The Dim-Post

October 31, 2011

Roger Kerr

Filed under: economics — danylmc @ 2:04 pm

I don’t have to much to say about Roger Kerr now that he’s passed away. I never met him – apparently he was a nice guy, and various people admired his intellectual prowess. It’s worth pointing out that at the beginning of his career, his neo-liberal, extreme-free market views were a respectable and sensible response to the obvious failures of both authoritarian and democratic socialism.

And some of the ideas that came out of the movement Kerr championed were very valuable. You only have to look at the institutional problems we have with our police, military, intelligence and diplomatic corps to recognise the merits of public choice theory. And Kerr played a key role in moving us away from an indiscriminate business subsidy economy.

Of course, the model Kerr championed turned out to fail just as spectacularly as the democratic socialist economy it replaced. The supply-side hypothesis – that the very wealthy would grow the entire economy by investing their excess wealth in productive capital and this additional wealth would ‘trickle down’ – did not eventuate. Turns out the wealthy like to convert their excess wealth into financial products and gamble it in various speculative markets. Instead of economic growth you get destructive bubble-bust cycles. And during the busts, the rich use their political influence to bail themselves out with public money. The model also failed to find market solutions to the economic problems of externality – most famously, the impact of various industries on the environment and public health.

Maybe future intellectuals will find solutions to these problems, and one day we’ll all live in Kerr’s free market utopia. Right now the tendency is for thinkers in Kerr’s tradition to deny that these problems even exist.

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51 Comments »

  1. Economics fail for you Danyl….”trickle down” is a lefty strawman fallacy….it has never featured in any free market school. And the model Kerr favored has never been implemented or even tried here. The state has always been in control of the NZ economy within living memory…no free market at all…you admit it yourself … Instead of economic growth you get destructive bubble-bust cycles. And during the busts, the rich use their political influence to bail themselves out with public money

    …That can only happen in a NON-free market,state controlled economy where politicians can be bought in exchange for favors.

    The model also failed to find market solutions to the economic problems of externality – most famously, the impact of various industries on the environment and public health.

    Private property rights upheld and respected….all that’s required.

    Comment by James — October 31, 2011 @ 2:39 pm

  2. You’re right, James!
    Because of course in a ‘free’ market, money never buys influence.

    Silly socialists.

    Comment by Gregor W — October 31, 2011 @ 2:49 pm

  3. No True Free Marketeer would ever rationally use their influence to maximise their own wealth.

    Comment by Trouble Man — October 31, 2011 @ 3:10 pm

  4. So what if the rich buy a million dollar property in rural Auckland? You still have to deduct what they would pay for a reasonable Auckland house, so your million bucks comes back to $600,000. Then there’s the real estate agent fees, the builders who built or modified the house, the home gardners etc to look after the place whilst the rich prick is in town earning a crust and managing his property portfolio..

    Whoops, that’s Phil Goff! err, moving on..

    The thing is you have to make some big assumptions that the rich man’s capital is doing less for his fellow man than the Govt taking a slice of it and pouring it into his pet political project.

    JC

    Comment by JC — October 31, 2011 @ 3:24 pm

  5. Instead of economic growth you get destructive bubble-bust cycles. And during the busts, the rich use their political influence to bail themselves out with public money.

    That’s not a relevant critique of free markets – that’s a relevant critique of PEOPLE everywhere, and their expectations of future outcomes. It doesn’t matter if you’re a Soviet-era oil oligarch, a Somali priate, a NYC banker, or a Waikato dairy farmer.

    Comment by Phil — October 31, 2011 @ 3:38 pm

  6. ” That’s not a relevant critique of free markets – that’s a relevant critique of PEOPLE everywhere”

    Umm, assuming free markets are going to be used by people, then it looks like a relevant critique to me.

    Comment by Pascal's bookie — October 31, 2011 @ 4:02 pm

  7. Private property rights upheld and respected….all that’s required.

    Who owns the atmosphere?

    Comment by danylmc — October 31, 2011 @ 4:24 pm

  8. Who owns the atmosphere?

    Vilos Cohaagen, Chief Administrator of Mars (if my recall is total).

    Comment by Gregor W — October 31, 2011 @ 4:33 pm

  9. Don’t you know that in the libertarian paradise?
    Externalities (positive or negative) don’t exist, or if they do they can be fully compensated (in dollars or course) or damage is fully reversible (what is lost can be recovered);
    Information is perfect so we know how much compensation is required;
    And everyone has equal access to means of recourse and by implication there are no transaction costs (going to arbitration/court is free).
    Doug

    Comment by Doug — October 31, 2011 @ 5:03 pm

  10. Government bail outs are free market.

    Keep the laughs coming.

