Kicking the Can down the Road

Inspection of the Administration’s approaches to previous policy issues provides some instructive precedents [0], [1], [2], [3], [4] to consider in light of current policy challenges in the financial markets.


George W. Bush at a March 17 speech on the economy. Source: “Bush: Economy facing ‘challenging times’,”

From my perspective, the common element is over-weighting ideology at the expense of expertise. The import of this observation can be gleaned from this article in Sunday’s NYT:

On the one hand, Treasury officials say they are convinced that today’s regulatory system is fragmented and out of date. The Treasury secretary, Henry M. Paulson Jr., has talked about the need to re-examine capital requirements for financial institutions.
But both President Bush and Mr. Paulson, a former chief executive of Goldman Sachs, remain philosophically opposed to restrictions and requirements that might hamper economic activity.
“What we’re looking at in our blueprint is how to make our regulatory structure more efficient, less duplicative and more in line with today’s capital markets,” said David G. Nason, assistant secretary of the Treasury for financial institutions. “We’ve got five regulatory agencies focused on depository institutions. We’re one of the only countries in the world that separates securities from futures, and our regulation of insurance is solely at the state level.”
But the entire discussion took a stunning turn last week after the Federal Reserve abruptly stepped in to prevent a systemic collapse on Wall Street.
Invoking its authority as the nation’s lender of last resort, the Fed offered a $30 billion credit line to JPMorgan Chase to help it take over Bear Stearns, which was about to go bankrupt. Even more significant, the central bank announced that it would lend hundreds of billions of dollars to big investment banks through its “discount window” — an emergency loan program that had been reserved strictly for commercial banks.
The Fed’s involvement highlighted what many experts see as the growing disparity in regulation between Wall Street firms and commercial banks. Commercial banks submit to greater regulation, partly in exchange for the privilege of being able to borrow from the Fed’s discount window.
But starting last week, Wall Street firms were getting the same protection without subjecting themselves to additional scrutiny. Some administration officials said they had little choice but to regulate Wall Street firms more closely.
“In the short term, it would make sense to have one umbrella regulatory agency,” said Sheila C. Bair, chairwoman of the Federal Deposit Insurance Corporation, which insures deposits at banks and thrift institutions and is one of several federal bank regulatory agencies. “Capital levels are the most important tool we have at the F.D.I.C., and investment banks have lower capital levels than commercial banks.”
Among Democrats and Republicans alike, there is a growing consensus that the existing regulatory structure, involving more than half a dozen federal agencies as well state offices, were not equipped to prevent a host of questionable practices that aggravated the housing and mortgage meltdowns.
The practices included abusive loans by independent mortgage brokers; risky and opaque transactions by financial institutions; credit-rating decisions that turned out to be wildly optimistic; and the underwriting of loans by mortgage brokers that were often based on fraudulent or inaccurate information.
Just as the Sept. 11, 2001, attacks highlighted deep cracks between the nation’s intelligence and law enforcement agencies, the credit and housing crises are forcing policy makers to scrutinize cracks between oversight agencies that aggressive mortgage brokers and deal makers were able to exploit.
“To anyone who looks at the regulatory system over the last few months, it is quite clear that the financial world has evolved dramatically and the regulatory system has not caught up,” said Senator Charles E. Schumer, the Democrat of New York who is the chairman of the Joint Economic Committee.
Even though Mr. Schumer represents Wall Street’s home state and has many financial supporters on Wall Street, he said he was on “the same page” as Mr. Frank and was preparing his own plan for regulatory overhaul. Senator Christopher J. Dodd, the Democrat of Connecticut who is the chairman of the Senate Banking Committee, is preparing legislation as well.
But Mr. Schumer cautioned that the Bush administration’s deregulatory mind-set could make it difficult to do anything this year.
The Treasury Department is hoping to unveil its own blueprint for regulatory overhaul in the next few weeks. Last week, Mr. Paulson acknowledged that the problems exposed by the housing crisis were diffuse and complex and could not be solved with a single action. But he suggested that he did not want to take any drastic regulatory steps while the financial markets remained in turmoil.
“The objective here is to get the balance right,” Mr. Paulson said last week. “Regulation needs to catch up with innovation and help restore investor confidence but not go so far as to create new problems, make our markets less efficient or cut off credit to those who need it.”
Given the philosophical differences about the value of government regulations, some experts were skeptical that Congress and the Bush administration would agree on more than cosmetic changes.
“There is a political will, but I’m not certain that it can overcome longstanding philosophic objections to dealing with free markets in a crisis environment,” said Arthur Levitt Jr., the chairman of the Securities and Exchange Commission under President Bill Clinton.

