Economics

Free exchange

Monetary policy

Those spoiled brats

Mar 10th 2011, 15:13 by R.A. | WASHINGTON

I SUSPECT Buttonwood knew I would respond to this post:

I have tried and discarded many analogies on thie issue but here's another one. We all want to protect our kids from harm; some of us wish we could fight their fights and sit their exams. But at some point, they have to stand on their own two feet and if we mollycoddle them too much, they will never manage. Central banks have sheltered the markets from harm, and raised a bunch of spoiled brats who always want more.

This is macroeconomic policy as morality play, and it's certain to lead us astray. The practical impact of tighter monetary policy is higher unemployment. The certain effect of this effort to punish spoiled brats so they learn their lesson is tougher times for workers who didn't necessarily take big mortgages, who didn't necessarily rush into structured financial products, who didn't necessarily want to spend outlandish sums on misguided government initiatives, and who didn't necessarily want to cut taxes on high earners. Their crime is to work in a cyclically vulnerable industry.

If you want to improve the incentives for market participants then improve the incentives for market participants. Support a regulatory system strong enough to allow firms that made bad bets to accept the cost of those bad bets. If Wall Street is spoiled, it's not because interest rates are low. It's because Washington has routinely stepped in to protect big insitutions from failure and has not managed to recover its implicit subsidies after the fact.

And remember, tight monetary policy makes future bail-outs more likely, by increasing the social pain associated with financial failure. If we prevent central banks from responding to the falling economic expectations associated with financial instability, then we ensure that financial crises will be followed by deep recessions, and that will make governments very eager to prevent financial crises by propping up shaky systemically important banks.

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1-20 of 25
Mar 10th 2011 3:50 GMT

The current policy-- keeping interest rates artificially low-- is a continuing bailout of the banks.

ShaunP wrote:
Mar 10th 2011 4:00 GMT

I think James Grant said it best when he said all you had to do was make financiers personal assets liable in the case of failure of bankruptcy. I think the issue is more one of the modern idea of a corporation, wherein by becoming an LLC or corporation their personal assets are exempt from recourse. Finance really is different and tweaking that law to include financial companies could change that, but congress is filled with too many cronies.

"I certainly am not against them making profits, but they can take their losses too." Jam Grant also said that. That is true capitalism.

OneAegis wrote:
Mar 10th 2011 4:19 GMT

"This is macroeconomic policy as morality play, and it's certain to lead us astray."

I agree with this statement, to a point. And I think we've moved well beyond that point. Our country is currently held hostage by financiers - either they make billions or the country goes down in flames. Moreover, we are literally handing them our children's and grandchildren's piggybanks and futures to do it.

At what point does the economy become "not worth it?" If you sell your soul to afford bus fare to the Pearly Gates it kinda defeats the purpose.

Mar 10th 2011 4:32 GMT

Buttwood: "Central banks have sheltered the markets from harm..."

What a hoot! Central banks destroy vital capital by creating massive bubbles with credit expansion and then an economist claims they are sheltering the markets!

Mar 10th 2011 4:35 GMT

You guys seriously need to read "Slapped by the Invisible Hand" by Gorton. It's the best explanation of how the MBS industry works and it shows no greed, misconduct or risk taking on the part of financial executives. Personally, they may be arrogant SOB's, but professionally they were very conservative.

Mar 10th 2011 4:37 GMT

Maybe I was too hasty criticizing Buttwood. I can see where one could view central banks as providing protection: it's protection life the mafia provides!

Mar 10th 2011 4:39 GMT

"If we prevent central banks from responding to the falling economic expectations associated with financial instability, then we ensure that financial crises will be followed by deep recessions..."

Yeah, I'm so happy we didn't go through a DEEP recession this time around!

ghaliban wrote:
Mar 10th 2011 6:32 GMT

Why have we given a bunch of unelected bureacrats the right to manipulate interest rates in the first place? Why can't we let the market determine the interest rate based on the supply and demand for capital?

Buttonwood is correct to point out that along with the power to set interest rates comes a dependence - banks employ dozens of Fed-watchers to uselessly try and forecast what the Fed is going to do, because it has a huge impact on their business. Much better that we got rid of the whole lot, and banks focused on what really matters - their customers and how best to serve them.

Monetary policy is a fiction that sustains itself. We should get rid of it.

Mar 10th 2011 7:39 GMT

Speculative bubbles have existed for centuries before the advent of the Fed. They are a human behavioral phenomenon. Over its ~100-year existence the Fed has managed to make economic booms and busts less extreme, with some notable screw-ups in the 70's and 2000's. Making the Fed more efficient and accountable is a worthy goal, while keeping in mind that the ups and downs will never completely go away.

To the "torches and pitchforks" crowd, I say "Rah, rah! Have fun at it".

bampbs wrote:
Mar 10th 2011 9:56 GMT

ShaunP, it used to be that investment banks had to be partnerships. It was the right way to run things. Letting them go public was a huge mistake.

I would make public investment banks subject to the same regulation as commercial banks. Partnerships risking their own capital would live and die under the old dispensation.

