Commercial banking was a good business all through the Great Depression.

A recent analysis by Daniel Gros of data from the Great Depression reveals that profits of commercial banking held up much better than profits in other financial services and non-financial businesses. This was a reason why the Glass-Steagall Act of 1933, separating commercial banking from investment banking, made sense and why its repeal in 1999 did not. Since the repeal, most of the largest banks have combined commercial banking with investment banking and other financial services. Not surprisingly, the recent losses and valuation declines in the other businesses are inhibiting commercial lending now. Daniel Gros:

The resilience of "normal" banking operations to a recession or even a depression strengthens the case for a separation of commercial and investment banking activities. The classic banking operations of deposit-taking and lending tend to remain profitable even under stressed conditions. But this classic function of banking would not be such a cause of concern today if the investment banking arms of banks had not gotten into trouble by investing in "toxic" assets. At present, the authorities in both the US and Europe have little choice but to make up for the losses on "legacy" assets and wait for banks to earn back their capital. But to prevent future crises of this type, policymakers should make sure that losses from investment banking arms cannot impair commercial banking operations.

Jamie Galbraith responds to Dick Armey

In a debate at the Texas Lyceum, Dick Armey spoke first and drew this response from Jamie Galbraith.  Between the zingers, Galbraith attributes the financial collapse to the prevailing idea of free market fundamentalism, to Phil Gramm the legislator, and to the Bush administration abandonment of state responsibility for financial regulation.  Then he discusses whether fiscal stimulus can get us out of trouble, saying yes but only if we're persistent--it won't be over in a year or two.

The financial crisis as described by Treasury insiders

The financial crisis—from Bear Sterns, to Fannie and Freddie, to Lehman and AIG, to the panic in money market funds and commercial paper markets, to TARP and beyond—is described by 3 top Bush Treasury insiders in this 75 minute video. Some highlights:

"We were afraid of a complete and utter collapse of the global financial system."

Treasury had great difficulty getting political support for new intervention authorities because hardly anybody on Capitol Hill understood the first thing about credit markets. Only when constituents told members they were going to do layoffs and curtail operations due to a lack of credit, and when the stock market tanked the day the House rejected the TARP legislation, did the necessary votes finally appear. Further TARP-like legislation would have no chance in the current Congress under present circumstances.

The idea to buy assets, which was the reason Treasury said it wanted TARP, was abandoned because the conditions kept getting rapidly worse, it was found that putting an asset purchase program in place would take too long, the Europeans announced they were going to aid their troubled banks with capital injections forcing Treasury into a matching program for US banks, and at Treasury, "we believed the banking system was fundamentally undercapitalized." (As we saw, the capital injections could be accomplished in days, not months.)

The Treasury team, who worked around the clock for months, still could never get ahead of events and were in a constant state of improvisation and reaction. Paulson told his team at one point, "We're doing this with duct tape and fishing wire."

Lehman was not saved because there was no private buyer who could be encouraged with some Treasury money to take over all of Lehman, because there was a clear lack of authority for the US to guarantee all $600 billion of Lehman's debt, and because there was no third alternative. Contrary to the speculation that Treasury wanted to send a signal that players should solve their own problems because they would not be bailed out, Treasury worked desperately all summer to try to save Lehman.

Washington Mutual was seized and worked out "by the book," using authorities and procedures that were designed for failing banks and had been used many times before. Wachovia got special treatment (thrown into the arms of BofA) because—to the surprise of Treasury—the credit markets had reacted very, very badly to the WaMu seizure. In other words, the markets were telling Treasury that seizure of Wachovia would push the system much further toward collapse, whereas Treasury had seen no such signal before WaMu. It was an art, not a science.

Treasury was frustrated with the leadership of financial institutions because they refused to accept the reduced value of their assets and liquidate at market prices. There are still asset valuation problems, and banks are necessarily shrinking their balance sheets, both of which keep new lending tight. But it was not intended that the TARP capital injections be used much for new lending—the major purpose became to provide "a buffer against losses," and this was TARP's major, and important, achievement.

Oil price spikes and recessions

Professor James Hamilton documents that 10 of the last 11 US recessions have closely followed crude oil price spikes and discusses causation in this post, where he also links to work he has been doing on this subject since 1980.

Is 4 seconds of waterboarding torture?

One of the "torture memos" approved waterboarding sessions that lasted no more than 40 seconds each. When I described this to a lawyer friend who is a navy veteran who went through the SERE training, he was surprised that the sessions were so short. Does the duration of a waterboarding session determine whether it is or is not legally "torture"?

My friend's SERE training was introduced by an instruction that the treatment they were about to receive was legally "torture" but that they had to be prepared for it because their adversaries (in Vietnam) might not adhere to the Geneva Conventions. The several-day experience, which also included other tortures, was very unpleasant, he said, but they knew they were going to come through it without serious injury.

