On Friday I joined fellow blogger Mark Thoma (and a good many other economists) at a very interesting conference on financial markets held at the Federal Reserve Bank of San Francisco. Here I share some ideas I expressed at the conference about the directions I feel this research ought to go.
The theme of the conference, and indeed the topic of a great number of academic papers now being written, is to try to describe what happens when capital markets have trouble efficiently bringing borrowers and lenders together. The motivation for this interest is the correct observation that interbank and other key lending froze up in the fall of 2008, with devastating consequences for the world economy. The objection that I have to many of these papers is that they focus too much on the effects of these disruptions and not enough on the causes. Many models take the view that credit markets were functioning more or less normally up until the fall of 2008, with the object of study taken to be understanding the consequences of how financial disruptions in 2008:Q4 were propagated to the rest of the economy.
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Taken literally, this view would imply that the huge run-up in debt over the last decade was largely benign, and that the core problem is that banks stopped lending in 2008. If that’s your perspective, then it’s very good news that the rapid growth of debt didn’t end just because banks stopped lending.
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My view is that the gross deterioration of underwriting standards suggests that it was the run-up in mortgage debt between 2001 and 2007, and not the failure of mortgage debt to expand further in 2008, that indicates a pathology in credit markets.
Here’s another variable that I think played an important role in what we’ve observed. Robert Shiller’s data imply that real home prices in the United States were remarkably stable for over a century. They began an unprecedented climb in the last decade, only to reverse course in equally dramatic fashion in 2006. One of the papers from the conference on which I was asked to comment took the perspective that credit markets were functioning essentially normally in 2008:Q3, with the goal of the research being to quantify the consequences of the disruptions that occurred in 2008:Q4. But surely those disruptions had a great deal to do with the decline in house prices that had been underway for several years at that point, and just as surely that decline in house prices had a great deal to do with the run-up in house prices that preceded the bust.
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I presume that everyone would agree that the dislocations of 2008:Q4 did not arise in a vacuum. But some might nevertheless defend modeling those disruptions as exogenous events, if the primary purpose is to try to understand how those events affected the rest of the economy. However, I worry that this is more than just a detail of what one chooses to model, but has the danger of becoming a prevailing paradigm of some in policy circles, who may interpret the core problem as the financial events in the fall of 2008, rather than viewing the core problem as the conditions that precipitated those financial events.
Understanding those precipitating conditions strikes me as a higher priority for this kind of research. Is our goal to know how policy should respond to these disruptions, or how to prevent them in the first place? In terms of the narrow objective of evaluating Federal Reserve policy over this period, should we ignore the potential contribution of the low interest rates and lax regulatory regime that accompanied the preceding real-estate price run-up? It is all well and good for the fire-fighters to ask us aren’t we glad they have such a high-powered hose with which to douse the raging conflagration. I suppose that a reasonable response might be yes, but where were you four years ago, and who started this fire anyway?
My suggestion for the many researchers interested in adding to our understanding of credit market imperfections would be to focus not so much on 2008 as on 2004-2006. Any economists or policy-makers who believe that the goal of policy is to restore the economy to the conditions of 2005 may be missing the core lesson here.
I could not agree more with you, Mr. Hamilton.
A consistent problem that seems to be a constant plague to analysis is confounding cause and effect. A suiting example would be if one claimed that if political party X makes decision Y that this would cause their end; however, a better (if you will) way to frame this would be the political party X making such a decision would not be the cause of their end but would only be an effect, or more properly stated: a symptom.
The same could be said of short selling; that is, short selling is not a cause but a symptom (just as a bank run is a symptom).
And so this time around, all that is being addressed are mere symptoms, but unfortunately this seems to permeate much of modern Western thinking–we can readily see it in our medical practice that spends much of its resources combating and lessening the symptoms, but rarely underlying causes (or another example is how the US is attempting to deal with its obesity problem). And to bring the example back to economics, it is a misunderstanding to say that the down turn in 1937 was due to the pulling of liquidity and stimulus; as it is a complete misunderstanding to say that the Great Depression was caused by the Fed tightening monetary policy–these were merely reactions and symptoms to a deeper underlying problem. It is usually the case that the seeds of destruction are planted so close in time to the reaping.