    Comment by Simon — October 31, 2011 @ 5:42 pm

  11. ?
    Is that
    Government bail outs ARE free market. – Keep the laughs coming.

    Or
    “Government bail outs are free market.” – Keep the laughs coming.

    Comment by Clunking Fist — October 31, 2011 @ 6:39 pm

  12. “Of course, the model Kerr championed turned out to fail just as spectacularly as the democratic socialist economy it replaced. The supply-side hypothesis – that the very wealthy would grow the entire economy by investing their excess wealth in productive capital and this additional wealth would ‘trickle down’ – did not eventuate. ”

    Indeed not. If it had worked, me and other employees like me would have bought our wide screen tvs by saving some of our amazing wages paid by our rich employer. Instead, we stole them.
    /sarc

    Comment by Clunking Fist — October 31, 2011 @ 6:44 pm

  13. “fail just as spectacularly as the democratic socialist economy it replaced”

    I must’ve missed the bit where our govt privatised hospitals, schools & roads, did away with welfare?

    Comment by Clunking Fist — October 31, 2011 @ 7:26 pm

  14. Here’s the thing James – if your preferred theoretical system requires 100% slavish completeness to work and completely fails with even the slightest variation to nirvana then IT’S NOT A VERY GOOD SYSTEM.

    Comment by garethw — October 31, 2011 @ 9:43 pm

  15. if your preferred theoretical system requires 100% slavish completeness to work and completely fails with even the slightest variation to nirvana then IT’S NOT A VERY GOOD SYSTEM.

    Yeah, it’s the old ‘communism in the USSR didn’t work properly because it didn’t follow the proper stages of social development’ argument reheated. You don’t get to do-over history.

    Comment by danylmc — October 31, 2011 @ 9:50 pm

  16. this additional wealth would ‘trickle down’ – did not eventuate. Turns out the wealthy like to convert their excess wealth into financial products and gamble it in various speculative markets.

    Any cursory glance at economic history will show that the business cycle has long been in effect. So I do not see how this is a relative critique of supply side policies. The period from the mid 80s up until the most recent and severe crisis was known in economics as “the great moderation” – a period of less volatile business cycle fluctuations. The causes for the recent crisis are well-known and well-documented the capital requirements under the Basel accords, government sponsored enterprises Fannie Mae and Freddie Mac (the federal guarantee of which gave risky securtizations of their mortgages an implied triple A rating), the Federal housing Authority directing mortgage lending to low income borrowers, changes to the Community Reinvestment Act (CRA) (the first private securitization of loans were of CRA loans) to make banks prove they were making efforts at lending to the ‘underprivileged”, which led to the creation of the subprime mortgage market in the US, the Federal Reserve keeping interest rates too low for too long, all leading to a spate of subprime lending and securitzation and of course the regulations that conferred upon the three major ratings agencies protection from competition and canonized their judgements. None of which is particularly ‘free market’.

    Comment by Quoth the Raven — October 31, 2011 @ 10:56 pm

  17. “None of which is particularly ‘free market’.”

    But then, what is? Markets exist in real (and politically interfering) worlds, not in some abstract vacuum. Has a truly free market ever existed? Is the concept even very meaningful? It’s a not very well thought out lefty cliche to say that a truly free market looks like Somalia. But actually, where in the real world looks like a genuinely free market?

    Comment by Dr Foster — October 31, 2011 @ 11:31 pm

  18. Foster – It’s not to compare it to some idealized alternative, but rather to show that a number of interventions in the market led to the financial crisis which contradicts Danyl’s tired narrative.

    Comment by Quoth the Raven — October 31, 2011 @ 11:38 pm

  19. An explanation of the GFC that doesn’t even mention AIG or Lehman Bros. Wow.

    Comment by danylmc — November 1, 2011 @ 6:11 am

  20. QTR accurately describes some of the major factors that kicked off the credit frenzy not the spectacular car crashes you note that happened at the end.

    Comment by little_stevie — November 1, 2011 @ 6:48 am

  21. Question: Does Danyl have a day light savings fetish?

    Context: The time setting on this blog never changes, it is always daylight savings time.

    Comment by little_stevie — November 1, 2011 @ 7:17 am

  22. An explanation of the GFC that doesn’t even mention AIG or Lehman Bros. Wow.

    …or repeal of the Glass-Steagall Act.