It seems from a reading of the memos that the water-boarding approved by DoJ was limited to 40 seconds per session precisely because it was judged that detainees might be made uncomfortable and scared enough to start talking but that they would not actually suffer any serious physical harm. Was the Bush administration correct that 40 seconds of waterboarding is not torture? What about 20 seconds, or 10 seconds? 4 seconds? Perhaps cutting off the air supply for even the briefest period is torture if the victim does not know how long it will last, has no control, and is not sure he will not be immediately killed. Elsewhere the DoJ memo demonstrates a sensitivity to the importance of the psychological effects by reciting that when a detainee is confined in a box with an insect he will be told in advance that it is harmless. The Bush administration and its lawyers seem to have tried to draw a line between inducing extreme fear and mental anguish, on the one hand, and lasting physical injuries, on the other hand. Did it succeed? Is the distinction legally significant?

Perhaps some people in government opposed disclosing the torture memos because that would expose as a bluff a technique intended to induce a fear of imminent death. On the other hand, didn't all the subjects of this technique figure out before the 83rd or 183rd session that they were not going to be drowned?

Update on Thursday, April 23, 2009 at 06:40AM by Skeptic

Just as waterboarding is described as "simulated drowning," maybe the Bush administration's enhanced interrogation program should be described as "simulated torture."  They wanted detainees to think there were no limits to the brutality, degradation, and injuries they might suffer if they did not cooperate, but they wanted everybody else to believe the US was not doing anything cruel or illegal.  Saddam Hussein wanted Iraqis, Iran, and other Middle Eastern nations to believe he had weapons of mass destruction, but he wanted UN weapons inspectors, the US, and others to believe he did not.  In both cases the cost of the duplicity was enormous.

Update on Thursday, April 23, 2009 at 04:51PM by Skeptic

I received an email with this comment:

Several print art/quotes in the current dust storm seem to imply the memos might violate the US "Torture Law", which appears to be a reference to 18 USC Part I, Section 2340 et seq. Perhaps the timing limitations on dunking, etc.,were intended to avoid the "prolonged mental harm" requirement for torture in the US code. Or the prohibition against "severe pain or suffering, whether physical or mental" in the 1984 Convention on Torture, etc.. The 1954 Geneva Convention, which is all there was back in the day, perhaps wisely doesn't attempt to define torture.

Update on Friday, April 24, 2009 at 07:23AM by Skeptic

A website devoted to waterboarding posts this abstract of information about duration and frequency of waterboarding session from the DoJ memos.

Whether torture “works” depends on the goal.

Interrogation experts frequently say they can get more and better information faster from a captive by their non-violent, relationship-building methods than by torture, and that torture yields wrong and unreliable information because a torture victim will say whatever he thinks will stop the pain. An important goal of the Bush administration was to get confirmation of wrong information, according to Jon Landay of McClatchy:

The Bush administration applied relentless pressure on interrogators to use harsh methods on detainees in part to find evidence of cooperation between al Qaida and the late Iraqi dictator Saddam Hussein's regime, according to a former senior U.S. intelligence official and a former Army psychiatrist.

Such information would've provided a foundation for one of former President George W. Bush's main arguments for invading Iraq in 2003. In fact, no evidence has ever been found of operational ties between Osama bin Laden's terrorist network and Saddam's regime.

Read the rest of Landay's shocking report here.

When does your legal advice make you a war criminal?

More "torture memos" were released last week, showing that Justice Department lawyers were intimately familiar with the details of "enhanced interrogation" methods and then approved them—or at least let them go forward. Ordinarily, I think, a lawyer does not commit a crime if the client commits a crime relying on the lawyer's erroneous advice that the conduct is lawful. Certainly, the lawyer would be looking at a malpractice action and potential disbarment for incompetence, but where is the line on the other side of which the lawyer is also a criminal? In this post, I try "crowd sourcing." Instead of my summarizing interesting material for you and providing a link, I'm asking you to help me figure this out by referring me to useful materials and/or explaining it to me.

The current Attorney General, Eric Holder, testified in his confirmation hearings that he believes waterboarding is "torture" within the meaning of US statutes and the Geneva Conventions that are binding on the US. His immediate predecessor, Michael Mukasey, very pointedly refused to say in his confirmation hearings that waterboarding is—or is not—torture. Before him, Alberto Gonzales, defended waterboarding as being lawful. But the lawyers most in jeopardy are senior Justice Department lawyers like John Yoo and Jay Bybee who actual signed off on the legal memos approving waterboarding which, in order to make this inquiry interesting, we need to assume is torture and therefore a federal crime and also a war crime subject to universal jurisdiction.

If the "rule of law" means anything, it cannot be the case that advice of counsel that the activity would be legal is a defense to a major crime, any more than "just following orders" is a defense, can it?

