Bush wants to give Federal Reserve more power

Bush's Treasury Secretary Henry Paulson going to propose new powers for the Federal Reserve to oversee various institutions in order to prevent "risky" investments. And what makes it worse is that the Democrats are siding with Bush and want him to go even further.

That's the problem with our financial markets--they're not regulated enough. If we can fully nationalize all banks in the Untied States, a disaster such as the subprime crisis would never happen again.

#2: Huh???

Short version: Lenders were required by law to relax their standards in order to accomodate minority borrowers and to avoid the accusation of having discriminatory lending practices... because a few guys in Washington acting out of political expediency know so much more about sustainable lending practices than anyone else does.

Weren't low interest rates under Alan Greenspan key to this mess? That, plus lack of transparency in investment banks? Greed, of course.

A family member was an investment banker in NYC: from his stories it was my impression that those fellows will not volunteer to take any measures for longterm benefit of their business or for country's wellbeing.

#4: "A family member was an investment banker in NYC: from his stories it was my impression that those fellows will not volunteer to take any measures for longterm benefit of their business or for country's wellbeing."

They shouldn't be required to benefit the country's well-being (so nebulous that goal is), but if they're not working for the long term benefit of their own business, doesn't that smell fishy enough to dig deeper? "Greed" is too simple an answer. Greed to do what? To rake in as much cash as they could in the short-term and sell the mortgages to someone else 'cause they knew the laws made it impossible to have any long-term reward from holding onto those mortgages, most likely. Long-term "greed" is a good thing. But when laws make that road impossible, don't be surprised if all that's left is short-term greed.

A few weeks ago I had heard that a huge percentage of the recipients of subprime loans were minorities. Obviously, with that small amount of information I thought they must have targetted minorities for some racist reason. But the article I linked to in #3 gives a much better explanation for why minorities were disproportionately affected by the crisis, because lenders were forced to.

Lunar, my tongue was planted firmly in my cheek when I wrote that. I posted a version Liebowitz's article concerning the relaxation of underwriting standards in the PoliCon group.

margd, like you, I often wonder why some businessmen do not take measures to ensure the long-term success of their businesses. One idea that has been bobbing around my head is that these very businessmen do not take sensible measures to ensure long-term success because they do not have the incentives to do so.

If you as a banker are required give out loans to people that would otherwise not meet previous underwriting standards, and knowing full well that many of these loans will go bad, would you continue on the course set by the previous underwriting standards, or would you change direction given the new information?

If you know that many of the loan recipients will default on their loans in the near future, wouldn't it make sense to extract as much revenue from them as possible before their loans default?

#6: Cool, I couldn't tell.

Here's the money shot from the above article:

Ironically, an enthusiastic Fannie Mae Foundation report singled out one paragon of nondiscriminatory lending, which worked with community activists and followed “the most flexible underwriting criteria permitted.” That lender’s $1 billion commitment to low-income loans in 1992 had grown to $80 billion by 1999 and $600 billion by early 2003.

Who was that virtuous lender? Why—Countrywide, the nation’s largest mortgage lender, recently in the headlines as it hurtled toward bankruptcy.

In an earlier newspaper story extolling the virtues of relaxed underwriting standards, Countrywide’s chief executive bragged that, to approve minority applications that would otherwise be rejected “lenders have had to stretch the rules a bit.” He’s not bragging now.

margd, like you, I often wonder why some businessmen do not take measures to ensure the long-term success of their businesses. One idea that has been bobbing around my head is that these very businessmen do not take sensible measures to ensure long-term success because they do not have the incentives to do so.

Have you considered that maybe they are not in it for the long haul? When I was trading equity options on the PCoast, there was a trader in one of the firms that held long deltas in one of his stocks. His rationale was, that for him, it was a free-roll. The stock was currently trading around $10 dollars. It had previously been trading the sixties. The way that the trader figured it, the most that he could lose was his job. Rising stock price worked to his advantage, though.

The incentive problem is enormous here.

First of all, bailouts on "too-big-to-fail" grounds are now simply assumed by financial market players. That is, they essentially know that if their institutions are large enough and they get into trouble, the gov't will bail them out. This motivates excessive risk-taking, since it creates the possibility of profit if risks pan out well, but no losses, or limited losses, if they don't pan out well.

In the wake of the S&L crisis (remember that?) there was an attempt to change the law pertaining to bailouts to deal with this problem. In particular, a bailout on "too big to fail" grounds now requires several people, including the Fed's Board of Governors and the Secretary of the Treasury, IIRC, to sign off. The idea was that this expanded set of hurdles to a bailout would eliminate the "Ah, they'll definitely just bail us out if necessary" perception. But this does not seem to have worked, because those people seem to just sign off as a matter of course.

I think the regulators should have slit Bear Stearns's throat. Rather, not intervene when it decided to slit its own throat. That would have been a sign of new firmness on the automatic bailouts problem. They really missed a good chance there. Their rationale wasn't hairbrained - they were afraid that a high-profile failure would throw confidence into the well - but it seems to be too late for that now anyway.

