Friday, December 17, 2010

Krugman: Government programs had nothing to do with the housing bubble

I must say that when Paul Krugman gets on a subject, he sticks with it, and the latest chapter in his "it's all the fault of free markets" mantra comes in today's column in which he deals with the report of Financial Crisis Inquiry Commission. Not surprisingly, he sticks to his other mantra -- Republicans always are the cause of all problems and ills and Democrats have all the answers -- in this screed.

Unfortunately, the one thing he does not do is to deal with the actual problem, but to Krugman, solutions to the current crisis are problems, while in his view, we "solve" this problem by, well, creating more problems.

He begins (predictably):
When the financial crisis struck, many people — myself included — considered it a teachable moment. Above all, we expected the crisis to remind everyone why banks need to be effectively regulated.

How na├»ve we were. We should have realized that the modern Republican Party is utterly dedicated to the Reaganite slogan that government is always the problem, never the solution. And, therefore, we should have realized that party loyalists, confronted with facts that don’t fit the slogan, would adjust the facts.
As one who has read Krugman for a long time, I definitely believe that the last statement describes him quite well. So, here we go with Krugman's "facts" about the bubble:
It’s not as if the story of the crisis is particularly obscure. First, there was a widely spread housing bubble, not just in the United States, but in Ireland, Spain, and other countries as well. This bubble was inflated by irresponsible lending, made possible both by bank deregulation and the failure to extend regulation to “shadow banks,” which weren’t covered by traditional regulation but nonetheless engaged in banking activities and created bank-type risks.

Then the bubble burst, with hugely disruptive consequences. It turned out that Wall Street had created a web of interconnection nobody understood, so that the failure of Lehman Brothers, a medium-size investment bank, could threaten to take down the whole world financial system.
Now, it is true that, in George W. Bush's words, "Wall Street got drunk," but as Peter Schiff noted in a speech at the Mises Institute in 2009, there is this little issue of who was supplying the liquor -- the Federal Reserve System. As I have noted before, the government has a number of programs to extend home ownership well beyond its logical bounds and there was pressure from authorities for banks to throw away the underwriting standards for mortgages. That this would build up into a bubble is no surprise.

There also is the matter of Lehman Brothers. I'm sorry, but the notion that the reason we had this crisis is because the government let Lehman fail is a bit much. Wall Street as a whole was overleveraged, but unlike Krugman, who wrongly says that it was because banks and the "shadow banks" were operating in a market totally unregulated by government, it seems to me that the famed "Greenspan Put" that also was part of Fed policy under Ben Bernanke created huge moral hazards that encouraged this drunken spree.

In Krugman's Keynesian world, markets don't respond to price signals, as prices have meaning only in the aggregate as part of an index. Things like relative prices and profits are meaningless, which is why Krugman can claim that the heavily-subsidized industry of "alternative energy" can lead us out of this depression. (Krugman does not seem to believe that free market profits have anything to do with the valuation of the factors of production, and why should they, given that in the Keynesian view, factors are homogeneous, economically speaking.)

Krugman's defense of Fannie and Freddie is pretty hilarious:
In the world according to the G.O.P. commissioners, it’s all the fault of government do-gooders, who used various levers — especially Fannie Mae and Freddie Mac, the government-sponsored loan-guarantee agencies — to promote loans to low-income borrowers. Wall Street — I mean, the private sector — erred only to the extent that it got suckered into going along with this government-created bubble.

It’s hard to overstate how wrongheaded all of this is. For one thing, as I’ve already noted, the housing bubble was international — and Fannie and Freddie weren’t guaranteeing mortgages in Latvia. Nor were they guaranteeing loans in commercial real estate, which also experienced a huge bubble.

Beyond that, the timing shows that private players weren’t suckered into a government-created bubble. It was the other way around. During the peak years of housing inflation, Fannie and Freddie were pushed to the sidelines; they only got into dubious lending late in the game, as they tried to regain market share.
In this view, Freddie and Fannie were the victims of those rapacious capitalists. There was no subprime market; the Fed had nothing to do with this, and government came in on the tail end of things.

This is NOT a defense of Wall Street or the Republicans. I will say outright that one cannot have both a deregulated financial system AND something like the "Greenspan Put." It is not possible because the kinds of moral hazards that such policies create are such that we should not be surprised when we see a meltdown of this magnitude.