An element of some crimes is that the defendant must have had a "specific intent" to cause a particular outcome (e.g., in the case of murder, death or serious bodily injury), but so far as I know the defendant's subjective opinion that the outcome he intends is lawful is not a valid defense. For example, for a battered wife to poison her husband to death over a period of months is probably murder—even if some lawyer advised her in advance that it would not be a crime. Am I wrong about that?

Assuming the DoJ advised unequivocally (assuming there's a lawyer alive who knows how to give unequivocal advice) that waterboarding is lawful, what, if any, additional circumstances would have to be proven to convict the lawyers of a war crime? Just that after all the appeals in a particular criminal case the Supreme Court holds 5-4 that the advice was wrong and waterboarding is torture? That seems pretty harsh. What if the opinion did not address major contrary precedents or was otherwise objectively unreasonable and the defense was unanimously rejected by all judges before whom the issue was raised? Does it matter if the lawyers were just incompetent or were acting in bad faith to give the client cover with a bogus legal opinion? Do the lawyers go to jail, or just get fired and disciplined by the state bar? Where is the line between giving professional legal advice and joining a criminal conspiracy with clients intent on waterboarding?

What if the lawyers' advice was that there was some legal uncertainty whether waterboarding was lawful, but that in their opinion it would be reasonable to raise certain potentially effective defenses in the event of a criminal prosecution? Actually, I have the impression that at least some of the torture advice was of this nature—DoJ identified legal issues that they considered had not been definitively settled by the Supreme Court of the United States (including that the President has inherent war powers that override statutes and treaties, that waterboarding is not torture, that the Geneva Conventions do not apply to "unlawful combatants" or outside the US, etc.) and undertook (at least implicitly) to raise them on behalf of agents of the United States in the event persons following its advice were charged. Wouldn't anybody engaging in waterboarding based on such advice clearly be assuming the risk that the suggested defenses might fail and that a criminal conviction might result? And wouldn't the lawyers clearly be protected from prosecution if the advice was accurate?

Or would they be criminally liable for failing to report to police or prosecuting authorities (in this case themselves) their belief that a serious crime was about to be committed?  In many States there is an imminent-crime exception to the general duty to preserve a client's secrets, and in others there is no exception.

I have little doubt that the lawyers involved strained very hard to facilitate waterboarding while making it extremely difficult for later administrations and international courts to prosecute either the lawyers or the clients. Did they succeed? If so, how can their methods be generalized to allow other lawyers to insulate their clients from other kinds of crimes?

Would the analysis be different if decided under customary international law or the laws of Spain, Iran, or Cuba (just to pick a few nations at random)?

Update on Tuesday, April 21, 2009 at 09:57AM by Skeptic

This doesn’t go to the central question I posed (criminal liability of lawyers), but this Congressional Research Service report notes (at 4) that Section 1004(a) of the Detainee Treatment Act of 2005 (DTA, P.L. 109-148) makes reliance on advice of counsel a qualified but probably very effective defense:

In any civil action or criminal prosecution against an officer, employee, member of the Armed Forces, or other agent of the United States Government who is United States person, arising out of the officer, employee, member of the Armed Forces, or other agent’s engaging in specific operational practices, that involve detention and interrogation of aliens who the President or his designees have determined are believed to be engaged in or associated with international terrorist activity that poses a serious, continuing threat to the United States ... and that were officially authorized and determined to be lawful at the time that they were conducted, it shall be a defense that ... [the] agent did not know that the practices were unlawful and a person of ordinary sense and understanding would not know the practices were unlawful. Good faith reliance on advice of counsel should be an important factor, among others, to consider in assessing whether a person of ordinary sense and understanding would have known the practices to be unlawful. Nothing in this section shall be construed to limit or extinguish any defense or protection otherwise available ... or to provide immunity from prosecution for any criminal offense by the proper authorities.

Update on Tuesday, April 21, 2009 at 10:31AM by Skeptic

The Center for Constitutional Rights filed a complaint with the German Federal Prosecutor in November 2006 contending that lawyers "aided and abetted" torture by giving the legal advice they did. The prosecutor declined to open an investigation, and that decision is on appeal. From the executive summary of the complaint:

The U.S. torture program that resulted in war crimes was aided and abetted by the government lawyers also named in this case: former Chief White House Counsel (and current Attorney General) Alberto R. Gonzales, former Assistant Attorney General Jay Bybee, former Deputy Assistant Attorney General John Yoo, General Counsel of the Department of Defense William James Haynes, II and Vice President Chief Counsel David S. Addington. While some of them claim to merely have given legal opinions, those opinions were false or clearly erroneous and given in a context where it was known and foreseeable to these lawyers that torture would be the result. Not only was torture foreseeable, but this legal advice was given to facilitate and aid and abet torture as well as to attempt to immunize those who tortured. Without these opinions, the torture program could not have occurred. The infamous “Torture Memo” dated August 1, 2002, is the key document that redefined torture so narrowly that such classic and age old torture techniques as water-boarding were authorized to be employed and were employed by U.S. officials against detainees.

