Month: January 2009

The Economic Crisis and the Crisis in Economics

The Economic Crisis

The global financial crisis of fall 2008 was unexpected. A few people had been predicting that serious problems were looming, and even fewer had placed bets accordingly, but even they were astounded by what happened in mid-September.

What did happen? There are many layers to unpeel, but let me begin with the three main events that triggered the severe global phase of the crisis. (See http://BaselineScenario.com for more on what came before, how events unfolded during fall 2008, and where matters now stand).

1. On the weekend of September 13-14, 2008, the U.S. government declined to bailout Lehman. The firm subsequently failed, i.e., did not open for business on Monday, September 15. Creditors suffered major losses, and these had a particularly negative effect on the markets given that through the end of the previous week the Federal Reserve had been encouraging people to continue to do business with Lehman.
2. On Tuesday, September 16, the government agreed to provide an emergency loan to the major insurance company, AIG. This loan was structured so as to become the company’s most senior debt and, in this fashion, implied losses for AIG’s previously senior creditors; the value of their investments in this AAA bastion of capitalism dropped 40% overnight.
3. By Wednesday, September 17, it was clear that the world’s financial markets – not just the US markets, but particularly US money market funds – were in cardiac arrest. The Secretary of the Treasury immediately approached Congress for an emergency budgetary appropriation of $700bn (about 5% of GDP), to be used to buy up distressed assets and thus relieve pressure on the financial system. A rancorous political debate ensued, culminating in the passing of the so-called Troubled Asset Relief Program (TARP), but the financial and economic situation continued to deteriorate both in the US and around the world.

Thus began a financial and economic crisis of the first order, on a magnitude not seen at least since the 1930s and – arguably – with the potential to become bigger than anything seen in the 200 years of modern capitalism. We do not yet know if the economic consequences are “merely” a severe recession or if there will be a prolonged global slump or worse.

The Crisis in Economics

Does this economic crisis constitute or imply a crisis for economics? There are obviously two answers to this question: no, and yes. Continue reading “The Economic Crisis and the Crisis in Economics” →

Causes: Hank Paulson

Eurozone Hard Pressed: 2% Fiscal Solution Deferred

One leading anti-recession idea for the moment is a global fiscal stimulus amounting to 2% of the planet’s GDP. The precise math behind this calculation is still forthcoming, but it obviously assumes a big stimulus in the US and also needs to include a pretty big fiscal expansion in Europe. (Emerging markets will barely be able to make a contribution that registers on the global scale.)

What are the likely prospects for a major eurozone fiscal stimulus? My presentation yesterday on this question is here. The main points are: Continue reading “Eurozone Hard Pressed: 2% Fiscal Solution Deferred” →

Risk Management for Beginners

For a complete list of Beginners articles, see the Financial Crisis for Beginners page.

Joe Nocera has an article in today’s New York Times Magazine about Value at Risk (VaR), a risk management technique used by financial institutions to measure the risk of individual trading desks or aggregate portfolios. Like many Magazine articles, it is long on personalities (in this case Nassim Nicholas Taleb, one of the foremost critics of VaR) and history, and somewhat light on substance, so I thought it would be worth a lay explanation in my hopefully by-now-familiar Beginners style.

VaR is a way of measuring the likelihood that a portfolio will suffer a large loss in some period of time, or the maximum amount that you are likely to lose with some probability (say, 99%). It does this by: (1) looking at historical data about asset price changes and correlations; (2) using that data to estimate the probability distributions of those asset prices and correlations; and (3) using those estimated distributions to calculate the maximum amount you will lose 99% of the time. At a high level, Nocera’s conclusion is that VaR is a useful tool even though it doesn’t tell you what happens the other 1% of the time.

naked capitalism already has one withering critique of the article out. There, Yves Smith focuses on the assumption, mentioned but not explored by Nocera, that the events in question (changes in asset prices) are normally distributed. To summarize, for decades people have known that financial events are not normally distributed – they are characterized by both skew and kurtosis (see her post for charts). Kurtosis, or “fat tails,” means that extreme events are more likely than would be predicted by a normal distribution. Yet, Smith continues, VaR modelers continue to assume normal distributions (presumably because they have certain mathematical properties that make them easier to work with), which leads to results that are simply incorrect. It’s a good article, and you’ll probably learn something.

