Some thoughts on the bubble/s and financial crisis/es

Nick Rowe provides us with some talking points on how we all got into this mess:

I am taking part in a roundtable on the financial crisis next week at Carleton (Wednesday 8 October 5.30-7.00 in 360 Tory, just in case anyone is interested in attending). The audience and other panel members will be mostly political scientists. I only get 10 minutes. This is what I am currently planning to say:

Opening Salvo: Could better regulation have prevented the financial crisis? Yes; restricting mortgages to less than 70% of the value of the home could have prevented the house price bubble and prevented the crisis. No; because that regulation could only have passed, in a democracy, if a majority of people had been convinced that disaster would happen if people borrowed more; and if a majority had been convinced of that, a bubble would never have happened anyway, and so regulation would not have been needed.

Politics: The left blames Bush, the Republicans, and deregulation. The right blames Obama, the Democrats, and the Community Reinvestment Act. Both sides sound convincing. But both sides are obviously wrong. The housing bubble is global; the financial crisis is global. Russia has a financial crisis, but the Republicans do not regulate Russian financial markets. England had a housing bubble, but does not have a CRA. The US bubble burst first, but other countries are following closely. Canadians watch too much US news. This is a global phenomenon, and needs a global explanation.

What is a bubble? Everybody talks about the house price bubble, but nobody defines what it means. Let me define it:
The amount you should rationally pay for a house, if you sell it one year later is:

1.    P = Annual Rent + [P one year later]/(1+r)

And if you (or the people you sell it to) sell it infinity years later, it is:

2.    P = Present Value of Rents to infinity + [P infinity years later]/[(1+r)^∞]

The second term on the right hand side is the bubble. If everybody expects, and expects future buyers to expect, that future prices will stay finite, the bubble term is zero, and they will not rationally pay bubble prices.

So why do bubbles happen, and why in so many countries at once? Irrational herd instinct maybe? I don’t know, but I can say something about when they are more likely to happen:
If rents and house prices are growing at rate g, and g<r, then:

3.    P = Rent/(r-g) + P[(1+g)/(1+r)]^∞

If g gets close to r, very small changes in any of the terms have very big consequences for the price you should rationally pay for a house. The ratio between today’s prices and today’s rents becomes very fragile, and very sensitive to expectations about the future. It gets very hard to distinguish between prices that are high because of a bubble, and prices that are high because other people expect slightly higher growth rates. Maybe other people are right? Maybe houses really are worth that much? (And if g ever exceeds r, we enter the financial twilight zone of pure bubbles, where chain letters are stable, and Ponzi schemes really can make everybody rich.)

So why did bubbles happen in so many countries at about the same time? First, because world interest rates were low. And world interest rates were low not because Greenspan set them low (central banks cannot set interest rates below the natural rate without causing accelerating inflation), but because world savings were high. And world savings were high because the world’s population is getting older, and when people get older they save more for their retirement (note China). And second, because world GDP growth was high (note China and India), Ricardian rents on inelastically supplied land (for houses or oil) had a high growth rate too. So g was close to r. Which made it easier for bubbles to form, in many countries.

So why did bursting bubbles cause a global financial crisis? Why are financial markets so fragile? Because financial markets try to do the impossible. Ultimate savers/lenders want financial assets to be Short, Safe, and Simple. Ultimate investors/borrowers have projects which are Long, Risky, and Complex. Financial markets and financial institutions try to give both sides what they want. In normal times the magic works. Without that magic, people would only save gold or canned food, and there would be no investment, and we would still be in the Stone Age. But the price of that magic is an inherent instability. Each individual can liquidate his savings at any time, but we can’t all liquidate at once. Beliefs become self-fulfilling, and we can also get a second, bad equilibrium, with a bank run or stock market crash. Most people can hold safe assets, if uncorrelated risks are pooled, but some people must always hold the remaining, correlated risks. And if those people go bankrupt, the safe assets too become risky. Many people can hold simple assets, provided some other people do the complicated research. But if their research turns out to be wrong, the simple assets become complicated too.

Efficient financial markets give both sides what they want, but are inherently fragile. There is an inherent trade-off between efficiency and stability. Changes in regulation can move you along that trade-off. Good regulation might improve the trade-off. But it cannot be eliminated. Government bailouts are just the government acting as one more financial institution. Governments too can become illiquid, or insolvent, or get their research wrong.