And so yet, again, we are facing another building crisis, and this one will be worse than the one we just came out of, simply for no other fact than that nothing was addressed and the problems were merely shifted from a financial crisis to a now building sovereign crisis.
And so we must go and look where the seeds were planted; but I suspect you would have to go even further back than 2003 because in 2000 we should of had a credit implosion that lead to a severe recession/mild depression and avoided it by pumping the credit again–and this time the pump is dry.
Here’s a trend to consider: in the 1970’s both parents began to work consistently; then in the 1980’s people began to spend their savings; in the 1990’s people began to supplement their income with credit; and then in the 2000’s people poured into an asset bubble as a means of speculating to make quick money, again, to supplement falling income that could not keep up with the cost of living.
A further problem that exasperates the problem is that economic data has been too tampered with in some regards to still be meaningful, and one of them would be the CPI number. Anyone, in my opinion, which I admit isn’t worth much, would have to overlook quite a bit to believe that the US had low inflation rates over the last decade. The US engaged in two wars on the other side of the world, we up military expenditures and all of this while lowering taxes? Also, with all the banking deregulation in the 1990’s (like sweep accounts) and the loosening of monetary controls (such as bank reserve requirements) in conjunction with the huge amounts of banks we have that were lending, and we still got low inflation? I find it hard to believe. Further, still, we see the signs of inflation in people’s economic behavior, that is, when people are struggling to keep up with the cost of living they tend to engage in more and more speculative endeavors in order to make up for that gap; and we saw rampant speculation in the housing market, which is uncommon for the ordinary person to engage in such wild speculation in the face of low inflation.
The ultimate problem here is that there has been a lot of covering up and lying about structural problems in the US that went unnoticed and misdiagnosed for many decades now, that we are now, just as a medical misdiagnose can allow a disease to fester beyond the point of conventional methods being effective, facing a problem of approaching terminal–and this misdiagnosing is still continuing.
If one is skeptical about the outright lying going on, then let me refer you to in 2008 when Congress threatened FASB when they wouldn’t suspend mark-to-market; and now every time a bank is ceased by the FDIC we are discovering rampant lying about asset valuation–and it is beyond me as why economists, for the most part, do not find this utterly disturbing.
Well, I wish you luck in trying to convince your colleagues about conducting their research in more fruitful hunting grounds, but I suspect you’ll have little luck, because for those who haven’t been able to see this problem building for at least the last ten years, I have little hope that the real problem and solution will now dawn on them–but this situation will still resolve itself, whether people see it coming or not.
We rightfully criticize the Bush Administration for creating more enemies of the United States in pursuing their foreign policies, but it very rarely dawns on these same observers that the plans for 9/11 were conducted during the Clinton Administration, the very same Clinton Administration that many are convinced that foreign policy as a benevolent superpower. The same mistakes we made in the political/policy realms are not being made in the economic realm.
i assume you meant assume rather than presume in third from last paragraph.
James, I agree with you that usually one must look for the causes of a crisis in what happened over several years before the crisis. For example, to understand the recession of the early 1980s one has to look at what happened since at least the credit crunch of 1966 that led to the changes in Fed policies after October 1979. In the study of the financial panic of 2008, one may have to go back to the 1980s. A large accumulation of debts is a necessary condition for a financial crisis and one has to understand why and how the accumulation took place.
There is, however, something critical to the understanding of financial crises that it’s circumstancial to how a large accumulation of debts turns into a crisis: how the conflict between creditors and debtors is resolved. We have learnt from past crises that bankruptcy is not a solution when simultaneously many debtors may not be able to service their debts as contracted (all reforms to bankruptcy as a judicial process have failed to deal with these situations). More important, we know that bankruptcy has never been a good mechanism to solve conflicts between creditors and debtors when banks or financial companies are the debtors. In part this has been due to how much governments have been involved in banking and in general in financial intermediation. The point is that when a crisis starts usually there is no mechanism to resolve the conflict, so creditors and especially debtors turn to government to solve it. And how government intervenes depends largely on how the political system works. If you’re interested in understanding this point just try to explain the similarities and differences between what has happened in your country and in Spain in the past two years.