The other significant incentive problem with the mortgage markets in particular is that Fannie Mae and Freddie Mac (who fall into a weird quasi-public, quasi-private category) have an explicit guarantee of a few billion dollars (forget the exact figure) from the Treasury should it be necessary, and everyone knows that the Treasury would pony up almost any amount to prevent a failure.

Since Freddie and Fanny are huge purchasers of mortgage-backed securities, they have constituted another source of demand for mortgages detached from any concern with reasonable risk assessment (until recently, of course).

Edit: Fannie and Freddie are both buyers and sellers of mortgage-backed securities.

My first attempt at this got eaten up. I'll just hit the high points.

The home loan crisis and all the poison that spreads from it are a direct result of Republic (mostly Reaganomics) economics.

Bear-Stearns should be allowed to collapse, and if it must take down whatever it will when it goes, so be it. Isn't this the Republic way? Aren't market institutions as responsible for their actions as any other? If we don't socialize the gains in good times, why must we socialize the losses from bad decisions and greedy actions in bad times? I don't want any of my taxes used to prop up the private sector. If we can't use them to address endemic social problems then we sure as hell don't need to guarantee gambling losses.

This problem is a direct result of Republic economics. In the 30's the banks went bust because of all the bad loans they made during the heady days of prohibition, post WWI. By the time the Democrats and a second WW (whose economic influence cannot be underestimated) managed to right the ship, the Repugs started creating the fairyland that would include such rides as trickle down economic theory, high deficits and indirect taxes that strike only the middle class and poor, as well as the idea above about personal responsibility and the nature of "free" markets. Anyone remember the Resolution Trust Corporation? We could have learned a lesson about economics then, but we didn't. So, here we are, once again on the edge of a possible depression given to us nice and neatly wrapped up in a bow by the Republics. Why did God make them soooooooooo stoopid? It's just beyond me.

If the market is supposed to separate the wheat from the chaff, how is saving the chaff following market principles? The market represents another aspect of Republic character, the do as I say, not as I do philosophy of social management. It's like the rich kid who acts irresponsibly, but gets bailed out by dad, well the American taxpayer ain't dad. In other words winning at the market is privatized. Losses, OTOH, if heavy enough are socialized. Well, if you can't see it in your way to socialize gains, then by gum don't you be trying to socialize the losses.

Anyway, this is the third time Republic economics (fourth, if you go back to the 19th century) has aggrandized the wealthy at the expense of the economic health of the country, only to ask that same country to bail them out when it all goes south. What a bunch of hypocrites.

What I don't understand is the lack of reaction to "borrow and spend" economics as opposed to the "tax and spend" formulation. When the Republics say "tax and spend" immediately millions of eyes glaze over, bodies snap to attention, and begin their lemming-like march to destitution and think it's all good. How disgusting! At least "tax and spend" implies that you're going to attempt, at least, to pay as you go. Borrow and spend implies we'll run the country on borrowed money and make no attempt to pay as we go. Now, that's something I call responsible economics! Hell, this isn't economic at all. It's a fantasy.

Finally, the dustbin of history is filled with countries and empires that acted just this way, all the way to the dustbin.

Two articles by Doug Henwood of the Left Business Observer Reflections of the Current Crisis and Reflections on the Current Crisis(part 2)

He has also had a variety of relevant segments on Behind the News

#6 Codyed, what you said as sarcasm is true none the less. The subprime crisis was not caused by any government regulation requiring loans to borrowers that were not creditworthy. It was a perfectly rational and natural result of unregulated markets. Countrywide CEO Angelo Mozilo and others of that type found they could grow the nominal value of their stock very rapidly by issuing all sorts of dubious mortgages, on the grounds that property values would always go up so there would always be equity in case the borrower defaulted.

Well, it worked very well for Mr. Mozilo. He got $57M in compensation last year, and then cashed in another $138M in stock options. Sure, he's now been forced out as CEO, but in this game, he's a big winner.

Some of the mortgages were then insured or sold in packages as derivatives. None of these arrangements were regulated. Bear Stearns bought in big, and James Cayne, the departed CEO, did very well, earning $238M before he walked.

Now, all of this was a Ponzi scheme and was going to collapse at some point. What made it work for the folks running the scam? The fact that knowledge of complex financial transactions is not shared. It is monopolized. So there can be no free market. There can be a fully regulated and fair market, or there can be a crook's carnival.

In the days before the New Deal, we really didn't regulate financial markets. The banks failed about every 15 years, and most people lost their savings. These crises were increasingly severe, until the Great Depression, when finally some laws were put in place to stabilize the situation.

Lunar, Codyed, without those laws, we certainly could go back to the old cycle of boom and bust. I do despise the fact that Bear Sterans had to be bailed out, because as a part of the "shadow banking system" it did not have to adhere to any of the rules that ordinary banks do. But if they hadn't bailed them out, many other financial institutions would have probably have failed. There is more aggregate debt in the system, relative to the real GDP, than at any time in the past, so the dominoes could fall very easily.

