Russ Roberts on moral hazard
Continental Illinois was just the largest and most dramatic example of a bank failure in which creditors were spared any pain. Irvine Sprague, in his 1986 book:
“Of the fifty largest bank failures in history, forty-six””including the top twenty””were handled either through a pure bailout or an FDIC assisted transaction where no depositor or creditor, insured or uninsured, lost a penny.”
The 50 largest failures up to that time all took place in the 1970s and 1980s. As the savings and loan (S&L) crisis unfolded during the 1980s, government repeatedly sent the same message: lenders and creditors would get all of their money back. Between 1979 and 1989, 1,100 commercial banks failed. Out of all of their deposits, 99.7 percent, insured or uninsured, were reimbursed by policy decisions.
Then Russ discusses LTCM and the 1995 Mexican bailout before eventually arriving at the current crisis:　
That brings us to the current mess that began in March 2008. There is seemingly little rhyme or reason to the pattern of government intervention. The government played matchmaker and helped Bear Stearns get married to J. P. Morgan Chase. The government essentially nationalized Fannie and Freddie, placing them into conservatorship, honoring their debts, and funding their ongoing operations through the Federal Reserve. The government bought a large stake in AIG and honored all of its obligations at 100 cents on the dollar. The government funneled money to many commercial banks.
Each case seems different. But there is a pattern. Each time, the stockholders in these firms are either wiped out or see their investments reduced to a trivial fraction of what they were before. The bondholders and lenders are left untouched. In every case other than that of Lehman Brothers, bondholders and lenders received everything they were promised: 100 cents on the dollar.
A few comments:
1. Reading Russ’s paper makes me realize just how much our system is biased toward debt. And by the way, it isn’t just moral hazard; our tax system is also biased toward debt and against equity. People talk about Americans borrowing too much, but given all these distortions it’s surprising that we don’t have even more debt. Why didn’t I take out some mortgages and buy Florida condos? I’d like to think it was civic virtue, but I suppose it was just laziness.
2. This also made me realize the importance of Lehman’s failure. It wasn’t just an isolated bankruptcy; it was a regime change that made enormous quantities of debt appear to be far riskier than just a few days earlier. And the change was made just as the US was entering a severe recession. I’m all for cracking down on moral hazard—but September 2008 was not the best time to do so.
Here Russ discusses how the system encouraged abuse:
George Akerlof and Paul Romer describe similar incentives in the context of the S&L collapse. In Looting: The Economic Underworld of Bankruptcy for Profit, they describe how the owners of S&Ls would book accounting profits, justifying a large salary even though those profits had little or no chance of becoming real. They would generate cash flow by offering an attractive rate on the savings accounts they offered. Depositors would not worry about the viability of the banks because of FDIC insurance. But the owners’ salaries were ultimately coming out of the pockets of taxpayers. What the owners were doing was borrowing money to finance their salaries, money that the taxpayers guaranteed. When the S&Ls failed, the depositors got their money back, and the owners had their salaries: The taxpayers were the only losers.
This kind of looting and corruption of incentives is only possible when you can borrow to finance highly leveraged positions. This in turn is only possible if lenders and bondholders are fools””or if they are very smart and are willing to finance highly leveraged bets because they anticipate government rescue.
When you read Russ’s paper you begin to wonder if much of the US economy is just a giant Ponzi scheme:
1. Bank creditors ignore risk, knowing they will be bailed out.
2. Bank equity-holders have an incentive to borrow at low rates (due to the protection of creditors), and so they take highly leveraged gambles.
3. Bank presidents have an incentive to take big risks, as they can earn large bonuses if the gambles pay off.
4. Bank depositors have an incentive to look for the highest rate of return, regardless of how reckless the bank is.
5. Home-buyers have an incentive to take out mortgages with the smallest possible down-payments, particularly in non-recourse states.
Taxpayers are left holding the bag.
