If You Walk Awy, I Will Follow

Roger Lowenstein has some arresting advice for people who are underwater in their mortgages - walk away:

White has argued that the government should stop perpetuating default “scare stories” and, indeed, should encourage borrowers to default when it’s in their economic interest. This would correct a prevailing imbalance: homeowners operate under a “powerful moral constraint” while lenders are busily trying to maximize profits. More important, it might get the system unstuck. If lenders feared an avalanche of strategic defaults, they would have an incentive to renegotiate loan terms. In theory, this could produce a wave of loan modifications — the very goal the Treasury has been pursuing to end the crisis.

Precisely. Government officials have been urging people, Lowenstein recounts, to "do the right thing" and pay if they can afford to. In fact, underwater borrowers are parties to contracts that state the penalties for nonpayment, and if those penalties exceed the cost of continuing to make mortgage payments, not only do borrowers have the right to walk away, they arguably should walk away. By doing so, they are conveying the message that lenders overestimated what houses would be worth, and made loans to people who shouldn't have gotten them. Borrowers who walk away will pay costs, as they should, in the form of worse credit ratings. How much worse is up to lenders, who will have to decide if a walkaway is a bad credit risk. The sooner the information about the wisdom of past lending practices gets into the price system, the better.

Lowenstein notes that a Bush Administration official dismissed walkways as "speculators," which is true. All market traders -- people deciding whether or not to go to college, whether or not to take a particular job, whether to lend to someone to buy a house, whether to walk away from a loan to buy a house -- are speculating. They are using the information they have and the prices they face to make the best decision they can, thus injecting that information into the price. Given the pejorative meaning it has taken on, "speculation" is not even economically meaningful, and financial reporters should probably refrain from using it.
It is true also that a walkaway commits a negative externality by lowering property values on his street. But a person who moves into a neighborhood and makes a bid on a house also commits a positive externality, and in any event many of these externalities are properly internalized because a single person has built the subdivision to begin with. So that is not much of an argument either.

I suspect that most of the economic argument against walking away boils down to macroeconomics -- the fear that an epidemic of walkaways will cause the housing market to once again spiral down, delaying macroeconomic recovery. But this macroeconomic idea -- the idea that "the economy" is a single organism -- is bunk. What we ought to be concerned about is whether the microeconomics are right -- whether the price system is incorporating all the information it needs to to function properly. Given the contracts that were written, and the rules of the game for breaking them, underwater borrowers would be doing society a service by giving up homes that do not serve their interests.

The New Chaos

Major depressions used to be common in the United States. We had them in 1837, 1857-8, 1873-8, 1897, and, most famously, 1929-1939. (As an aside, until 1929, the general attitude was to do nothing. It was not taken for granted that the president had a magic button in his office that he could push to end any economic problems that came along. Somehow, the economy always righted itself, and we continued to move forward.) But with one exception, we until recently had gone almost 70 years without one. The exception, the economic dysfunction of the late 1970s and early 1980s, was idiosyncratic because it was in a sense intentional, the result of having to wage extraordinarily contractionary monetary policy to fight the inflation caused by the misbegotten expansionary monetary policy during the oil-shock period.

But in 1994 on these events have been commonplace around the world. India in 1991, Mexico in 1994, East Asia in 1997, Brazil and Russia in 1998, Turkey in 2000, Argentina in 2001, the Arab Gulf states in 2006. And now, most of the planet.

It seems to me that the fact to be explained is not just why we are having this crash, but why we went so long without one, particularly in the advanced economies of the West. Financial crashes, I think, are usually the follow-up to financial bubbles. And those bubbles occur when major positive disruption to production possibilities brings overall opportunity, but great ignorance about how the opportunity is best to be exploited. The frequent depressions in the US through 1929 were caused by an economy dramatically remaking itself from predominantly agrarian to predominately industrial, the replacement of small farms with large factories. This was a revolutionary process that was not well understood at the time, so mistakes were frequent. When the mistakes reached critical mass, they had to be cleared out, and that was the function of the crashes.

