Saturday, June 26, 2010

It's Nothing to Do With Us

It’s Nothing to Do with Us

1. “Global saving intentions … chronically exceeded global intentions to invest…. In short, geo-political events ultimately led to a fall in long-term mortgage events.”

2. “I define a bubble as a protracted period of falling risk aversion that translates into falling capitalization rates that decline measurably below their long-term trendless averages.”

3. “We have chosen capital standards that … cannot protect against all potential adverse outcomes…. Hundred-year floods come only once every hundred years.”

4. “The global house price bubble was a consequence of lower interest rates, but it was long term interest rates that galvanized home asset prices, not the overnight rates of central banks, as has become the seeming conventional wisdom…. The 30-year mortgage rate had clearly delinked from the fed funds rate in the early part of this decade.”

5. “Could the breakdown that so devastated global financial markets have been prevented? Given inappropriately low financial intermediary capital and two decades of virtual unrelenting prosperity, low inflation, and low long-term interest rates, I very much doubt it.”

Alan Greenspan, The Crisis, March 2010.

These are some of the Federal Reserve’s excuses for the recent crisis. Its disclaimers of responsibility have become famous. We are not sure that they are without merit, but they are not well-reasoned. Most of the evasive statements of Federal Reserve officials have been unsupported assertions of innocence, untroubled by the careful explanations that we are entitled to expect from the “experts” that we have raised to “responsible” public positions. Their actions and calls for action are justified by hysterical claims that if we don’t do something, the world’s financial system will melt down. We won’t have an economy tomorrow. We are looking at an abyss (see the 9/14/09 blog). The transparency so often promised is not forthcoming, although we don’t know whether this is because the Federal Reserve is secretive or because it doesn’t know what it’s doing.

Once in a while, however, one of them provides pieces of an account of events – such as former Fed Chairman Alan Greenspan’s explanation of The Crisis, excerpts from which are listed above. It was not well-received (e.g., The Economist, March 20, 2010), but it might provide an inkling of the economics behind the policies that have baffled students of the Fed. I consider the stated elements of what might be his model in the order listed.

1. They made us do it. Greenspan has an unusual view of how interest rates are determined (we will see more of this below), which in standard economic theory depends on the supply (thrift) and demand (investment) for savings, that is, on the competition for funds. Saving is a fairly steady proportion of income, so that the demand for capital goods drives interest rates and growth. That is why investment, interest rates, and income are procyclical. Greenspan, however, sees no effect of investment on interest rates (ignoring a blade of the scissors that Alfred Marshall used to illustrate the determination of price by the intersection of supply and demand) and attributes low real interest rates to the global saving that accompanied rising income. Funds were so abundant that savers could not be careful about the risks of their lending. It was a borrowers’ market.

Not only is Greenspan’s explanation wanting because it ignores demand during the global boom of the early part of the decade, so is his observation. The figure shows that real long-term interest rates (LTR – p) were not low by historical standards.

2. Changed people or changed incentives? The penchant of each generation to be convinced of declines in morals and the work ethic is not new. Greenspan has joined the crowd in blaming the bubble on a rise in greed (a fall in risk aversion), and neglects the possibility that the boom was due to a change in incentives.

The title of his book, “The Age of Turbulence,” like Kenneth Galbraith’s “The Age of Uncertainty,” reveal his lack of historical perspective. The Tulip Craze of 1630, the South Sea Bubble of 1720, the Panic of 1873, and the 1929 Crash might as well never have happened. Instead of considering the opening lines of Dickens’ “Tale of Two Cities,” Greenspan treats each event as unique and without precedent, and therefore not susceptible to analysis.

He fails to account for the implied government guarantees behind the government-sponsored subprime mortgage creators (Fannie Mae and Freddie Mac), the Too Big to Fail frame of mind of regulators, and the Greenspan put (bailout promise) on the risks perceived by lenders. An increased expectation of bailouts is a reduction in perceived risk rather than risk aversion. However much Greenspan likes the easy explanation, recent events suggest more continuity than change in human behavior.

3. The hundred-year flood metaphor is false. Snake-eyes occur on average once every thirty-six throws of a pair of fair dice. This changes if the dice are loaded. Similarly, although we might reasonably estimate a financial collapse once every hundred years in a given environment, the odds change if we alter the environment by increasing the incentives to take risks.

Capital has been a poor predictor of financial failures, as must be the case if we are not careful about the risks of assets. The capital sufficient to protect depositors against the dangers of high-risk loans exceeds that for low-risk loans. Capital regulation has never been successful (as was noted in my 9/29/09 blog), partly because capital ratios are determined by the same factors (such as the perceived risks discussed above and the seriousness of regulation) as assets. Regulation in general and capital regulation in particular are popular solutions for those unwilling to admit the effects of information or incentives on the behavior of financial (and other) institutions.

4. The claim that long rates were “delinked” from short rates denies economics and central banking. Long rates depend on expected short rates, and central banks have operated through short rates from their beginnings. A classic defense of “bills only” (short-term Treasuries) as its primary instrument was issued by the Fed in the 1950s. If short rates have no effects, one can only wonder what Greenspan thinks the Fed is doing.

5. It was inevitable. Booms have often been followed by busts, but central bankers have usually “leaned against the wind,” as Fed Chairman (1951-70) William McChesney Martin, Jr., put it. He also said: “It’s my job to take away the punch bowl just as the party gets going.” Martin and other central bankers have made plenty of mistakes, but they have usually accepted responsibility for moderating financial developments. Greenspan rejects this and other responsibilities, although his stated economic ideas suggest that he couldn’t have been effective anyway.