PKP801 wrote:
Mar 10th 2011 9:57 GMT

I understand that FE has a different take on economic policy from Buttonwood, that much is clear. After studying different economic policies, I am still unable to say for certain whether Keynes or Friedman is the better choice. And I would imagine many economists have the same problem. It seems to boil down to which models one uses and which variables one sets. Very much to a Pepsi vs. Coke debate.

If I may make a sweeping statement, loose monetary policy just seems worse in the long run. There is a lot of money sloshing around, and it is still cheap to borrow. Interest rates HAVE to go up some time (because they can't go down). Isn't keeping interest rates low now just reinforcing the bad habits that caused the problem, and increasing the pain when they eventually do rise?

Mar 10th 2011 10:06 GMT

PKP801, there is a third option, Austrian econ. As you have noticed, empirical data and models are fickle and can support anyone who strokes them. So how does one decide?

As my old statistics teacher said, theory comes first. Models and data can refine and lend support to theory, but they can never decide which theories are correct. Austrian theory is correct because it is based on human nature and how people think and act. Monetarism and Keynesian econ are based on the false assumption that economic aggregrates respond to each other in a mechanical way, as in physics.

Mar 10th 2011 10:15 GMT

bampbs, read Gorton's "Slapped by the Invisible Hand." None of the regulations that applied to commercial banks would have changed the way investment banks did business.

Investment banks took cash deposits from large firms such as mutual funds and invested those funds in the safest, AAA and AA-rated securities as collateral. When large firms with cash saw the advantage of such safe deposits of their cash, they demanded more. But there wasn't enough government debt to meet the demand.

That's where MBS's came in. They helped recycle cash to commercial banks so they could make more home loans, and they provided safe, AAA and AA-rated securities to back deposits of cash by large firms. The system worked perfectly for about a decade. No one saw this as risky until the top of the real estate market.

A lot of people claim they saw the problem coming when they saw how many bad mortgages were in the pools, but the investment banks kept the bad mortgages out of the AAA and AA-rated securities pools. And the bad mortgages weren't a significant part of the total pool of mortgages, hardly bigger than they had ever been before.

The problem was the collapse in housing prices, which made destroyed the value of the bonds. Bad mortgages did not cause the collapse in housing prices. Rising interest rates did, not to mention over building.

OneAegis wrote:
Mar 10th 2011 10:42 GMT

I take issue with the statement, "Bad mortgages did not cause the collapse in housing prices."

Working in Stockton, CA, often listed in the top 3 for worst hit by foreclosures, bad mortgages absolutely caused the collapse in housing prices. Once the ponzi scheme of selling overinflated houses to new buyers who used liar loans / poor underwriting standards to make the initial purchase dried up, and further people couldn't kite funds by refinancing with cash out or home equity, the supports dropped out from underneath and the market crashed. The income needed to actually make the payments and support those prices never actually existed - they were bad mortgages, through and through.

I literally spent every day of the week trying to help people (who somehow were able to get loans in the first place) refinance, when they couldn't even afford the interest only payments on a 3.5% 3/1 ARM teaser rate. Was it the individuals responsibility? Yes. Was it also the hugely sophisticated international bank's responsibility to underwrite responsibly? Sure. But when you had high school grads on the ground making $30,000 per month, the incentives were there to just get it done, damn the cost.

junius brutus wrote:
Mar 10th 2011 11:18 GMT

You're basically saying that dad should keep running up the credit cards because the kids didn't sign the charge slips.

migmigmigmig wrote:
Mar 11th 2011 2:03 GMT

Yes, exactly.

They're not spoiled brats, they're hostage takers. :)

"Gimme the bailout money or this Main-Street gets it!"

Mar 11th 2011 3:40 GMT

Oneaegis, The percent of bad mortgages just weren't much larger than they have always been. I know it makes good headlines for the mainstream media, but the problem was much larger than just bad mortgages.

OneAegis wrote:
Mar 11th 2011 5:39 GMT

fundamentalist -

Can you please define "bad mortgages"? I just don't understand how you can think that the huge number of mortgages given out to people who could only afford them by taking cash out as long as they were appreciating weren't bad mortgages.

OneAegis wrote:
Mar 11th 2011 5:42 GMT

Also, at Wells Fargo, a more conservative home lender than others, they cut off their broker funding in February of '07. They were seeing a large number of brokers with 50% or higher first month default rates. Can you post any type of substantiation to your claim that "the percent of bad mortgages just weren't much larger than they have always been"?

Mar 11th 2011 6:32 GMT

You have to distinguish between bad mortgages before the crisis and defaults after it. The bad mortgages (given to people who couldn't pay the monthly mortgage) were small. Most were given to minorities.

I don't remember where I saw the actual figures. Maybe hedgefundguy can help us out. He is good at digging up the data. But from what I remember the risky mortgages were something like 6%.

Defaults increased after the housing bubble popped because people lost their jobs, housing prices had fallen so far that people didn't want to keep them, and a lot of people had bought houses intending to flip them; when they couldn't they just walked away.

1-20 of 25

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