Note that Sheila Bair has had a different perspective on regulation from the rest of the Administration (see my discussion in this post); in some sense I’d say she’s the exception that proves the rule. But some sort of government intervention is probably necessary. From Bloomberg on Sunday:

March 24 (Bloomberg) — Forget lower interest rates. For the Federal Reserve to keep the financial markets from imploding it needs to buy troubled mortgage bonds from banks and securities firms, say the world’s biggest Treasury investors.
Even after cutting rates by 3 percentage points since September, expanding the range of securities it accepts as collateral for loans and giving dealers access to its discount window, the Fed has been unable to promote confidence. The difference between what the government and banks pay for three- month loans doubled in the past month to 2.03 percentage points.
The only tool left may be for the Fed to help facilitate a Resolution Trust Corp.-type agency that would buy bonds backed by home loans, said Bill Gross, manager of the world’s biggest bond fund at Pacific Investment Management Co. While purchasing the some of the $6 trillion mortgage securities outstanding would take problem debt off the balance sheets of banks and alleviate the cause of the credit crunch, it would put taxpayers at risk.
“An RTC-type structure is interesting, and it may not be that much of a burden on taxpayers in the long run,” said Barr Segal, a managing director at Los Angeles-based TCW Group Inc. who helps oversee $80 billion in fixed-income assets. The government should purchase the mortgages and reissue “debt that’s backed by the U.S. government and there you go, you’ve unclogged the drain,” he said.

“Something like that would be very helpful, but the Fed was not designed to and shouldn’t assume a huge amount of risk on behalf of taxpayers,” said Alan Blinder, a Princeton University professor and former vice chairman of the central bank. “That should come out of the elected parts of the government, which means the administration and Congress.”
Resisting Calls
President George W. Bush and Treasury Secretary Henry Paulson have resisted calls urging the use of government funds or guarantees to stem a record amount of mortgage foreclosures, the root of the financial crisis, preferring that the markets resolve the trouble. Bush said March 15 he wanted to avoid “bad policy decisions” that would do more harm than good.
President George H.W. Bush, the current president’s father, signed the 1989 law which created the RTC to dispose of the assets of insolvent savings and loans banks. From 1986 through 1995, 1,043 savings banks with over $500 billion in assets failed, costing taxpayers $75.6 billion, according to a Federal Deposit Insurance Corp. analysis.

I have a couple of observations.


First, methinks the Administration protests too much, about “not bailing out” investors. If it were indeed the case that it was against further contingent liabilities being taken on by the Federal government, it would not have allowed the increase in the maximum size of conforming loans guaranteed by the Government Sponsored Enterprises, Fannie Mae and Freddie Mac. Nor would capital requirements have been reduced at exactly the time that a higher capital cushion would be in order, given the state of the economy. In addition, it would have taken some sort of action to limit the borrowing taking place through the Federal Home Loan Banks (see [5], [6] for discussion of recent actions, and implications).


So to me, it seems that the Administration is engaged upon a delaying action, and hoping to unload this problem upon the next Administration (an understandable, albeit less than fully public-minded, impulse). Meanwhile, it maintains the best “optics” in terms of making it look like it’s not taking on risks to government funds in order to help out financial firms. In so doing, it’s allowing an even bigger build-up of contingent liabilities, surreptitiously. But by virtue of being less transparent, it threatens to present a bigger, and more unpleasant, surprise for future policymakers (of either party).


Second, whatever the reasons for the Administration’s actions, I think a very serious problem is that, by virtue of the Administration’s abdication of a substantive role (see Hubbard’s comment on this point), the Fed is lending to entitites it does not regulate. The Bear Stearns collapse might have been seen as a case where the Fed had to undertake unconventional actions, because of the rapidity of developments. But with the Administration providing an uncompromising stance, who will step in the next episode? If it’s the Fed again, then Blinder’s critique will take on heightened relevance.


As I have stated before (to some opprobrium), I think realistically, some commitment of government resources will be necessary to work through this crisis. I’m not against the Fed’s initiatives on an ad hoc basis, and I’m not necessarily against loosening the reins on the GSEs and the FHLBs. But I am against hypocrisy, especially hypocrisy which might delay transparently devised policies that would minimize the eventual costs of any bailout.


I freely admit I may be wrong — that I might be too cynical. It might be that the Administration’s assessment of the current economic situation is not as pessimistic as mine. Consequently the Administration’s call for limited action can then be seen as the corollary of a perceived modest slowdown and manageable financial crisis (“containable” seems to have dropped out of the lexicon). In that case, one might reasonbly hew to this line:

… The establishment of credit stability and ample capital through the Federal Reserve System and the demonstration of the confidence of the Administration by undertaking tax reduction with the cooperation of both political parties, speak more than words.
The next practical step is the organizing and coordinating of a forward movement of business through the revival of construction activities, the stimulation of exports and of other legitimate business expansion, especially to take such action in concert with the use of our new powers to assist agriculture. Fortunately, the sound sense, the capacity and readiness for cooperation of our business leaders and governmental agencies give assurance of action.

These words are those of Herbert Hoover, November 15, 1929.

51 thoughts on “Kicking the Can down the Road

  1. BobDylanHasSoul

    even if the bush admin wanted to intervene in some way, i think, realistically, it would be difficult. strategically, the democrats have every interest to see the economy in a stark recession. a terrible recession reduces the appeal of a republican candidate. maybe i’m too cynical, but i think political parties are willing to play that sort of hardball in order to win votes come novemember. the dems have the upper hand and i doubt they will relinquish it. i am an independent, btw.

  2. mh497

    Could you bump up the political slant of your posts a little please, as it’s not 100% clear to me which way your views lie.

  3. kharris

    Thing back to Mexico’s Tesobono problem during the Clinton years. Treasury was able to do quite a bit without the permission, or pleasure, of Congress. Republicans at one point refused to allow Rubin to testify in the Hill because he had done such a good job of crafting a package for Mexico that got around Congressional efforts to make Clinton ineffective.
    I realize you have not argued for the White House not trying, but it needs to be said – we hire these guys to serve the national interest, not to calculate their own political interest. We hire them to do whatever they can to arrive at the optimal outcome. If they aren’t willing to do what we hire them to do, we have every reason to dump them and their buddies and let the other guys try.