BTW, the reason these financial derivatives are completely unregulated was a law passed in 2000 that was introduced by Senator Phil Gramm, and written by the financiers. That law, combined with Alan Greenspan's easy credit, led inexorably to the current situation where taxpayers have to bail out the financial system -- just as happened with the Savings and Loans. Gramm is now a leading economic advisor to McCain.

#14: "without those laws, we certainly could go back to the old cycle of boom and bust"

Are you sure about that? Are booms and busts really that old? Beause I found something that says...

"The Fed was created as a response to the periodic bank runs of the late 19th and early 20th centuries. Some of the greatest economists have explained that part of that instability was caused not because private banks were free to issue currency (even as late as 1907) but because the government maintained a policy of rewarding irresponsible behavior by rescuing financial institutions when they reached the verge of collapse. In any case, as Milton Friedman wrote, the instability of the pre-Federal Reserve years was nothing compared to the booms and busts caused by the monetary authorities after 1913."

Come to think of it, I haven't ever heard of another time in history in which economies were subject to booms and busts without a role being played by a state-run central bank. Maybe you can help find such a case?

#15 Yes, Lunar, ALL capitalist economies have experienced boom and bust cycles, ever since the advent of financial markets. Consider the panic of 1763, which affected all of northern Europe. There was no regulation of bills of exchange, which were privately issued and became widely used at the time as a medium of exchange. Without that regulation credit could expand without limit, and did, until the crisis of confidence hit.

This is the way it works, in the absence of regulation: Banks (or other financial institutions) get N dollars (or escudos or pistoles or whatever) deposited. They then loan those dollars out, so that they can pay interest to the depositors. The borrowers spend the money and it is redeposited in the banks, who loan it out again, and again, and again, until there is, in effect, many times the amount of money (credit) in circulation than there is real money in the system. Then depositors get worried or get in a financial pinch and need to make withdrawals. But far more money has been deposited than actually exists (the same money having been deposited many times over). A run on the banks follows, and then a collapse of credit, and then a depression or recession.

So, starting in the 30s, there were rules that a bank must have at least x% of the cash on hand as was deposited in the bank. When a bank doesn't have enough cash, it borrows from another bank that does. And the Fed becomes the borrower of last resort. This is the way it works the world over, and this is why the boom/bust cycle turned in to 50 years of moderated and fairly steady growth.

However -- there has now been enormous growth of unregulated transactions in the financial markets -- a "shadow banking system." As a result, banks such as Bear Stearns can have nominal deposits out of any proportion to the amount of real cash or other real assets that they actually have. They become "highly leveraged." The financiers that run these banks use this fact very rationally, extracting very large salaries, and making a quick exit when the house of cards collapses and the run on the bank eventually occurs, exactly as happened with Bear Stearns. There are two ways to prevent this problem. First (theoretically) you can have rational markets, where depositors make a careful judgment about what the bank is doing with the money, and deposit accordingly. Yeah, right. Do you know what your bank does with it? Can you really evaluate the safety of all the mortgages they issue? How can you know that they are telling the truth? Second, you can have government regulation.

We need police because there are people who steal. This applies to financial markets every bit as much as the liquor store till.

>14 jmcgarve:

The notion that derivatives are unregulated is simply false. To mention just a few examples off the top of my head:
(1) The Schedule RC-L reports that commercial banks must file quarterly with the Federal Reserve System. These reports must list, among other things, the bank’s derivatives positions. This leads to...
(2) The bank capital requirements, which are greater if the bank is running a large derivatives book, especially if the regulators assess the derivatives positions as being particularly risky. (This was put into place in one of the Basel agreements, IIRC.)
(3) The margin requirements that apply to some derivatives, e.g., futures, options.
(4) The fact the certain kinds of financial intermediaries aren’t allowed to be involved with derivatives. E.g., mutual funds can’t, or rather they can, but the regulatory burdens on their use of derivatives are so great that they don’t bother with them very much.

“Angelo Mozilo and others of that type found they could grow the nominal value of their stock very rapidly by issuing all sorts of dubious mortgages...”
Precisely because of the government guarantees I mentioned in 10 and 11. Understand I am not conjecturing here: For example, the buyers of Fannie Mae and Freddie Mac’s mortgage-backed securities explicitly say things like “There’s no default risk, since they’re backed by the government.” And the sellers say this too. In fact, it is their biggest selling point. I am not saying that markets would never drop without the government’s involvement; going up and down is what markets do.* But there would not be such an enormous demand for these securities, causing the bubble, without the government guarantee of them, and we know this because (apart from common sense) the buyers of these securities explicitly tell us so.
* They have to, because they respond to incoming information, which is sometimes good and sometimes bad.

“...combined with Alan Greenspan's easy credit...” Excellent point, and I’m glad we agree on something. Now remind me, was Greenspan acting as an employee of a private firm, or the head of a government policy board and financial system regulator? (By the way, the entire FOMC is responsible for its policy actions, not just one person. But that’s another topic.)

>15 Lunar: "Come to think of it, I haven't ever heard of another time in history in which economies were subject to booms and busts without a role being played by a state-run central bank. Maybe you can help find such a case?"