CCR's longer discussion of aiding and abetting (under German law) is here and argues (at 27) that intentionally giving incorrect advice to facilitate the criminal conduct makes a lawyer an accessory:

Yoo and Bybee intentionally gave incorrect legal advice, because only this fit the administrative and political concept for the use of torture, of which they were aware.

Update on Wednesday, April 22, 2009 at 05:09PM by Skeptic

Four lawyers discussed this at lunch today and raised several points, one of which I’ll pass on.

It is very common for a lawyer’s formal communication to a client to be either (i) a comprehensive and even-hand explanation of the state of the law as it applies to certain facts because the client wants to weigh the pros and cons of a course of action, or (ii) a one-sided argument leading to a conclusion that the course of action the client has chosen is lawful. Either may be called a “legal opinion,” but it is useful to keep in mind the distinction many lawyers would make and call (i) a memorandum and (ii) an opinion. In a large law firm, a memorandum would be a routine output prepared mostly by an associate and signed off by a partner or two, whereas an opinion might have to be approved by a committee and would be issued on letterhead paper.

Usually, clients don’t want to pay for “opinions,” and usually when they do want “opinions” the reason is to be able to show them to some third party, now or if/when something goes bad. For example, a client may want a formal opinion that its new trademark does not infringe an existing mark, an opinion that the new widget does not infringe an existing patent, or an opinion that an ambiguous provision of the tax code authorizes a certain deduction because those opinions are useful later to show that the client acted in good faith and not recklessly. If the “torture memos” were not thorough, even-handed, and mainstream in their analysis, as many critics have charged, probably the reason is that they were not meant to be category (i) “memoranda” but were meant to be category (ii) “opinions” and both DoJ lawyers and senior Administration officials understood with perfect clarity that the torture "memos" were really torture "opinions."

Does Obama have to dumb down the TARP explanation?

Paul Krugman, Matt Yglesias, and Brad DeLong are worrying that the Obama Administration does not have a clear and consistent narrative about its policies for the financial industry. They enumerate 5 possibilities:

1. We have to enrich undeserving banksters by driving up asset values because there is absolutely no other way to prevent the economy from getting much, much worse for everybody else.

2. Because government investments into the financial system are not infected by the recent "irrational pessimism" of the private sector, the government investments will stabilize the system in the short term and pay off handsomely later.

3. It is likely we will need to do more to rescue the economy—even dramatically more—but we can't get Congressional approval for more unless and until our current authority proves insufficient.

4. Receivership (opponents call it "nationalization") for the largest banks is impossible for feasibility, political, and/or ideological reasons.

5. The current approach of Public Private Investment Partnerships will cost the US government less in the long run than the receivership option.

These pundits wring their hands because the Obama Administration has not settled on a single narrative to the exclusion of all others. Krugman even compares the lack of a single focus to the shifting rationales that the Bush Administration used for tax cuts in 2001 and the invasion of Iraq. I note that there is no inherent inconsistency among the 5 narratives—they could all be true. Maybe the best way for the Administration to explain what it's doing is comprehensively instead of in sound bites.

What credit default swaps are and why they should be banned

Willem Buiter has a long and useful description here of credit default swaps, refutes the argument supporting them, and makes 6 arguments against them. He concludes:

The endless churning of contingent claims, including derivatives, when the purchaser has no identifiable insurable interest, turns financial intermediation into a market-mediated betting shop. Then the betting slips become bearer securities and are themselves traded, either OTC or on organised exchanges, and the derivative transactions volumes expand to dwarf the transactions in the markets for the underlying financial claims (let alone the markets for the underlying real resources). At that point, the betting tip of the financial tail of the real economy dog does all the wagging. It does not create value but redistributes it in a way that consumes real resources and exposes the real economy to unnecessary risk. It's time to tame the tiger.

How mortgage backed securities increased systemic risk

The securitization of mortgages and other debt obligations gives senior tranche holders less risk of individual defaults, but increases the risk to a general economic downturn. Coval, Jurek, and Stafford demonstrate this in The Economics of Structured Finance a working paper published last week by the Harvard Business School. The paper contains exceptionally lucid descriptions of how structured finance works and uses simple examples to demonstrate the sources and magnitudes of under-appreciated systemic risks. It's 36 pages including charts and graphs and well worth the 1-2 hours it might take to understand it. Here's my summary of the essence. (Except as otherwise noted, all citations are to the PDF of the working paper.)

The main reason people buy investment grade bonds is that they want a very high degree of security that the promised income stream will not be interrupted even if there is a severe economic downturn causing a deep slump in the stock market. In other words, they want investments that are as weakly "correlated" as possible with general economic conditions because the values of other classes of investments, such as corporate stocks and commodities, are highly correlated with general economic conditions.