I don't think the banks were "suckered" by the government; they were in bed with the people who were supposed to be regulating them. Unlike Krugman, however, I don't think that this lack of oversight was due to free market ideology, as I know no free-market economist who believes that markets and moral hazard can exist simultaneously without creating real problems.

No, people were getting rich and not having to work very hard at it. As in a bubble atmosphere, even if everyone knows there is a bubble, the trick is to jump off before the whole thing peaks and then pops.

Because Krugman is stuck in his ideological and political ghetto, he really offers nothing but inflation as a "solution." He claims to understand the effects of financial bubbles, but his ideology, partisanship, and Keynesian thinking blinds him to the cause of bubbles. And if he cannot understand the cause of the problem, he hardly is qualified to recommend solutions.

25 comments:

AP Lerner said...

I'm curious, if government programs caused the housing bubble, then which government programs caused the credit bubbles in leveraged loans, commercial real estate, auction rate securities, investment grade corporate bonds, the LBO boom, high yield bonds, CDS, etc?

And if government programs caused the housing bubble, then which government programs caused the housing bubbles in Ireland, Spain, Latvia, the UK, and Australia?

Thanks.

AP Lerner said...

Also, maybe you could help me understand how Fannie and Freddie caused a housing bubble, but were not a top issuer of sub prime loans?

http://www.ritholtz.com/blog/wp-content/uploads/2010/12/ffcrajazz1.jpg

And maybe you could explain how they contributed to a housing bubble despite shrinking their balance sheets during the early/mid 2000's?

Thanks.

Daniel Hewitt said...

AP Lerner,

Fannie and Freddie were not the root cause; that would be the Federal Reserve and its too-low interest rates. Low interest rates were not confined to just USA.

Also, Fannie and Freddie did not issue suprime loans at all. They were confined to the secondary market.

AP Lerner said...

"Also, Fannie and Freddie did not issue suprime loans at all. They were confined to the secondary market."

Sorry. That is correct. I mispoke. Allow me to rephrase.

Maybe you could help me understand how Fannie and Freddie caused a housing bubble, but were not a top holder of sub prime loans? In fact, how did they contribute to the housing bubble when their balance sheets were shrinking during the run up in home prices?

AP Lerner said...

I'd suggest this book for anyone that wants to get to the truth behind the credit bubble, supported by actual facts and data.

http://www.amazon.com/exec/obidos/ASIN/0470520388/thebigpictu09-20

Prof. Anderson - this would make great reading in one of your econ classes. Simple. Factual. Accurate. No theories. Real data.

Daniel Hewitt said...

AP Lerner,

The bubble was not a subprime-only housing bubble. It was all residential housing and even commercial property. I think Krugman has made this point in the past on his blog (sorry I can't offer a link for evidence).

The GSE's were the main contributor at first, then the private sector came in after that. I'll see if I can find a link to back that up....

Thanks for the book recommendation also!

Daniel Hewitt said...

APL - see Chart 1 for what types of securities were issued when:

http://www.imf.org/external/pubs/ft/survey/so/2008/pol100308a.htm

Daniel Hewitt said...

APL - and here is Krugman saying that the bubble was broad based:

http://krugman.blogs.nytimes.com/2010/01/07/cre-ative-destruction/

Next time maybe I will get my act together and have the links ready before I post :)

AP Lerner said...

"The bubble was not a subprime-only housing bubble. It was all residential housing and even commercial property"

Bingo. So blaming the GSE's is not correct since credit bubbles formed in markets beyond housing, as you, I pointed out earlier. Also, according to the article you sent:

"A Federal Reserve study estimated that 30-year mortgage rates were around 7 basis points (0.07 percent) lower on average due to their existence, with the large majority of the implicit taxpayer subsidy going to share- and bondholders and managers."

So how again did the GSE's contribute to a bubble when 1) they were late to the sub prime market 2) were shrinking their balances sheets after 2003 and 3) there was no evidence of any kind of subsidy or support to the home buyers since the benefits of subsidy accumulated to the share and bond holders?

Sorry, there's a lot to blame the government regarding this topic, but blaming the GSE's is just a political/ideological argument not based on facts or data.

Daniel Hewitt said...

blaming the GSE's is just a political/ideological argument not based on facts or data.