What should Canada do? Our housing bubble is perhaps smaller than in other countries, and our financial institutions are perhaps more stable. But nevertheless this is a global crisis, and we ought to share in the global rescue. The Canadian government should borrow several hundred billion dollars, and use it to buy risky assets at fire-sale prices. Swap T-bills for toxic waste. We might also make a profit!

Hmmm. I don’t know if I can say all that in 10 minutes.

Comments? Criticisms? Useful advice? What did I get wrong?

Comments

[Robert McClelland]

I don't think you have the causation quite right. For the past decade we've been playing whack-a-bubble as too many investment dollars chase too few highly profitable investment opportunities. Paper wealth has essentially become an unsatiable monster that gorges itself when it finds a meal to the point where it inevitably throws up.

We've been here several times over the past century and the each time the problem seems to have corrected when--you're really, really going to hate this--we experience a period of high inflation. I'm not certain why this seems to be the case but I surmise it's a result of the paper wealth monster finding a satisfying, stable diet in government debt.

[Style]

A housing bubble is one thing - a housing bubble that causes global credit markets to seize up when it bursts is another. The argument over regulation strikes me as less about preventing the bubble as preventng the credit market consequences, particularly the consequences that flowed from under-priced risk on mortgage-backed derivatives. The point on savings is soft too, since the savings are concentrated in Asia (or the lack of investment is concentrated in Asia, if you prefer to use Bernanke's perspective) while the US has negative savings rates. And you probably want to check the state of the financial system in China before asserting that individuals are saving for the retirement (my impression from Roubini's blog is that the savings are government savings in the form of Treasuries etc. (and the bubble burst partly because the Government of China started selling Fannie Mae bonds)).

Why would the Canadian government buy assets at fire-sale prices? The US government is buying assets at "fair market" prices to recapitalize institutions. If Canada bought at fire sale prices, we would only be acting as speculators, profting from rather than stemming the crisis.

[seaandthemountains]

While I can't speak to the issue of a bubble or the causation of the meltdown nor solutions (in an informed way), I think I can speak to your treatment of the issue of regulation in an informed and hopefully helpful way.

You opening salvo dismisses the potential impact of regulation: "No; because that regulation could only have passed, in a democracy, if a majority of people had been convinced that disaster would happen if people borrowed more; and if a majority had been convinced of that, a bubble would never have happened anyway, and so regulation would not have been needed."

This amounts to a reasonable rational analysis of the situation. But I see two problematic assumptions that I think the political scientists may well pick up on if they are directly responding to your points.

First, it assumes that individuals always act in their best interest if fully informed about consequences. We all can point to obvious cases that make clear this is not the case (e.g., abuse of addictive chemical drugs).

Second, and more more fundamental to your argument, if I understand your point, it assumes that the 'majority of actors' whose support is required to pass the regulation are the same pool of actors whose behavior is to be regulated.

I am not crystal clear who you are inferring the majority of actors whose support is required to pass the legislation. I have two hunches.

1) Loan takers: given your reference to democracy as it is, I take it you mean the citizenry who are also the potential loan seekers; or,

2) Loan makers: alternatively, given, the power of the corporate lobby in the US, you may mean the individuals who represent the organizations giving the loans.

As per above I disagree with the rationale that if the majority of them supported regulatory legislation it would pass, but given their informed opinion they would not take the action.

But more important here, it seems to me this is not a fully accurate representation of the legislative process. By virtue of the legislative process in both the US and Canada, the only actors who a majority of support is directly demanded to pass any particular piece of legislation is members of the legislature (who would not be the entirety of the target of the legislation, though they could be included). Neither country employs a referendum of any sort that demands wider majority support of any single piece of legislation.

In both cases they wield influence over legislators (obviously) but I think the whole point of the regulatory argument is that A) getting the full membership of either group fully informed is unlikely; B) they may still not act accordingly; and C) given A&B, regardless of what either loan takers or loan makers thought, if the majority of (somewhat) informed law-makers supported legislation it would have precluded loans of greater then 70% (or whatever threshold is deemed appropriate).

Not sure if this is clear or not, but I take it you WCI has access to my email if you want further clarification as to my thoughts (I will check comments again too prob), so pls free feel to email.

Btw, first time posting, but this is a great blog and it is fantastic to be able to have informed convos like this one.

[Manny, in Moncton]

" The Canadian government should borrow several hundred billion dollars, and use it to buy risky assets at fire-sale prices. "

You theoreticians are sick. Americans buy our lumber to build their houses. We are going to have a brief but hard crisis in the forestry business. We should keep taxpayers' money for them.

