Not Much Has Changed Since 1949

At least, as far as public opinion about economics goes.

Reason Magazine points out the contradictory responses to changes in prices by the public and the media, who of course consider themselves great economists - otherwise they could not offer such profound arguments as to why the prices are dangerously high or low:

Rising prices are bad, and so are falling prices. As recently as mid-August, we were worried about runaway inflation. In an article headlined "Higher Costs Are Taking a Toll on Business," The New York Times reported that "rising prices have seeped into much of the economy, led by higher costs for food and energy." At the end of last month, under the headline "Fear of Deflation Lurks As Global Demand Drops," the Times warned that reduced consumer demand could lead to "persistently falling prices," "suffocating fresh investment and worsening joblessness for months or even years."

Rising home prices are bad, and so are falling home prices. As home prices rose through 2006, newspapers across the country ran stories bemoaning the lack of "affordable housing." Now that prices are falling, newspapers across the country are running stories about the disaster of negative equity, the loss of what used to be a reliable investment, and the financial havoc caused by the assumption that home values would keep climbing forever.

Rising oil prices are bad, and so are falling oil prices. Last summer, with crude oil going for more than $140 a barrel and gasoline over $4 a gallon, politicians were falling all over each other to do something about rising oil prices, which made food and a wide range of other products more expensive. Now oil is around $60 a barrel, but instead of celebrating we're supposed to worry, because the price reflects fears of a prolonged worldwide recession.

Mises pointed all of this out in 1949. He explained stock market price changes are always vilified, no matter which direction they are going:

Popular opinion finds something objectionable in every possible aspect of stock market transactions. If prices are rising, the speculators are denounced as profiteers who appropriate to themselves what by rights belongs to other people. If prices drop, the speculators are denounced for squandering the nation's wealth.

He also described how different groups want prices and wages to go in different directions. As we all know, interest groups drive politics and public opinion: concentrated benefits and dispersed costs.

So, public opinion and populist policies follow these interest groups, reacting to the price changes as if they are a dire emergency. But this prevents the adjustments which must be made in the free market, in order to reallocate resources as demands change or as ventures are deemed to have failed or as policies by government or by businesses need to adjust because they are simply too costly.

Mises explains:

To the wage earner no wage rates, however high, appear unfair. But the farmer is quick to denounce every drop in the price of wheat as a violation of divine and human laws, and the wage earners rise in rebellion when their wages drop. Yet the market society has no means of adjusting production to changing conditions other than the operation of the market. ... The absurdity of all endeavors to stabilize prices consists precisely in the fact that stabilization would prevent any further improvement and result in rigidity and stagnation. The flexibility of commodity prices and wage rates is the vehicle of adjustment, improvement, and progress.

Both the desire to denounce business and the wealthy, and the rallying cry from interest groups who want government to protect them from competition in labor and product markets drives the conversation. When the price of oil goes up it is evil speculators, when it falls it is a depression. The evil speculator who controlled the price of oil has conveniently disappeared in the fog of fear around the supposed depression.

Though if a crisis has caused the price to drop this must be due to a fall in demand, it is never a rise in demand that has caused the price to go up - it is always greed. The fact that these arguments are entirely inconsistent has never seemed to bother these popular economic scientists of the media and political elite.

It also doesn't bother those who favor antitrust regulation: they have laws against "predatory pricing," setting prices too low, and also against "monopoly pricing," or "price gouging," setting prices too high. These are also relics of the 1930s-era confusion about competition and free market price setting. John Stuart Mill spoke about this problem of seeing only one half of the market, and believing price to be hurting either the worker or the consumer, forgetting about the other half of competition. If competition is seen to drive down prices then it is bad because it hurts the company who can no longer pay high wages (what about competition for wages?) if it is not seen, then it is bad because it hurts the consumer.

Causes and Cure for the Credit Crunch

This crisis is often complicated way out of proportion to what is necessary. It is really quite simple. This article makes a nice rundown, and I will give you some basic bullet points. Then I will attempt to convince you that the best medicine is to let the market detox.

Causes

The crisis was triggered by a collapse in housing. There was first a bubble - with housing prices rising and rising and rising and everybody knew it couldn't last - and then it popped. Crash. And then - oops - it took down all related lending, since so many firms had a major portion of their lending wrapped up with mortgages. Hence, credit crisis.

Now, what could have caused the bubble and the pop? Well, before jumping right to culprits, lets remind ourselves what drives prices up and down: supply and demand. So, for prices to rise, there must be greater demand than supply (lots of bids on few houses) and for prices to crash, there must suddenly be greater supply than demand.

OK. So what could have gotten supply and demand out of whack? In normal times, if demand is high and prices rise, more suppliers will come in, prices fall again; but here the supply never caught up with demand. Why?

Supply and Demand

Several policies and programs have been put into place to encourage home ownership, but which drove a wedge between supply and demand. These include:

(1) Fannie and Freddie which ensure cheap mortgages as they buy bad loans back from places like AIG and which dominate at least half of the housing market, drove reasonable lenders out of business, and made poor lending and bad loan packaging possible by being a massive customer (read: subsidy) to places like AIG.