Rating agencies (Moody's, S&P, Fitch) developed methods to compare the creditworthiness of bond issuers against one another. For example, they tell us that this AA rated General Electric bond is less likely to default than that A+ rated utility bond and both are less likely to default than a certain A- rated municipal bond. "However, credit ratings, by design, only provide an assessment of the risks of that security's expected payoff, with no information regarding whether the security is particularly likely to default at the same time that there is a large decline in the stock market or that the economy is in a recession." At 18-19 (emphasis added).

When the rating agencies began to rate collateralized debt obligations ("CDOs"), they continued to ignore correlation of risk to general economic conditions. Regrettably, while pooling of mortgages and other debt obligations does reduce the risk to senior tranches of individual defaults, it increases the correlation to general economic conditions. As a result, a AAA rated CDO is more subject to systemic risk than a single AAA rated corporate or municipal bond. "[T]ranches written against highly diversified collateral pools have payoffs essentially identical to a derivative security written against a broad economic index." At 20. Consequently, much to the consternation of most of them, holders of CDOs had bet on the overall health of the economy, not on mortgage default rates in Tallahassee.

If this had been widely understood—it was not—buyers of AAA rated CDO tranches would have demanded higher yields than they did, and the business of "structured finance" would likely have been much smaller. However, the Basel I and II international banking agreements created additional impetus by providing that banks need to hold only half the reserves against AAA rated securities that they must hold against lower rated securities. At 26.

It gets worse. There developed a practice of securitizing the mezzanine tranches of CDOs into CDO-squareds, thereby creating additional AAA rated bonds. At 17. Coval et al. show mathematically that any tiny underestimate of default rates or correlation of performance among the underlying obligations is hugely magnified in CDO-squareds. At 15. According to Moody's, CDO-squareds accounted for 55% of the notional value of all CDOs issued in 2006! At 17. It seems shocking that a AAA tranche from a CDO-squared is much more likely to default in a recession than a AAA tranche from a CDO, but that seems irrefutable.

There is some evidence that Wall Street executives realized it would end one day, but in the meantime, they had little incentive to move to the sidelines. In July 2007, the then-CEO of Citigroup, Chuck Prince, acknowledged that the cheap credit-fueled buy-out boom would eventually end, but that in the meantime, his firm would continue to participate in structured finance activities (as reported in Nakamoto and Wighton, 2007): "When the music stops, in terms of liquidity, things will get complicated. As long as the music is playing, you've got to get up and dance. We're still dancing."

At 26. See also Risk management means taking the risks your competitors take.

Update on Thursday, July 9, 2009 at 04:16PM by Skeptic

A nice overview of how the CDO industry developed is here.

Neglect of fiduciary duty by investment advisors contributed to the financial crisis.

John C. Bogle, legendary founder of Vanguard Group, adds institutional money managers to the list of those whose failures contributed to the current financial crisis, reports Gretchen Morgenson whose NYT piece is the source of all facts and quotations below.

Professional money management firms like Fidelity, Vanguard, and Putnam today control 70 percent of the shares of large public companies, by making investment decisions on behalf of pension plans, IRAs, 401(k)s, and mutual funds. This gives them enormous potential power over board structure and governance, director elections, executive compensation, stock options proxy proposals, dividend policies, and other matters of concern to shareholders at the companies they own, but they rarely exercise any of this power. Their passivity enables managements to ignore the interests of shareholders and exploit their positions for their own gain.

But that isn't all. Despite the Investment Company Act of 1940 requirement that "mutual funds should be managed and operated in the best interests of their shareholders, rather than in the interests of advisers," money managers routinely abuse their positions of trust by exploiting investors.

Consider fees. Charges levied on mutual fund investors are much higher than those that the identical firms exact on pension clients, for example. The three largest money managers, Mr. Bogle pointed out, charged an average fee rate of 0.08 percent to pension customers. This compares with 0.61 percent charged to fund shareholders.

Money managers also haven't done the kind of due diligence that might have protected their investors from titanic losses. "How could so many highly skilled, highly paid securities analysts and researchers have failed to question the toxic-filled, leveraged balance sheets of Citigroup and other leading banks and investment banks?" Mr. Bogle asked.

. . . .

Some money management firms are publicly traded themselves, and Mr. Bogle says that those firms offer an added layer of deep and serious conflicts because executives running them try to serve two masters: their shareholders and their fund clients.

. . . .

In the face of all this, Mr. Bogle suggests that we force our agents to relearn what being a fiduciary means. A fiduciary, these managers seem to have forgotten, acts for the sole benefit and interest of another. We need to replace the agency society with a fiduciary society, he argues.

Update on Tuesday, April 21, 2009 at 01:45PM by Skeptic

Bogle addresses the issues again in this Wall Street Journal opinion piece.

There are no bad assets, only misunderstood assets. Part 2.