While Smith focuses on the problem of using the wrong mathematical tools, and Nocera mentions the problem of not using enough historical data – “All the triple-A-rated mortgage-backed securities churned out by Wall Street firms and that turned out to be little more than junk? VaR didn’t see the risk because it generally relied on a two-year data history” – I want to focus on another weakness of VaR: the fact that the real world changes.

Continue reading “Risk Management for Beginners” →

The Importance of Accounting

Or, as I thought of titling this post, SEC does something useful!

Accounting can seem a dreadfully boring subject to some, but it gets its moment in the sun whenever there is a financial crisis . . . remember Enron? This time around is no exception. During the panic of September, some people were calling for a suspension of mark-to-market accounting, and while they did not get what they wanted, they succeeded in inserting a provision in the first big bailout bill to study the relationship between mark-to-market accounting and the financial crisis.

A brief, high-level explanation of the dispute: Under mark-to-market accounting, assets on your balance sheet have to be valued at their current market values. So if you have $10 million worth of stock in Microsoft, but that stock falls to $5 million, you have to write it down on your balance sheet and take a $5 million loss on your income statement. The criticism was that mark-to-market was forcing financial institutions to take severe writedowns on assets whose market values had fallen precipitously, not because of their inherent value, but because nobody was buying these assets – think CDOs – and that banks were becoming insolvent because of an accounting technicality. Under this view, banks should be able to keep these assets at their “true” long-term values, instead of having to take writedowns due to short-term market fluctuations.

I am instinctively skeptical of this view, and in favor of mark-to-market accounting, because I believe that while market valuations may not be perfect, they are generally better than the alternative, which is allowing companies to estimate the values themselves, subject only to their auditors and regulators. But the issue is considerably more complicated than either the simple criticism or my simple defense would imply.

Earlier this week, the SEC released its study of mark-to-market accounting as required by the bailout bill. Their conclusions are simple:

fair value [mark-to-market, as will be explained] accounting did not appear to play a meaningful role in bank failures occurring during 2008. Rather, bank failures in the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence.

Continue reading “The Importance of Accounting” →

The G20: Gordon Brown’s Opportunity

Prime Minister Gordon Brown has been trying to drum up support for some form of Bretton Woods Two, i.e., a big rethink regarding how the global economy is governed. So far, little support has materialized for any kind of sweeping approach to these issues.

Still, the chairmanship of the G20 affords him a great opportunity to make progress in other ways. (The G20 website still needs updating, as does the group’s Wikipedia entry; the key point is that this is now a forum for heads of government, rather than for ministers of finance/central bank governors. The chair was due to rotate to the UK in any case; the fact that it falls to Mr Brown in person is an amazing stroke of luck for him.)

The G20 focus in November, as you may recall, was largely on re-regulation and it remains to be seen how much of that agenda will be implemented by the next meeting on April 2nd. But that meeting was substantially under French auspices, despite taking place in Washington. Mr Sarkozy’s staff were jubiliant by the meeting’s end: “we have put the bell on the American cat” was the most memorable quote. The next meeting will take place in Britain, with a new US President at the table, and looks likely to be a much more serious affair. Continue reading “The G20: Gordon Brown’s Opportunity” →

Reliving the Fun Times

With the holidays coming to an end, my little burst of reading books (as opposed to newspapers and blogs) is coming to an end with the recent collection Panic, edited by Michael Lewis, which I got for Christmas. (I also got Snowball, the new biography of Warren Buffett, but that’s 900 pages long, so it may be a while.) The book contains several as-it-happened articles on each of four recent financial panics: the 1987 stock market crash, the 1997-98 emerging markets crisis, the collapse of the Internet bubble, and the thing we’re going through now. It’s long on entertainment – both the entertainment of hearing people say things like, “The more time that goes by, the less concerned I am about a housing bubble,” and the entertainment of reading legitimately good writing, some of it by Lewis himself. But given the format, it’s necessarily short on analysis, and its main point, if any, seems to be that all panics are alike: people underestimate risk, they think they are different, they do silly things, Wall Street people make a killing, and then bad things happen.