I concur, but so is absolving the GSE's. The root cause was the Fed. The GSE’s and the investment banks were secondary causes. They directed the money to the housing industry. Assuming for now that I accept your hypothesis that the GSE’s contribution was 0%, the investment banks have a government-granted oligopoly and government-granted immunity from failure. Is it realistic to consider them “private”? The title of the book you suggested says no. Who is responsible for the secondary cause is simply not reducible to "GSE's did it" or "investment banks did it".

You are doing a great job of refuting the conservative argument (Fannie, Freddie, and the dirty Dems did it!) but I don’t think you will find anyone who subscribes to that theory here.

Mike M said...

If I may offer a different perspective. There is a natural tendency for people to try and identify a singular cause and effect to things that happen in life. I believe that is incompatible with how the human mind thinks and how people behave. Perhaps the causes you seek are really syntheses of several things all operating both independently and in concert whether knowingly or not. That would be more compatible with human behavior. A Pavlovian explanation of economic behavior will always fall short.

That said I believe all of those “several” things have two things in common, a flawed monetary system and government intervention in free market decisions. Each of these creating thier own ripple complications.

Bob Roddis said...

Blaming the GSE's is just a political/ideological argument not based on facts or data.

Blaming them for then entire mess is wrong, but they certainly caused a vast army of people who couldn't afford it to buy homes which were subsequently foreclosed. They contributed to the mess and these certainly were indeed government programs and not the free market.

Any suggestion that the free market contributed to the mess is THE BIG LIE.

Which, of course, is Krugman's middle name.

Lord Keynes said...

That the dysfunctional neoliberal system of financial regulation was the fundamental cause of the 2000s bubble is undoubtedly true.

Contrast the flawed US system with that of Canada.

Canada’s banks were restricted by regulators from mass securitizing of mortgage debt. Canada’s banks also were prohibited from taking on high levels of leverage to make larger and riskier loans. The Canadian mortgage industry was regulated to maintain high lending standards, instead of lax ones allowing an explosion in sub-prime mortgages.

In 2008, the World Economic Forum ranked Canada’s banking system as the soundest in the world. The U.S. system was ranked at number 40 and Germany and Britain ranked 39 and 44. Canada’s banks have required no bailouts to save financial institutions.

Because Krugman is stuck in his ideological and political ghetto, he really offers nothing but inflation as a "solution."

Pathetic. This ridiculous statement is so obviously wrong.
Krugman supports effective financial regulation, jobs programs, fiscal stimulus, and a trade policy that deals with China's undervalued currency.

Lord Keynes said...

And another point: there was NO housing bubble in Germany, yet Germany's financial institutions loaded up on toxic asset backed securities. The crisis was actually 3 diffrents events:

(1) asset price speculation and a housing bubble (from reckless lending, securitization, LIAR's loans etc)

(2) a financial crisis of the type explained by Minsky's financial instability model, and

(3) contractions in aggregate demand (and world trade) causing severe recessions (and made worse by debt deflation as in the models of Irving Fisher and Minsky).

Not all countries experienced (1), yet still experienced (2) and (3).

Tel said...


So blaming the GSE's is not correct since credit bubbles formed in markets beyond housing, as you, I pointed out earlier.


This argument is much the same as putting poison into a person's right arm, then after the person dies taking a blood sample from their left arm.

Once you discover poison in the left arm too you then claim, "Oh it couldn't have been me that killed him, after all the poison was nowhere near the place where I put it in, I blame the fact that he had a heartbeat and circulatory system."

The FHA took in high risk mortgages, and stamped them with a taxpayer-backed government guarantee (i.e. mortgage insurance) and fed those insured mortgages back into the system. The FHA had political mandate to manipulate the price of risk, firstly by charging a flat fee for insurance and secondly by pricing that fee low enough that poor people could obtain homes they would not have otherwise been able to obtain. This is exactly equivalent to a systematic injection of moral hazard into the marketplace (i.e. systematic destruction of the market's ability to correctly put a price on risk).

Fannie Mae, Ginnie Mae, etc took high risk mortgages in on one side and pump out asset backed securities on the other side. This also served to systematically interfere with the market's ability to price risk by hiding the details of the risk behind the securitization process.

Damaging the risk-pricing process is no different to feeding poison into the free market mechanism.