Gamble you own money.

[westslope]

I disagree that Canada has to do anything beyond what the Bank of Canada is already doing in terms of pumping more money into the overnight markets.

Canadian banks can make their own private arrangements to recapitalize like CIBC did just recently with Cerberus Capital Management for a US$1.05 billion investment.

The risk of direct bail-outs is that it effectively bails out "Trust me I'm an economist" Prime Minister Harper's strategy of cutting GST during this recent out-of-control commodity-driven boom along with his recent plethora of questionable promised policies such as $5,000 gifts to first-time home owners, or promised reductions to taxes on diesel fuel.

Western Canadians, Albertans in particular, need to learn how to better manage resource-driven booms. Blunting the impact of the lessons will not help. The Canadian federal state will soon be reporting a deficit. Holding the course is the best action. Let the automatic fiscal stabilizers do their thing.

Many in Europe and to a lesser extent in the USA have suggested that buying preferred shares in financial institutions would be a better way to inject capital into the system. The Swedish model.

Surely of interest to political scientists has to be a number of questions:

Why did this bubble occur while the USA was waging an international war against terrorism (sic) and in the process had occupied not one but two Islamic countries?

Why were Americans and Europeans not called upon to make sacrifices in this highly orchestrated epic struggle against Islamic terrorism and for the control of strategic petroleum resources and presumably for sustainable control of religious monuments of significant cultural importance to Jews and Christians (e.g., those found in Jerusalem)?

Have US-sponsored colonial wars of aggression devolved into simple consumption acts of cultural symbolism and on-going entertainment?

[Nick Rowe]

Thanks for the good comments!

Robert: inflation might be one way of fixing the debt problem, since the real value of nominal debts would be reduced, but I'm not sure that's the best or only solution, and it would seem to set us up for the next debt bubble.

style: my post wasn't clear enough; I agree that good regulation is aimed as much at preventing the consequences of bubbles as it is at preventing bubbles from forming. The US had low savings, and China had high savings, but if Chines savings can flow freely to the US (and around the world) then it is world savings that matter for interest rates, not the savings in any particular country. But you are right that China's savings may be public as well as private savings. I think many US commentators make too big a distinction between buying assets at fair value vs fire sale prices. If the government buys assets at fire sale prices, this increased demand will raise the prices of those assets, which by itself will tend to re-capitalise the banks (under mark-to-market accounting). And if markets for those assets are very illiquid (as they are now) any small increase in demand could increase liquidity and have a big effect on those fire sale prices, and help bump them up to fair value.

seaandthemountains: I understand what you are saying (I think), and agree that my implied theory of democratic politics if massively over-simplified. The "majority" who could pass regulation is not the same "majority" who could have prevented a bubble. In principle you are right, but my guess is that it wouldn't make a lot of difference in practice. Imagine trying to get a law passed a couple of years ago, which was designed (or would be labeled as such by the opposition) to make it harder for people to borrow and buy houses! Instead, governments (both in Canada with CMHC, and the US with Freddie and Fanny) seemed to be pushing to make it even easier for people to borrow to buy houses. In other words, governments seem so often to fall into exactly the same bubble mentality as the population, and would never pass the regulation needed to prevent the bubble. But it will be interesting to see if the political scientists come up with your argument; you have forewarned me, and I am now prepared!

Manny: I think this will be much worse for Canada than a short decline in the forestry sector. And I think it will be much cheaper for the taxpayer to try to prevent the worst of the crisis than letting the crisis happen and trying to help those who get hurt.

westslope: as far as I know, Canadian banks don't need a capital infusion from the government. But if they did, I agree that some sort of direct injection (mandatory dividend holiday, buying shares, etc.) would be a good solution. But market illiquidity is a problem in its own right, and can sometimes bast be fixed by a player with deep pockets who is able and willing to jump the system from the "bad" equilibrium into the "good" equilibrium. The assets are illiquid because nobody buys them; nobody buys them because they are illiquid. I don't see the connection between bubbles and military spending. If anything, military spending (financed by deficits) should increase world interest rates and make bubbles less likely. And if we look at countries/places around the world with housing bubbles, there doesn't seem to be any obvious correlation with their military activities or participation in the war on terrorism.