I too have been rather amazed about the Lehman focus many economists are taking (I hate to pick on economists all the time, but they seem to be economists, so). As far as I can tell they spent 2003-2007 sequestered in a cave in Northern Canada, presumably with a satellite link to Fred so they could download current data series and fine tune their models to explain why the economy was doing so well. And perhaps give presentations of preliminary results to Sasquatch to get some feedback on whether they were on the right track or not. Sasquatch shook his furry head and said no cave bubble, so they knew everything was good. There was that problem in Japan like that.so maybe something to worry about there, but all is well in the USofA.
But in searching under every rock and stone for a reason to be thankful for the one quarter impact analysis is this. We should remember that in the early 2000s both Greenspan and Bernanke (new nickname: Benny and the Inkjets) voiced strong opinions that we cannot have deflation in the US, we know how to deal with it.we have a printing press.we studied Japanwe arent having a housing bubble and wouldnt know a bubble if we saw one, which is why we are sure we arent having one and other bits of highbrow economic thought. So they got their chance to show us their stuff, and we can all decide if we would like to do it again someday, if given the chance. Cheers for a great performance!
Now on to sovereign debt bubbles.
One of the most troubling things about most models is that they assume exogenous financial crises. That is that financial crises are somehow a random draw in stochastic processes and not a symptom of an endogenous process of either the real economy or the financial markets. I think that what you point out is fundamentally correct with regards to this housing bubble as well as housing bubbles in other countries such as Spain and Britain in the contemporary period as well as Japan in the late 1980s and the Asian Tigers in the mid-1990s. The probability of a financial crisis is certainly a function of the deviation from the underlying economics of a given asset class with real estate historically seeming to be the most potent proximate cause of a financial crisis.
Modeling such a thing is difficult, but I’m sure we can come a lot farther than we have. When we look at the financial and asset markets preceding the “shocks” to the economy, we can see historical patterns that should be able to be modeled. I will confess I am not as up on the academic literature as I would like to be, but I have not seen many major publications that deal exclusively with this subject.
A very interesting post.
May be worth to see how solvent the creditors were
http://research.stlouisfed.org/fred2/series/LLRNPT?cid=93
Two issues are emerging today,liquidity a sufficient condition to maintain banks afloat,debtors solvency an economic requirement.
How exactly do you model the impact of credit without throwing away existing models and starting over from scratch?
Every micro model I’m familiar with (and obviously I’m not familiar with them all) starts with:
1. A consumer, with tastes and initial endowments as a given, who chooses a set of goods he most prefers out of all sets of possible goods, constrained by his income.
2. A firm, with technology as a given, that maximizes profit by maximizing out put subject to cost constraints determined by the available technology.
Everything is effectively an instantaneous exchange process. Firms exchange factors (labor, capital) for finished goods. Consumers exchange income for bundles of those goods. In the factor market, labor and capital are exchanged for profits and wages. Etc.
This is not a model of the real world.
In the real world, as Minsky noted – before a firm can produce, it must make a real investment in productive capacity, before it can make that real investment, it must arrange financing for it.
Likewise, as Keynes noted (along with Fisher, Mill, and many others before him), a monetary economy is fundamentally different from a barter economy. A decision to save today is simply that, a decision not to consume today, not NECESSARILY a decision to instead consume in the future by purchasing an investment good today. Individuals may decide to hold money for its own sake, as a precaution against future uncertainty.
In short, if a model of a credit economy is created, it must have micro foundations, it must recognize money not merely as a simple medium of exchange but also as a store of value, it must integrate finance/credit as an integral part of the production process, and it must incorporate uncertainty (in a Knightian sense). I would very much love to see such a model.
Professor,
A great start. You are much closer to becoming relevant than most economists. That said I would push down even farther. Bad policy can take decades to make its destructive nature known. Termites to not eat a house in one large gulp. And contrary to what many seem to believe the government actually does create economic disasters. Local government creates local disasters. State governments create statwide disasters. But it takes a federal government to create a national and international disaster.