  4. jult52

    It seems to me that the set of regulations which are pspecifically applicable to the solvency problems at banks & brokerages are the Basel requirements rather than domestic US regulations. When you read about the equity ratios at some investment banks (upwards of 25-1 assets to equity), you have to raise an eyebrow and know that, one of these days, institutions with such ratios were going to have solvency problems. Was the introduction of Basel II delayed too long? Is Basel II flawed itself?
    Don’t let a pretty weak Times article skew your perspective on the problem.

  5. Menzie Chinn

    BobDylanHasSoul: I think Democratic incumbents in Conress have an incentive to implement some policies which would stabilize the financial system.

    mh497: OK, will do.

    jult52: I’m certainly not an expert on the Basel II accords, but I’m not sure that even if the principles had been implemented as expected that the crisis would have been avoided. See [1], [2], e.g. That’s not to deny that matters might have been in less serious straits had Basel II already been in place. (For a contrary view, see here). But the jury is out.

  6. DickF

    The first part of the Hoover quote is much more instructive than the last:
    I have during the past week engaged in numerous conferences with important business leaders and public officials with a view to the coordination of business and governmental agencies in concerted action for continued business progress.
    I am calling for the middle of next week a small preliminary conference of representatives of industry, agriculture and labor to meet with the Secretaries of the Treasury, Agriculture, Commerce, and Labor, together with the Chairman of the Federal Farm Board to develop certain definite steps.
    For instance, one of the results of the speculative period through which we have passed in recent months has been the diversion of capital into the security market, with consequent lagging of the construction work in the country. The postponement of construction during the past months, including not only buildings, railways, merchant marine and public utilities, but also Federal, State and Municipal public works, provides a substantial reserve for prompt expanded action. The situation is further assured by the exceptionally strong cash position of the large manufacturing industries of the country.
    The magnificent working of the Federal Reserve System and the inherently sound condition of the banks have already brought about a decrease in interest rates and an assurance of abundant capital – the first time such a result has been so speedily achieved under similar circumstances.
    While Hoover talked of tax decreases his primary focus was on government intervention especially throught increased (Keynesian) government spending, the same policies we are hearing from Congress, our FED and Treasury. And as we all know Hoover actually increased taxes more than any previous president. Almost any book you read on the Great Depression will point out that the economic decline was actually small and would have been short lived if the government, the Hoover Administration, had not kept wages high and prevented the liquidation of marginal firms.
    Listen to those in our government with control of the economic tools and you hear Hoover all over again. It is not the administration that is calling for more government interference.

  7. E. Poole

    So the NYT article implies that there is a technocratic solution to Sept. 11-type, low-budget box cutter attacks. US and close ally aggressive colonialism can continue without worry. The barbaric hordes can breathe a sigh of relief. Americans and Europeans will save them.

    Perhaps the problem for Bush II and fellow traveling companions is that he is deeply mired in the colonial settler ideology of open access that spurred the US to kill so many North American aboriginals, civilize the rest, and open up western continental USA to the European hordes?

    It would explain his time inconsistency problem.

    On a more sobering note, if indeed the first-come, first-serve, might-makes-right colonial attitude is the fundamental problem, then nobody should expect miracles from the Democrats as these colonial attitudes are widely shared.

  8. Michael

    Well some Asian countries have done total debt repurchase.. Malaysia Danaharta for one prime example. Bough back ALL NPL (Non Performing Loans) from banks.
    The 1997 economic crisis roiled
    the country’s banking system.
    Set up to help avert the collapse of the banking system,
    Danaharta brought relief to beleaguered banks.
    And, despite trials and tribulations,
    the banking system survived intact.
    Over its seven and a half year lifespan,
    Danaharta dealt with 2,902 NPL accounts, 2,563 borrowers,
    and from an NPL portfolio of over RM50 billion
    – recovered over RM30 billion.
    Its final lifetime Loan Recovery Rate of 58% surpassed
    the typical 20 – 50% range experienced by
    similar agencies in Asia.
    Danaharta did its job.

  9. Charles

    Dick F. says, “Almost any book you read on the Great Depression will point out that the economic decline was actually small and would have been short lived if the government, the Hoover Administration, had not kept wages high and prevented the liquidation of marginal firms.”
    As long as one carefully restricts one’s reading list to AEI and Heritage publications.

  10. Rich Berger

    I am not so sure that I would go so far as DickF in describing “Almost any book”, but Herbert Hoover is conventionally viewed as an passive president, but he was interventionist as far as the economy was concerned. And yes, taxes were radically increased in the depression. Isn’t it curious that our longest and deepest(by far) economic downturn occurred just when the geniuses in Washington exercised their powers?
    mh497 – when Menzie lets you know, could you send me an email?

  11. Babinich

    Mezie says:
    “I think Democratic incumbents in Conress have an incentive to implement some policies which would stabilize the financial system.”
    Please enlighten us with the specifics of these policies.