The six months report of the Congressional Oversight Panel for TARP is out. It describes the basic strategic options for fixing sick banks. Here's what it says about the strategy adopted by Treasury for TARP:

One key assumption that underlies Treasury's approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from nonfunctioning markets for troubled assets. The debate turns on whether current prices, particularly for mortgage-related assets, reflect fundamental values or whether prices are artificially depressed by a liquidity discount due to frozen markets – or some combination of the two.

If its assumptions are correct, Treasury's current approach may prove a reasonable response to the current crisis. Current prices may, in fact, prove not to be explainable without the liquidity factor. Even in areas of the country where home prices have declined precipitously, the collateral behind mortgage-related assets still retains substantial value. In a liquid market, even under-collateralized assets should not be trading at pennies on the dollar. Prices are being partially subjected to a downward self-reinforcing cycle. It is this notion of a liquidity discount that supports the potential of future gain for taxpayers and makes transactions under the CAP and the PPIP viable mechanisms for recovery of asset values while recouping a gain for taxpayers.

On the other hand, it is possible that Treasury's approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth. The actions undertaken by Treasury, the Federal Reserve Board and the FDIC are unprecedented. But if the economic crisis is deeper than anticipated, it is possible that Treasury will need to take very different actions in order to restore financial stability.

Massive defaults in home mortgage debt caused the Great Depression too.

Why did destruction of $10 trillion in stock values when the dot-com bubble collapsed not damage the banking system, while a $3 trillion loss in housing values has driven banking and the credit system to its knees? Gjerstad and Smith dig into these events and the Great Depression and suggest the reasons here.

Only a small fraction of the money in dot-com stocks was margined. So when that bubble popped, investors lost their own money and the banks did not not suffer substantial loan defaults. But as the subprime mortgage bubble has collapsed the losses have fallen much more on the lenders than on the nominal equity owners who cannot pay or, under the laws of most States, are not required to repay mortgage loans if they walk away. Gjerstad and Smith re-examine the Great Depression and, disagreeing with Milton Friedman and Anna Schwartz, say it was not precipitated so much by the stock market crash as by the later collapse of a bubble in residential mortgages. Their conclusion:

The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge.

Update on Sunday, May 10, 2009 at 07:46AM by Skeptic

In the 1920s, President Hoover made a big federal push to increase homeownership rates, including encouraging expansion of credit for home mortgages.  The story has been repeated several times since, most recently by the Bush administration, always with a bad ending.  Steven Malanga has the story here.  Thanks to Christine for sending it to me. 

Update on why crude oil prices spiked last year

This recent blog post by Professor James Hamilton at UCSD tries to tie last year's crude oil price spike to fundamental market forces.  I commented that in high price ranges large sovereign suppliers have a reversed supply curve--they want prices lower because they don't want customers to shift away from petroleum and they only need enough income to balance their budgets.  I also linked to Mark Thoma's persuasive argument that crude oil prices were being bid up in substantial part as part of a broader waive of coordinated commodity price increases (even though the likelihood of coordinated changes in fundamentals across all commodities is miniscule). 

Then Get Rid of the Fed commented with a link to an undated paper by Paul Krugman several years ago in which he showed a reversed or serpentine supply curve for petroleum and suggested there could be multiple equilibrium prices. When Krugman addressed crude oil prices in a series of blog posts in the spring of 2008, I don't think he referred to this.  As I recall, he started with rather conventional crossing SS and DD curves and ended with a vertical SS curve, all the while talking about whether there was hoarding that could distort fundamentals.  He never warmed to the idea that speculators in the options market could be affecting current OPEC prices.  He should.

Update on Monday, April 6, 2009 at 09:49AM by Skeptic

Light crude oil futures on NYMEX had traded in the range of $50 to $78 from March 2005 to August 2007, when they had retreated a bit to $70. At that time the Goldman Sachs index of combined commodities futures was about 480. Charts are here. After that they rose together until July 2008 and then both declined in concert. Crude oil futures rose 110% from $70 to $147 and then declined 73% to $40 in December 2008, while the Goldman index rose 81% from 480 to 870 and then declined 63% to 320. Crude oil was somewhat more volatile than the Goldman index, but both made big moves in the same directions at the same times. In conclusion, it seems to me that everything above about $70 per barrel was speculative bubble.

Update on Friday, September 25, 2009 at 08:17PM by Skeptic

Speculators, who held 20% of oil futures in 2002, now hold 50%, and movements in oil prices have become more correlated with dollar exchange rates, according to this recent paper.

A new policy paper by Rice University's Baker Institute for Public Policy shows a clear increase in the size and influence of noncommercial traders, or "speculators," in the oil futures market since regulations were eased by the Commodities Futures Modernization Act of 2000. Speculators now constitute about 50 percent of those holding outstanding positions in the U.S. oil futures market, compared with only about 20 percent prior to 2002.