    Comment by Gregor W — November 1, 2011 @ 10:07 am

  23. So, to summarise …

    James: “I read a website written by a guy who read a book about how all this will work, so don’t tell ME about free markets!”

    Quoth the Raven: “It was the Gummint made them do it … what else could you expect self-interested financial institutions to do except react to attempts at regulation by blowing up the world?”

    little_stevie: “I don’t have anything to contribute, but I like being noticed.”

    Ah … that Roger’s passing sparks such wisdom is cruel irony indeed.

    Comment by Grassed Up — November 1, 2011 @ 10:50 am

  24. Gregor – You are going to have to explain how precisely you think the repeal of Glass-Steagall had major practical effect in contributing to the financial crisis. That is why co-ownership (allowing investment banks to have commercial bank subsidiaries) was a major problem leading to the financial crisis. Europe didn’t operate under Glass-Steagall. Do you really think that buying Traveler’s insurance contributed to Citi’s troubles? Even uber progressive Matt Yglesias thinks the repeal of glass-steagall is a red herring. It did allow tottering investment banks to be saved by bank mergers hence stopping the financial collapse from being even worse.

    Danyl – Are you going to try to derive some systematic explanation of the financial crisis (a systematic failure) from two institutions?

    Comment by Quoth the Raven — November 1, 2011 @ 11:10 am

  25. QtR, that’s actually mostly not true. Freddie Mac, Fannie Mae and the CRA were bit part players. Here’s a link. Only one, as you can find links to all sorts of analysis there. I’m not going to mention it all, because if you really care you’ll read some of it, but most of the sub-prime loans were from private institutions, not Freddie and Fannie. One of the rating agencies actually threatened to downgrade one or both of those due to their declining share of the mortgage market, though I can’t find a link to that at the moment.

    http://www.google.com/search?q=it+wasn%27t+the&btnG=Google+Search&domains=http%3A%2F%2Feconomistsview.typepad.com&sitesearch=http%3A%2F%2Feconomistsview.typepad.com#sclient=psy-ab&hl=en&domains=http:%2F%2Feconomistsview.typepad.com&source=hp&q=it%20wasn%27t%20freddie%20fannie%20cra&sitesearch=http:%2F%2Feconomistsview.typepad.com&pbx=1&oq=&aq=&aqi=&aql=&gs_sm=&gs_upl=&bav=on.2,or.r_gc.r_pw.,cf.osb&fp=d1c0b00cfe3f0c3e&biw=1440&bih=655&pf=p&pdl=300

    Here’s a piece by the New York branch of the Federal Reserve exonerating the CRA.

    http://www.federalreserve.gov/newsevents/speech/20081203_analysis.pdf

    Comment by Nick — November 1, 2011 @ 11:59 am

  26. QtR –

    I don’t have to explain it.

    I’ll let Huffington Post,Robert Reich and Michael Hudson do it.

    Comment by Gregor W — November 1, 2011 @ 12:39 pm

  27. Nick – Fannie, Freddie, and the CRA were only parts of a thick web of interventions and regulations that built up and up over many years and interacted in ways that regulators were ignorant of to create the systematic risk that lead to the systematic failure. That’s why I listed a number of interventions perhaps most importantly the Basel accords, central bank policy and the labyrinthine mess of regulations protecting the ratings agencies from competition. It is certainly true that you can directly follow a number of US government policies to expand home-ownership amongst the poor into the subprime mortgage market. From the critical review paper A crisis of politics not economics.

    Peter J. Wallison’s “Cause and Effect” names the Community Reinvestment Act (CRA) as one of the first causes of the crisis, because new regulations governing its enforcement, issued in 1995, led directly to subprime lending. First enacted in 1977 in an effort to rectify perceived racism (“redlining”) in mortgage lending, the CRA was then revised to require that all mortgage-lending banks (for purposes of this introduction, “commercial” banks, but including savings and loans) prove that they were making active efforts to lend to the underprivileged in their communities. Wallison allows that most subprime lending did not occur under CRA auspices. But he argues that the new CRA regulations were only one aspect of a government-wide effort to expand homeownership rates among minorities and the poor.