  12. Charles

    Rich H says, “And yes, taxes were radically increased in the depression.”
    One can believe this unless, of course, one consults Samuelson, who says: “After the crash Hoover instituted a tax cut equal to 4 percent of federal revenues.” It was not until 1932, when the Depression was at its peak, that Hoover raised taxes.
    Look, guys, I know the noise machine makes it sound as though everyone believes the view that the Depression was minor and extended only because of taxes/the New Deal/the New World Order/the bogieman d’jour, but the economics literature is actually much more diverse.
    There are–believe it or not– even people who think that once a third of productive capacity is shut down, millions of people are displaced and hopeless, and faith in the markets and the credit system has collapsed, it’s not as easy as flipping a switch to get things back to normal.

  13. mock turtle

    did you read any of the citations at the top which indicate a lack of responsible regulation on the part of this administration?
    wake up…it’s all politics… we should have the best politics reason and debate can allow.
    i dare you to read the third citation about California energy deregulation and the theft and gaming of the energy industry and then tell us which “facts” alleged by the article you would would call “political” and care to debate or deny???
    this administration is corrupt, and criminal and sacrifices the good of the many for the preferred treatment and enrichment of a select few…and often does so at the public expense.
    mock turtle

  14. Thomas Mayer

    There are two problems that should be kept distinct. One is to manage the immediate situation, the other to reduce the probability of it recurring. The latter will probably require more regulation. But exactly what type of regulation is hard to say. Bad regulation is not necessarily better than no regulation. So we should set up a high level Presidential commission (chaired by Volcker?) to spend perhaps two years studying this complex issue.

  15. Anonymous

    Perhaps the most respected book concerning the Great Depression is “A Monetary History of the US.” Beyond Keynes you will be hard pressed to find a commentary on the Great Depression that is contemporary to the events that does not recognize the reality of the failure of government intervention. Only after the fact do Keynesians justify government intervention to pad their own pockets with government largess (Lionel Robbins is a gross example).

  16. jult52

    So why would regulatory oversight by the government be more effective than oversight by providers of financing to banks & brokerages?
    Menzie: I was trying to focus the discussion on the type of regulatory actions that might help to prevent the next crisis. Any regulation won’t do, obviously. There has to be a specific proposal on the table before informed discussion can even begin.
    Beyond Basel (maybe), one of the problems is surely GAAP. I don’t think it’s surprising in retrospect that problems have arisen in a sector – financial services — where GAAP P&L and B/S accounting reigns supreme. Other industries are evaluated more on a cash flow basis; not so the banks. But solving that aspect of the problem is going to require a lot of technical discussion. And it certainly won’t be interesting enough for blogging purposes 🙂

  17. PrefBlog

    March 24, 2008

    Menzie Chinn of Econbrowser reviews the policy response to the credit crunch:
    First, methinks the Administration protests too much, about “not bailing out” investors. If it were indeed the case that it was against further contingent liabili…

  18. Charles

    Rich says, “Thanks for bringing up that pimple. For a list of tax rates see
    I looked, Rich. It confirms what the “pimple” said. For the vast number of Americans, there were no tax increases, because few made more than the threshhold tax bracket ($1,500/year ($3,500 married).
    In short, you were wrong.
    Mightn’t you be gracious about it?

  19. Menzie Chinn

    jult52: I see. I guess the key problem in my mind is the difficulty in valuing these derivatives when they are not well traded. So it seems to me regulation — or self-regulation — is in order such that derivatives are somehow more easily traded. The Basel II regulations would’ve relied upon the same sort of statistical models of valuation which failed so badly in recent months, so while I think Basel II still makes sense, something else is needed as well.

    There is a separate problem I see. In the old days, commercial banks (as opposed to investment banks) overcame the asymmetric information problem by monitoring, and a variety of textbook measures (collateral, lines of credit, etc.) Securitization eliminated a lot of the incentives to overcome the asymmetric information problem. So it seems some method of requiring the banks to retain some portion of the loans they originate would make sense. These are not systematic formulations, but they’re the ones that occur to me now.

  20. pianoguy

    Rich – Thanks for posting that fascinating link, which shows that Charles was correct that tax rates didn’t climb dramatically until 1932 but was mistaken in claiming that Hoover’s initial tax cut was a response to the crash. It appears that he began his administration with a tax cut, which he rescinded in response to the crash. The rates in 1930-31 are the same as those in 1925-1927 – which, except for 1913-1915 and 1929, happen to be the lowest rates in the history of the income tax. So choking taxes can hardly be fingered as having caused the Depression to last until Roosevelt took office.
    As for the Great Depression being the longest and deepest by far, some economists would dissent, at least as far as depth. The depression of the 1870s may have been deeper. It was less disruptive only because we still had a largely agrarian economy: Millions of people could still hunker down on farms and practice subsistence agriculture, which wasn’t possible in the 1930s. (And of course, the Dust Bowl made such a course of action even more difficult in the 1930s.)
    As for the geniuses in Washington being responsible for the depression’s length and depth – of course you realize that Washington geniuses been exercising their economic powers ever since, with no repeat? (At least yet.) There’s no single cause for an event as complex and widespread as the Great Depression.

  21. DickF

    It is a Keynesian economic mistake to assume that because a tax increase does not touch the broader population that it does not have a negative impact on the economy. Jobs are created by the wealthy and products are produced by the wealthy. While the less wealthy are on the whole consumers of products. The contraction of capital for the wealthy restricts jobs and wealth and directly impacts those who are less wealthy because they can least afford to lose their jobs or face product shortages. If you understand this you begin to understand the essence of Supply Side economics and why Keynesian economics is actually counter productive.