Tulip Crash?
South Seas Bubble?

#17 Derivatives trading is indeed regulated, but since Phil Gramm's "Commodity Futures Modernization Act" there are holes in the regulations that one can drive a truck through, as indeed Enron did. (Gramm's wife got a nice position with Enron.) Arguably Clinton should have vetoed the bill, but it was attached as a rider to omnibus legislation, and anyway Clinton was far too influenced by Robert Rubin and other financier advocates of minimal regulation. Another loophole allowed by this act is that mortgage backed securities are deregulated, and states are prohibited from regulating them.

Most of the mortgage backed securities are in no way protected by government guarantee. Companies bought them, not because of government guarantees, but because they thought that real estate prices couldn't fall. The probability of a bailout of Bear Stearns wasn't what influenced the CEO of Bear Stearns to run his Ponzi scheme. The bailout affects him not at all. He had already pocketed the money. Also, investors in Bear Stearns lost their shirts despite the bailout. So their decisions were not predicated on a bailout either.

Greenspan was indeed acting as the head of a policy board. He and the board had hold of the reins that could have held back this enormous expansion of credit. They let loose of those reins. I fail to see how this can be a good argument that the reins shouldn't exist.

#15 Oh, Lunar, I forgot to make specific response to the comment about how booms and busts got worse because of actions by monetary authorities after 1913. That is true, in the case of the great depression. The monetary authorities had weak regulatory power before the new deal, so that all sorts of wild speculation could occur. But they still made matters worse, by doing exactly the wrong thing. During the growth of the speculative bubble in the 20's, they maintained a very loose money policy. And then, when the crash came, they followed the economic ideology of the time and tightened down hard on the money supply. This made the depression worse than it would have been otherwise.

So, it doesn't help to have regulations if they aren't administered wisely.

Well, now we're getting somewhere. So we agree that they're regulated. We might disagree on whether there are holes are "big enough to drive a truck through," but that's a different statement.

"Most of the mortgage backed securities are in no way protected by government guarantee." Hmm, off the top of my head, I don't think this is true, but I can't swear to that on a stack of Bibles. Before digging into this, here is my impression: The vast majority of the underlying securities are issued by Fannie and Freddy (Edit: which have an explicit guarantee of a few bill and an implicit guarantee that everyone in these markets thinks is limitless). Investment banks can then construct derivatives based upon these derivatives. The second-order derivative is ultimately based upon the first-order derivative that is issued by Fan/Fred. That this happens is not conjecture; it's fact. What proportion of all mortgage-backed securities fall into this category I'm not sure. It is, at the very least, a very large minority of such securities. I think it's a majority.
But even if it's only 1%, the govt's involvement is still causing the incentive problem because "everybody knows" the gov't would step in if a big disaster happened. Of course, this is exactly what's going on now with the Fed's policy actions. On the horizon we have other propospective gov't responses like the Democratic candidates' proposals for foreclosure freezes and the recent Bush proposal.

"Also, investors in Bear Stearns lost their shirts despite the bailout." See, the problem is that they're not losing their shirts. That's the whole point of the Fed's guarantee of Morgan's buyout of Bear Stearns. They're taking a bath, certainly (in that the value of their BS stock fell a lot), but they're not holding paper that has become worthless, which is what would have happened w/o the Fed-backed bailout. This is a textbook example of a too-big-to-fail bailout.

Regarding Greenspan and the board letting loose the reins, the better metaphor is that they stepped on the gas pedal. The difference is where the expansionary impulse is coming from. You can't keep the Fed Funds rate at 1% and thereabouts (which is where they had it a few years back) without extensive money creation. (You can see what they did to the fundamental reserve money aggregate at the New York Fed's web site; find the history of the Fed's portfolio of Treasury securities. All those securities are acquired via money creation.)

> 20
I suspect that the disastrous policy mentioned in this post is something everyone here agrees on. (I'm sure someone will let me know if not!) In fact, it's pretty much what I was going to say in response to 18.

Here are the macro facts for the US: We indeed had spates of bank failures every several years before the Fed was created, as someone mentioned upthread. Then the Fed was created, and it almost single-handedly caused the Great Depression. (Note I say almost; yes, it’s complicated, etc.) It also made it worse with some extraordinarily ill-timed policy moves ~ 1937. (It raised the required reserve ratio twice, for any monetary policy wonks present.)

After the1930s, there was a Keynesian consensus that stabilization policy and some shrewd changes in regulation had ended all that. Christina Romer challenged this view in a mid-1980s paper in The American Economic Review. Her thesis was that when we construct data series the same way for the pre-and post- WWII periods, we see no significant difference in macro volatility. (Edit: In other words, standard practice about the way economic data series were assembled had changed over time; Romer realized that was messing with our across-time comparisons.)

(Edit: Christina Romer, "Is the stabilization of the post-war economy a figment of the data?" American Economic Review, June 1986.)

So we created a “stabilizing” policy body that kicked off the Great Depression and then didn’t do much one way or the other after that. (This is my characterization, not Romer’s.)