In this view, the disappearance of major bubbles and crashes after 1929 was not due to government learning how to manage the business cycle better but to the much slower pace of economic transformation. Western economies matured, and so chances for speculative bubbles to build up essentially disappeared.

So what would explain the chaos of recent years? We are once again in a time of truly radical transformation. Part of it is technological -- the mainstreaming of the Internet in the late 1990s led to a huge number of highly speculative commercial ventures, all of which are plausible at the time but with the passage of time and the learning of knowledge about what consumers want proving that some of them were mistaken. This, I think, is the explanation for the Internet bubble during that period.

But the truly big story is the emergence of literally billions of people into the global economic system. They bring with them their energy, their dreams, and their ideas. Clearly, in the aggregate, the removal of these people in places like India, China, and Brazil from the imposed stagnation of state-dominated economies is a tremendous step forward for humanity. But how will the merging of all these people into the modern world change our possibilities? This has yet to be decided, and entrepreneurs have to decide it one gamble at a time. Even the current financial crisis is in part due to the introduction of new financial instruments, which are not currently well-understood. This is not unprecedented. The introduction of common stock led to the South Sea bubble, the introduction by John Law of paper currency into France did much the same there, and even the famous Dutch tulip bubble was driven in part by the introduction of tradeable futures contracts. All of these tools are still in use centuries later, and so too will be securitized mortgages, credit default swaps, and the other financial exotica that are blamed for the current mess. Being novel, they were often used irresponsibly, but it takes a while to learn the limits of any new invention.

More broadly, this introduction of people, the generators of ideas that change what is possible, into the global system is the phenomenon; the technological changes are only the epiphenomenon. And the scale of this great merging has brought with it a new instability -- the end of the artificial stability caused by the relative stasis in the number of people participating in the global system owing to the popularity of socialism. For centuries most of the heavy lifting with respect to advancing the human condition has been done by a relatively small number of countries -- the UK first, then continental Europe, the US, Canada and Australia, then Japan and the other early East Asian Tigers. Now, huge numbers of people in countries all over the world are getting into the game, and they will bring disruption with them. This will bring tremendous benefits, but it will be a bumpy ride. The current financial turmoil will not be the last.

Whom Should We Be Angry At?

Baron Bodissey at at Gates of Vienna has an unconventional interpretation of the manufactured outrage over AIG-exec bonuses. Leave aside that, cosmically speaking, this is a matter of no consequence, the state of the financial system, how it got this way, and what we should do about it being the questions a legislative assembly worthy of our respect would be spending the most time on.

The Baron's point is that the AIG executives more than earned those bonuses, because they were able to bring in over $173 billion in revenue to the firm. How? Why by shaking the Washington money tree, of course.

To paraphrase the great sage Obi-Wan Kenobi, who's more foolish? The fool who stole the money, or the fool who gladly gave it to him?

Ignorant About All The Wrong Things

President Obama said something revealing the other day:

On the other hand, what you're now seeing is profit and earning ratios are starting to get to the point where buying stocks is a potentially good deal if you've got a long-term perspective on it. I think that consumer confidence -- as they see the American Recovery and Reinvestment Act taking root, businesses are starting to see opportunities for investment and potential hiring, we are going to start creating jobs again.

"Profit and earning ratios" is not a term that comes up much among financially literate people. (Google it, and you find that President Obama's statement is the only thing that comes up.) Profits are earnings, and so that ratio would always be one. Or perhaps he meant profit ratios and earnings ratios, but in that case the two would always be identical, so he is being redundant.

He was probably trying but failing to repeat something he once heard someone say on CNBC or something, which is "price to earnings ratio," the price of a stock divided by its profits. This is a financially meaningful term, and people in the know often say that the historical range for it is between 17 and 20; anything above 20 is a priori overpriced, anything below 17 is presumably a good buy.