  22. kharris

    What, exactly makes the claim that taxes at the top are less damaging than taxes more widely felt “Keynesian”? I would also point out that, at least in the ADP data, it is small firms, rather than large ones, that create net new jobs. I’m sure that the wealthy create some small firms, but I know for a fact that middle-income folks create small firms, too. The blanket assertion that the wealthy create jobs, to the extent it is meant to claim that they are somehow special in this regard, is simply wrong. Any your claim about the superiority of “supply side economics” is playground nonsense, a “my dog’s bigger than your dog” sort of thing. Fun to say, I suppose, but why should intelligent people believe it?

  23. jult52

    Menzie: Like yours, my understanding of Basel II is that it is a move towards self-regulation and wouldn’t necessarily have prevented the current crisis.
    I agree that agency problems associated with securitization are a major cause of the crisis.

  24. Rich Berger

    You will note Charles, that the IRS pdf shows the rate on those with income under $4,000 was increased from 1.125% in 1931 to 4% in 1932. That came along with a jump in maximum rates to 63% which was now imposed on income in excess of $1MM rather than $100K. You argue that the effective rate on most taxpayers was zero because of exemptions and therefore that there was no radical increase in taxes. I would argue that for many, including most of those critical to investment and direction of the economy, taxes were sharply increased and that increase was a tremendous disincentive to economic activity.

  25. pianoguy

    And Rich, you will note that what Charles wrote was this: “It was not until 1932, when the Depression was at its peak, that Hoover raised taxes.” So you two are in complete agreement with regard to Hoover’s not raising taxes substantially until 1932.

  26. DickF

    Guys it was not tax increases that caused the Depression. It was the Hoover administration stepping into business decisions and preventing the necessary liquidation of excess. Holding wages high created unemployment. Smoot-Hawley virtually stopped international trade as nations retaliated, and through it all Hoover was asking businesses not to lower wages or prices.
    From 1928 (his election) until he was mercifully removed from office Hoover engineered unemployment and business failure with the coup de grace being his massive tax increase that sealed the deal.

  27. DickF

    Kindly explain how increasing demand for goods will solve any problem without increased production? Hint: There is no need to mention dogs.

  28. Rich Berger

    Maybe I’m missing something, but it does seem that Charles and now pianoguy are rebutting things that I haven’t written. Among my claims – Hoover was an activist president; taxes were raised substantially during the depression; the tax reduction that Charles referred to was very minor (I believe it was 4% of governmental receipts – following Charles’ logic it had no impact since almost nobody paid taxes).
    Over its course, the depression varied in depth but was still going when WWII started. I guess the medicine wasn’t effective.

  29. oops

    i love the title “kicking the can down the road”. this is so typical of lame duck presidents. why mess with prosperity and make things right when i can just ride the wave and if it breaks then it breaks.
    one night a good friend of mine and i met an atty for a govt org back when the dotcoms were lying about earnings. he used the term “coasting and not making waves” to describe the powers that be at the time.
    kinda like that report saying bin laden was a big threat that got passed to bush. “don’t call us- we told you about it (we jsut didn’t kill him”. some say bush sr. did the same to clinton with somalia.
    lame duck = CYA while coasting

  30. Anonymous

    Dick F.
    “It is a Keynesian economic mistake to assume that because a tax increase does not touch the broader population that it does not have a negative impact on the economy. Jobs are created by the wealthy and products are produced by the wealthy.”
    Hum…no! The biggest number of jobs are created by entrepreneurs who start small businesses. Eventually, some of these will become large, even behemoths. The wealthy do contribute, but they most certainly do not create as many jobs as the entrepreneurs.
    BTW, trickle-down economics have been refuted by facts. Just look at the facts, all the facts…if you dare.

  31. Buzzcut

    The timing of this post is uncanny. I’ve finally gotten around to reading “The Future and its Enemies” (copyright 1998). I’m in the middle of it.
    Menzie, technocrat that he is, sees the subprime/ credit crisis and thinks “more regulation”.
    I think that that would be a disaster of an outcome.
    Look, this subprime crisis came about because of INOVATION. People were coming up with new, innovative financial products that we ALL benefited from.
    I myself have a 5 year ARM, interest only. I bought my first house with 5% down. Thanks to record home appreciation, I made a boatload on one of my Chicago area homes, which allowed me to eliminate my PMI on my next home.
    We would never have hit a home ownership rate of 68% without these financial innovations.
    We would never have gotten African American home ownership rates as high as they are without these innovations.
    Now, you can Monday Morning Quarterback what went wrong, but I think that the history of regulation shows that regulators could never have prevented the crisis beforehand, other than by preventing the innovation from occuring in the first place.

  32. Menzie Chinn

    Buzzcut: Like most economics PhD’s over the last 20 yers, regulation is not my first impulse. But we have prima facie evidence that the extant system is not working. If I could think of equally effective ways to reorient incentives without regulation — taxes, subsidies, alternative means of overcoming the agency problem — I’d suggest those. At the moment, my limited intelligence precludes me from forwarding those options.