And that is just the banking system. Insurers like AIG (and their customers) had an incentive to take enormous ricks, knowing they would be bailed out. Hospitals in McAllen Texas spent vast amounts treating poor patients, knowing Medicare will bail them out. Then there is our pension system; corporations have an incentive to have underfunded pension plans. And does anyone think Uncle Sam would allow states like California or Illinois to default on pension obligations? And why stop at states? Perhaps whole countries are playing this game. What about lenders to Greece? How about Iceland; didn’t their citizens recently vote down a proposal that they pick up the cost of meeting deposit insurance obligations in British and Dutch branches of Icelandic banks? I am certainly not suggesting that the Icelandic banking fiasco was some sort of nefarious plot hatched by Icelandic taxpayers, but rather that there may be a good reason why they never contemplated the tax liability associated with the European branches of Icelandic banks. With the possible exception of taxes, government-created moral hazard is the primary factor distorting market economies around the world
Some of my commenters suggest that if we had my monetary nirvana of 5% expected NGDP growth, then people would take greater risks. Perhaps, but also think about this. The biggest single factor driving bailouts is the fear that failures would worsen a recession. If government policymakers knew there was going to be 5% expected NGDP growth regardless of whether Lehman was bailed out or not, then I think it would be easier for them to ‘do the right thing” and refrain from bailouts. I don’t recall all that many bailouts during the prosperous Clinton years. Gambles were made (in tech stocks) but for the most part those who lost money paid the price. My point is not that Clinton himself had anything to do with the difference, rather that we are more risk averse when a financial failure seems likely to trigger a recession.
I have been a long-time foe of Fannie and Freddie (going back 20 years) and I am pleased that Russ was able to dig up a lot of dirt. Here is just one of many examples:
The most important change at Fannie and Freddie, however, was their approach to the down payment. In 1997, fewer than 3 percent of Fannie and Freddie’s loans had a down payment of less than 5 percent.
But starting in 1998, Fannie created explicit programs where the required down payment was only 3 percent. In 2001, it even began purchasing loans with zero down. With loans that had a down payment, it stopped requiring the borrower to come up with the down payment out of his own funds. Down payments could be gifts from friends or, better still, grants from a nonprofit or government agency.
A few weeks ago I was kind of shocked to see respected bloggers speak well of the financial reform package. I can’t see how it addressed ANY of the major causes of the 2008 fiasco. But easily the most inexcusable aspect of the bill was that it didn’t even address Fannie and Freddie. People excuse that on the basis that there is a lot of political support for F&F. But if you can’t reform them right after a $165 billion taxpayer bailout, when will they be unpopular enough that we can address their flaws? (And the best way to address the flaws would be to phase them out of existence.)
And no ban on sub-prime mortgages? I thought that was the cause of the crisis. You’d think a minimum 20% down-payment would have been the centerpiece of the bill. Two years ago all my left wing friends said; “See how bad capitalism is? All those unregulated banks made lots of sub-prime loans.” OK left-wing friends, where is the regulation that prevents banks from reverting back to sub-prime lending?
When the crisis broke in 2007 I was completely ignorant about some of the details of what had been going one. Of course I had heard that there were lots of sub-prime loans, and that in recent years almost anyone could get a mortgage. But when I bought my house in 1991 I was told I needed to put 20% down or else buy mortgage insurance. I had no idea that the practice had been phased out. Here is Russ describing what happened:
When the down payment was less than 20 percent, Fannie and Freddie required private mortgage insurance (PMI). On a zero down payment loan, for example, the borrower would take out insurance to cover 20 percent of the value of the loan, protecting Fannie and Freddie from the risk of the borrower defaulting. But starting in the 1990s, an alternative to PMI emerged””the piggyback loan, a second loan that finances part or all of the down payment. The use of piggyback loans grew quickly beginning in the 1990s through 2003 and even more dramatically in the 2004-2006 period. For example, in a study of the Massachusetts mortgage market, the Warren Group found that in 1995, piggyback loans were 5 percent of prime mortgages. The number grew to 15 percent by 2003. By 2006, over 30 percent of prime mortgages in Massachusetts were financed with piggyback loans. For subprime loans in Massachusetts, almost 30 percent were financed with piggybacks in 2003 and more than 60 percent by 2006.
Here is something I haven’t heard many people talk about. Couldn’t one argue that moving away from mortgage insurance for less than 20% downpayment mortgages was a factor in the crisis? Maybe I am missing something simple here, but it seems to me that with mortgage insurance you actually have institutions with “skin in the game.” Perhaps the mortgage insurance companies would have been just as reckless as AIG, and allowed O% no -income verification mortgages with phony appraisals. But even in that worst case scenario the existence of mortgage insurance have reduced the losses to the banking industry. Even if the mortgage insurance companies had to be bailed out, at least they would have absorbed some of the losses now absorbed by banks and taxpayers. And I think in practice they would not have been quite that reckless.