    Subsidizing homeownership for the poor had long been a mission of the Federal Housing Authority (F.H.A.). The F.H.A. insured around one million no-down-payment mortgages in each of fiscal years 1998, 1999, 2000, and 2001 (England 2002, 73). But in 1994, according to Wallison, HUD ordered Fannie and Freddie to supplement, and eventually to far surpass, the F.H.A.’s efforts, by directing 30 percent of their mortgage financing to low-income borrowers. In response, Fannie Mae introduced a 3-percent-down mortgage in 1997. Traditionally, non-F.H.A. mortgages had required 20 percent down, giving them an initial loan-to-value ratio (LTV, in the trade) of 80. But such large down-payments were the biggest barrier to homeownership among the poor.

    In 2000, HUD increased the GSEs’ low-income target to 50 percent (Schwartz 2009, 20); in the same year, Fannie launched “a ten-year, $2
    trillion ‘American Dream Commitment’ to increase homeownership rates among those who previously had been unable to own homes” (Bergsman 2004, 55). Freddie Mac followed, in 2002, with “Catch the Dream,” a program that combined “aggressive consumer outreach, education, and new technologies with innovative mortgage products to meet the growing diversity of homebuying needs” (ibid., 56). In 2005,
    HUD increased the target again, to 52 percent (Schwartz 2009, 20). In the end, according to Wallison, about 40 percent of all subprime and
    nonprime loans were guaranteed by the GSEs.1 However, private-sector lenders, such as Citibank, Countrywide, Bank of America, and Washington Mutual originated the rest, and they started doing so long after the 1995 CRA changes. Moreover, not just the GSEs but commercial and especially investment banks, such as Lehman Brothers and Bear Stearns, turned these mortgages into “mortgage-backed securities” by taking vast pools of them and selling shares of the mortgage and interest payment streams to investors around the world. The first private securitization of subprime loans did take place as a result of the CRA: In 1997, Bear Stearns securitized and sold $385 million
    of CRA loans that had been pooled together by First Union Capital Markets. However, the initial wave of privately securitized subprime
    loans petered out by the end of the twentieth century; subprime securitization began to take off again only in 2001, 2002, and especially 2003 (Jaffee et al. 2009, Fig. 2), and the peak years were 2004-7 (Zandi 2009, 43)—a decade and more after the CRA’s enforcement was strengthened.

    Of course these were only small parts of a much wider complex picture of regulation and intervention, no one denies that. What is clear is that regulation and intervention in these markets was pervasive and to adhere to some narrative about a laissez-faire marketplace going out of control as Danyl does is incredibly tenuous and naive.

    Comment by Quoth the Raven — November 1, 2011 @ 12:59 pm

  28. You’re right, QtR.

    Corruption, cronyism, financial lobbying and avaricious capitalism had nothing to do with the GFC.
    It was all the fault of over-regulation and naughty politicians fiddling with naturally perfect and equitable market mechanisms.

    Silly me.

    Comment by Gregor W — November 1, 2011 @ 1:48 pm

  29. “What is clear is that regulation and intervention in these markets was pervasive and to adhere to some narrative about a laissez-faire marketplace going out of control as Danyl does is incredibly tenuous and naive.”

    While there is truth in that, it’s also true that much of the pressure (housing bubble) built up, and was released, under the supervision of those who were looking to reduce regulation and intervention. Greenspan did nothing to prevent the bubble (and ended the Great Moderation that more active central bankers had helped create), Glass-Steagall was repealed (evidence of the mindset, if not as critical as some think), the SEC relaxing capital requirements under Bush etc..

    Why would it all come to a head when the regulation that was supposedly causing it was being relaxed? That interpretation is as tenuous as Danyl’s.

    Further, much of the damage emanated from the shadow banking sector, which was not subject to most the regulation or oversight. Laissez-faire may be exaggeration, but it’s not completely wrong when talking about some the causes.

    Comment by Nick — November 1, 2011 @ 1:58 pm

  30. “it’s also true that much of the pressure (housing bubble) built up, and was released, under the supervision of those who were looking to reduce regulation and intervention.”
    The supervisors being the central bank and the politicians who, presumably for political reasons, kept interest rates “too low” and govt deficits too high? Please.

    It is indeed true that bankers (capitalists) fucked up. Big time. I like the analogy that regulators created this big old steam train that rocketed along, very exciting. But the bankers chose to climb aboard. Some of it was greed (on the part of the bankers, others involved in property, politicians) some of it was fuck up.

    Comment by Clunking Fist — November 1, 2011 @ 2:31 pm

  31. Nick – There are 115 regulatory agencies that regulate finance in the US. The SEC had the biggest ever budget under George W Bush and its budget tripled in real terms since 1980. There is no regulation that was repealed that would have prevented the securitization of mortgages, or prevented banks from holding securitized mortgages as investments. Sure some regulations were repealed, but others were added like Sarbanes–Oxley and the capital requirements under the Basel Accords (one of the single biggest contributors to the financial crisis). Deregulation did not cause the financial crisis.

