Thursday, April 29, 2010

Russ Roberts on the Crisis

Russ Roberts of Cafe Hayek has an excellent paper on the Crisis--Gambling with Other People's Money.

Roberts blames the crisis on a pattern of creditor bailouts by government. The government has developed a policy of making sure that people who lend money don't suffer losses. On its face, that is absurd. Banks take losses from bad loans all the time. Robert's point, however, is that the households and businesses that lend to financial firms are shielded from these losses. He emphasizes that government policies are aimed at limiting the losses of any financial firm to stockholders of that particular firm.

For commercial banking, his account rings very true. Deposit insurance explicitly protects insured depositors from loss. Insured depositors have no reason to worry about the risks taken by their banks. Losses are borne first by the bank's stockholders and then by uninsured depositors and other creditors. However, FDIC has made it a habit to protect all of the uninsured depositors and other creditors from loss as well by using the "purchase and assumption" method of resolution for insolvent banks. FDIC guarantees enough of the bad assets of a failed institution, so that some larger, hopefully sound bank, will then take the remaining assets of the failed bank as well as take responsibility for all of its liabilities.

Roberts emphasizes that the GSEs, Freddie Mac and Fanny Mae, borrowed by selling bonds that had an implicit federal government guarantee. As expected, the lenders were protected from loss when Freddie Mac and Fanny Mae became insolvent. Harder to explain was lending to stand-alone investment banks, like Goldman Sachs, Morgan Stanley, Bear Sterns, and Lehman Brothers. None of these borrowed using insured deposits. There was no implicit government guarantee... oh wait. The government bailed out all of the creditors of these institutions except for Lehman Brothers.

Roberts builds a convincing argument that bailing out creditors leads to perverse incentives. However, I disagree with his claim:

The punishment of equity holders is usually thought to reduce the moral hazard created by the rescue of creditors. But it does not. It merely masks the role of creditor rescues in creating perverse incentives for risk taking.

I think that making equity holders take losses does reduce the moral hazard created by bailouts. For example, the initial TARP proposal was for the federal government to buy "toxic assets" from commercial and investment banks. This would bailout the banks for making bad loans, and so, the equity holders as well.

Fortunately, that plan was dropped. Instead, the TARP money was used to purchase stock in the banks. This resulted in some dilution of ownership, but it still involved bailing out stockholders.

If the various commercial and investment banks had been given the more standard FDIC treatment, all creditors would have been made good, but the stockholders would have been left with nothing. Bush and Paulson made moral hazard worse.

Robert's point, of course, is that even if the stockholders had lost everything and only the creditors were covered, there is still serious moral hazard. Before deposit insurance, banks needed to maintain higher capital ratios to attract depositors. The way to make sure that depositors or those holding the deposit-like short term commercial paper of investment banks insist on high capital ratios is for them to lose some money in banks that fail.

I think Roberts fails to emphasize the "bubble" element in the housing market. While he discussed a variety of government policies that were aimed at raising housing demand and so the equilibrium prices of homes, the "bubble" is the mistaken projection of past price increases into the future. In my view, this is what leads to the overshooting and an inevitable collapse.

If we think about "greater fool" investors, who understand that past price trends should not be projected into the future, but who believe that there are some "fools" who do and that profits can be made at their expense, the resulting "game" is very much like poker. This is especially true when the goal is to fleece not only the fools, but also others seeking to sell out to greater fools. And it is in that poker game, that Robert's point about gambling with other people's money rings true.

I strongly disagree with part of Robert's conclusion:

Be aware that the Fed is certainly part of the problem and may not be part of the solution. The Fed created the artificially low interest rates that helped inflate the housing bubble. The Fed then raised interest rates too quickly with disastrous effects for the adjustable-rate mortgages encouraged by their low-interest- rate policy. Monetary policy should not be left to any self-proclaimed or publicly anointed maestro. Following an automatic money growth rule or the Taylor rule would have avoided much of the pain. Somebody needs to hold the Fed accountable for funding exuberance.