My second observation is that the big mistakes were made in the 1990s, when we allowed F&F to dramatically lower their standards and stopped requiring mortgage insurance on less than 20% down mortgages. And this loosening of standards occurred right after one of the biggest banking fiasco’s in American history–the S&L crisis, which required an enormous taxpayer bailout of our deposit insurance system. When this happened everyone was running around saying “See deregulation doesn’t work, we need to re-regulate the banking system.” And I think that they did tighten up in a few areas like capital requirements. But the most important trend in the 1990s was actually deregulation, the dramatic lowering of the standards on who could get a mortgage. I don’t know how much of this was explicit deregulation, and how much was a failure of regulators to do something affirmative in the face of financial “innovation.” So I am not trying to make an ideological point here, or point fingers at one party of the other. My point is that we responded to the S&L crisis by talking about the need for tighter regulation, and then acted in a completely contrary way. As far as I can see our current actions also have little to do with the 2008 crisis.
I think the debate over regulation gets clouded by ideology. What does “increased regulation” mean? Does it mean more government involvement in banking, or less? Consider our current banking system in America, where we essentially nationalized all bank liabilities in 1934. When you deposit $100 in the bank, you are loaning it to the Treasury, which re-loans it at the same rate to the bank. Those are insured deposits. Now consider a “regulation” that said banks could only lend out money from insured deposits on mortgages with more than 20% down-payments. While this proposal would increase “regulation,” it would also reduce the role of government in our banking system. Instead of the government being liable for deposits in any bank failure, they would only be liable for those where banks were engaged in relatively safe behavior. It would dramatically reduce the scope of deposit insurance.
I agree with Russ’s Hayekian perspective, we can’t solve these problems by trying to micromanage the economy. But I also think that libertarians must be careful in offering policy advice in complex environments. When Iceland’s government deregulated banking, and allowed Icelandic banks to open extensive branches in Europe, the Icelandic government was in many was becoming more involved in the Icelandic economy, exactly the opposite of how it may have initially appeared. Their government took on vast new liabilities associated with the British and Dutch deposits of Icelandic banks. That’s a responsibility that the Icelandic government did not have before deregulation. Deregulation is usually good, but not when it increases the role of government in our financial system. I’m afraid that much of the banking “deregulation” of the 1990s did exactly that, it enormously increased our government’s explicit and implicit liabilities.
Tags: Fannie Mae & Freddie Mac, Moral hazard
7. July 2010 at 12:41
I really enjoyed this post. Of course, underwriting standards need to be tightened, and maybe ratings agencies funded by pool contributions, rather than hired directly by RMBS issuer.
Of course, no one ever wants to talk about how the mortgage interest tax deduction also encourages over-investment in the housing market….especially at the upper-end of the market….
BTW, some at AEI says money is too tight. http://www.aei.org/outlook/100971
Speaking with the fervor of a newly converted zealot, I think Scott Sumner should stay “on point” and post often about QE. I am seeing glimmers of hope that others are becoming receptive….
7. July 2010 at 13:14
Yep… the whole political system is corrupt. What I think needs to happens is some serious macro economic thought on how to legally economically profit in a corrupt political system like we have in the US.
7. July 2010 at 13:32
In regards to your point about the US system being biased towards debt: I’m actually presently writing something that requires me to do a lot of studying of the Bible, and I was surprised by the degree to which it discourages debt generally.
I’m not a religious person myself, but I find it somewhat interesting that some rules about attending church or sexual purity seem very important to modern churches, but they don’t seem to have a lot to say about debt – which, unlike the other two examples, might benefit society more generally.
7. July 2010 at 13:56
I think it was Kling who had data a bit ago saying that Canadian Banks, with their 20% down rule had effectively no sub-prime crisis. Can’t find the link….maybe it wasn’t Kling.
7. July 2010 at 14:04
Great article; thanks.
7. July 2010 at 14:41
[…] Scott Sumner does a very nice job summarizing and adding to my paper on the crisis. […]
7. July 2010 at 14:45
Benjamin, Yes, the mortgage interest tax deduction is another problem. Not only am I against it, I oppose the entire income tax.
Thanks for the AEI piece. It is very good and I may link to it.
Michael, Believe me, many people are currently profiting from all the corruption.
David, I haven’t given that much thought. I’m not opposed to debt, just government policies that encourage debt.
aretae, Yes, Kling has a lot of good posts on that. I did a post a year ago on the Canadian system, which is far superior to our banking system. We should have just copied their system, instead of passing finreg.
Thanks Bruce.
7. July 2010 at 15:09
Scott, I am not an economist but I do read Cafe Hayek a lot and I did read Russ Roberts’ paper. I was pleased to learn that you agreed with most of it as it made a lot of sense to me.