    Greenspan did nothing to prevent the bubble (and ended the Great Moderation that more active central bankers had helped create),

    The problem was that he kept interest rates too low for too long following the dot com crash. That is arguably being too active.

    To explain the financial crisis you have to explain why so many bankers engaged in the same behaviour at the same time (and they’re gweedy won’t suffice). There is no systematic risk if only a few players engage in such behaviour they will fail or change and it won’t pose a threat to the whole system. That is if there is sufficient heterogeneity in it. However, what regulations do is push the system toward greater homogeneity and hence put it at greater systematic risk. What occurred in the lead up to the crisis is that government intervention led to a spate of subprime mortgages and low interest rates led to credit expansion the capital requirements under the Basel rules coupled with the canonization of the ratings agencies judgements via regulation led bankers to hold GSE-backed and double and triple A rated securities (remember they could have chosen to hold higher yielding more risky assets if they were so gweedy, but they chose lower-yielding less risky ones the overwhelming majority of the time and Basel rules were designed to buffer against excessive risk taking). The judgements and confidence in those securities was at it turns out not well-founded and it all came crashing down.

    Comment by Quoth the Raven — November 1, 2011 @ 2:33 pm

  32. “Further, much of the damage emanated from the shadow banking sector, which was not subject to most the regulation or oversight.”

    The main (non-shadowy) banking sector produced the collateralised debt instruments after lending to subprime borrowers. It was what they did to get the toxic stuff off their balance sheet. The theory is that, unfortunately, they didn’t tell their shadowy colleagues on the other side of the Chinese wall. If the shadowy folk had any real inkling what these CDIs were like, they’d have treated the offerings from other banks with suspicion. Because they had no idea (“there are mortgages all the way down!”), what one part of the bank sold, the other part of the bank, effectively, bought back.

    Comment by Clunking Fist — November 1, 2011 @ 2:38 pm

  33. Raven, you’ve explained it too well, you’ll just be ignored.

    Comment by Clunking Fist — November 1, 2011 @ 2:40 pm

  34. To explain the financial crisis you have to explain why so many bankers engaged in the same behaviour at the same time (and they’re gweedy won’t suffice).

    Because they knew politicians would buy the ‘too big to fail’ arguement.
    With regulators and legislators bought and paid for and the revolving door between the Fed, Investment Banks and The Executive, the deck was stacked.

    However, what regulations do is push the system toward greater homogeneity and hence put it at greater systematic risk.

    I guess like speed limits cause more car crashes.

    (remember they could have chosen to hold higher yielding more risky assets if they were so gweedy, but they chose lower-yielding less risky ones the overwhelming majority of the time and Basel rules were designed to buffer against excessive risk taking).

    Isn’t it merely sensible investment policy to spread risk?

    Comment by Gregor W — November 1, 2011 @ 3:39 pm

  35. Because they knew politicians would buy the ‘too big to fail’ arguement.

    They didn’t know that before the fact (ask Lehman Brothers). Moral hazard had been created by previous interventions, but the point is they didn’t know it was all going to fall down. They were overconfident.

    I guess like speed limits cause more car crashes.

    No. That’s just your poor analogy.

    Isn’t it merely sensible investment policy to spread risk?

    This is why I made the whole point about regulations creating homogeneity and hence systematic risk. See for instance: Why Financial Regulation is Doomed to Fail.

    Comment by Quoth the Raven — November 1, 2011 @ 4:40 pm

  36. CF: As QtR says, Greenspan’s negligence in keeping interest rates low was a factor in the housing bubble. QtR puts this down to being activist, while I would suggest that an inability to even imagine a bubble occurring (an ideological position) played a part in that decision, though I don’t know what the Fed’s OMC motivation was at the time.

    QtR: Why do regulations necessarily push the banking sector towards greater homogeneity?

    If the level of risk of the subprime mortgage backed securities had been correctly identified from the beginning (and I agree that the regulations pertaining to the credit agencies are poorly designed, and counter productive), then they wouldn’t have such demand for them. But once that risk was identified, it was shifted off to the shadow bank sector, where many of the rules (for example, about leverage ratios) didn’t apply, and once that knowledge became widespread, the shadow banking institutions became susceptible to bank-runs (and where I think the repeal of Glass-Steagall comes in, is by enabling this to spread to retail banking more easily, eg Citibank, though G-S’s existence may just have slowed this spread rather than prevent it).