  33. Charles

    Pianoguy says, “It appears that he began his administration with a tax cut, which he rescinded in response to the crash.”
    You make a common mistake, pianoguy, assuming that tax cuts are not retroactive. They very commonly are. The 1929 tax cut was a *response* to the 1929 crash. As the history says
    Refusing to accept the “natural” economic cycle in which a market crash was followed by cuts in business investment, production, and wages, Hoover summoned industrialists to the White House on November 21, part of a round-robin of conferences with business, labor, and farm leaders, and secured a promise to hold the line on wages. Henry Ford even agreed to increase workers’ daily pay from six to seven dollars. From the nation’s utilities, Hoover won commitments of $1.8 billion in new construction and repairs for 1930. Railroad executives made a similar pledge. Organized labor agreed to withdraw its latest wage demands.
    The President ordered federal departments to speed up construction projects. He contacted all forty-eight state governors to make a similar appeal for expanded public works. He went to Congress with a $160 million tax cut, coupled with a doubling of resources for public buildings and dams, highways, and harbors.

    In other words, the tax cuts were part of the response to the crash.
    DickF says, “It is a Keynesian economic mistake to assume that because a tax increase does not touch the broader population that it does not have a negative impact on the economy.”
    I make no such assumption. Hoover lowered taxes after the crash. It did not prevent the Depression. He raised taxes at the darkest moment of the Depression. It did not make it worse. The *facts*, Dick, show that taxes had very little to do with the Depression either way. Further, I endorse kharris’s point that your assumption that the wealthy create jobs is an insult to intelligence. Labor and capital, producer and consumer, are equally important to a sound economy. Attempts to pretend otherwise are simply non-starters.
    Rich says, “You will note Charles, that the IRS pdf shows the rate on those with income under $4,000 was increased from 1.125% in 1931 to 4% in 1932.”
    In other words, when the Depression was at its worst, Hoover raised rates and the Depression did not get worse. This is what you are arguing, Rich, and it does not support ypur point of view.
    Rich says, “Maybe I’m missing something, but it does seem that Charles and now pianoguy are rebutting things that I haven’t written.”
    Are you or are you not arguing that raising taxes was a cause of the Depression? If they are not a cause, then why have you introduced them into the discussion? If they are a cause, why did the raising of taxes at the nadir not cause things to get worse? And if taxes are the crucial issue, why did Hoover’s tax cut of 1929 not prevent the Depression?
    Unlike Dick, I accept that people have are different opinions about the causes of the Depression. But in arguing one’s case, it is not sufficient to grab one fact out of context, throw it against the wall, and see if it sticks.
    Especially ::ahem:: if the fact contradicts what you are asserting.

  34. kharris

    I assume that, by answering a question with a question, you are admitting to having no real answer to the questions I put to you. It is jnot even clear that your question has anything to do with the points I raised. It reads more like one of those things that lovers of Say’s Law toss out when they have nothing else to say.
    However, the answer to your question is that it is possible to have demand fall short of supply. In such situations, revving up demand can put people to work, make capital more productive, and lift growth back toward trend. You may not be willing to admit it, but it seems a common enough circumstance.

  35. DickF

    Yes, your implication is correct. You and I see economics from such different perspectives that we will have a very difficult time communicating.
    Supply cannot be greater than demand and demand cannot fall short of supply. You supply the marketplace with goods and services (labor) so that you can satisfy your demand. No increase in your demand will change that formula, only your ability to increase your supply, you work two jobs, you upgrade your manufacturing process. The attempt by modern attempts to increase prosperity through the economic slight of hand of currency debasement or income redistribution simply reduces supply as producers are forced to protect themselves from the dislocations.
    In another thread Menzie posted the data on the weak economic growth of the US. This smoke and mirrors economics is exactly what is causing our weak growth. Sadly, neither Democrats nor Republicans seem to be able to grasp this. The people have been fed a lie so long that they have difficulty grasping the truth.
    Just as an aside: Many here seem to think that small business is actually equal to the poor. Small businessmen fall into the left’s definition of rich. Corporations and corporate officers have protections from the wiles of congress (Dept. of Commerce, etc.) but that mom and pop store owner down the street does not. You increase his burden and force him to lay off people when you increase taxes on the “rich.” Your recognition that small business drives employment does not support your demand for higher taxes on the “rich” it simply recognizes the truth, but to then turn your back on these small businesses as they are forced to pay higher taxes is hypocracy at its worst.

  36. Paul

    Buzzcut: there is nothing wrong with innovative financial products. The problem lies in the agents properly pricing these products.
    This may be stretch but I believe nearly all depressions and booms are due to aggregate “mispricing” of some kind of asset. (Look at the situation, or S&L for example)
    Regulations simply act as a means of inforcing incentives upon agents to act accordingly. Otherwise they have an incentive to misprice mortgages (i.e. lend to people who are at a high risk and claim that they are low risk). This kind of thing has been documented to have happened quite frequently.
    Of course you benefitted from the innovations. But regulation would not have stopped you from achieving what you have. It would have simply made pricing on the lower end more accurate.
    As prices are the key to allocation of capital, it is integral in a sound economy that they are priced correctly.

