Tuesday, April 01, 2008

April Fools

Brad DeLong has a long post how to handle financial crises where he states that the capitalization of financial intermediaries drives their demand for risk assets. If they are well capitalized, they are happy to take on risk (because they don't fear a bank run), and if they are poorly capitalized, they will not want to take on as much risk (because they want to avoid a bank run). Of course, if we ditch the fractional reserve system, and maturity mismatch, we do away with bank runs altogether, but that's a post for another time.

He then connects these two states with a, frankly ludicrous, cross line, making an "S" shaped demand curve. I personally see this bizarre supply curve crossing the demand curve on 3 separate occasions, but Brad focuses on just the top and the bottom. Basically, this curve says that when banks have money they take on risk, and when they don't, they don't.

The Fed increased demand for risky assets by making safe assets (Treasuries) yield a paltry 1%. The risky assets of choice (this time) turned out to be mortgage backed securities, and low and behold, banks are now undercapitalized as the highly levered securities turned out to be worth zilch.

Banks, now undercapitalized, no longer want to buy risky assets, and so have switched to the low equilibrium. The Fed will once again reduce interest rates so safe investments are worthless, hoping to get banks to start buying risky investments again. BUT, if they don't have enough money to buy risky investments even when the safe investments are worthless, Brad says that they can simply be given tax payer money (be re-capitalized by the government) and the lending binge can begin again.

Yves calls BS on it. He argues that the "good equilibrium" that DeLong wants to spend tax payer money to get us back to was bogus, it was a just the peak on a frothy bubble, and trying to get us back there is like trying to get Pets.com revalued at $1T (or whatever).

I certainly would love to talk about bubbles, and prices being out of alignment and needing to return to historic norms. Does he do this? Well, let's see:
The fundamental value of any risky asset--housing, say--depends on (a) per-period value or profit, (b) the time profile of safe interest rates, (c) the quantity of risky assets that the private financial sector must bear, (d) the amount of risk associated with each tranche of risky assets, and (e) the risk-bearing capacity of the private market. All of things are things that can be high or low--and that the government can affect:
He then goes on to list how a competent government can do all of those things. He dismisses "over production" arguments
It says that the root problem is overproduction--that we have too many houses. Attempts to change fundamentals will mean that those who build more houses will continue to earn more profits, and so we will have more and more and more houses, and we will have an even greater overproduction crisis some time in the future. So we must make sure that housing prices are so low that nobody builds another house for a long time to come, and that is the only way to minimize the misery coming out of the collapse of the housing bubble.

I have never been able to make this "overproduction" argument make sense. If the government provides a subsidy--like a mortgage insurance subsidy--then we will indeed have more of whatever the government subsidizes, but there is no reason to think that this is in any way a big problem or an unsustainable situation. It may well be a waste of the government's money to provide the subsidy: taxpayers might rather endure a housing crash and a depression than be forking out extra taxes to pay mortgage guarantees.
At this point, I'm completely baffled, and call BS on Brad. I'm thrilled that "per-period value", "time profile", and "risk asset quantity" makes sense for him, but I'm also sad that simple supply and demand no longer do. If you build more houses than people need, and those houses are priced higher than people can afford, then the prices have to fall until people can afford them again. This is not complicated, and I don't see why Brad thinks the government can handle any of this in a way that does not penalize savers, tax payers, and renters.

All of the strategies that Brad's "competent government" can employ are simply different ways to print money. And while it is true that the government can literally print money via it's printing press, it cannot actually create value, and those new dollars dilute the value of the old dollars, transferring wealth from people who have old dollars (aka. savers) to people who have new dollars (aka whomever the government hands its newly printers dollars to. In this case, banks and investment banks).

This is not surprising. If a number of firms are under capitalized and need money, then that money has got to come from places that have it. Right now in the world, that would be the few benighted individuals in the US who decided to save for a down payment in 2002-2007 instead of jumping into what was clearly an unsustainable bubble (except to Brad, who thinks we can sustain it) and China/GCC.

Given that their hard saved dollar holdings are being diluted to save wealthy bankers, it looks like the jokes on them.


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