Who cares? When George W. Bush was running for president in 2000, a reporter tripped him up by asking him the name of the president of Pakistan, which he did not know. Now, this was clearly an egocentric exercise by the reporter, but it was fair game. Mr. Bush was bidding to lead the most powerful nation in the world, and that he be aware of the names, let alone the philosophies and personalities, of the leaders of the rest of them was not an unfair thing for the American people to expect.

So people could in fairness increase their personal probability that Mr. Bush was a man who didn't know much about the world. We are now in a position to increase the probability that the 47-year old community organizer we elected as president, a man who has never run anything other than presidential campaign and legislative staff organizations, who has never created a single private-sector job, is clueless about how the economy operates. He is, one might suppose, the sort of person who thinks that big declines in the stock market on his watch have no useful information to impart to him, and that wealth is a thing that magically falls from the sky for politicians to cut up and distribute to the grateful masses.

President Obama is a highly intelligent man; you don't get into and excel at Harvard Law if you're the village idiot. But being smart is no guarantee of anything. (See Theodore Dalrymple's recent piece, among many others, for the reasons why.) Being smart is not the same thing as being wise, and our new president appears to have no wisdom at all about finance, economics, and incentives. Right now, that is an underwhelming endorsement at best.

American Housing and the Great Crash

The global financial crisis happened because the US, by failing to oversee lending markets, recklessly let a housing bubble develop. When it popped the whole world, having bought into the bubble through securitized mortgages, fell too. Right?

Think again. Oh, it's true that the US housing market developed a bubble. As I have noted here , that is because of the politicization of housing loans by the federal government, which made lenders' job difficult. But it is also true, as I've argued here, that the crash is more likely a function of the global boom that unfolded, depending on one's preferred starting point, in 1982, 1991 or 1998. This boom was profound, changing hundreds of millions of lives, but ended the way such booms always do, with a backlog of mistaken ventures in need of cleaning out. At worst, the U.S. housing bubble was nothing more than the needle that popped the bubble that particular day.

Can this be? Below is a chart that links two numbers. On the vertical axis is the percentage fall in stock markets around the world in 2008. On the horizontal is the country's rating for clean governance by Transparency International, an anti-corruption group.

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Note the close relationship between lack of transparency (i.e., more corruption) and the size of the fall. Indeed, the correlation between the two quantities for the 28 countries I arbitrarily chose (because market data were easily available) is 0.69, which in social science is very large.

So what does it mean? In any society economic actors make mistakes relative to what they know after the fact. In societies with a lot of corruption (which masks information, because each government bribe is by construction hidden from the investing public) or with miserable accounting or other problems with financial information the number of such mistakes over any interval is larger. Thus, this crash is a major cleaning out of a large pile of accumulated mistakes, not an outburst of irrationality or the residue of some strangely unprecedented spasm of greed. The correlation would undoubtedly be even more impressive if it used the quality of financial reporting and information instead of overall government transparency, but is very informative as it is.

For more evidence that this is a rational resolution of a rational bubble (driven by the emergence of many countries with great potential but unknown strengths and low information conductivity into the global system), note that China suffered one of the biggest market declines despite the fact that foreigners are not allowed to trade in its stock markets to any significant extent. How can that be if the crash is simply contamination from U.S. housing? Pakistan too has suffered a dramatic fall, despite the lack of importance, I suspect, of U.S. housing securities on the Karachi exchange. The U.S. and the U.K., in contrast, despite being the epicenter of the housing bubble, had (relatively) modest declines.

What is going on is, as I have said before, an information problem, not a liquidity problem. Only by discovering the information many want but few have - information about which ventures undertaken during the great bubble are sustainable, and which were errors; about where, in other words, the remaining unexploded economic bombs lie - can order be restored.

But why let the data get in the way of a good political fable?

Do Macroeconomists Know Anything?