The report also finds that the correlation between oil and the dollar has strengthened significantly over the past several years. The coauthors of "Who is in the Oil Futures Market and How Has It Changed?"-- Kenneth Medlock and Amy Myers Jaffe -- advocate that the government should revise its policies to reverse these trends. Kenneth Medlock is an energy fellow at the Baker Institute and adjunct professor of economics. Amy Myers Jaffe is a fellow in energy studies at the Baker Institute and associate director of the Rice Energy Program.

Update on Thursday, December 10, 2009 at 12:06PM by Skeptic

Professor Hamilton has evolved.  In this post, he cites recent work of others that persuades him that commodities speculation was a major cause of the crude oil price spike in 2008.  He presents charts showing that price movements of oil and several other commodities, which had been essentially uncorrelated for 20 years, started in 2005 to become quite correlated.  Since fundamentals of supply and demand for cotton, live cattle, soybean oil, copper, etc. do not change in synch with the fundamentals for crude oil, the most reasonable explanation for the increasing correlation is that investors were buying all commodities as another asset class. 

Professor Hamilton goes on to warn that this trend of heavy "investment" in commodities continues and that it could drive inflation in the real economy even though labor costs and demand are stagnant.  I wonder if the oil price spikes of the 1970s were a major contributor to the stagflation we had then. Commodities speculation is one way in which the financial economy affects the real economy--and not in a good way.  Even more destructive than the impact on energy prices is how the spike in commodities prices greatly increased food insecurity in much of the world. The renewed threat of food insecurity has caused many nations to reconsider whether trade liberalization and globalization are good for them. Commodities speculation on a modest scale can dampen volatility, but at the higher volumes we're seeing now, speculation can greatly increase volatility, which is bad for everybody that is not playing in that market.

Policy is influenced by interests AND ideas.

While the populist rage against financial institutions continues, it is well to keep in mind that these special interests could not have captured government policy by money alone. It was also necessary that there was widespread acceptance of a worldview they could wrap around their causes. Dani Rodrik makes the point:

No-one could deny that interest groups play a role in shaping policy. But I would argue (i) that the identity of the groups that get to exercise power and (ii) the manner in which their interests are advanced are also determined by prevailing world views about the proper role and functions of government. On the first point, isn't it the case that the reason trade unions, say, have lost power in recent decades is the ideology of deregulation which swept Washington, D.C.? Or that U.S. auto makers have been unable to get large-scale import protection because this was a no-no in the prevailing ideological climate?

So, while campaign finance reform is important, it would not be enough to change the direction of history. We need to challenge, and ultimately to change, conventional wisdom. Read Rodrik's whole post here.

A big hole in the TARP

Paul Krugman identifies here something that's been bothering me about TARP. Its not-quite-admitted purpose is to prop up the prices of whole asset classes in order to save some financial institutions that are insolvent or nearly so. Because the benefits of that action get dispersed and captured by many other financial institutions and investors that are not in particular trouble, the program is a very inefficient way to fix the insolvency problems of a few.

Furthermore, why is the government in the business of propping up asset prices anyway? When asset prices were inflating obvious bubbles—remember Alan Greenspan spoke of "irrational exuberance" in connection with the dot-com bubble—the government decided it should not second-guess markets. Is the new policy to second-guess markets only on the downside, or will it henceforth act to moderate irrational exuberance also?

Dr. Bernanke, vascular surgeon of last resort

This helpful narrative from the Federal Reserve Bank of Dallas presents the financial crisis of the last two years as a series of emergency vascular surgeries to unblock or bypass arteries normally carrying the flow of money from savers/investors to borrowers.

The first key event discussed is the halting of redemptions by several European investment banks 14 August 2007 because they could not price parts of their portfolios invested in securities backed by subprime mortgages and other risky assets. This led to a slow-down in interbank lending and a general increase in preferences for cash. A tightening of credit standards and reduced lending ensued. The collapse of Lehman Bros. in September 2008 is credited with triggering a run on money market funds and the drying up of markets for commercial paper. The problems at Freddie and Fannie are discussed in detail. In each case, graphics show the blockages and the bypasses placed by Dr. Bernanke in the ER.

Incidentally, the story shows the normal flows of funds and the growing displacement of banks by largely-unregulated securities-market funding mechanisms. This shadow banking system had grown from supplying less than one-third of total debt funding in 1979 to supplying almost two-thirds in 2008. AIG is not mentioned, and other events and circumstances important to the crisis are omitted, but the article is worth reading for what it does explain.

My kind of economist

Dani Rodrik concludes a recent Powerpoint presentation with this slide.