    I’m not arguing that poorly designed regulation didn’t contribute to the GFC, obviously it did. But part of the problem was people making the most of loopholes and information asymmetries, as well as regulation capture. Some would call that greed (or even gweed), but it’s a rational response to the rules and the pressure individual bankers would have been under, and giving it a moral perjorative is something I disagree with. And given that, as per your excerpt above, about 60% of subprime mortgages originated outside of the GSEs, much of the systemic nature of the risk can be attributed to private actors. Regulations didn’t force private banking institutions into NINJA loans. And much of the worst of the bubble in the USA was places like Miami, Phoenix, and parts of California, in suburbs outside the scope of the govt intervention.

    And the solution to a problem caused by a poorly structured regulatory system is not to deregulate completely, but to use the problem to help design a better structure. Surely the fate of the shadow banking sector would give pause to the idea that less regulation is necessarily better.

    CF: “I like the analogy that regulators created this big old steam train that rocketed along, very exciting. But the bankers chose to climb aboard. Some of it was greed (on the part of the bankers, others involved in property, politicians) some of it was fuck up.”

    Where does regulation capture come into this story? Did some of the bankers hijack the train, disable the brakes and pack too much coal into the boiler?

    “you’ve explained it too well, you’ll just be ignored.”

    Projecting, perhaps?

    Comment by Nick — November 1, 2011 @ 5:10 pm

  37. They didn’t know that before the fact (ask Lehman Brothers).

    Bollocks. Lehman was strung up through inside dealing. If it wasn’t them another target would have been presented to the Wall St wolves. You seriously believe that backroom deals weren’t done when Geithner et al knew the jig was up? We’re talking unfathomable amounts of money here. None of this was chance.

    Moral hazard was created by corruption; for and by the same cabal of people who would benefit – the pure self interest described by public choice theory in action.

    If you would be so kind, please explain to me why the car crash analogy is poor. You made the assertation that regulation created an environment for systematic risk (unless I totally misread you?), de-facto limiting the human agency aside from the totally rational from your premise.
    I’m merely attempting to extend your ‘people don’t kill people, gun regulation does’ illogic.

    This is why I made the whole point about regulations creating homogeneity and hence systematic risk.

    I don’t understand. You didn’t make this point.
    You asserted that regulation created market/response homogeneity and hence systemic risk, but then stated correctly that not all players took advantage of the opportunity because not 100% of bankers invested all their assets in this ponzi scheme.
    Therefore the market behaviour by default was not homogenous at all as the risk appetite (and hence spread) was determined by participants appetite for individual risk, not strictly on a rational profit maximisation basis.
    Or have I got totally the wrong end of the stick?

    Comment by Gregor W — November 1, 2011 @ 5:15 pm

  38. However, what regulations do is push the system toward greater homogeneity and hence put it at greater systematic risk.

    I guess like speed limits cause more car crashes.

    An accurate (and, best of all, true!) analogy would be like how seatbelts, crash helmets, and airbags, make people drive/cycle with less care and attention than they really should.

    Comment by Phil — November 1, 2011 @ 5:46 pm

  39. If the level of risk of the subprime mortgage backed securities had been correctly identified from the beginning (and I agree that the regulations pertaining to the credit agencies are poorly designed, and counter productive), then they wouldn’t have such demand for them.

    But on top of that the risk capital is not set by the banks rather they must conform to regulatory requirements. Enter the Basel rules and their role in the crisis. From my previous link:

    One might think that the ideal regulations would be those that find the right numbers for these portfolios, not too small and not too large—the Goldilocks of risk.

    Surprisingly enough, it is not possible. It turns out that no algorithm for calculating the required risk capital for given portfolios results in lower systemic risk.

    In Maymin and Maymin (2010), we prove why this is so, both mathematically and empirically….

    We also show empirically that the securities with historically low volatility tended to have almost twice as much subsequent risk, while those with historically high volatility tended to have almost half as much subsequent risk. For both the riskiest and least risky securities, therefore, historical risk is a statistical illusion.

    Here’s where the problem of objective regulations comes in. To see it, consider the perspective of a bank deciding what to invest in. It can invest in any of the 1,000 securities, but if it invests in the special ten that exhibit less than 80 percent of their true volatility, it will have to put up one-fifth less capital than otherwise. At least to some extent, those ten securities will be more favored than the others. What’s worse, every bank will favor the same ten securities because the objective regulations are the same for everyone.