One might argue that Capitalism needs to be redesigned to be more resilient to such poison; and if anyone has sensible suggestions to do so then by all means outline how it could work and why. Just handing more control to government will not fix the moral hazard -- government is forever politically motivated, and willing to swap bribes for power.

jk said...

A book recommendation for you:

http://www.amazon.com/Financial-Fiasco-Americas-Infatuation-Ownership/dp/1935308130/ref=sr_1_1?s=books&ie=UTF8&qid=1292673111&sr=1-1

Bran Kearsey said...

It seems that APLearner created a straw horse argument to refute - i.e. that commentary blamed gov't programs and GSE's as the root cause of the bubble. A quick puff of truth scatters the straw. The point of the piece is honed in the first paragraph - to refute Krugman's delusion that "the free market" created this pestilence. To disprove this, the author immediately notes the primary cause, noting that Wall St indeed got drunk, but "...there is this little issue of who was supplying the liquor -- the Federal Reserve System."

Only after the heroine of fiat money was injected into our economy did the gov’t programs and GSE’s, along with greedy credit agencies, lenders, investors, and buyers, circulate the poison:

“As I have noted before, the government has a number of programs to extend home ownership well beyond its logical bounds and there was pressure from authorities for banks to throw away the underwriting standards for mortgages. That this would build up into a bubble is no surprise.”

As he clearly stated, the author is NOT defending Wall St or the Republicans. His point is that Krugman is demonstrably wrong to claim free markets in any way played a part in this calamity. The market is in no way, shape or form “free” when Congress colludes with the private bankers at the Federal Reserve to grant them monopoly control over the supply of money and credit to our economy (money that they conjure into existence out of thin air with a few strokes of a keypad no less!) and allows Wall St to write the regulations under which it operates. Only once the game is rigged was Wall Street allowed to run wild and “free” to keep the proceeds they raked in at the rigged roulette wheel. But when their bubbles burst, their cohorts in Congress were there to bail them out on the backs of ordinary Americans (private profits; socialized losses). This is a corporatocracy, not a free market, and Krugman’s answer, to cede ever more power and control to the very silk suited criminals who created the problem, is dead wrong.

Mike M said...

LK said "Krugman supports effective financial regulation, jobs programs, fiscal stimulus, and a trade policy that deals with China's undervalued currency."

Undervalued compared to what? The USD? Perhaps it is the USD that is overvalued. A US Centric point of view assumes the USD is fixed as a static standard of value. It is not. If it were not a reserve currency thereby with artifical demand it would be interesting, and disturbing, to see its real value. Then again perhaps the gold market is starting to send that message.

AP Lerner said...

“The root cause was the Fed”

More specifically, Greenspan. And if we are digging for roots, then Ron Reagan is the root, since he appointed Greenspan.

“the investment banks were secondary causes”

Only because Paulson deregulated their balance sheets and removed the 12x leverage cap for no good reason other than greed.

“the investment banks have a government-granted oligopoly and government-granted immunity from failure”

I guess Lehman shareholders missed this memo.

“You are doing a great job of refuting the conservative argument (Fannie, Freddie, and the dirty Dems did it!) but I don’t think you will find anyone who subscribes to that theory here.”

The author of this blog subscribes to the conservative argument, as do the Republican members of the FCIC who are trying to rewrite history, and pass along myths for facts

http://www.nakedcapitalism.com/2010/12/republican-members-of-fcic-to-promote-crisis-urban-legends-shift-blame-from-banks.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+NakedCapitalism+%28naked+capitalism%29&utm_content=Google+Reader

Lord Keynes said...

Undervalued compared to what? The USD?

To ALL of its major trading partners and even to those of its export competitors in the Third world.

Mike M said...

LK
It was a bit of a rhetorical question to make a point that you missed. Both the USD and the RMB are floating abstracts with the USD distorted by being a reserve currency and the RMB manipulated in its own way to foster a mercantilist strategy. Neither is an anchor to chart your value course. So is the RMB undervalued? The USD overvalued? A mixture of both? If so, what percentage of over/under would you allocate to both?
The point is neither you, I nor anybody else really knows. Currency trading is for speculators not investors conducting value analysis so the currency markets can’t tell you much in this regard. So maybe the Chinese think the USD is overvalued and they are the anchor. Why not, it’s all a fiction anyway.

James E. Miller said...

To Lord Keynes:

http://globaleconomicanalysis.blogspot.com/2010/12/canadian-borrowing-gone-mad-look-at.html

Canada's housing market is so great, huh?