Then we had the soi-disant “Great Moderation,” which one could argue is now over.

(/lecture mode)

> 15, 18. These are valid points. The Madness of Crowds is a problem in any age and in any country. But we keep getting these promises about how just a few more regulations will put an end to all that - we've been getting these promises for, at a rough estimate, a century and a half - and it keeps happening. I mean, here we are again, ~75 years after the Best and Brightest told us they'd solve all this. And sometimes, as with the Fed causing/heavily contributing to the GD, it's made worse.

Regarding bank deposits, someone asked Lunar, "Do you know what your bank does with it? Can you really evaluate the safety of all the mortgages they issue?" I doubt any of us know, but I'll tell you why I haven't bothered to find out: It's because I know my deposits are insured by the federal gov't. So I have no incentive to find out. Who cares how unsafe it is? FDIC deposit insurance has had some good effects too, some people have argued. Untangling their good effects from their bad effects is a real challenge. The idea is to make depository institutions safer for depositors, but that removes depositors' incentive to discipline (by taking their money out of) unsafe institutions.
My libertarian (surprise!) principles tell me "F*** deposit insurance," so it's an easy call for me. But if you're a left-liberal person with warm feelings toward gov't intervention, this is a tough call, I would think.

#23 "that removes depositors' incentive to discipline (by taking their money out of) unsafe institutions." I claim such discipline is completely impossible. There is no way for me as the typical depositor to know or to evaluate the safety of a given bank. Absent regulations, the bank has no reason to tell the truth. Moreover, unless all depositors enforce this type of discipline, there will be enough bad banks out there to cause the collapse of credit and recessions or depressions. Credit institutions are institutions of trust. There is no way to establish this trust reliably. Every time we deregulate (as with the S&Ls) the crooks take over.

#24: "I claim such discipline is completely impossible. There is no way for me as the typical depositor to know or to evaluate the safety of a given bank. Absent regulations, the bank has no reason to tell the truth."

You don't need everyone to have that same amount of discipline, though, and it's certainly not justified to remove incentives for it. If we could go back to Enron as an example. Part of the lead up to the news coming out was discomfort from investors over the fact that Enron wasn't opening their books up to the public so that their finances could be properly scrutinized. You don't need every individual investor or depositor to be able to independently have the skill to comb through an institution's transactions to see if they're trustworthy. Groups of investors could hire an independent analyst to do that for them and then financial analysts would be competing over who gave the most accurate assessment of the institution's finances, or newspapers could do the same thing and then sell that information to newspaper subscribers. Whenever trustworthy information is valuable and in demand, that creates a market for it.

Lunar -- this may be unfair of me -- but I always get the feeling that your starting point, almost as an article of faith, is that a libertarian society with minimal government involvement in the economy would work better, and that you then construct the arguments as after the fact foundations for this castle in the sky?

Take a look at your last post. You are citing Enron as an example of how unregulated financial dealings can have successful and rational outcomes. This is a positive example???? Enron took the savings of thousands of families when it went down. In the absence of government regulation, Enron was completely able to corrupt the accountants that reported its status, and they produced bogus accounts for years. There was a market for trustworthy information, and that market was easily corrupted -- JUST AS ALL MARKETS ARE whenever resources and information can be monopolized.

Market relations are power relations, nothing more, nothing less.

I'm clearly becoming addicted to independent.org's resources, but here's an interesting point they make about how Enron was able to hide its debts from its shareholders for as long as it did.

"How did 19th-century capitalism—which was much more “basic” than today’s—worked, while there were no legislated standards of disclosure? How were investors able to evaluate corporations? According to Wharton professor Jeremy J. Siegel, the answer is simple: a firm signaled that its earnings were real by paying dividends. This signaling device doesn't work anymore because of tax distortions: with dividends being taxed at higher rates than capital gains, shareholders prefer the latter. While the average dividend yield on stocks was 5.8% in the 19th century, it now stands at less than 2%. Add the fact that the tax system encourages debt financing as opposed to equity, and you have the recipe for Enron types of debacle."

The reason I originally brought up Enron was to point out how difficult it is to hide questionable business practices. You brought up a separate point about the scandal itself as if I were somehow describing it as a plus. I think articles of faith only come into play when making statements like "I claim such discipline is completely impossible."

No, saying that market forces can't discipline banking is hardly an article of faith -- there is LOTS of real world evidence. We have a looong history where in the absence of regulations, the crooks take over. Case after case after case after case. The 19th century was full of that. What we don't have, is ANY example of unregulated capitalism actually working well for the great majority of people. Not one. Not ever. That's why I say it's an article of faith to think that it can -- you have to somehow show it. The 19th century was the century of trusts, robber barons, company hired armies that smashed any attempt of workers to organize, railroads that forced ranchers to sell at absurdly low prices because they were the monopoly purchaser, hideously corrupted food (read The Jungle), etc. etc. So, the reason I bring up this "article of faith" business is that I can and have shown so many concrete examples of just how lousy unregulated capitalism is ... and the counterexamples just aren't there.