There is a backlash against mainstream economics and against economic globalization

But the real problem lies with inappropriate application of mainstream economics

Economics is a tool-kit

Multiple models, based on multiple assumptions about the nature of second-best problems

Economic policy is a craft, not a science, and depends on skillful choice of models that apply

When used well, economics can help us understand the world and clarify the strategies moving forward

As I have tried to illustrate using experience with economic development and financial globalization

The key is to go beyond Econ 101 and the habit of first-best thinking

Will make economists less certain of their prescriptions and more humble (appropriately so)

The presentation generally documents with real-world data the failure of the Washington Consensus and other orthodox economic theories of trade and financial globalization. Among the salient points:  Nations that ranked poorly on the Heritage Foundation index of Economic Freedom, like China, India, and Vietnam, have performed much better economically than many other nations with high ratings.  One reason, Rodrik suggests, is that it is not possible in real emerging nations to create perfect conditions assumed for well-functioning market economies, but great progress can be made by pragmatically removing the most significant barriers that exist in a specific situation.

The economic crisis and animal spirits

Richard Posner's long and rambling critique of Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by Akerlof and Shiller has this neat little summary of the causes of the current financial crisis:

There was more than the usual amount of mortgage fraud during the housing bubble, but it was not the cause of many millions of people overpaying for houses, as we know with the benefit of hindsight that they did. Cheap credit and soaring house values were the immediate causes of the bubble and of all that followed when it burst. The underlying causes were the deregulation of financial services; lax enforcement of the remaining regulations; unsound decisions on interest rates by the Federal Reserve; huge budget deficits; the globalization of the finance industry; the financial rewards of risky lending, and competitive pressures to engage in it, in the absence of effective regulation; the overconfidence of economists inside and outside government; and the government's erratic, confidence-destroying improvisational responses to the banking collapse.

That's a pretty good list and includes several failings of the federal government. However, Posner has little or no faith in the ability of other government actions to end the crisis unless those actions inspire a resurgence of "animal spirits." He thinks Akerlof and Shiller inappropriately malign animal spirits as a cause of bubbles, when animal spirits (he prefers the word "confidence") are what we need to end the crisis.

The complexity of a modern economy has defeated efforts to create mathematical models that would enable depressions to be predicted and would provide guidance on how to prevent them or, failing that, to recover from them. The insights of behavioral economics have not done the trick, either. Shiller is to be commended for spotting bubbles, but few if any other behavioral economists noticed them; and he and Akerlof offer no concrete proposals for how we might recover from the current depression and prevent a future one. They want credit loosened, but so does everyone else--so did Keynes, who criticized our government for tightening credit in the early stages of the Great Depression.

We will discover soon enough whether the measures taken by the Obama administration are reviving the animal spirits of producers and consumers. The intentions are good. But the lack of focus, the partisan squabbling, the dizzying policy oscillations, the delays in execution, and the harassment of bankers are bad. By increasing the uncertainty of the business environment, these things are dampening the animal spirits--the courage to reason and act in the face of an uncertain future. Seventy-three years after the publication of The General Theory, it may still be our best guide to recovery from our present distress, not least because of its common-sense psychology.

I detect in Posner's review a dichotomy that I've seen elsewhere: The notion that it is "liberal" to see animal spirits as the cause of our problems and "conservative" to see them as the solution. Could be both, couldn't it?

Thanks to Christine for the link.

Modern financial innovations have been like a black hole—sucking in money and talent and letting nothing escape.

Paul Krugman is concerned that the Obama Administration apparently wants to restore the financial system to 2007 or perhaps to 1997, when a 1977 model would be much better for America.

And the [post-Depression] financial system wasn't just boring. It was also, by today's standards, small. Even during the "go-go years," the bull market of the 1960s, finance and insurance together accounted for less than 4 percent of G.D.P. The relative unimportance of finance was reflected in the list of stocks making up the Dow Jones Industrial Average, which until 1982 contained not a single financial company.

It all sounds primitive by today's standards. Yet that boring, primitive financial system serviced an economy that doubled living standards over the course of a generation.

After 1980, of course, a very different financial system emerged. In the deregulation-minded Reagan era, old-fashioned banking was increasingly replaced by wheeling and dealing on a grand scale. The new system was much bigger than the old regime: On the eve of the current crisis, finance and insurance accounted for 8 percent of G.D.P., more than twice their share in the 1960s. By early last year, the Dow contained five financial companies — giants like A.I.G., Citigroup and Bank of America.

And finance became anything but boring. It attracted many of our sharpest minds and made a select few immensely rich.

. . . .

Much discussion of the toxic-asset plan has focused on the details and the arithmetic, and rightly so. Beyond that, however, what's striking is the vision expressed both in the content of the financial plan and in statements by administration officials. In essence, the administration seems to believe that once investors calm down, securitization — and the business of finance — can resume where it left off a year or two ago.

. . . .

As you can guess, I don't share that vision. I don't think this is just a financial panic; I believe that it represents the failure of a whole model of banking, of an overgrown financial sector that did more harm than good. I don't think the Obama administration can bring securitization back to life, and I don't believe it should try.

Update on Saturday, April 3, 2010 at 10:06AM by Skeptic

Robert Reich was already complaining about this in 1980. He said there was too much "paper entrepreneurship" and not enough "product entrepreneureship" and that there should be policy changes to rebalance.