I’m not sure I would say that real estate prices have been “remarkably stable” for the past century. Shiller’s data (assuming it’s right) shows that prices were oscillating between about 70 and 125 for most of this time. Those are fairly large swings. Sure, they’re lower than the big one from about 2001, but the series isn’t exactly stable.
That also doesn’t necessarily mean that prices were completely inflated. The 2000s saw the American public develop a fetish for improving their homes with appliances, size, and refinements that people simply didn’t used to put into homes. If more capital is expended to build homes that are bigger, smarter, better then we should see the real prices of homes go up. Perhaps not up to by 100%, but they should increase because the underlying assets are not the same.
I’m in great agreement with RueTheDay, that the simplifications and viewpoint implicit in academic financial and economic modeling, results in distorted understanding and consequent poor decisions and unintended results.
I can comment, that there has been constant criticism of fiscal deficits (since the Vietnam War), as well as criticism of the reduction in reserve and capital requirements in banks since the mid-80’s (enabled by the rise of securitization and derivative products). Despite these admonishments, avarice has triumphed; enabled by the dysfunction and corruption of government. Hence my respect for E. Barandiaran’s comments.
Excellent post.
“But some might nevertheless defend modeling those disruptions as exogenous events, if the primary purpose is to try to understand how those events affected the rest of the economy.”
I would find it hard to defend such a modeling strategy even in this case. One has the fundamental problem that the adjustment (disruptions) would need to come in any event. To paraphrase Herb, if a thing can’t continue, … it won’t.
As for causes, I continue to think the savings glut abroad played an important role. As Krugman points out in his lecture notes, it reduced real interest rates in the U.S. And much of it is the result of forced savings through currency interventions.
Comparing your second and third graphs, it seems that another credit crisis may be brewing – home prices have dropped a lot, but not mortgage debt. There must be a lot of underwater mortgages. Mightn’t this result in another painful spike in mortgage defaults? Or are banks simply lying about their assets?
Don,
Plenty is brewing.
1) 30% of mortgages are underwater.
2) Banks are forecasting nearly twice the defaults this year over last year.
3) Commercial real estate values dropped 40%, and a huge amount of loans need to be rolled over in the next few years, and someone is going to eat the 40% collateral that disappeared.
4) Banks are allowed to mark-to-model now if their regulator approves. It’s not lying, just unlikely to be the truth. As a result of recent bank closings, the FDIC announced it will be auctioning off a billion of assets next month. This sent the banks into an uproar because it will give these assets, similar to the ones operating banks are still holding, a market value that banks fear won’t compare well to the model. Banks are complaining this will make them appear insolvent! So it’s not that they’re lying, it’s just that you can’t tell if you are in business or not in that business.
Agreed. Absolutely.
For an interesting perspective on the financial markets situation around 2004/2006, I might recommend a story in this month’s Vanity Fair on Michael Burry. Burry spotted the opportunity in credit default swaps early on moved to purchase them. His view was vindicated, in spades.
The story is not about greed, or fraud, or any kind of malfeasance. It is about the extent of liquidity in the market and how this drove the creation of high risk, ultimately toxic assets that were poorly understood. A good read for those interested in the topic.
…we demonstrate that credit growth is a powerful predictor of financial crises,
suggesting that such crises are “credit booms gone wrong” and that policymakers
ignore credit at their peril.
This conclusion from the Shularick and Taylor research, was the only bright spot in the mind-numbing mediocrity of the papers presented at the “Financial Market Imperfections” conference at the FRBSF.
I was particularly irritated by the Del-Negro, Eggertsson, Ferrero, Kiyotaki paper- since it only considered and plotted the effects of monitary and market intervention over short time periods- ignoring the effects on future output and credit risk from monitary expansion during a crisis. I suppose that I should have expected apologists, since three out of four of the authors work at the Federal Reserve Bank of New York.
Cedric,
Thanks. Wonder why we aren’t hearing more about this apparently dire state of affairs.
A year or so ago, I read an article from IIRC the New Yorker Magazine about Ben Bernanke’s tenure at the fed.
I think it was this one:
http://www.newyorker.com/reporting/2008/12/01/081201fa_fact_cassidy
One thing that impressed me, was that Bernanke was working very hard throughout 2007 to keep the system going. His actions included a number of unprecedented things like the term loan facility.