>> By the way, dividends are a horrible signaling mechanism as an indicator of real stock worth. It's the oldest trick in the book: the company pays high dividends for a while, basically giving the investors some of their own money back. MCI paid fine dividends, right up until they had to file for bankruptcy and Bernie Evers went to jail. If it hadn't been for regulations, Evers would be a free man, living off his ill gotten gains today.

#28: You're making the classic mistake of confusing capitalism with corporatism. Thomas DiLorenzo addresses the myth of "capitalist" robber barons in How Capitalism Saved America. Corporatists can only survive the free market by being in bed with government. The story of the robber barons being "capitalists" is a myth that, intentionally or not, is told in order to propound the acceptability of government's role in everyday life. But it's just an article of faith.

"MCI paid fine dividends, right up until they had to file for bankruptcy and Bernie Evers went to jail. If it hadn't been for regulations, Evers would be a free man, living off his ill gotten gains today."

If the investors got their dividends, then who got ripped off? I sense an incomplete picture here.

Edit: Upton Sinclair wrote The Jungle for the purpose of promoting socialism, although when I read it, his call to unionize at the end of the book seemed rather tacked on. Whatever his political views were, it was not written to be an accurate journalistic exposé of canned foods.

Whoa, you step away from LT for half a day and you fall behind!

I’d like to speak to 24.

“I claim such discipline is completely impossible. There is no way for me as the typical depositor to know or to evaluate the safety of a given bank.”
Well, if you had the incentive you’d learn about it or you’d take other steps to protect yourself. The examples of people learning are not as numerous as one might hope - a point you’ve made - but more on that below. Back when we didn’t have government deposit insurance - e.g., the entire 19th century - we had banking panics that occurred every ~7 years on average. We also had people limiting their exposure to this risk by not putting all their money in the bank. It was common for people back then to find clever ways to hide some of their money on their own property (burying it in the back yard) as well as not so clever ways (the proverbial coffee can). I think that if people want to take the risk of depositing their money in a risky institution, let them: If it goes under that doesn’t hurt me.

Aha!, you say. But it does hurt you, because a banking panic can cause a recession, which could cause you to be laid off, or be forced to close your business due to low demand, etc.
But no, I respond, the conclusion of Romer’s work speaks to this: When banking panics became a lot less common (and you can argue that this was partly due to deposit insurance) - it didn’t actually decrease economic volatility! If anything, it seemed to make the little corrections less common, and the big blowouts like the Great Depression and the S&L crisis more common. I’d rather have relatively small corrections every now and then than everything be fine for a while and then the GD or the S&L meltdown.

Speaking of depository institutions like S&Ls, we’ve been drifting off topic as we go from the mortgage markets to banks and other depository institutions. (Bear Stearns was not a depository institution.) The hilarious (if you like black humor) thing is that govt policies artificially inflate the mortgage markets. Thrifts (which include S&Ls) are required to make lots of mortgage loans. They must have 65% of their assets be mortgage loans to satisfy the “qualified thrift lender” test and qualify for special tax and regulatory treatment. This is another policy that pumps up the supply side of mortgage lending. There’s also the tax code’s treatment of interest on mortgage debt, which is another policy that encourages it on the demand side.

The thing that gets me about these policies is that they’re all obviously well-intentioned. The stated purpose of the QTL test for thrifts is to support the American dream of home ownership. It’s just that the people who write these laws need to have the Law of Unintended Consequences tattooed to the insides of their eyelids.

Speaking to this part: "There is no way for me as the typical depositor to know or to evaluate the safety of a given bank."
Let's assume this is completely true. I don't think so, and Lunar has spoken to this, but let's suppose it's true for the sake of argument. Another problem is that it applies just as well to the regulators. I.e., you can't evaluate what they're doing either, which is why you get things like regulatory capture by the regulated. E.g., often when regulatory bodies have their powers reduced, the prices of the regulated goods/services drop, even though the intention of the regulation was to keep prices lower! Trucking is an example. In other words, people who know that there are informational barriers to their performance being assessed can become corrupted, regardless of whether they're private or gov't employees.

Informational barriers lead to corruption -- so we have to minimize the "informational barriers". This is done using: LAWS. Well -- what about the law of supply and demand? Answer: It doesn't work for monopolies. In the absence of regulatory laws, financial institutions will always monopolize key information, and your best policy is to bury a coffee can in your back yard. Even scarcer than information is understanding. People pick bad banks and bad advisors, and the people running those banks or giving that advice are not incented to do it wisely -- they can usually make a quick buck more easily by doing very foolish things.

Regulatory laws and policies can be good or bad. If they are bad, we can try to vote out the administration that institutes them. There is incentive to corrupt this process to be sure, but also many powerful actors on the scene who have an interest in it not being corrupted.

I don't buy this idea that volatility has not gone down. The S&L mess (a product of deregulation) did not cause a recession, because we had government institutions to protect against it. We haven't had a depression since the thirties, and recessions have become more infrequent. Bernanke is a student of the great depression, and he has the tools to prevent that particular lockup. He can't solve the problem that the people of the US consume more than they produce -- so the necessary sideeffects of Bernanke's efforts will be stagflation.