[Style]

The point is that the regulations needed to prevent the current crisis would not have been aimed at the mortgage market, but at the derivatives market more broadly. That would not have been open to as stark an attack as you suggest. On fire sale versus fair market, this is a vital distinction. The US government is paying a premium over current prices in order to revive the system - the hope is that reverse auctions will bring these prices close to fair market, the equity warrants are to protect taxpayers if that is not the case. Your rebuttal is a good defence of financial speculation, but doesn't really explain why the Canadian government should engage in financial speculation. Rather than buying risky assets, the Canadian government should buy stock in (temporarily) distressed firms, as Iceland has done (and as the Swiss(?) did much earlier).

The mechanism between China/Asia and the US is important for understanding the low interest rates. Pegging its exchange rate forced China to acquire US treasuries, leading to the high savings in Asia and low interest rates in the US. Alternately, there are no viable investment projects in Asia so Asian investors bought safe US assets (like Treasuries) leading to low interest rates in the US. Neither of these suggests an aging Asia saving for its retirement.

[Top Quark]

Why do bubbles occur? For a great variety of reasons, as you know, so the question is unanswerable as posed. The tulip mania has little in common with the current situation besides psychology of the herd. Why has this bubble occur and precipitated a financial crisis --- these are the questions that one hopes to tackle.

I personally start out by accepting as an empirical regularity the fact that the herd's belief formation is affected by powerful economic agents. In marketing, those agents are "early adopters" of a new brand, and their power derives from celebrity or expert status, wealth, etc. In the present case, the powerful economic agent that effected the change that later became a bubble is the U.S. government, namely, Congress. Yes, I am referring to The Community Reinvestment Act (1977). In its original version, it has no known deleterious effects until being rewritten by Rubin on Clinton's orders and promulgated by Congress (Rep. Barney Frank and Sen. Chris Dodd) in 1997-1999. Freddie and Fannie were now allowed capitalization of 2.5% vs. 10% for banks in exchanged for compliance with an order to increase the percentage of subprime loans they issue. This percentage was increasing through 2007.

In sum, we are dealing with the case of regulation. The objective of regulation was not financial, however, but social: increased homeownership by minorities. The measures were very, very successful: the ownership rose from 64% to 69%. By now, the entire culture moved left, and the results where liked by both Democrats and Republicans (while concerned and trying to curtail Freddie and Fannie in 2002-2003, the Bush Administration nonetheless tried to take credit for the results; Maxine and Frank blocked HUD because they wanted even more).

The question is, therefore, not whether we need more regulation but what kind of regulation. Clinton's version of The Community Reinvestment Act attained its objectives. It is the markets and public at large, including the minorities, that are paying the price now.

As you can see, one cannot even blame the heard here: it was RATIONAL to buy real estate. The heard went were it was led; incentives have predictable outcomes. The Wall Street merely acted as facilitators in the process. Please observe also that it is not entirely stupid to think, after a decade of housing prices outpacing the rest of inflation, that current prices are reasonable: it is a new equilibrium created by the above-mentioned Act.

It is a different question to ask why all this translated into a financial crises. The answer here, in my opinion, is even simpler: unreasonable leverage exacerbated by mark-to-market regulation (another wise measure of the government to "prevent" another Enron). As a small individual investor that cannot possibly influence the American economy, I am allowed a 2:1 leverage in buying stock. In contrast, Lehman, whose income is comparable to that of a small country, is allowed 33:1; Citigroup ha now, I hear, 10:1. This is simply stupid: in the case of controlling a car, it would be like making the car susceptible to every pebble on the road. The mark-to-market rule is comparable to forcing you continue with the left turn once you have started such a turn ---- where else would you end up but in a ditch? These two points are technical: I am referring here to control of dynamical systems, and any control engineer would recognize what I am talking about here. This expertise is readily available; social engineers such as Maxine Walters and Bernie Frank do not want the truth --- they want a different economic system.

Thus, the questions of what (i) has started the phenomenon, (ii) subsequently made it akin to a bubble and (iii) rendered unstoppable until a financial crisis ensued have quite reasonable and simple answers. The crisis continues and becomes deeper for the same reasons. To stop an unwanted deviation of a system from equilibrium, you either (i) wait for the oscillation to die out or (ii) apply a force that pushes the system back towards the original equilibrium. Neither option applies to the present circumstance. We have now raised a couple of generations in luxury and made them spoiled whiners; they are not going to wait while things are uncomfortable. And, socialism has become the accepted and shared mindset --- in Europe and Canada almost completely so, and but now overwhelmingly in the U.S. Where would a force toward free markets come from? Thus the deviation from equilibrium increases unabated. In fact, the Europeans and now the U.S. introduce socialist measure (coming into ownership of previously private assets, calling this "bailout") while combating the effects of the previously introduced socialist measures (e.g., the above-mentioned Act). Putting oil on fire is not the way to put it out, so it continues to burn and gets hotter.

