Friday, July 11, 2008

Bye Bye Reaganomics

Since the Reagan years, free-market cliches have passed for sophisticated economic analysis. But in the current crisis, these ideas are falling, one by one, as even conservatives recognize that capitalism is ailing.

E. J. Dionne, Washington Post

A great article in today's Washington Post about the crisis of Regan era economics. The key point in the current (and apparently metastasizing) credit crisis is that it represents an exploitation of market inefficiency. At business school, we learned that an efficient market is usually the best solution to an economic issue. However, markets cannot be perfectly efficient, and regulation is necessary to ensure people don't game the system. The problem with mortgage bonds is that they represented an enormous gaming of the system. 

The fundamental issue is that companies lent money, then packaged the loans and sold them off to others. They made money not as a return on the investment (the mortgages) but through fees generated by parceling the loans out to others. The purchasers of the loans were expecting the same type of risk as historical mortgages, very low. However, the historical low default rate on mortgages was the result of conservative lending practices. Those practices arose because the people doing the lending were ones who would lose money if the loan defaulted. Mortgage bonds broke that connection. The ones lending the money were not going to be on the hook if the loans went bad. Market efficiency depends on that relationship between risk and return. These bonds broke that relationship. Without adequate regulation, the result becomes inevitable. Billions in bad loans that will never be re-paid. 

Why does that matter beyond the dopes who bought this crap? Because a lot of those dopes were banks. Banks can only lend money as a proportion of their assets. Usually they can lend $10 for each $1 in assets. If you reduce their assets by a billion dollars, they have to start calling other loans to stay within the required asset/loan ratio. Those other loans are personal lines of credit, small business loans, other mortgages, etc. So the damage spreads. Its that spreading damage that has created the crisis. Nobody knows how much of the questionable mortgage assets will go bad, so nobody knows how much exposure the US banks have. The easy thing to do is pile out of the US dollar and buy assets valued in Yen or Euros. The dollar goes down and the price of everything in $US goes up. Inflation. How do you cure inflation? Raise interest rates. But raising interest rates will push more of the questionable mortgages into default.

Make no mistake, this is entirely a failure of Executive regulation and oversight. The US Federal Reserve, SEC and Department of the Treasurey are the agencies responsible to conduct that oversight.