Consumption is going to have to go down in this country. I would prefer to cut the military budget first, but we aren't going to be able to consume as many big cars and big houses -- government regulation or no.

Another way of looking at this is to look at the natural trends of an unregulated system. If credit is expanding, and if there are no laws to limit it, the bankers are incented to extend more credit, and then still more. Now suppose you have a few prudent bankers who maintains good cash reserves and only issues loans to the really creditworthy. Of course, he can't pay competitive interest rates, so there will be a bunch of suckers depositing with the other banks. And people won't really know what the policies of their banks are, so how can they help but be suckers? So there will be a large number of unwise depositors and unwise banks -- until somebody, and then a bunch of people, withdraw their money and put it in coffee cans. At that point all the banks fail, whether prudent or not. And even the creditworthy loans then become no good, as deflation takes over. The progression of an unregulated credit system is informed by natural mathematical rules, and like many dynamic systems governed by feedback processes, that progression is chaotic.

BTW, this Romer idea about volatility having not decreased is nonsense. There's a chart at this link that shows real GDP change, and it has smoothed greatly. See chart 1 in this PDF: http://www.bea.gov/scb/pdf/beawide/2000/0100od.pdf

I credit the institutions of the New Deal.

Oh -- a couple of other points in response to Lunar:

MCI paid dividends up until they went into chapter 11. Then all their creditors got ripped off, and their stockholders experienced losses out of all proportion to any dividends. So dividends are a very poor indicator of the health of a company.

Also, about DiLorenzo -- you need to take that guy's stuff with a suitable dose of salt, in his case about a bushel. Consider this review (by a conservative) of the "How Capitalism Saved America" book:

http://www.claremont.org/publications/crb/id.990/article_detail.asp

"This book has several things going for it, but objectivity and balance are not among them. DiLorenzo makes no pretense of trying to present evidence on both sides of historical debates, a failure that some scholars argued marred his previous book, The Real Lincoln (See Thomas Krannawitter, "Dishonest About Abe, Spring 2002), an all-out condemnation of the 16th president. Much of the scholarly literature is ignored. He does little or no original research, but superbly describes the work of a select number of other scholars.

While errors are inevitable in a book-length treatise, the number in this volume is high, ammunition for detractors who will argue that this is nothing but a polemic."

#30: From what I've seen, the primary consequence of all these laws encouraging mortgage financing is to drive up housing prices, with the result that the average householder needs a mortgage in order to afford the average house. It is very frustrating.

“BTW, this Romer idea about volatility having not decreased is nonsense. There’s a chart...”

Pfft. You can not necessarily learn anything by looking at a chart, especially if the data used in constructing the chart are changing over time. This is the whole point. Data from the earlier period look noisier because the data collection process itself was noisier.
This chart in particular is annoying: What variable is plotted on the vertical axis? According to the legend at the top, it’s annualized GDP growth, but look at the 1930s: For some years it shows growth of over 10 percent! That did NOT happen during the Great Depression!!!

Edit: As far as I know, there has never been 10% growth in the entire history of the US economy. If there was, it certainly wasn't during the GD.

Now one can find zillions of other charts, but make sure they use the correctly-constructed data series.

Quoting from the article: “The resulting chart...showed a dramatic decrease in the volatility of GNP in the postwar period...Others have disagreed as to whether policy is really stabilizing and even whether the economy has become more stable...”

I can’t say anything more without digging out the Romer paper. If the library doesn’t have it I’ll have to get it through Interlibrary Loan, so (if you’re hardcore) we may be here a few more days, ladies and gentlemen. If I misremembered her point I’ll acknowledge it; I promise (or you can always dig it up yourself).

A decrease in volatility that is not controversial is the Great Moderation, which is dated from 1983 to the present. The GM is a dramatic decline in the variances of key macro variables, in particular that of GDP growth. That is not corrupted by possible changes in the data collection methods from the 19th century because of the date at which it started, early 1980s. But there are many proposed explanations for this in the literature. One is improved monetary policy. Another is good luck, i.e., the economy hasn’t been buffeted by shocks as severe as in earlier periods. There are others: Improvements in computers, which led to much better inventory control methods - (inventories count as part of investment, and investment is the single largest category of GDP that contributes to GDP volatility.*) “Escape dynamics,” which also involve learning by the central bank, but in a weird way that veritably guarantees that they’ll eventually unlearn and go back to the bad old days of high volatility (see Sargent 1999).

*Consumption is the biggest category of GDP; investment is the biggest in terms of its volatility and its contribution to overall GDP volatility.

My point in mentioning the Great Moderation is that it is extensively discussed by macroeconomists these days, so if you search on the Net it is very easy to find mentions of a decrease in volatility, papers with titles like “What explains the Wonderful Decrease in Volatility,” etc. But that s a separate phenom that started in the 1980s, long after the dawn of modern stabilization policy & relevant financial system regulations. So, if we’re going to continue discussing this we should be mindful of that.