I also read an article just published by David Stockman (President Reagans budget director) that is very interesting. See: http://www.marketwatch.com/story/some-inconvenient-facts-about-fiscal-austerity-2010-07-07
Mr Stockman talks about the causes of the depression which I think is the subject of your upcoming book. I would be very interested in your reaction to David Stockmans ideas.
7. July 2010 at 15:09
Scott,
You make the argument that bail outs will not be seen as necessary if the central bank effectively backstops the economy. I would turn that around: if the Fed promises no recessions, what would be the ideal leverage on a portfolio of assets? The more credible the promise, the lower the expected volatility of returns, the higher the optimal leverage. Then a small, unforeseen disturbance leads to the failure of over-levered institutions. At that point, to keep its no-recession promise, the Fed has to ensure that the credit channel does not break down. That is, it has no choice but to bail out failed institutions.
Something like the above happened after Bear Stearns. The Fed rescued Bear’s creditors in March. In the second quarter of 2008, commodity prices spiked, and market participants believed that the Fed, through its actions, had skirted a deep recession (in fact 2q08 gdp rose 2.7%). This left the system even more vulnerable once Lehman failed.
In a 5% NGDP-target regime, perhaps the Fed would have offered markets a blanket guarantee of financial liabilities (a la Caballero). Imagine, in 2009-?, how much leverage the system would pile up if no major firms had been allowed to fail in 2008.
You might say, “dismantle leverage by regulatory fiat.” Except when you force de-levering on a system-wide basis, you invite the same deflation risk you are trying to avoid. Leverage, to borrow from an old trader’s adage, “takes the stairs up and the elevator down.” Also, regulations usually fight the last war, and an entire financial system of highly-paid bright people exists to pour fuel on leverage wherever it can.
7. July 2010 at 15:17
Professor Sumner,
Here is the key issue that has to be explained: Was the New Deal financial regulatory system good or bad? Before the 30s we had 100 years of endless financial panics, during the next 50, none. Krugman and everyone else will tell you that Roosevelt’s system kept our financial system sound for 50 years, and it was only until we deregulated finance in the 80s that the financial crises started to happen in the US and over the world. I’m sure you know the whole story.
In Mishkin’s textbook, pretty much every example of financial crises in the US and the world is “For decades the financial system in country xyz was sound, then they deregulated, which caused bankers to be extremely risky, and then there was a massive financial crisis.”
He does of course add that this was all complemented by moral hazard and too-big-to-fail. In which case, is the argument you’re making, that financial deregulation would not have resulted in 30 years of endless financial crises had everyone known that banks would all fail? Such an argument, I feel, would convince few people, among liberals and even conservatives.
I feel this area would have to be a crucial part of your defense of neoliberalism. Defenses of neoliberalism, yours and others, always involve defense of lower taxes, free trade, deregulation of transport, telecom, and energy, and privatization. But the one Achilles heel of neoliberalism (at least from the prospective of the opposition) is that financial deregulation ruined everything.
Then again, my fall-back argument is that if we privatized money there would be no business cycle! But I always keep that in my back pocket….
Best,
Joe
7. July 2010 at 15:19
Thank god.
“Now consider a “regulation” that said banks could only lend out money from insured deposits on mortgages with more than 20% down-payments.”
So glad to be reminded we agree on things. Add in ending mortgage deductions, and we’ll really see housing prices fall. It baffles me that we don’t view people spending a smaller percentage of their income on housing as an expense, rather than on housing as an investment as a at minimum a neutral thing… if not a positive. We need a highly mobile workforce, one that can run from bad state policies as quickly as possible.
Question #1: You still haven’t explained why buying T-Bills doesn’t just end up as giant bank reserves.
Taking it back to housing again, that’s what banks are sitting on cash for… they knew their assets are worth far less than book, and they want to buy those assets from other failing banks when the time comes.
It baffles my mind that you think banks are going to start lending money. We’ve seen virtually no reduction in cost of borrowing in ANY consumer loan, unless originated by retailer.
Question #2: Why not have the Fed unwind all it’s MBS and sell them the retail assets at auction? Isn’t that big “loss” like printing money anyway? As the cheap auctioned assets newly appreciate? Doesn’t that bring all the private capital to table, and get all the banks off their reserves?
7. July 2010 at 15:51
@scott
“And I think that they did tighten up in a few areas like capital requirements.”
But they tightened up in a highly distorting way.