When I was in graduate school getting a Ph.D. in economics, I had the hardest time passing my macroeconomics comprehensive exam. I found much of the material counterintuitive, and the mathematics more difficult than in microeconomics or the field exams that I took.

Well, now I have my revenge. Macroeconomists, and those in policy circles they have trained, aren’t coming off looking too good right now. Here is Marketwatch on the Fed running out of interest-rate ammunition in its attempt to get the U.S. economy moving again:

Rates are already very low and are not playing much part in the credit crunch that is strangling the economy.

Investors should know that the Fed still has plenty of ways to stimulate the economy, even with rates near or at zero, economists said.

The bottom line on Fed policy is supply of money. The Fed typically targets the price of money, but, with the price so low, it will focus on increasing the quantity of money through its balance sheet.

Vince Reinhart, a former senior Fed staffer who is now at the American Enterprise Institute, said the Fed will make a promise in its policy statement "to use the balance sheet to help foster economic recovery and better-functioning markets."

Macroeconomics is premised on the idea that there is this single entity called “the economy,” and “the economy” can be treated the way a diseased organ is. But “the economy” is really the coordination of the conflicting desires of 300 million people (or, nowadays, six billion people). At any moment, changes will leave some people worse off, some better off. Even now, recent economic changes are operating in favor of some people. Lower oil prices are making truck drivers better off, lower home prices are making homes more affordable, etc.

If the collective sum of everyone’s changed circumstances is on balance negative at any moment, we can defensibly talk about the abstraction called a “recession” or “depression.” It is no fallacy of composition to say the economy right now is on balance terrible. But it is such a fallacy to suppose that the remedy lies in treating the entire “economy.” Undergraduate textbooks still speak of how “spending” and “the economy” respond to particular actions by the government, in the same way a doctor can say how a bacterial infection will respond to an antibiotic. But the economy is not an organ; it is not even a body, in which all the parts generally work together to advance the prospects of reproductive success. Instead, it is a network of people both competing and cooperating as they try to advance their interests, based on the rules of the game. The macroeconomic measures of trouble we are observing are really the sum of millions of microeconomic mistakes (in conjunction with a smaller number of successes). Those mistakes have to be liquidated, no matter how painful it is.

There is a reason that interest rates have failed to do the trick, and that is that what we face is not a liquidity problem but an information problem. People are not yet certain how many financial bombs remain unexploded, and the only way out is to let them blow up so we can learn what we need to learn as fast as possible. There is no magic tool in the Fed’s workshop – not interest rates, not the “balance sheet,” not anything else – that will do what rate cuts have failed to do. Nor can any crude stimulus package coming out of Washington, which operates on the mistaken premise that some mistakenly conjured aggregate abstraction called “spending” is too low. (Large cuts in taxes would be somewhat more effective, not, as even a now-and-then smart economist like Paul Krugman argues, because spending will go up, but because politicized decisions about resource use will be replaced – in fact, more than replaced, because of greater incentives to take risks – by market ones.) Washington can however easily make things worse by constantly rewriting the rules of the game – voiding debts if the borrowers have enough political strength, bailing out this guy but not that, announcing a big spending program and leaving it to the future to figure out how to pay for it – etc. Political uncertainty multiplies market uncertainty. The unpredictable effects of both Congressional and Fed responses to current circumstances are making things worse.

All macroeconomic problems are fundamentally microeconomic problems, and the continued defiance of this fact by our ruling classes is costing us a fortune.

How Not to Solve the Global Financial Crisis

Next month there will be a summit involving something called the G20 on the global financial crisis, says Pres. Bush, according to The Chicago Tribune:

"This summit will be the first in a series of meetings aimed at addressing this crisis. The summit will bring together leaders of the G20 nations -- countries that represent both the developed and the developing world. And the summit will also include the heads of the International Monetary Fund, the World Bank, and the Financial Stability Forum, as well as the Secretary General of the United Nations.

