1 Boring Old Man

Frank Partnoy is a Law Professor at the University of San Diego and is the author of Infectious Greed: How Deceit and Risk Corrupted the Financial Markets and F.I.A.S.C.O.: Blood in the Water on Wall Street. In the mid-1990’s, he worked as a trader in the derivative market, and has made market regulation his specialty in the Law. The part of the elephant he feels is the credit default swap problem.

^{Congress also must decide whether, after ten years of steady deregulation, the post-Enron derivatives markets should remain exempt from the regulation that covers all other investment contracts. In my view, the answer is no. A headline in Enron’s 2000 annual report states, “In Volatile Markets, Everything Changes But Us.” Sadly, Enron got it wrong. In volatile markets, everything changes, and the laws should change, too. It is time for Congress to act to ensure that this motto does not apply to U.S. financial market regulation.}

Buy the Loans
By FRANK PARTNOY
September 26, 2008

^{Here’s a key reason Treasury Secretary Henry Paulson’s bailout proposal stalled: it had an overbroad definition of the troubled assets the government would purchase. Under the Treasury’s definition, the government could spend much or all of the proposed $700 billion to buy complex derivatives held by Wall Street firms, instead of directly purchasing actual mortgage loans.}

^{Fortunately, there is a compromise. The most efficient means of providing support to the credit markets would be for Congress to limit the definition of troubled assets to actual home mortgage loans. Congress should give the Treasury authority to purchase only the real financial assets at risk — the actual loans — not the derivatives whose prices depend on the values of those loans. If the government takes this approach, and buys and renegotiates mortgage loans directly, it will indirectly support the mortgage-based derivatives that have caused widespread losses at banks. But it will do so without favoring banks at the expense of homeowners…}

Deficits and the Future
By PAUL KRUGMAN 

^{Right now there’s intense debate about how aggressive the United States government should be in its attempts to turn the economy around. Many economists, myself included, are calling for a very large fiscal expansion to keep the economy from going into free fall. Others, however, worry about the burden that large budget deficits will place on future generations.}

^{But the deficit worriers have it all wrong. Under current conditions, there’s no trade-off between what’s good in the short run and what’s good for the long run; strong fiscal expansion would actually enhance the economy’s long-run prospects. The claim that budget deficits make the economy poorer in the long run is based on the belief that government borrowing “crowds out” private investment — that the government, by issuing lots of debt, drives up interest rates, which makes businesses unwilling to spend on new plant and equipment, and that this in turn reduces the economy’s long-run rate of growth. Under normal circumstances there’s a lot to this argument.}

^{But circumstances right now are anything but normal. Consider what would happen next year if the Obama administration gave in to the deficit hawks and scaled back its fiscal plans. Would this lead to lower interest rates? It certainly wouldn’t lead to a reduction in short-term interest rates, which are more or less controlled by the Federal Reserve. The Fed is already keeping those rates as low as it can — virtually at zero — and won’t change that policy unless it sees signs that the economy is threatening to overheat. And that doesn’t seem like a realistic prospect any time soon.}

^{What about longer-term rates? These rates, which are already at a half-century low, mainly reflect expected future short-term rates. Fiscal austerity could push them even lower — but only by creating expectations that the economy would remain deeply depressed for a long time, which would reduce, not increase, private investment. The idea that tight fiscal policy when the economy is depressed actually reduces private investment isn’t just a hypothetical argument: it’s exactly what happened in two important episodes in history.}

^{The first took place in 1937, when Franklin Roosevelt mistakenly heeded the advice of his own era’s deficit worriers. He sharply reduced government spending, among other things cutting the Works Progress Administration in half, and also raised taxes. The result was a severe recession, and a steep fall in private investment. The second episode took place 60 years later, in Japan. In 1996-97 the Japanese government tried to balance its budget, cutting spending and raising taxes. And again the recession that followed led to a steep fall in private investment…}

^{One more thing: Fiscal expansion will be even better for America’s future if a large part of the expansion takes the form of public investment — of building roads, repairing bridges and developing new technologies, all of which make the nation richer in the long run…}

^{But right now we have a fundamental shortfall in private spending: consumers are rediscovering the virtues of saving at the same moment that businesses, burned by past excesses and hamstrung by the troubles of the financial system, are cutting back on investment. That gap will eventually close, but until it does, government spending must take up the slack. Otherwise, private investment, and the economy as a whole, will plunge even more.}

^{The bottom line, then, is that people who think that fiscal expansion today is bad for future generations have got it exactly wrong. The best course of action, both for today’s workers and for their children, is to do whatever it takes to get this economy on the road to recovery.}

^{… he thinks the subprime meltdown had more to do with psychology and sociology than economics. People believed themselves into a bubble, to the point where even rational, conservative people like the heads of Fannie Mae and Freddie Mac couldn’t forsee price drops of more than 13.4% in the housing market.}

^{There is a strong theme of irrational responses in the face of fundamental uncertainty in this book, something The Black Swan author Nassim Taleb (who wrote a blurb for Shiller’s book) has a lot to say about. Most of the leaders of the day couldn’t see the subprime crisis as it happened, simply because they didn’t think these issues could ever get that bad.}

^{Shiller spend a lot of time comparing the housing bubble in the US from 2000-2007 to the housing bubble which existed in the 1920’s just before the stock market crash of 1929 and the ensuing Great Depression. Then, as now, people let prices of houses outstrip the prices of building those houses, and people borrowed cheap money, knowing the interest rates wouldn’t stay so low, in the hopes of flipping the house or re mortaging it later on based on continually rising house prices. People bought to flip, and in that Ponzi game type scenario, when there are no more willing buyers, the bubble collapses…}

^{But how to solve the problem?}

^{First, Shiller is in favour of bailing out those worst affected right away, and on a massive scale. Think Dobb-Frank on steriods. Shiller wants to stop millions of people getting thrown out of their homes, because to allow this would be an injustice… Second, Shiller wants policy makers to change regulatory environments and financial institutions in the same broad sweeping reforms we saw after the Great Depression. Shiller wants a New New Deal. For example, changing the rules on selling variable rate mortgages to people who most likely will default would kill the subprime crisis. People in the financial industry knew this would happen, but no one wanted to tell them this, because they weren’t legally obliged to do so. The incentives weren’t set correctly, and those are what Shiller wants to change through institutional reform. Third, Shiller wants us to understand the psychological nature of the crisis: over-confidence created the crisis, but under confidence made it worse. Fourth, the subprime crisis is a truly global financial crisis, perhaps on the scale of the Great Depression, but the problems generated by the crisis’ effects like the credit crunch can be solved before they are allowed to worsen…}

But even if my objection is part of the explanation, Shiller’s question, "Why don’t people recognize bubbles until it’s too late?" is extremely important. Everyone thought and acted as if this rapid rise in house prices would slow down, then level off. In retrospect, that seems absurd, but that’s what many of the best minds thought [Greenspan, Bernanke, etc.].

• Un-Deregulate banks and financial markets in general
• Regulate the hell out of the derivatives market in the specific
• Don’t bailout speculators in either the housing market or the derivatives market.
  They were part of causing the problem, not its victims
• Bailout the real victims buy buying their loans and renegotiating them.
• Go after reviving the economy and the flow of credit with a vengence
  [just like F.D.R. did in the 1930’s]
• If Robert Shiller smells a bubble, jump on it yesterday!