Two links from the indispensable Mark Thoma. First, Tyler Cowen writes,
A newbank rescue plan may be more crucial right now than the fiscal stimulus package enacted last month. Yet we don’t seem capable of finding a clear path toward cleaning up our major financial institutions.
…It is quite possible that the reputation of a nationalized bank would be so impaired that it would incur even greater losses as its web of commercial dealings collapsed. These far-reaching commitments are a reason that the F.D.I.C. model of rapid shutdowns cannot be applied so easily here.
Read the whole thing. Tyler thinks we may just have to muddle along, trying to use band-aids and tourniquets. I continue to prefer the approach I suggested from the beginning.
1. Close any bank that is clearly insolvent.
2. If a bank may be solvent but fails to meet rigorous capital standards, then put it under close supervision until the situation resolves. The bank is not allowed to make any new risky loans, but otherwise it can continue to operate. The bank can borrow from the government to cover short-term liquidity needs, but not to expand operations, pay dividends, or compensate executives in cash (it can award them stock or stock options).
3. Leave healthy banks free to operate.
The difference between (1) and (2) is that in (1) the shareholders are wiped out immediately, while in (2) the shareholders have some upside. The difference between (2) and (3) is that with (3) the managers can actively try to increase shareholder value. With (2), the bank is effectively on probation, with shareholders only able to earn a return if it becomes clear that the bank’s toxic assets are not sufficiently bad to take it into insolvency.
Second, David Colander and others write,
In our view, economists, as with all scientists, have an ethical responsibility to communicate the limitations of their models and the potential misuses of their research. Currently, there is no ethical code for professional economic scientists. There should be one.
I count a total of 8 co-authors for the paper–quite unusual in economics. Read the whole thing. One point they make is this: did economists know that the models that financial firms were using were flawed? If we answer “no,” then we were spectacularly incompetent. If we answer “yes,” then we were spectacularly unethical, because we failed to convey these flaws to decisionmakers. Along the latter lines, you will find if you do a search that Paul Volcker thinks that geeks are using the Nuremberg defense in defending their role in the financial crisis.
I don’t think the authors’ recommendations for future research are helpful. They advocate fancy-shmantzy econometrics. They need to read my lost history paper. They also recommend trying to develop ways to anticipate and control bubbles. I think that is like recommending trying to develop world peace. It’s easy to endorse the ends, but you will never agree on the means.
READER COMMENTS
Neil Pelkey
Mar 1 2009 at 10:02am
What both you and Tyler seem to miss is that it is insolvency of the mortgagor that is a key problem here. It was not the failure of the markets, but backdoor Keynsianism that led to the this roller coaster to serfdom. The market did not guarantee and facilitate the securitization of the mortgages. The market did not bail out LTCM, S&L’s, Chrysler, Continental, etc.. The federal government did. The legal requirement lending were a lot closer to Hobbes than to Smith.
The fix, rather than bailout of the banks, is a partnership between the treasury and the homeowners.
1. Each homeowner behind in payments may submit a tax credit for up to twelve month of back payments. This can only be for back payments.
2. The feds owns whatever percentage of the house they just paid for (So if you have 20,000 in equity and the feds pay for 20,000, they own 50% of the equity at sale) I think a standard tax lien handles the transaction.
3. Any homeowner accepting these payment must pull their house off the market for 3-6 months depending on the number of payments received.
4. The payments are distributed as a tax credit—but directly to the bank/mortgage owner. This targets the money toward toxic assets instead of the best lobbyists.
Then
Let FDIC close the banks that are still insolvent and mover the accounts to other solvent banks.
Moral hazard does raise its specter here, but I think no worse than the trillion dollar bank bailout.
Furthermore comment on banking and bubbles is rather an old topic. See–
http://www.jstor.org/stable/60205873
for a fun read.
[N.B. Neil Pelkey’s jstor.org link leads to an 1828 republication of a David Hume (1711-1776) tract: “An address to the proprietors of bank stock, the London and country bankers and the public in general, on the affairs of the Bank of England”. I wouldn’t have described the original or the republication as “a fun read.”–Econlib Ed.]
daniel
Mar 1 2009 at 11:13am
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Danny
Mar 1 2009 at 12:03pm
“The bank is not allowed to make any new risky loans, but otherwise it can continue to operate. The bank can borrow from the government to cover short-term liquidity needs, but not to expand operations, pay dividends, or compensate executives in cash (it can award them stock or stock options).”
I agree with your plan to take a hard line approach on this crisis, but if you enact the above on shaky banks, they will quickly turn from shaky to downright insolvent. Banks need to expand operations and make new loans in order to earn their way back to insolvency. If you don’t allow well-compensated executives (hopefully they bring in someone new), to make new (who defines what is risky? gov technocrats?) loans, and expand operations, they will never earn their way back to solvency. So your plan for shaky banks would lead to the tourniquet procedure for the vast majority of banks entering the plan, wouldn’t it?
Danny
Mar 1 2009 at 12:04pm
Correction: ‘earn their way back to SOLVENCY’ not insolvency
tim
Mar 1 2009 at 12:21pm
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hacs
Mar 1 2009 at 12:46pm
Paul Volcker was reacting perfectly normal, but he has forgotten “why the worst get on top” (Hayek), so, the “Nuremberg defense” from geeks sounds plausible to me (that does not free of responsibility those specific quants).
Greg Ransom
Mar 1 2009 at 12:57pm
David Colander continues to be one of my heroes.
This is just awesome:
“In our view, economists, as with all scientists, have an ethical responsibility to communicate the limitations of their models and the potential misuses of their research. Currently, there is no ethical code for professional economic scientists. There should be one.”
Greg Ransom
Mar 1 2009 at 1:35pm
If you’ve seen CNBC’s “House of Card” you know that Alan Greenspan essentially took the Nuremburg defense himself — “the Congress wouldn’t have let me shut off the money explosion filling the housing bubble.”
Anonymous
Mar 1 2009 at 2:48pm
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hacs
Mar 1 2009 at 3:55pm
Some comments against regulation (without extremes) seem the discourse of the radical conservationists: every increase in emissions will lead us to a cataclysm.
Nevertheless, Hayek has written on the extreme situation post WWI and the socialist preconditions of Germany as the background to the Nazism.
??
Barkley Rosser
Mar 2 2009 at 5:08pm
The Colander et al paper comes out of a conference held in Dahlem in Germany in December. I was originally scheduled to be in that session there, but was too busy to attend. If I had, there would have been nine coauthors and some relatively minor changes, not worth discussing. I am largely in agreement with it.
In reply to Arnold on his “lost history paper,” which I think is quite fine, I would make two points. One is that I do not see it as dealing directly with Colander et al. While there is an advocacy of some alternative econometric approaches, I do not see those as addressed by your paper. Furthermore, the main argument had to do with using agent-based modeling. Do you disagree with that.
Also in connection with your paper, I do not think that the Lucas critique is necessarily tied to assuming rational expectations. Of course, Lucas made that link, but the argument that people might change their behavior based on a change in their expectations in response to changes in government policies was one made by Keynes in criticizing the macroeconometric modeling by Tinbergen, as well as somewhat more formally in 1950 by Jacob Marshak. However, they avoided the fantasyland assumption that somehow people would be adjusting their assumptions according to rational expectations.
Comments are closed.