I am not sure that the Fed's excessively low interest rates were part of the problem. If the natural interest rate falls and the Fed properly allows the market interest rate to fall with it, then housing prices will rise.

Worse, following "the Taylor rule" or anything like it is a mistake. Interest rates should depend on supply and demand, not manipulations of the quantity of money by a central bank based upon observations of past inflation and estimates of an output gap. Further, a money growth rule is equally bad. Money is an economic good, and its quantity should adjust to the demand to hold it.

Naturally, I favor a target for a slow steady growth path of aggregate cash expenditures. To the degree possible, market forces should be allowed to freely adjust both interest rates and the quantity of money consistent with maintaining that stable macroeconomic background.

In conclusion, I must ask, what "crisis" do we mean. I believe that the Fed's policy of interest rate targeting was responsible for the real crisis that has left total cash expenditures about 10 percent below their long run growth path. I won't deny that a long standing policy of creditor bailouts was responsible for the solvency problems of leading Wall Street investment banks, and many commercial banks as well. The degree of malinvestment in housing, as well as the inevitable disruption to production when insolvent financial institutions are reorganized might also be laid at the door of this policy of creditor bailouts. But these things pale against the failure of the Federal Reserve to do its job--keeping aggregate cash expenditures on a stable growth path.


  1. There is no "natural interest rate." The market sets interest rates partially based on "fundamentals" and partially based on what it thinks the Fed will do. It knows well the Fed cannot tolerate any fall in the price level as the banking system would go bust given the leverage involved.

  2. Bill:

    Many studies, if not most, show the actual real ffr was below the natural (or neutral) rate during the early-to-mid 2000s. For example, remember this figure which comes this post? It is based off of Laubauch and Williams 2003 RESTAT paper. Or try this study which shows an increasing natural rate during this period. Given these findings, why don't you believe the Fed's interest rate policy was distortionary?

    Regarding the Taylor Rule, it is nothing more than a special case of a nominal income targeting rule. (Or some might say a nominal income targeting rule is a special case of the Taylor Rule.) Maybe it should be forward looking, but even in its standard form it does a good job--when used to show how the ffr deviated from the Taylor ffr target--in explaining the housing boom in the U.S. and in the OECD more generally.

  3. Anonymous:

    Thank you for your comment.

    I think there is a natural interest rate. It is the level of interest rates that exist without an imbalance between the quantity of money and the demand to hold it, and so, the interest rate where saving equals investment, and also, the interest rate where real planned expenditure equals the productive capacity of the economy. I don't doubt that market interest rates depend on both expected fed policy and also the fundamentals that determine the natural interest rate.

  4. David:

    Thank you for your comment.

    The problem with the Taylor rule is interest rate targeting. If the economy is in equilibrium and the rule is forward looking, it should work in theory. If it has already failed, I am not so sure. Remember, Taylor claims that monetary policy has been must fine for the last couple of years.

    I believe that the natural interest rate depends upon expectations and it role is coordination. And it is entirely possible that housing prices would rise as an equilibrium response to a change in the market and natural interest rate that was due to expectations that turn out to be based on mistaken expectations.

    None of this should be taken to mean that I am sure that the Fed didn't create an excess supply of money and push the market interest rate below the natural interest rate.

  5. Before deposit insurance, banks needed to maintain higher capital ratios to attract depositors.

    Why are owners generally inclined to take more risk than lenders? Is it just because equity generally attracts higher risk capital? Or is the full explanation more complicated?

    I think that making equity holders take losses does reduce the moral hazard created by bailouts.

    It's not immediately obvious to me how/why both these statements would be true. If owners already want to take more risk than lenders allow, why would higher risk for themselves deter them?

  6. It troubles me that Roberts alludes to 'the repeal of the Glass-Steagall Act'.

    I've done a lot of reading about the financial crisis without reaching many firm conclusions. But one thing I'm sure of is that 'repeal' of Glass-Steagall never happened. It's a Big Lie, repetition of which is devastating to any commentator's credibility in my opinion.

  7. The fed did buy toxic assets directly from the banks.

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