"During this summit, we will discuss the causes of the problems in our financial systems, review the progress being made to address the current crisis, and begin developing principles of reform for regulatory bodies and institutions related to our financial sectors. While the specific solutions pursued by every country may not be the same, agreeing on a common set of principles will be an essential step towards preventing similar crises in the future.

The idea that a bunch of heads of state, joined by a bunch of bureaucratic micromanagers of the sort who tend to populate the World Bank, the UN and particularly the IMF, can hold a meeting in the de facto capital of the world, Washington, and fix what ails the world economically is misplaced. We got into this mess because of years of accumulated mistakes that inevitably arise during a a great boom, which must be cleaned out. In this case the problem is worse because of the extra noise in housing markets introduced by Washington’s social engineering, which, combined with the global securitization of mortgages, has allowed everyone else to first enjoy our bubble and now imbibe our bitter medicine.

The only way out is the same approach that Andrew Mellon, President Hoover’s Treasury Secretary, was said (by Hoover) to have recommended: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate." Once the mistakes are out of the system, growth resumes. The mistakes have piled up because of combined dramatic growth-driven economic uncertainty and political uncertainty. Recent evidence – stock markets continuing to decline around the world despite one Keynesian/FDR remedy (stimulus, bank bailouts) after another – suggests that we cannot use macroeconomic management to get us out of this mess. There is nothing that a bunch of leaders can do from on high to fix a problem that is fundamentally, like all economic phenomena, an individual one – this individual decision now seen to be a mistake, that one not, that one over there a wonderful opportunity yet to be exploited.

What the summit does represent is risk – political risk in particular. This is because politicians and bureaucrats will want to do what they like to do - enhance their control, try to be seen as doing something right now instead of telling their constituents that it will be necessary to wait a bit. The combination of a lame-duck U.S. President, a more micromanagingly interventionist Administration and Congress in the wings, and Asian nations looking to reengineer global economic management for their own political interest while European nations look to increase state control for philosophical ones, is an explosive one. A quarter century of economic progress is at risk. If we take the 1930s way – control, management, administration, regulation – and forget Mr. Mellon’s advice, the results will be the same.

Dead Man's Hill

What caused the housing bubble? Greed, lack of regulation, or too much regulation?

Below (a little fuzzy, unfortunately, but I think the story is clear) is a plot of home ownership rates in the U.S. from 1965-2008, from the Bureau of the Census (Table 14).




You can see that historically ownership rates fluctuated between 63-65%. But beginning in roughly 1994 they began a rise to historically unprecedented levels. What happened? Between 1993-7, particularly in 1994 (the Wikipedia history is a little fuzzy) the government increased pressure on banks in a variety of ways to lend to those who didn't get loans, particularly the poor and those in inner-city neighborhoods. This was a shock to the financial system - a changing of the rules that required lenders to reevaluate their risk exposure. Against traditional risks of nonpayment on one side had to be weighed new, unclear risks concerning the risk of government punishment for not meeting government targets about loans to politically favored but financially troubling borrowers.

Added into the mix was the decision by the Federal Reserve after Sept. 11 to loosen monetary policy dramatically. (We all remember how nervous everyone was about the economy after the attacks, with Wall Street falling badly on the day the markets reopened.) As much as economists like to think no one with rational expectations would fall for it, politicians know through their repeated use of the tactic that they can rely on money illusion to give the economy a short-term boost. And so easy credit followed easy money, and this combined poisonously with the CRA reforms to generate the pattern above. All financial bubbles have their roots in a combination of new developments and broad uncertainty, and that is what the CRA reforms, in combination with the new subprime mortgage-security instruments the financial industry developed to help companies navigate them, did. In hindsight it is clear that the bubble popped in 2006, and took much of the global economy (how much remains to be seen) with it.

The numbers do not lie. Markets correctly solve the problem of who should and shouldn't own a home, once we take cognizance of the fact that for some people to have a home will impose very large costs on others. This is a disaster made in Washington, by politicians for their short-term interests at the expense of the rest of us.