Even the first part of 2008 was not quite. There was a crisis in the municipal bond market that started with the collapse of the auction rate bond market. The Bear Stearns collapse occurred in March 2008. Rumors about Lehman were rife.
September was the blow-off, but like a tornado, it had been preceded by numerous frightening thunderstorms.
Should we agree on the premises (not difficult)the whole is the sum of the parts, then
models should factor:
Prices in relation to incomes and revenues
Loans,credits to carry the same relationship.
The difference between banking and usury?
A good banker should not need the securities
The usurer only need the securities.
Don,
Just going from memory, but I think I read most of it on Calculated Risk. That’s where I get most of my housing/mortgage market info.
Mr. Hamilton,
Speaking of credit risks: what do you make of the happenings (for lack of a batter word) in the US bond market over the last couple of months? Very bizarre; and very disturbing–everything from heavy participation form the Primary Dealers (not to mention the Fed hasn’t had much luck adding more PDs) to much of the auction takes place at the highest rate, indirect bidder acceptance rates are high, and so on–as a matter of fact the entire UST market has been…well, strange, to say the least.
Certainly a lot of us are aware that Mr. Bernanke is monetizing much of the debt (or was), but that still wouldn’t explain such…”happenings” in the UST market. I have been expecting to see such events transpire, but if I am to be honest, then I must admit that it is a whole different thing to expect it (or even read about it in other times and countries) and actually witness it–never seen such a thing in the US bond market before (not sure, perhaps the 70’s were similar?). What do you make of it?
OT:
Could we have a let’s-stop-picking-on-Brazil article? The US is carping about losing the WTO ruling on cotton. From what I can find, the Brazilians are looking for $1-2 bn in counter-measures annually.
Consider: Just four US companies–FMC, Cameron, GE Vetco Gray and Dril-Quip–will export something like $3-4 billion in subsea production equipment (a modest piece of the offshore oil and gas business) to Brazil in the next twelve months.
That’s just subsea production equipment, just four companies.
Brazil is going to be a huge boom-town in the next 3-5 years, and perhaps the US’s fasest growing export market.
Could we stop picking on Brazil (visas, ethanol, cotton), especially when we’re in the wrong? Let’s jump on the bandwagon instead.
“…and who started this fire anyway?”
I don’t have a problem with assigning blame when it is deserved, but there have been plenty of bubbles without a clear-cut evildoer. But if one starts out with that question, one tends to find someone.
Looking back, the episode seems to me a fairly standard bubble, complicated by the presence of mortgage-backed securities and derivatives of those. It doesn’t seem easy to come up with a clean explanation of bubbles, generally. At least, I can’t think of anything more clear than Kindleberger. (Who is, for me, a little less formal and predictive than I’d like — I’m not saying it’s a full and ideal theory, just the best I’ve seen.)
The FDIC Fire Sale happened sooner than I thought. Here’s how that works…
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The FDIC has just announced that it has closed the sale of $1.8 billion of Notes backed by RMBS “from seven failed bank receiverships.” The value of the actual aggregate balance: $3.6 billion. And somehow banks still keep their RMBS books marked at par. Furthermore, “the timely payment of principal and interest due on the notes are guaranteed by the FDIC, and that guaranty is backed by the full faith and credit of the United States. Sure enough, smelling this insane deal, the vultures came out to snack on the taxpayer’s corpse: “The transaction was met with robust investor demand, with over 70 investors participating across fixed and floating rate series. The investors included banks, investment funds, insurance funds and pension funds. All investors were qualified institutional buyers.” Just how many of these “banks, investment funds, insurance funds and pension funds” are viable to begin with, courtesy of the FDIC’s permission for every failed bank to continue existing is an amusing question, and Zero Hedge will attempt to get an itemized list of the participating buyers.