  37. Charles

    DickF says, “Supply cannot be greater than demand and demand cannot fall short of supply.”
    So, if tomatoes rot in the field because the price is too low to pay to pick them, there is not a demand problem, and if the price of medical care rises at twice the rate of inflation because immigration limits the number of foreign doctors that can come to the United States (not to mention medical schools limiting enrollments and HMOs engaging in oligopolistic pricing), there is no supply problem.
    Within rounding error, this makes exactly zero sense.
    Even Milton Friedman, hardly a liberal, understood that sometimes markets do not achieve socially-optimal equilibria. His utilitarianism is based on the notion that it is often possible to negotiate a better solution for everyone by refusing to accept the “natural” equilibrium. Just as a catalyst allows a thermodynamically favorable chemical reaction to proceed at a practical rate, sensible intervention can allow better economic equilibria to be achieved at a practical rate.
    But the idea that there is never a mismatch of supply and demand is fundamentally conceptually deficient. If there were no mismatch, there would be no mechanism to move from one equilibrium to another. Even if there were never any market failures, even if adjustments in equilibria always followed perfectly smooth trajectories, even if we account for utilitarian “multiple minima” as kinetic phenomena.

  38. Anonymous

    Buzzcut wrote: “We would never have hit a home ownership rate of 68% without these financial innovations.”
    Was that homeownership rate – actually topping 69 percent for most of 2004 – ever anything but an illusion created by too-easy availability of credit? We’re currently
    back to 2002 homeownership levels
    , and all signs are that we’ll drop below those.
    Charles – thanks for the clarification re: Hoover’s tax cut.
    Rich – I didn’t rebut something you didn’t say. I merely pointed out that you appeared to have rebutted something Charles hadn’t said.

  39. Movie Guy

    I hate to say it, but your knowledge of what is ongoing with retail, commercial, and investment banks isn’t as strong as it could be.
    Clearly, this was more of a political slam post (well deserved is not the issue) than a factual examination of current issues placed within a historical context.
    It’s disappointing to see this type of junk on Jim’s fine web log.
    While banking and investments do not appear to be your strong suit, it would be worth the effort to address all of the key issues including the status of FDIC insured retail and commercial banks than play the kick the can game.
    I am surprised at you. But now I am warned regarding what to expect.

  40. DickF

    You are trapped by econometrics. Economics is a behavioral science. Econometrics can be used to explain economics but it does not drive economics.
    If tomatoes rot in the field the supply equals the demand, both are zero, in this case. No one wants the tomatoes and so the supply goes away. Simply because you supply something does not mean there is a demand.
    Once again this is a problem with demand side economics. The assumption is that if a particular product or type of labor is supplied it is an oversupply if there is no demand. This is wrong. The demand for a product or labor is what it is and the product is “priced” based on the supply demand relationship. If the supply is such that the exchange value is below the cost, the supply demand relationship still exists even at a loss. In demand side economics there is an attempt to “fix” the problem from the demand side rather than the supply side and this usually involves some kind of government intervention to force the acceptance of the labor or product other than what the market demands. This is the primary cause of the huge dislocations (costs higher than market value) in the cost of education, health care, and other government subsidized programs.
    It is this kind of coerced demand by government that hinders production and lowers growth rates.

  41. Charles

    Movie Guy, if you have a criticism, it would be nice to know what it is, rather than just hearing a generalized you don’t know what you’re talking about so it must be liberal bias type of slam.
    Here are the basic things Menzie has said or implied agreement with:
    1. Ideology is trumping pragmatism in this Administration. This claim is not particularly controversial. EPA, DOJ, NASA and other agencies are awash in scandals having to do with ideology being imposed.
    2. The current regulatory structure is fragmented and needs review. This is not controversial. The system failed. There’s a problem. There should have been congressional review much earlier, and there was not.
    3. Investment banks need more regulation. Again, no controversy. Regulation is a natural consequence of putting public funds at risk. If the banks don’t want regulation, they can avoid screwing up or, failing that, avoid taking public money.
    4. For that matter, intervention is necessary. This is debatable, but senior figures like Bill Gross are arguing for it.
    5. The Administration is pretending not to bail out investors, while it is doing so, as evidenced by changes in requirements on the agencies. I’ve heard this in the financial press at least twice in the last two days, not from particularly liberal sources.
    6. The Administration is intending to dump the problem on the incoming Administration. This is debatable. None of us are mind readers. But it wouldn’t exactly be unusual for an Administration to avoid unpleasant decisions in its last months. Menzie admits that he may have become too cynical. So, on the one really subjective point, he states it up front.
    What’s the beef?

  42. Buzzcut

    Menzie, you’re not a technocrat because you favor regulation over taxes, or whatever.
    You’re a technocrat because you think the answer is for the government to do SOMETHING. In fact, I think that there was very little that they could do to prevent this mess.
    The history of regulation is that the regulators are always fighting the last war. They NEVER are ready for the next sneak attack. They have never prevented Pearl Harbor, if you will.
    Your one suggestion (reserve requirements) doesn’t sound all that bad to me, and if that’s the only regulation developing from the current mess, I would say that we’re lucky.
    More likely, we’ll get something like Sarbaines-Oxley, which even Chucky Schumer thinks is bad regulation.

  43. Menzie Chinn

    Movie Guy: I readily admit my failings. I hope to do better in the future, and meet your expectations for a more holistic and comprehensive understanding of the workings of the economy.