    If those securities continue to rise, then no problem will be apparent. But if they should fall, then, suddenly, all banks will need to liquidate the exact same positions at a time when those positions are falling anyway. This sets the stage for systemic failure. Consider sub-prime mortgages as an illustration. These assets appeared to be historically low-risk and were, therefore, regulatorily favored. Banks invested more in them than they perhaps should have. For a while, as real estate prices continued their ascent, no problems surfaced. But once the market turned, banks began experiencing more losses on their sub-prime mortgage holdings than their regulatorily-mandated risk calculations had planned for. Banks needed to raise capital quickly and began doing two things: selling the sub-prime mortgages, dropping the prices even lower; and selling other assets. Because the banks all acted nearly simultaneously, and all in the same direction, the impact on the markets was both broad and deep, and systemic collapse became a real threat.

    Regarding the shadow banking system few of these entities are unregulated. The mortgage specialists were savings and loans regulated by the Office of Thrift Supervision (OTS). The investment banks, like commercial banks and most OBSEs, are regulated by the Basel accords.

    Remember it is commercial banks (which are much more heavily regulated) which lend to businesses in the real economy and hence any problem in investments banks has to be transmitted to the real economy by producing a decline in commercial bank lending.

    And the solution to a problem caused by a poorly structured regulatory system is not to deregulate completely, but to use the problem to help design a better structure.

    Unless the better structure is actually a deregulated one which is where we’d have to agree to disagree.

    Comment by Quoth the Raven — November 1, 2011 @ 6:01 pm

  40. Yeah, I read that link. My initial response is to be skeptical that a result based on homogeneity of actors and securities is a good model of how the financial world actually operates (like most economic models…).

    Anyway, let’s leave it here:

    “agree to disagree”

    Comment by Nick — November 1, 2011 @ 6:28 pm

  41. QTR: … I made the whole point about regulations creating homogeneity and hence systematic risk. See for instance: Why Financial Regulation is Doomed to Fail (“It turns out that no algorithm for calculating the required risk capital for given portfolios results in lower systemic risk.”)

    Nick: … My initial response is to be skeptical that a result based on homogeneity of actors and securities is a good model of how the financial world actually operates

    – Regulators regulate against outliers (as they see it) creating homogenity => a herd mentality and in the main this is exactly how the financial world operates.

    Comment by little_stevie — November 1, 2011 @ 7:06 pm

  42. Fannie & Freddie were/are two of the most regulated companies in the world.

    They are watched over by their own government agency. http://www.fhfa.gov/

    For laughs because this is DIM post here is Fannie & Freddie’s regulator mission statement:

    “Provide effective supervision, regulation and housing mission oversight of Fannie Mae, Freddie Mac and the Federal Home Loan Banks to promote their safety and soundness, support housing finance and affordable housing, and support a stable and liquid mortgage market.”

    Government regulation failed. In the face of Federal Reserve money printing and manipulation of the banking system government regulation will always fail.

    Comment by Simon — November 2, 2011 @ 6:51 am

  43. Simon, you’re a moron. The FHFA is the post-GFC successor to three difference agencies that failed in regulation because they didn’t have enough powers. The FHFA has much more power than all the other three agencies combined, and its existence is a result of exactly the lack of oversight that occurred pre-GFC.

    Back in 2007, Ben Bernanke said that Freddie and Fannie needed much greater oversight because there was a problem with a lack of regulation in the markets they were involved in. Until the establishment of the FHFA, Freddie and Fannie, operating as a government owned (but not government supported or run) company had very little oversight and were involved in markets not sanctioned by government and that deviated from their prime purpose of backing securities for subprime mortgages to support the subprime market.

    Excessive government regulation didn’t cause this. And if you think it did, then you’re really fucking stupid and you need to go back to the start and get reading.

    Comment by Dizzy — November 2, 2011 @ 7:50 am

  44. Phil, you are right.
    That is a better analogy.

    My overall point being that human agency (sensible or otherwise) has a lot more to do with creating disasters than regulation does.

    Comment by Gregor W — November 2, 2011 @ 9:24 am

  45. Gregor – All analogies obscure something of the truth especially simplstic ones and most especially when we are dealing with something as horrendously complex as banking and finance.

    My overall point being that human agency (sensible or otherwise) has a lot more to do with creating disasters than regulation does.

