Credit Crisis Severity

Why do some asset booms end so much worse than other asset booms? Why did the housing boom end so much worse than the tech boom for example? The answer is amount, debt, and expectations.

The amount most have invested in equities is much less than they have invested in real estate, partially due to less leverage, partially due to the necessity of shelter, and substantially due to real estate coming in such large units.

Consider an asset that rises from price p to price 2p before falling back to p. Anyone that held it for the duration would be no better or worse off. Someone that sold at the peak would have a gain of p, and the buyer would have a loss of p when the price fell. In total, there is no gain or loss, only a transfer from the buyer to seller. It is zero sum to first order. Any losses leave no debt behind. Wealth was not created or destroyed overall, only redistributed.

Now consider the same situation where the asset is acquired with borrowed money. Since these asset prices are afforded by incomes which change little over a boom, they will often vary roughly inversely with interest rates, with rates falling by half before rebounding. Anyone that held it for the duration and did not refinance would be no better or worse off. Anyone that refinanced the same amount to a lower fixed rate at the peak would be better off, while anyone that refinanced to the full amount at the peak may or may not be worse off depending on the terms of the loan, but may be much worse off than they expected if they did not anticipate the decline. Someone that sold at the peak would have a gain of p, and the buyer would have a loss of p when the price fell. The lender will also have problem if the owner cannot make the payments, must sell the asset, or even is no longer willing to pay, as the asset no longer provides sufficient collateral for the loan. This is not something the lender expected. Though this is also zero sum to first order, expectations make the result worse. Some will have consumed temporary gains leaving themselves more indebted. Some will have lost any equity they may have had. Some won't be able to afford it. Some won't be able to repay the loan if they have to sell. Some won't want to pay for something that has lost so much. The lender will suffer unexpected losses. Losses often leave debt behind, debt being the residual of crushed expectations. Wealth was not created but it very often is destroyed by being consumed during the boom leaving only the debt afterwards.

So what makes equity markets so much different from real estate markets? Equities amount to much less then real estate in most instances. Equities are much more liquid in most cases. Equity markets offer much lower leverage to retail investors, a factor of 2 (50%) compared to 10 (90%) or more for real estate. Equity markets are callable and marked to market daily, limiting losses, while real estate is at the option of the owner and marked to market only on sale. Equities are volatile, fast, and changes are expected, while real estate has low volatility and changes slowly with considerable inertia and momentum.

Happy and Not-So-Happy Markets

The problem with the Efficient Market Hypothesis, EMH, is eventually proponents have to assume it and whatever happens becomes its confirmation. This makes it unprovable and useless, but better that than wrong.

How compatible are efficient markets and psychology? Can psychology just be treated as an exogenous variable to efficient markets? I would call this the happy markets theory, or the markets are efficient except when they are not theory.  Was the market failure the failure to anticipate such a change, to anticipate the effects of such a change, or in the reaction to such a change? Were prices too high before, too low now, both, or neither?  What are markets failing to anticipate next? What are they overreacting to now?  Will they fall by half or double tomorrow?  Are prices anything other than the whims of participants?  There is nothing wrong with treating psychology as exogenous other than making a mockery of EMH. It is notable how the same reasons are used at times like these, psychology, technology, .. and there may well be some truth in them, but such truth would be far more significant than the meaninglessness of EMH.

A Hyper-Ricardian Hypothesis

Conservative economists simply assume recessions don't exist, that they can't exist, that there are no idle resources, no involuntary unemployment. Since everything is already optimal and in equilibrium, the economy is a zero sum game and any attempt at change can only make things worse. Because of this no stimulus is even possible as it can only redirect resources from their current use to the use of government. There is even a bit of truth in this during normal times when the economy actually is operating at capacity. There is no cure for recessions because they are figments of our imagination. It certainly saves a lot of work trying to predict, explain, and remedy them. In this bizarro world, there is no output gap, empty homes and idle factories are just speculations for higher future prices and the unemployed are just enjoying leisure. Putting more people to work is just denying them their leisure and recessions are just long awaited and much desired vacations. If you believe this, not only is fiscal stimulus impossible, even monetary policy is unnecessary so one has to ask them why it should be pursued. One can only imagine what other innovations they might suggest, an end to unemployment and welfare, balanced budgets, and the rest of liquidationist policies.

Now over the long haul stimulus would not be stimulative because the economy would be operating near capacity and it would just redirect otherwise occupied resources within the economy, possibly to less desirable ends. But the same is not true in the short term if there are idle resources. In fact, if Ricardian equivalence holds there is little reason to expect people have not already taken these government stimulus actions into account in their planning from the start and have planned for the government to do just this for them in a situation like this. Call this the Hyper-Ricardian Hypothesis. In that case to not do it would be disappointing expectations that had been previously established.  Far from people countering fiscal action to make it ineffective, they will have planned for it and be relying on it to smooth their consumption.  Lack of stimulus could mean they may not be able to.  

Ricardian Equivalence

I think of it as rational expectations and efficient markets theory taken to its farcical limit, the market always efficient, the economy always operating optimally, unemployment and recessions figments of our imagination. It shows how ludicrous a theory it can be and if you take it seriously, you have just missed the joke.

The Low Interest Rate Myth

Probably the most common explanation for the financial crisis is that interest rates were too low for too long.  I would dispute this.  The whole point of our financial ponzi scheme was to promise and keep interest rates higher than what they would otherwise have been.  Had only good lending been permitted, vast sums would have had no investment opportunity driving interest rates far lower than they had been.  Interest rates were not too low but too high given the available investment opportunities.  So when people ask, how can more of the same which got us into this trouble solve our problems they are incorrect.  This is not more of the same but something very different, the truly low interest rates the investment possibilities offer us.  It is the spur in our sides to take more risk to build a better future because our current one is not very promising.  

Incentives and Investments

The incentives were wrong, but the incentives are always wrong. It is in the interest of those that profit from the incentives to insure they are wrong so they can benefit from them. That is why it requires an honest regulator, but despite the incentives rather then because of them, as their incentives are wrong as well.

If only good lending was allowed, then interest rates would have had to have dropped further and lenders would have to decide whether to continue to lend or to speculate or consume. If they continued to lend, the bubble would have been sustained, speculate and it would have been diverted into equities, consume and it would have expanded the economy. Any of these would have been a better solution than what we had. The big problem is when there is a paucity of good investments for the amount of saving people want, the only thing left to invest in is ponzi schemes.

On the Causes of the Current Crisis

While the low interest rates and abundance of savings amplified the result, it was bad lending that really created it. Bad lending is not only bad in itself but turns even good lending bad by increasing asset prices beyond their true value. Part of the job of regulating the value of money is regulating credit. Failing to do the latter is failing to do the former.

Whenever one hears of the profits of financial innovation the presumption should be someone is getting robbed and if you don't know who, it is probably you. There were no profits, only hidden future losses for the taxpayer to pick up. The innovation consists of fooling others and looting the treasury.