The capital requirements favored F&F, requiring only 1.6% to hold their debt: more than sovereign debt (0%) but far below what was required to hold standard mortgage debt (4%).
Those “tighter” capital requirements pretty much handed the entire secondary mortgage market to F&F.
The need to compete and regulatory arbitrage combined in the SIV, which being off-balance sheet implicitly required only 0% until told otherwise (regulators later confirmed this explicitly) and brought the private guys back into play.
All told, those “tighter” capital requirements, with their arbitrary risk weights and distortions had a huge role in organizing the market the way it came out.
7. July 2010 at 16:22
What did mortgage regulations look like in Spain and the UK and Ireland, each which experienced similar severe housing bubbles (as did Japan 20 years ago)?
It seems somewhat implausible that all these were the result of a significant weakening in lending standards and the creation of significant moral hazard in the implicit government guarantee of deposits. Did these countries have their own versions of Fannie/Freddie/Ginnie/FHA? Did we all do something new and risky that created a land boom and bust?
It seems more likely to me that the common thread to the various bubble phenomena in all these countries was consistent with the simple basic debt-bubble theory – what was once an ordinary purchase assessed at a value according to ordinary usefulness became the subject of highly-leveraged speculation which counted on achieving profits through mere temporary possession and a reliance on the continuation of apparent price momentum.
In other words – debt-financed bandwagon gambling, tulip-mania, or whatever else you want to call it. Low underwriting requirements weren’t essential to the problem, but they probably added a great deal of fuel to the fire, and took away the equity buffer from financial institutions thereby aggravating the damage of the inevitable pop.
7. July 2010 at 16:43
re Iceland, One of the State department documents given to Assange, covers the Iceland gov, and oppos, trying to avoid a referendum.
7. July 2010 at 16:48
@Indy:
What do you think caused the “tulip-mania?”
Excessively low rates?
Average age getting too high?
Excessive expansion in money supply in china leading to people fleeing to the safety of foreign denominated debt?
One thing that was odd in this last bubble was that it was a bubble in traditionally “safe assets” like the gold bubble in the 70’s.
7. July 2010 at 16:49
o/t. i’ve been inspired to code, a piece of software that would allow bloggers to require commenters to read certain, previous posts before commenting.
7. July 2010 at 16:52
Some good news! It sounds like the conservatives are coming around: http://economistsview.typepad.com/economistsview/2010/07/the-rising-threat-of-deflation.html . The AEI is starting to talk about tight money!
7. July 2010 at 17:13
@Indy
You might want to read this post from Russ Roberts, and the linked WaPo article, on political lending in Spain: http://cafehayek.com/2010/05/european-housing-prices.html
Remember also that Basel was an international accord, so there are a number of similarities in both policy and regulation across borders.
7. July 2010 at 17:15
If there is so much supposed inducement to overinvest in housing in the U.S., but not in Canada, why are the average homeownership rates so similar? 68% and 67%, respectively. Canada has the Canadian Mortgage Housing Corporation, which is most comparable to the FHA, but certainly nothing like Fannie or Freddie. And, of course, mortgage interest is not tax deductible in Canada.
Second, why does the inducement towards debt show up in such weird ways? Corporate debt has been very stable, and low, for a very long time. In fact, this has been a puzzle in corporate finance for a long time: firms are under leveraged, on balance.
Third, on Tulip-mania – there was, associated with the time period, a sharp increase in money supply in Holland. Have a look at Doug French’s book on the topic.
7. July 2010 at 17:43
@Jeff:
“Third, on Tulip-mania – there was, associated with the time period, a sharp increase in money supply in Holland. Have a look at Doug French’s book on the topic.”
Thanks! I’ve been working on a model of bubbles as a function of money supply changes, in my spare time. This should help.
7. July 2010 at 17:55
‘If there is so much supposed inducement to overinvest in housing in the U.S., but not in Canada, why are the average homeownership rates so similar? 68% and 67%, respectively.’
This suggests somewhat that the incentives had no effect on ownership rates, but did have an effect on prices, volatility, and stability. There is a very Hayekian centralization vs free market argument in there some where.
7. July 2010 at 20:24
Joe: you cannot treat “regulation” or “deregulation” as undifferentiated lumps. Japan’s financial system is highly regulated and has performed appallingly. Australia’s financial system is generally very lightly regulated EXCEPT it has strong prudential regulation.