Follow-up:

It seems to me that it breaks down into two possibilities.

If I correctly remembered Romer's work, there has been no decline in volatility, or only a tiny one, since the 19th century. That settles the issue of whether modern policies have helped address volatility.

If I misremembered Romer's work - or if subsequent work ripped her to shreds; I haven't been following that - then there really is a decline in volatility we can be confident of (even before the Great Moderation). But even in that case, establishing that that's the result of the policies (e.g., "I credit the institutions of the New Deal") is a post hoc ergo propter hoc argument. One could make the argument, certainly. But people have been debating THAT for the last 70 years without settling it, and we're not going to settle it on this thread. So in that case I'll exit the debate and let others carry on. (Hmmm, maybe I'll exit in either case.)

I have more points to make later, but I want to address the “this Romer idea about volatility having not decreased is nonsense.”

Christina Romer is a respected UC Berkeley macroeconomist.
The American Economic Review is a top-five Economics journal in the world in every journal ranking I can think of, using standard measures of journal quality such as number of citations to the journal, impact per citation, impact per article, etc. It typically shows up in top-three lists, and frequently in the number one slot. This doesn’t mean you should take papers that appear there on faith (you should never do that). But it means this is serious academic work; the forum is not, e.g., a think tank with an ideological axe to grind.

Romer actually bends over backwards to be fair to the pro-stabilization policy point of view, since she excludes the Great Depression (caused by our enlightened steersmen). The periods she compares are the pre-WWI period and the post-WWII period, which of course exclude the GD. If you were to argue that she stacks the deck - and I don’t think she does - you’d have to argue that by excluding the most wrenching contraction of all, she is if anything stacking the deck in favor of the stabilization argument.

I managed to get Romer’s paper, AER June 1986, today. I haven’t thoroughly read it, just scanned it for the money lines. There are several, but to keep this brief:

“Depending on which data series and which measure are used, somewhere between half and all of the observed stabilization is the result of comparing inconsistent data. (my emphasis.) When a consistent series is compared over time, the amplitude of the cycle is is roughly similar before World War I and after World War II.” (Page 322).

Furthermore, when we apply statistical significance tests to the two periods, we find “The slight stabilization shown in the consistent data is not significant.” (Page 322.)

Carnophile -- Fair enough, I should not dismiss Romer's work without having read it ... and I have not read it. I think the GDP numbers in the chart I pointed to are pretty good (US Bureau of Economic Analysis) but they might not prove what I say they do.

What about the mathematical argument -- where the dynamical system represented by credit is inherently chaotic? The energy of the system seems to be continuously increasing as new forms of credit, high margin futures markets, derivatives and hedge funds, expanded international financial speculation, and similar phenomena drive it. Mathematically, you can tamp this behavior down by appropriate damping controls. In the absence of government regulation, you could still have the damping, but people in aggregate would have to be very very smart and information would have to flow very quickly and freely, neither of which seems likely.

jmcgarve,

If you're delving into chaos, you've left me behind. I've never studied chaos theory.

Regarding the complexity of the system, I have heard that people are indeed concerned about this as it pertains to Fannie and Freddy. Their financial positions are so large and complicated (notional value in the trillions of dollars) that no one really understands them, not Fannie, not the regulators, not anyone. A classic case, it seems, of the left hand not knowing what the right hand is doing. Since the mortgage markets are being stressed, to put it gently, and Fan & Fred are a big part of those markets, we might get a chance to find out just how intelligently coordinated all their positions are.

But I really hope we don't get a chance to find out.

"people in aggregate would have to be very very smart and information would have to flow very quickly and freely, neither of which seems likely."

Indeed! It's a problem, IMO. Rather, I think info does flow well these days, but the intelligence that's used to assess the info...Oy.

I'm not slagging the intelligence of anyone in particular; it's just very complex.

The metaphor that pops into my mind is that collapse of the phone system in the 1990s. If you remember, they had software in the millions of lines of code, and after a few years a line of code that had never been called to before, was. Result: A significant part of the phone system shut down.

A most brief laypersons description of chaotic systems and bifurcation.

One starts out with a system that efficiently handles the energy pressed upon it by its own actions (feedback loops) and actions taken by other systems with which our test system interacts. As long as the energy input is fairly stable the system will function well. However, changes in energy input, either more or less than the amount the system functions well at, will decrease the stability of the system as it attempts to launder the additional (or diminished) energy. This increase in instability leads to a precise point (which no one can know ahead of time) at which the system will do one of two things (bifurcate, or take one of two paths), it will either spontaneously reorganize itself in such a manner that it is now capable of consuming the additional (or less) energy and go back to functioning smoothly, or it will collapse to a less complex level in which it can handle some of the energy well and totally ignore, as if it did not exist the rest of the energy, rendering it meaningless to the new system. This retrenchment may even be a total collapse, depending on the amount of energy injected or withdrawn to/from our starter system at the outset.

I hope this brief look at a very complex (but not complicated) topic was helpful. Chaos is at the heart of all human created systems.