I believe the book was released in November, but it seems like the final touches were put on sometime in late spring or early summer – Bear Stearns had fallen, but Freddie and Fannie were still independent, and Lehman was just another investment bank. So the book provides this past summer’s perspective on the crisis: a collapsing housing bubble taking down isolated hedge funds that had invested in mortgage-backed CDOs, and one investment bank (Bear Stearns) for no clearly explained reason: Lewis’s own essay on the topic focuses on the inherent complexity of Wall Street firms and how even their CEOs don’t understand them. Reading the articles from 2007 and early 2008 reminds you how few people if any foresaw the impact the collapsing bubble would have on the financial sector as a whole.

Continue reading “Reliving the Fun Times” →

Causes: Econbrowser Speaks

Other posts in this occasional series.

As you might imagine, I read (or skim) a lot of economics blogs. One of my favorites is Econbrowser, written by James Hamilton and Menzie Chinn. Whereas many blogs tell me good ideas that I didn’t think of but that theoretically I might have come up with (given infinite time and mental alertness), Econbrowser almost invariably teaches me something I absolutely couldn’t have known beforehand.

In the last week, both Hamilton and Chinn have written about the causes of the current economic crisis.

Menzie Chinn

For Chinn, the current situation was created by a “toxic mixture” of:

Monetary policy
Deregulation
Criminal activity and regulatory disarmament
Tax cuts and fiscal profligacy
Tax policy

He thinks that lax monetary policy was not particularly significant (or, more specifically, the policy was not lax given the information available at the time). He says that some examples of deregulation were more significant than others (repealing Glass-Steagall OK, the Commodity Futures Modernization Act not so much, which is the distinction I also made in an earlier post). Deregulation bleeds into the third point – the abandonment of regulatory agencies of their policing functions, along with examples where regulators committed actual fraud to aid the companies they were supposedly regulating (IndyMac being the prime example).

But the last two points are the ones you don’t hear a lot about. The Bush tax cuts fueled the asset price bubble, especially the second one (in 2003), which came long after the recession had ended and when housing prices were on the steep part of their climb. Under tax policy, Chinn takes aim at the tax deductibility of second homes; combined with tax cuts that largely favored the rich, this increased demand for second homes, and therefore the prices of homes. Right now many people are calling for tax cuts as a way to stimulate the economy, and while you can debate whether tax cuts are more effective than increased spending, that is a reasonable debate to have. In retrospect, the error Chinn is pointing to is cutting taxes – providing a fiscal stimulus, in other words – when it wasn’t needed, at the same time that interest rates were low. Since the Reagan administration, the argument for tax cuts has been to shrink the size of government, increase the incentive to work, and return money to people who know how to spend it better than the government. Only this time, we’ve reached a point where (almost) everyone agrees we need a fiscal stimulus, and the need is so pressing we’re going to ignore the fiscal handcuffs created by the Bush tax cuts, which makes no one happy.

James Hamilton

In a November 2008 lecture, current IMF chief economist Olivier Blanchard discusses the boom in oil prices in a footnote:

How could the very large increase in oil prices from the early 2000s to mid-2008 have such a small apparent impact on economic activity? After all, similar increases are typically blamed for the very deep recessions of
the 1970s and early 1980s.

Hamilton takes almost the opposite approach: maybe it was high oil prices that tipped the global economy into recession. While this may sound preposterous (everyone knows it was housing, right?), remember that the U.S. housing bubble has been front-page news since at least early 2007, yet the peak of financial panic didn’t occur until September-October 2008. Was there really a lot of new information about the subprime mortgage market that appeared during that time? Christopher Dodd was already holding hearings on the subprime meltdown in March 2007 (thanks to Michael Lewis’s book Panic! for reminding me of that.) Or was it something else?

Hamilton takes a 2007 model created by Lutz Kilian and Paul Edelstein of how changes in energy prices affect personal consumption. (Summary: an increase in energy prices that would require a 1% reduction in other purchases to buy the same amount of energy actually leads to a 2.2% decrease in consumption over 15 months.) He then applies the model to actual energy prices since the middle of 2007 and (according to my eyeballing the chart) shows that about half of the falloff in consumption over the period is due to increased energy prices.

The (possible) implication is that if oil had remained at its early 2007 prices, the decline in housing prices that was already clearly visible would not have been enough to cripple the financial system and bring the global economy to its knees. In the process, of course, we ended up with oil in the $30s, but the damage has clearly been done. Hamilton promises to continue this topic in a future post, and I’ll be watching out for it.