8. July 2010 at 04:03
I did think of one issue that might be causing Canada’s home builders not to overbuild, at least in the West. Back in the 1980s, when there was an oil-price fueled boom, there was a great deal of excess housing built and several home builders got into trouble including going out of business. Home prices tumbled and took a while to recover. Now, demand far outstrips supply because builders did not ramp up construction so quickly in the past boom since the memory of the 80s bust was still relatively fresh. So, the industrial structure of banking has a role, sure, but there is also a cultural issue here.
8. July 2010 at 04:09
[…] nicely summarizes the financial reform legislation I can’t see how it addressed ANY of the major causes of the 2008 fiasco. But easily the most […]
8. July 2010 at 04:34
I am glad you did not stop blogging. This is second thoughtful post in one day. I find it hard to write one in month.
8. July 2010 at 04:35
@ “What does “increased regulation” mean?”
On this issue I recommend the follwing paper, which does a great job at conceptual clarification:
Viktor Vanberg “Markets and Regulation: On the Contract Between Free-Market Liberalism and Constitutional Liberalism”, Constitutional Political Economy, Vol. 10, 1999, S. 219-243.
8. July 2010 at 05:42
Scott said “Some of my commenters suggest that if we had my monetary nirvana of 5% expected NGDP growth, then people would take greater risks.”
David Pearson said “if the Fed promises no recessions, what would be the ideal leverage on a portfolio of assets? The more credible the promise, the lower the expected volatility of returns, the higher the optimal leverage.”
I can see guaranteed 5% NGDP growth cutting the other way. Shouldn’t debtholders now have to worry about being decimated by price inflation in the wake of a systemic event? Thus, debtholders wouldn’t allow a bank/hedge fund to take on so much leverage.
8. July 2010 at 05:56
Fractional reserve banking only exists because of positive government action that makes it legal, otherwise it would be known simply as fraud. Deregulated banking would mean 100% reserve banking.
8. July 2010 at 06:00
Bob, I think Stockman is wrong. The Depression was caused by tight money, not overinvestment in the 1920s.
David Pearson, I don’t see how you can use 2008 as an example of why 5% NGDP targeting won’t help. The severe financial crisis in late 2008 was mostly caused by falling NGDP expectations. See my post from a week ago with the graph.
And my proposal to get rid of bailouts would reduce leverage. Who would want to lend money to highly leveraged investment banks if they knew they wouldn’t be bailed out?
Joe, You said;
“Here is the key issue that has to be explained: Was the New Deal financial regulatory system good or bad? Before the 30s we had 100 years of endless financial panics, during the next 50, none. Krugman and everyone else will tell you that Roosevelt’s system kept our financial system sound for 50 years, and it was only until we deregulated finance in the 80s that the financial crises started to happen in the US and over the world. I’m sure you know the whole story.”
The main problem in the Depression was the US branching restrictions. Canada had nationwide banking and had no bank failures. The 50 years of good luck had more to do with going off the gold standard that New Deal regulation. We basically had a 50 year upswing in inflation that boosted all sorts of asset prices. When asset prices are rising fast, loans will be repaid.
When the back of inflation was broken in 1981 then banking problems set in. It wasn’t just the US, problems occurred all over the world. I don’t think Reagan was in charge in France, Sweden and Latin America.
As I indicated in my post, allowing banks more freedom to use federally insured deposits actually increases the role of the government in the economy, and hence is not a neoliberal policy. Was it “neoliberal” for the Icelandic government to insure billions of dollars in British and Dutch banks deposits, given Iceland has only 300,000 people? That’s not my definition of neoliberalism. But critics call that “deregulation.”
Morgan; You asked:
“It baffles my mind that you think banks are going to start lending money. We’ve seen virtually no reduction in cost of borrowing in ANY consumer loan, unless originated by retailer.”
I am not trying to get banks to lend, I am trying to get them to reduce their demand for reserves. NGDP rises when the supply of base money rises or the demand for it falls.
The Fed could sell all its MBSs.
Symbolicalhead, Thanks for that info. The best solution is to abolish F&F.
Indy, I don’t know enough about those markets, but does your hypothesis explain why Spain had a bubble but not Germany? Land use regulations may be part of the story. In Texas and Germany there are weak zoning laws, and thus buildable land is cheap. Of course housing bubbles are actually land price bubbles.
edeast, Thanks for the Iceland info, and I like your software idea.
John, I saw the Makin piece as well–it is a good article.
Jeff, I don’t know the answer. Are land prices lower in Canada?
Things like the mortgage interest deduction are bad even if they don’t cause over-investment in housing. Ditto for moral hazard in banking.