Only a true Keynesian would think that a household debt of 148% of disposable income is great. Because housing prices will just keep rising just like the U.S. and Spain right?

What bank in their right mind would recklessly lend money if they didn't believe that money printers would be there to back them up when the market finally corrects itself? Sure Lehman wasn't so lucky, but then again they didn't have as many friends as, say, Goldman Sachs in the federal government and the federal reserve. Hell, Peter Orszag (Obama's former budget director) just joined Citigroup.

One of the recent Wikileaks cables showed that the Fed bought a bunch of Goldman Sachs' risky assets and Goldman in turn used the money to pay back their TARP loan. It's almost as bad as GM using a government provided escrow account to pay back their initial loan.

Must be nice to have friends in high places in our crony-capitalist society. Mussolini said fascism involved socializing losses while privatizing profits. Please explain to me how Bush and Obama are not fascists by this definition.

Lord Keynes said...

Only a true Keynesian would think that a household debt of 148% of disposable income is great etc etc

A very good example of the straw man argument.
Read my statements above.
I did NOT say there was no housing bubble in Canada. There certainly is. But it was not caused by subprime or liar's loans.

I said:

Canada’s banks were restricted by regulators from mass securitizing of mortgage debt. Canada’s banks also were prohibited from taking on high levels of leverage to make larger and riskier loans. The Canadian mortgage industry was regulated to maintain high lending standards, instead of lax ones allowing an explosion in sub-prime mortgages.

That is correct. And explains why the financial crisis did not hit Canada.

Also, have a look at the delinquency rates in Canada as compared to the US in the graph at the bottom of the page:

http://www.ritholtz.com/blog/2010/02/canadian-housing-bubble/

Canada's rate is flat. The US one is sky high.
That Canada will have trouble in the future when the bubble bursts is true.

But their system of financial regulation has prevented the type of collapse that happened in the US, and will minimize the damage when the present bubble ends too.

James E. Miller said...

Lord Keynes,

Yes, Canada's tighter lending standards may prevent a less disastrous bursting of the bubble whenever it comes. But even tighter lending standards and low interest rates have failed to stop a bubble from occurring and I guess we will have to just wait and see if the Bank of Canada will be there to fix the balance sheets when the day of reckoning comes.

I love how you recognize the bubble, but fail to mention that it may have resulted from a continual lowering of the interest rate, though they have raised it recently, (http://www.troymedia.com/2010/12/07/bank-of-canada-leaves-interest-rates-unchanged/) and an increase in credit taken out through mortgages. (http://www.troymedia.com/2010/12/18/the-household-debt-conundrum-facing-the-bank-of-canada/)

As long as the government is there to regulate, nothing bad will happen right? I thought F.D.R. stopped the excesses of capitalism by regulating the banks enough to so we wouldn't experience another economic downturn. I guess stagflation in the late 70's didn't count. And I thought Sarbanes-Oxley (supposedly the toughest bank regulation since the New Deal) was supposed to prevent financial crises too. I just don't get why some people think banking regulation will create stability when the banksters always find another way to cheat the system and rely on their friends in Washington and the Fed to guarantee their big bonuses. The financial system is like a constantly flowing river of water which the government continually pretends to damn the flow of only to let the pressure build up and destroy all hopes of containment. Rather than have the tax payers fund a regulatory apparatus so perverted by outside influence that it fails to do its job effectively, banks that make risky loans for short term profit should fail miserably compared to those which act responsibly.

Though Keynes' animal spirit theory is a product of human greediness and nature itself, a misinterpretation of a lowering of the interest rate by the central bank which has not been a subsequent effect of increased savings by the public tends to result in economic downturns. Those who occur a massive loss from the unsustainable investments should learn from their mistakes on their own accord rather than to rely on the government to force the public as a whole to make up for their failures through forced taxation and a devaluation of the currency they are forced to use. Only then will the public finally realize how destructive to the capital structure a central bank is. That, or eliminate the institution that relies on less than 15 people to literally play God with the economy.

Instead of dropping bags of cash from his sleigh, Santa Bernanke has brought us $3 dollar gallons of gasoline. Merry Christmas.

Tocano said...

Republicans always are the cause of all problems and ills and Democrats have all the answers (unless they too aren't expansionist enough)

Fixed that for ya.