    You cannot separate out those agents from the system within which they operate. They respond to incentives and information and in the case of the financial crisis capital regulations created incentives for banks to securitize assets and shift them off their balance sheets (regulatory arbitrage), the judgements of the ratings agencies (whom are protected from competition by regulation) canonized in regulation coupled with the capital requirements strengthened the incentive for banks to buy and retain these securities, deposit insurance intended to solve liquidity problems created moral hazard and perverted incentives leading to imprudent lending, public policy eroded mortgage-underwriting standards, artificially low interest rates as a result of central bank policy (the longest sustained expansionary monetary policy in half a century) shifted time preferences and expectations and created a strong incentive for people to borrow. You cannot ignore the system within which your agents are operating.

    Regarding your earlier comment I wouldn’t deny that corruption exists, but I think that Geithner et al genuinely believed that the bailouts were necessary to save the financial system and that they were doing what they thought was best. I don’t necessarily agree with them, but I don’t believe this was all the result of corruption. The moral hazard created by such things as FDIC are I think by and large made with good intentions not malevolent forethought.

    Comment by Quoth the Raven — November 2, 2011 @ 1:20 pm

  46. Qtr –

    Banking and finance is not complex. It’s buying and selling the time cost of money.
    It’s been made complex so that the Wizards of Capital can practice their obscure, arcane arts in with impunity in finding ever more devious ways to rip you and me off.

    You cannot separate out those agents from the system within which they operate.

    But you can seperate how they act within that system. It’s called ethics, or morals, whatever you like.
    Otherwise the implication is that systems rules are immutable, and the actors are coerced to act in rigid conformity within that system. This is plainly not the case.
    The participants in this fraud had choices. They took the easy road; one in which they grossly enriched themselves at the expense of pretty much everyone else on the planet.

    Fair enough to give Geithner et al the benefit of the doubt if you like.

    I don’t.

    So to paraphrase Nick, we’ll agree to disagree.

    Comment by Gregor W — November 2, 2011 @ 1:50 pm

  47. Gregor – People respond to incentives. Regulations change incentives. That’s the point. Bad regulations create perverse incentives and bad outcomes (as they did in the financial crisis because regulators were ignorant as were bankers). You can argue that it was all a “ponzi scheme” or “fraud” (which it wasn’t) and the evul gweedy banksters knew all along (which is obviously false) or you can see that it was a systematic failure of the financial system which resulted from a complex series of interventions and regulations dating back years and sometimes decades which crested systematic risk that both regulators and bankers were blind to. It wasn’t corruption or avarice or some bizarre conspiracy to devise “ways to rip you and me off” it was just failure due to ignorance.

    Comment by Quoth the Raven — November 3, 2011 @ 1:26 am

  48. “Banking and finance is not complex. It’s buying and selling the time cost of money.”

    Eh? That’s like saying surgery is not complex. It’s cutting and stitching stuff.

    Comment by Clunking Fist — November 4, 2011 @ 1:11 pm

  49. Not really CF. I’m saying finance has been made artificially complex.
    Surgery is actually complex.

    Plus no-one dies when if their derivatives go tits up.

    Comment by Gregor W — November 4, 2011 @ 1:45 pm

  50. To be a “good” surgeon, you need to know your way around the human body.
    To be a “good” banker, you need to know your way around finance, accounting, psychology, engineering, marketing, meteorology, Tengenjutsu (no, seriously) and a myriad of other disciplines you’re expected to engage in/with and trade upon.

    (I work in finance. This might be self important wankery… I’m honestly not sure yet).

    no-one dies when if their derivatives go tits up

    Personal financial difficulty is often contributing factor in suicide.

    Comment by Phil — November 4, 2011 @ 2:01 pm

  51. OK, Phil. You got me. Banking is exactly like surgery.

    In fact, let’s be honest, banking is far more skillful and important than surgery because you merely need to “know your way around the human body” be be good at it.

    Shit, who needs to go to University for 8 years to specialise in a medical discipline when banking is so much more important.
    I mean, you have to have an understanding of meteorology and accounting! Need your appendix taken out to avoid dying of septicemia? Ask your banker!

    Banking obviously saves way more lives than surgical medical intervention does every year.
    I’m surprised in fact that a key plank of the government’s health policy doesn’t revolve around publicly funded banking for all.

    Fuck me.

    PS – Yes. Conflating the benefits and complexity of banking to surgery it is self important wankery. But that’s OK – this is a blog.

    Comment by Gregor W — November 4, 2011 @ 2:19 pm


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