Some more details on the transaction:
(see post)
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FDIC Sells Failed Banks’ Toxic Crap Back To Soon-To-Be-Failed Banks At 50% Haircut With Explicit Taxpayer Guarantee
http://www.zerohedge.com/article/fdic-sells-failed-banks-toxic-crap-back-soon-be-failed-banks-50-haircut-explicit-taxpayer-gu
May a market practitioner add to the discussion? I oversee interest rate derivatives products at a commercial bank, and have been active in the securitization of various asset classes over the past 20 years. Ever since the financial crisis started, I’ve been grappling with the relationships among the securitization markets, monetary policy and interest rates, and I’m curious to know what work is being done on this topic from a macroeconomic perspective. Let me make a few observations:
1) Throughout the 2000’s, practicing commercial bankers lamented the impact of “too much money chasing too few deals,” which drove down credit spreads and weakened deal structures in the mortgage markets, syndicated loan markets, student loan markets, etc. To me, this idea sounds a lot like a monetarist’s definition of inflation.
2) From a microeconomic perspective, securitization is used to help an individual financial institution “make more efficient use of its capital.” Given the size of the securitization markets at the peak, this suggests that, for every dollar of reserves created, commercial banks leveraged it into loans (retained and sold) at a 20:1 ratio rather than the 10:1 dictated by regulation.
3) The increased use of leverage by homeowners, auto buyers and college students allowed for inflation of the prices of these goods. In discussing this issue with my clients, I call the rise in prices of autos, homes and college tuition “phantom inflation,” because the higher prices were masked by increased use of ARMs, longer loan maturities (6+ year auto loans, for example), delayed principal payments, etc.
4) The way I see it, this inflation spread to the broader economy via home equity loans, as well as the redeployment of the profits from overvalued real estate into other asset classes… maybe commodity funds in mid-2008?
Does this make sense? Has anyone modeled credit markets in a way that addresses (confirms / refutes) this perspective?
Tom Toerpe: I really appreciate the facts you’re pointing to and your question. Good points — here is a paper by Markus Brunnermeier that is trying to take into consideration issue (1):
http://www.princeton.edu/~markus/research/papers/macro_finance.pdf
Difficulty is matching this into inflation, let alone certain goods’ inflation (commodities, etc.). With commodities, I was pretty comfortable thinking consumption and production fundamentals had a lot to do with it — JDH has made this point and written a recent paper in the case of oil. This was basically because commodities require physical delivery, and so taking futures bets that don’t pay off leave holding the bag. But a few related facts are making me pause with that understanding, particularly with regards to metals. One, the cost of carry (at LME warehouses) is currently very low. Two, those inventories are pretty high. Three, some commodity based funds are actually taking delivery of the goods and holding them (mostly the precious metals from what I understand). So perhaps speculative positions have a place in the price run-up. But then I have to ask myself, what will fuel the higher prices that these inventory-holders are waiting for? If its not future economic growth (and the associated consumption), what is it?
Tom Toerpe:
I’m sort of glad your observations, as a practitioner, coincide with my amateur, and outsider, study of the phenomenon.
One ancient Fed Chairman stated that the job of the Fed is to “take the punch bowel away when the party gets going.”
This go around the party was in securitization, but the Fed chose to ignore it. And the mantra “make more efficient use of its capital.” means “leave no penny unflipped, there’s a commission in it” and that led to the “surprising” problem of financial fragility due to very high leverage and very nervous counterparties.
Some want to call it purely a regulatory issue, but I don’t think you can ignore the monetary aspect. I remember well the lament of too much capital chasing too few good investments, and I wonder if we did clamp down on credit growth, would we have got DOW 3600 instead? (via PEs = 60)
Instead the Fed chooses to focus on their stupid PCE inflation indicator. Here things like healthcare, housing and education costs are very underweighted, but somehow the price of these things went up a lot! Then oil started the decade at $20 and finished the decade at $70. Food is up a good bit too. But they tell us that these are “volatile”, meaning they go up and down a lot so we shouldn’t worry about it. Personally, I’m still waiting for the down part. And once again today the Fed is trying to fix whatever went wrong with the 2001-2002 economy with even more expansive monetary policy.
Then the final absurdity is the consumer buck (from MEW and other consumer credit expansion, not necessarily a job) created huge growth in China, other BRICs and oil exporters.
The USG is now buying up the bad debt and putting it on the taxpayers future bill.
I love it when a plan comes together. Fools!