and a lack of transparency makes that very difficult. In general, the really high notional amounts are for market makers who sold offsetting derivatives, creating a very misleading amount of exposure. [tech fact: I'm using TotalAssets/BookEquity as leverage--other measures give similar results].

Later, Solow notes:
I have deliberately kept this story stylized, omitting the juicy details about complicated derivative securities that seem to bear only the most tenuous connection to the everyday economic realities of production, employment, consumption, and so on

Consider that the main assets in trouble are all based on mortgages, which are linked to home prices. If home prices did not fall, this crisis would not be happening. The link between the economy, and the derivatives based on it, could not be more direct. Many times people talk about Wall Street as if it competes with the working class for economic spoils, but when you look at periods good for workers, they were generally good for the stock market, and so too with bad periods (30's and 70's bad for both, 50's and 90's good for both).

At the end, Solow argues for greater regulation:
I find it hard to believe, and I suspect that Judge Posner shares my disbelief, that our overgrown, largely unregulated financial sector was actually fully engaged in improving the allocation of real economic resources.

The less regulated hedge fund sector was not at the epicenter of this crisis, and they lost only about 25% in value in 2008, as opposed to the 60% average for banks. The bad actors were all heavily regulated by our mishmash of Federal Reserve, Treasury, State, and Federal oversight (eg, you need to get a good Community Reinvestment Act rating if you want to merge): CountryWide, IndyMac, Wachovia, Washington Mutual, Lehman, Fannie Mae, Lehman, etc. These institutions were much more regulated than the industrial sector of the economy.

These regulators litigated against lenders who failed to meet targets for serving 'historically underserved markets' (aka, 'those that can't pay back debts'), and Presidents, Congressmen and these same bankers made many speeches together extolling the costless benefit of increased home ownership. If you had 10 times more regulators, I fail to see these extra government employees telling banks to quit making so many NINJA loans because these loans served the objective of increasing home ownership, especially to minority communities. Further, traditional lending criteria (like a hefty down payment, no teaser rates, income verification) were seen as redlining in another guise because as home prices in aggregate had only risen since WW2, credit losses for these mortgage innovation were absent empirically, supporting the allegation they were arbitrary lending criteria used to keep poor folks down. Regulators may not have been necessary nor sufficient for this bubble, but they were definitely encouraging it the whole way up.

17 comments:

Anonymous said...

Are there any 'facts' that you don't get from Rush and Kudlow? Though I understand Ann Coulter didn't lose much money when equity markets fell because she was flat.

Anyhow, you really need to move away from the "Loans to Negros" caused this mess theme.

Banks and investment banks fail all the time. First Boston, DLJ, Drexel, First Penn, AG Becker, DuPont Glore Forgan, Hayden Stone, Bache Halsey Stuart Shields, Continental Illinois, Paine Webber, EF Hutton, Silverado S&L, Barings, Drysdale Securities, Penn Square -- and few of them had anything to with Negros. Besides, C and JPM (in its Chase incarnation) get in deep doo doo almost as frequently as they have those World Cup soccer games.

I also suspect, can't prove it though, that the Options Clearing Corp. might have been in bad shape October 1987.

Some of the failures (Drysdale, Drexel, Penn Square) had deep reprecussions throughout the financial system.

The difference between say the failure of LEH and BS and the earlier failure such as CINB in 1984, Drexel in 1988, Hutton in 1987? We didn't have George W. Bush, Timothy Geithner, Ben Bernanke, Hank Paulson and Chris Cox in positions of power.

Anonymous said...

thought this was an interesting piece of analysis:
http://www.debtdeflation.com/blogs/wp-content/uploads/papers/KeenPhDFinancialInstability.pdf

Patrick R. Sullivan said...

Anon, the analysis doesn't come from Rush or Ann, but from U of T-Dallas's Stan Liebowitz, and it's pretty detailed.

In short, a lousy paper by Alicia Munnell, published by the Boston Fed in the 90s, was the snowball placed atop a hill, and all kinds of dopes collaborated in seeing it roll down and accumulate more snow, until it hit bottom and the sun came out and melted it.

But, hey Steve--sub sci.econ intellect--Keen of Debunking Economics! I once introduced him to a real economist (Chris Auld of U of Calgary) at the Economic History site; hilarity ensued.

Anonymous said...

Fascinating stuff, Pat. A few questions that weren't addressed in that so academic paper:

1) How did the CRA and Jimmy Carter force AIG, UBS, LEH, BS, C, GS, MS, MER to sell PAUG CDS on home mortgages to Negros? Is that some secret part of the act that we missed? Was Jerry Falwell selling tapes on this conspiracy?

2) How did the CRA and Jimmy Cater force investors to buy mortgages backed by loans to Negros? Did they get some special tax benefits?

3) Why wasn't the Wall Street Journal and Larry Kudlow warning us about this problem? I know, I know, the WSJ was busy singing the praises of the Taliban ('students' as they called them) and how Hillary Clinto may have killed Vince Foster. But you would think CNBC, Rush, Flattie Annie might have spoken some words of warning that these loans to Negros were going to bring ruin. All I recall, was Kudlow snorting that th Bush/Bernanke economy was the greatest story never told.

Anonymous said...

I have to say this is the second time i have come to this site only to see good thinking fall awry because of some political falsehood. The CRA factor has long been discredited by facts and I would to agree with anon that only fox news or some hannity would actually not notice that the over representation of subprime within the private sector as opposed to GSE. I also cant understand why anyone who is quick to point out the difference between investment banks (who had 30+ leverage) and more regulated banks (which had 10+ leverage) cannot take the time to notice how much better off we would have been if we had more regulation! All the investment banks went bust; we can ignore that thanks to the current charade, but the history shows that thanks to their leverage they were not viable on their own.
Now given the fact that we (Rep and Dem) have shown a clear need to intervene and support or underwrite the market, it is clear that we need more regulation rather than less to prevent this mess happening again. No regulation requires no bailouts, and clearly we are not disciplined enough to stomach a world like that.

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