Lorenzo, Those are good examples.
Thanks Rahul.
bbb, Thanks for the tip.
8. July 2010 at 06:05
thruth, I would have thought that NGDP targeting made debt safer?
Noah, I don’t see why.
8. July 2010 at 06:17
A public mention of stopping the payment of interest on reserves, here:
http://www.washingtonpost.com/wp-dyn/content/article/2010/07/07/AR2010070705100.html
I wonder if this had anything to do with the market rally yesterday.
8. July 2010 at 06:37
@Scott:
“Some of my commenters suggest that if we had my monetary nirvana of 5% expected NGDP growth, then people would take greater risks. Perhaps, but also think about this. The biggest single factor driving bailouts is the fear that failures would worsen a recession. If government policymakers knew there was going to be 5% expected NGDP growth regardless of whether Lehman was bailed out or not, then I think it would be easier for them to ‘do the right thing” and refrain from bailouts.”
I think thats just what they sell the public. No one actually thought that GM or Chrysler going bankrupt would contribute to a recession. Bailing them out was a political calculation that pitted the interest of their unions against
the interests of their bondholders. (Unlike banks, their bondholders were not bailed out, their unions were.) Then GM went bankrupt anyway.
@Noah
No it doesn’t, Noah. The scottish free banking experience says you are completely wrong. FRB is the natural result any time someone makes a promise on money. Every private debt based institution is fractional reserve. The only time 100% reserve happens is when governments get involved; for example currency boards, and central banks sometimes have 100% reserves.
@Jeff Oxman:
We had the same experience in Texas wrt the oil boom and crash. It made us rather wary of housing at an institutional level. Also, its very easy to build new housing here, so supply was able to rise as demand rose to keep the price fairly level.
8. July 2010 at 06:44
[…] […]
8. July 2010 at 06:57
Scott,
On another note, you may find this article on the Fed’s recent discussion of a zero IOR interesting:
http://www.washingtonpost.com/wp-dyn/content/article/2010/07/07/AR2010070705100.html?wprss=rss_business
8. July 2010 at 07:36
Sumner- I entirely agree with your last two paragraphs, the state of US financial guarantees coupled with deregulation is bat guano crazy.
I have one minor quible with your focus on deposit insurance, as the examples of Illinois Continental, LTCM, AIG, Bear Stearns and the S & L bailouts all make clear Fed lender of last resort credit rescues and hierachical lender of last resort bailouts are as big of an issue.
8. July 2010 at 07:48
Scott “thruth, I would have thought that NGDP targeting made debt safer?”
Safer from default risk in a systemic event, but not necessarily inflation risk. An NGDP targeting regime presumably makes no assurances about the amount of inflation. Relative to the current regime, your policy produces (more) countercyclical inflation exposing bondholders to loss of (more) real value when the Fed “prints money” in the face of shocks.
8. July 2010 at 09:06
@Scott_Sumner: “The Fed could sell all its MBSs.”
LOL! Not at anywhere near the value it’s booked them at! And why not just, like, not buy them in the first place?
8. July 2010 at 09:44
[…] -Moral Hazard: Scott Sumner looks at a paper by Russ Roberts on moral hazard. “When you read Russ’s paper you begin to wonder if much of the US economy is just a giant Ponzi scheme: 1. Bank creditors ignore risk, knowing they will be bailed out. 2. Bank equity-holders have an incentive to borrow at low rates (due to the protection of creditors), and so they take highly leveraged gambles. 3. Bank presidents have an incentive to take big risks, as they can earn large bonuses if the gambles pay off. 4. Bank depositors have an incentive to look for the highest rate of return, regardless of how reckless the bank is. 5. Home-buyers have an incentive to take out mortgages with the smallest possible down-payments, particularly in non-recourse states. Taxpayers are left holding the bag.” […]
8. July 2010 at 09:46
@scott:
There’s another reason besides rising asset prices why this happened. Bankers face two fundamental risks. One is that loans might not be repaid. As you point out, rising asset prices lessen this risk. The other risk is from a mismatch between the long maturities of bank assets and their shorter maturity liabilities. By reducing the effective maturity of non-indexed debt, inflation also helps with the maturity-matching problem.
8. July 2010 at 10:56
[…] Russ Roberts on moral hazard (The Money Illusion) […]
8. July 2010 at 15:07
@scott
Agreed, abolishing F&F would make the world a better place.