Demand: Much more demand by the lower income buyers, demand for bad loans by gov.
Supply: Private market crowded out by Fannie/Freddie except those making loans that gov. buys

(2) The Community Reinvestment Act which forces lenders to offer cheap loans (with quotas) and which, together with Fannie and Freddie, led government to create the securitized secondary mortgage market, and which also drove potentially profitable lenders out of business, expanding Fannie and Freddie's dominance.

Demand: Much more demand by the lower income buyers, demand for bad loans by gov.
Supply: Private market crowded out again, only the few big ones can meet gov. quotas

(3) Fed-induced low interest rates which made mortgages more affordable, tax write offs and personal tax credits for mortgages, etc.

Demand: Much more demand by all buyers
Supply: Supply contingent on interest rates staying low, otherwise defaults


Now, what was the point of Fannie and Freddie? Their charter states that it is to ensure loans to those who cannot normally afford them by buying low-income private loans up on a secondary market. This is not a recipe for profit maximization, it is a recipe for excessive risk. Now, it is non-profit insurance - risk sharing - in theory. If that could work.

But it can't for several reasons. Moral hazard and plain old demand will go up, when rates are this low, so losses grow. Government has actually fed the demand of low income buyers, not only by offering them cheap housing but also by driving interest rates down, offering tax credits, etc. In fact, they kept expanding and expanding further into low-income and sub-prime lending, in the dream of reaching 70% home ownership.

Meanwhile those who would offer low-income loans at rates which would allow profit are all crowded out of the market. The only ones left who can make a profit are those who depend on Fannie and Freddie to buy their risky loan packages. So long as Fannie and Freddie stay in business, they are OK. But Fannie and Freddie can only appear as if they are above water so long as housing prices keep rising, so long as fuel keeps going on the fire of demand.

But they are going deeper and deeper and crowding out everything around them. They are swollen with risk and poised right in the center of the credit market, waiting to explode.

Why did it all come a head now? Because:

Between 2005 and 2008, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers — more than three times as much as in all its earlier years combined, according to company filings and industry data.

Boom.


Cure

I keep stressing that we understand what caused the problem. The reason for this is that (as the first link above mentions) the cure that we are putting in place is actually more of the same-- more of what caused the crisis. If the crisis was caused and fueled by these policies, why do we expect them now to save us?

Fannie and Freddie caused the crisis by not pursuing profitable business strategies - by risky lending and loss-making pricing - and yet, Paulson promises that to cure our ails he will make sure that Fannie and Freddie stop worrying about being profitable. Put the homeowner first.

Fannie and Freddie caused the crisis by expanding into the sub-prime market, the answer to foreclosures a year ago? Expand Fannie and Freddie's mandate for low-income lending. Today? More of the same.

Fannie and Freddie caused the crisis by subsidizing a risky secondary market for mortgage-back securities. Our initial response a year ago? Buy more bad loans. Our current plan? Buy more mortgage backed securities (bad loans).

The fed fueled the fire with easy money. Answer? Easy money.

This is classing government intervention feeding on itself.

What is the right cure? Leave it be. Let the market restructure. Don't feed the crisis. If you think it will hurt, you may be right. But won't $700 billion in transfer from taxpayer to government also hurt? Won't feeding the loss-making machinery of socialized companies, which will need to be bailed out again and again hurt? Won't subsidizing failing companies which drive out regular business hurt too?

There is no pain-free answer. But there are cures that hurt because they detoxify, and there are cures that feel good right now, like a mamosa over breakfast after a drinking binge, but fail to actually solve the problem. In fact, they make it worse. And the final detox hurts more.

This crisis, the more I learn of it, the more it reminds me of the transition in Russia. We have to cut the strings. We are being made a muppet.

Universal versus Quantitative

Economic Laws are universal. As Mises explained, contra Caplan, because supply and demand laws - marginal utility, preferring more at a lower price - are universal, it isn't a quantitative matter but a qualitative matter that maximizing output is better achieved with a free market solution. For the given ends (maximizing output), the best means are to allow the free market to work rather than intervene.

However, while this means that markets are better than socialism, does this mean all interventions are bad? Clearly the qualitative result - the end is better achieved with markets than socialism - is true. But how much better? That is the quantitative question. The answer is clear at the system level: a lot better. But, at the intervention level, one must weigh the objectives.

If the objective of a given intervention is only to maximize output, one need not ask the quantitative question: the market will better serve. But, if one has multiple ends: (1) raise the wages of the poorest worker (2) without reducing total output by very much, then the quantitative question surfaces. For, even if the only end is to increase the wages of the poorest worker, there is a time component, and total output will ultimately lead to lower wages in the long run for the poorest worker (if higher output over time leads to higher real wages of the poorest worker, over time).

This is where the Krugmans and Card & Kreugers (and Galbraiths, who dispute the condition) like to fight. Maybe the quantitative aspect isn't large enough to offset the first round effect of the command benefit. When they argue this line, some turn to "natural rights" arguments: it isn't right to command benefits. But an economist must look at the quantitative aspect of the universal truth, and weigh the losses against the benefits. How does total output respond? How does the universal rule of competitive wage setting and profit maximization induce the employer to respond to command wage hikes? How will the benefit accrue - will it at all? To whom will it go?

And hence economics becomes difficult, and dynamic, quantitative and empirical analysis is required. Hat tips to Mises, Caplan and the struggling economists on both sides.