  44. bellanson

    I think a lot of the acrimony here stems from different expectations of what “Regulation” is.
    Regulation of the “shadow banking” sector might very well take the shape of mandated disclosure, e.g. when a MBS fund is created, it might mandate that things like: X% of mortgages are 103% of assessed value, and The issueing bank has decided to not carry any of the loans on their books, preferring to have other investors shoulder the risk.
    Another possible regulation might be: The issuing bank must retain X% of the mortgages (or offered securities)
    Surely Buzzcut and DickF etc. are not opposed to reducing the information asymetry?

  45. DickF

    kharris wrote:
    What, exactly makes the claim that taxes at the top are less damaging than taxes more widely felt “Keynesian”?
    Sorry for not addressing this question. Reading back over our discussion I realized that I unintentionally left this hanging. What I mean by Keynesian in this case is the demand side myth that the it is better to giver government largess to the lower income classes because they will consume and so increase demand. The whole argument is based on demand side thinking, Keynesian thinking.
    In onther words the demand side will redistribute wealth in an attempt to artificially stimulate demand while the supply side will respect the market realizing that under market forces dollars flow toward the greatest need for increased supply.

  46. DickF

    Bellanson wrote:
    Surely Buzzcut and DickF etc. are not opposed to reducing the information asymetry?
    The information asymetry as you call it has been distorted by government.
    In the marketplace it is most important to allow free speech in whatever form into the market. What has the government done? It has prosecuted “insider trading” creating a situation where those who knew what was going on at ENRON could not reveal it because of insider trading laws.
    One of the most important tools to identify weak businesses and institutions is short selling, but such government actions as those taken by government regulators Here is a quote that should be chilling if its full implication is understood ““The commission is in uncharted territory,” said Peter Henning, a former U.S. Justice Department prosecutor who teaches at Wayne State University Law School in Detroit. “The problem will be separating out the trading from the noise in the market. There was a lot of speculation about Bear.” Are we to actually believe that government regulators should be the ones who determine free speech. This is even more shocking when you consider that members of congress use insider information more than any other group of people in our nation.

  47. Charles

    DickF “If tomatoes rot in the field the supply equals the demand, both are zero, in this case. No one wants the tomatoes and so the supply goes away. Simply because you supply something does not mean there is a demand.”
    I was certain you would answer this way, Dick. So, now, indulge me by answering just one more question.
    Suppose that yesterday, people were willing to pay $2/pound for the tomatoes, a price that is sufficient to make a good profit. But one of four events has occurred:
    1. The farmer’s accountant cleaned out his bank account, so the farmer can’t pay the railway to ship the tomatoes and he doesn’t have an established credit line.
    2. The railroad track was washed out by a flash flood. Local truckers who might otherwise agree to ship the tomatoes don’t learn about the problem for several days because information does not travel instantaneously.
    3. Other farmers had a bumper crop and price has fallen to where it is no longer economic to ship the tomatoes.
    4. The town to which the farmer ships had massive layoffs and everyone is cutting back on expenditures.
    In which cases does the price of tomatoes fall or rise, and in which cases has the desire of people for tomatoes at $2 actually changed?
    This is pretty simple stuff.
    * Case 1 will bring no tomatoes to market at any price. It’s a market failure.
    * Case 2 will bring tomatoes to market at a higher price. Still, the price is higher than could be achieved if information were disseminated more efficiently. It’s a partial market failure.
    * Case 3 represents supply exceeding demand at a price consistent with transportation cost. No tomatoes will be delivered until many rot…unless a new market is discovered.
    * Case 4 represents a change in income, causing an actual shift in the demand curve as people substitute other foods for tomatoes. The price will probably fall.
    This is all Economics 101. It has nothing to do with econometrics. It does not assume a particular cause for price shifts, but looks for explanations consistent with the data. It does not involve government forcing anyone to do anything. It involves thinking things through, rather than operating by dogma.
    Where government comes in is by a free people deciding what they want from life. Do they want there to be malnutrition if a small expenditure to support incomes through unemployment insurance could prevent it? Do they want farmers to suffer losses if those could be prevented by getting information out a little more efficiently?
    The New Deal is 75 years old. Most of its elements are still in place. Where they are not, disaster has swiftly followed, as with the repeal of Glass-Steagall. A free people, having seen the destruction wreaked upon this nation by reactionary economics has voted, year after year, decade after decade– in the face of a flood of paid-for propaganda by so-called “think tanks” like Heritage– to maintain the eminently sensible policies of FDR.
    Like King Canute, one can rage against reality, but one cannot alter it.

  48. Charles

    DickF says “It has prosecuted “insider trading” creating a situation where those who knew what was going on at ENRON could not reveal it because of insider trading laws.”
    Nothing forbade them from disclosing it to law enforcement officials. Nothing except fear of what Enron would do to them prevented non-insiders– which includes almost all of the people in the company– from screaming their heads off.
    The real problem is not a lack of free speech. It’s a lack of ability on the part of employees to protect themselves against retaliation.

  49. Patrick

    Menzie, interesting post. Would you be interested in syndicating your content on the home page of my site? It’s an online community of finance professionals ( ). I could add an RSS feed that will allow me to promote your blog posts to my home page (when i think it will lead to a good discussion and/or is appropriate), but I wanted to make sure you were comfortable syndicating first. The syndicated post would have a link back to your original post. Thanks, Patrick (you can reach me at [email protected] if you have any questions)

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