If you are in the mood for Mercatus Center papers, you may want to read Arnold Kling’s paper ‘Not What They Had in Mind’ as well. He has a lot to say on capital requirements, with some very interesting quotes from regulators and the Fed on the subject as well.
I liked it well enough that I took my name from the illustration on the cover.
8. July 2010 at 18:54
[…] along with Tyler Cowen, since Brad DeLong’s mostly doing policy advocacy these days) has a post on how systematic bailouts in financial crises over the past three decades have possibly shap…. It’s an interesting, though somewhat complicated, post that I wish more people would talk […]
8. July 2010 at 21:50
[…] Russ Roberts on moral hazard, by Scott Sumner […]
9. July 2010 at 02:47
I will just remind folks that there are reasons–driven by land use regulation–why housing bubbles occur in some housing markets and not others, as I posted about here.
The scale and details of housing bubbles will no doubt be affected by how financial markets operate but monetary and financial factors do not cause housing bubbles on their own.
9. July 2010 at 16:27
JimP, Thanks, I did a post.
Doc Merlin, You might be right about GM, but what about the banks?
David Pearson, Yes, I did a post on that. Thanks.
OGT, The more I look at the numbers, the more it looks like FDIC, Fannie and Freddie are the main problems. After the TARP loans are repaid, most of the net transfer to the banks is through FDIC, not bailouts of big banks. But I agree with your general point—all of these things are problems.
thruth, Elsewhere I have argued that we should abolish the concept of inflation, because what really matters to debtholders is NGDP growth, not inflation.
Silas, Haven’t the MBSs gone up in value since they started buying them in March 2009? But I agree, no reason to buy them at all. The Fed should buy T-bonds.
Jeff, That is a very good point.
SymbolicalHead, Yes, Kling’s stuff on banking is excellent.
Lorenzo, Yes, it was from you that I learned about land use rules in Germany. I highly recommend your papers to any interested reader.
9. July 2010 at 18:30
Scott: having now read Russ Roberts’ paper, I agree it is terrific. If he turned it into the book he should call it The Destruction of Prudence. It is something of a case study in support of Jeffrey Friedman’s extension (pdf) of Hayek’s cognitive economics arguing for the cognitive superiority of markets over politics.
And thanks for the plug 🙂
10. July 2010 at 04:55
The problem isn’t deregulation, which hardly occurred, it’s bad regulation. Basel and Basel II said that mortgage backed securities had a 20% risk weighting and actual mortgages, including ones the bank had done themselves and had the opportunity to vet, had a 35% risk weighting. So everyone sold MBSs. And funds bought them because they had to by law buy things rated AAA by the credit ratings companies, even though these agencies almost went bankrupt in the seventies because people (quite correctly) distrusted their ratings. So when the ratings on MBSs proved as rubbish as the other ratings the funds could say “We bought AAA-rated, you can’t blame us.”.
10. July 2010 at 06:19
Lorenzo, I also liked a Jeffrey Friedman paper on the crisis.
10. July 2010 at 23:11
Russ Roberts’ paper makes the point that, although shareholders were generally let hang, depositors and bondholders were looked after by public policy. Indeed, near-absolutely guaranteed.
A lot of people now hold a lot of bonds. Could that be the interest which is driving the relentless antipathy to even considering any inflation? Could a “bond holder veto” be driving monetary policy just as it drove finance sector policy?
11. July 2010 at 08:22
You mention pension funds; you mean defined benefit pension funds, of course. I can recall a time, not that long ago, when any company with an overfunded pension plan became a takeover target so that the excess in the pension fund could be taken and used for “other purposes.”
11. July 2010 at 09:39
Michael, That is a good point. But some of the deregulation was also clearly harmful (as in Iceland.)
Lorenzo, Perhaps, but recall that the bond market was also hurt by the tight money policy of late 2008.
GPhammer, Yes, the governemtn policy of insuring pensions creates all sorts of moral hazard. I understand why firms like GM underfunded pensions.
15. July 2010 at 02:55
This is rapidly moving beyond my area of understanding, but, in the bond market, is there a difference between new entrants and existing incumbents? Were existing bondholders hurt by the tight money, or only those entering? And can attitudes to any increase in inflation be another matter?
15. July 2010 at 09:45
Lorenzo, It’s complicated. Corporate bonds did poorly, but T-bonds did well. New entrants were affecte dless in both cases.
5. January 2011 at 21:35
[…] See Scott Sumner on moral hazard and why finance does deserve big rewards; See here for a more technical explanation of a lot of […]