[seaandthemountains]

No problem Nick

While you are spot on that "governments (both in Canada with CMHC, and the US with Freddie and Fanny) seemed to be pushing to make it even easier for people to borrow to buy houses", I am not sure it substantiates your assumption that the problem is that "governments seem so often to fall into exactly the same bubble mentality as the population" (as it relates to law making).

I am not sure that there would have been any significant public outcry in Canada if mortgages were restricted to less than 70% or even 60% of the value of the home. I would argue the point on two fronts:

1) as I understand it the mortgage regime was already more restricted here then in the US. If I am not mistaken, this suggests there was leeway.

2) Canadians tend not to be the most engaged folks in the country on matters of pending regulation.

I suspect had Canada made changes that what you would have a is a few poorly organizled and relatively week voice of outcry, but by and by not much reaction. Pretty much all regulation is contested by someone/some group... but their are often more resilient/stronger interests in support. On the other hand governments introduce and maintain all kinds of regs that are unpopular to often powerful interests (bank mergers).

While I don;t know that I completely disagree with your response, I think specificity strengthens your point. Where would the opposition come from? Where are the pressures is favour of dereg?

I don;t see the population as the challenge here and I am not sure of the reg not a solution theory.

But as you say, who know if it will even go that way... best of luck. Who is on the otherside of the panel?

[seaandthemountains]

Sorry to clarify that last post:

"I don;t see the population as the challenge here and I am not sure of the reg not a solution theory."

should be:

I am not sure of the notion that 'regulation is not a solution' is well-sustained on political, as opposed to economic, grounds, especially if it points to the population as the dominant interest in all of this.

[westslope]

Nick Rowe,

Thank you for sharing your notes and thank you for responding to the comments.

You are absolutely right that under typical conditions, deficit-financed war expenditures should lead to an increase in the world real interest rate and lower the likelihood of asset bubbles. But they didn't, due to the global glut in savings originating in the emerging economies and the US Federal Reseve's decision to drop overnight rates to a nominal rate of 1% and leave them there for some time.

You may recall President Bush Jr.'s suggestion to American citizens following the Sept. 11 box-cutter attacks on the twin financial towers to go out shopping? As many have already pointed out, the fed certainly facilitated that notion aided and abetted by an absence of inflationary pressures thanks to the inflation targeting innovation, increasingly globalized input markets, new inventory techniques and so on.

There is another theme here that should interest political scientists and those such as yourself who wish to minimize the moral hazard problem. Throughout time, priests, secular and otherwise, have used their power to obfuscate events and knowledge as part of rent-seeking strategies. Unfortunately, a credible pre-commitment to deterrence of this kind of rent-seeking behaviour will inevitably involve significant collateral damage. So on a personal level, I sympathize with the notion of massive state intervention as needed. Despite the risks.

[Phillip Huggan]

I agree with much of what you say Gordon, but I do believe interest rates were set way too low. Neocons were addicted to a pro-market and pro-growth mentality.
I also think you miss the derivative natural of the banking industry's risk misassessment. Mortgages are derivative investments. They are indexed to future employment income of homeowners. Investment banks marketed this as a safe non-derivative asset. They used this lie to borrow at artificially low rates; would've hed to pay more if mortgages collateral was accurately portrayed as a derivative. I think your thesis the bankruptcy of risky players makes all safer assets less safe, is correct, but that is not primarily what we see here.

[Arman (Allan Manchester)]

A general reduction of price is symptematic of deflation. There just is not enough money in the system, and the deflation is moving through the marketplace one sector after another.
The reason that the cash shortage is global is two fold.
First, the finacial arena is global, and the US is the heaviest hitter. A cash shortage in the US is a cash shortage for the world.
Secondly, the strategies of the Federal Reserve are mimicked in most of the central banks around the world.
What has caused the cash shortage? The trouble is that local banks are not so enticed to lend as they were a year ago. Why? Because the central banks, in their "wisdom" have tried to "stimulate" the economy by cutting interest rates. The interest rate cuts do almost nothing to the costs incurred by the local banks in their money creation activities. Lower rates only make these activities less profitable.
Lower rates discourage lenders from lending. Higher rates encourage lenders to lend. I think that the poorly devised Keynesian experiment has gone on long enough to tabulate some results!