Wednesday, December 22, 2010

How Gov't. Failure Caused the Great Recession

The banking crisis that began in August 2007 shocked markets and precipitated the Great Recession. To fully explain the banking crisis, one must account for its timing, severity, and global impact.  For example, why didn’t a banking crisis erupt sooner—say, in the recession years of 1990-1991 or 2001-2002? What changed in recent years that led to business risk-taking capable of wrecking the U.S. housing market and the U.S. banking system and other banking systems throughout the world? Further, why were prudent credit practices reasonably maintained in credit card and commercial mortgage securitization in recent years, but wholly abandoned in residential mortgage securitization?

In answer to the questions about what specific factors explain the: causes and timing of the banking crisis and the extraordinary departure from historically sound underwriting and securitization standards for residential mortgages, we identify a potent mix of six major government policies that together rewarded short-sighted collective risk-taking and penalized long-term business leadership.  

From my article "How Government Failure Caused the Great Recession," (with Robert Dell) now available at The American.

42 Comments:

At 12/22/2010 9:37 AM, Blogger morganovich said...

very well written and argued.

well done.

 
At 12/22/2010 11:26 AM, Blogger Tom said...

Reagan had it right - big government IS the problem.

It is crystal clear that government MANDATED the subprime financial behavior which gave the world a financial heart attack. Perry enumerates the government directives nicely. I would have added the seven layers of fake regulators who couldn't see a subprime financial tsunami coming, any more than they could catch Bernie Madoff even after he was explicitly fingered five times by Harry Markopolos.

The Democrats (socialists) cannot possibly admit their dead hands pulling the levers, nor can the lamestream media turn their backs on their komrades, and do their job - investigative journalism.

This is a political matter, from start to finish, and it is continuing. The question is how long we will ignore massive government interference in and domination of our economy, and the catastrophic consequences.

The situation is preposterous. Government spending is now 44% of GDP, and regulation costs another 20% of GDP. That regulation costs us eight times as much of GDP as does all of our police, fire/rescue, courts, and jails and prisons (2.5% of GDP). Are we really such a dangerous, chaotic society that we need that much regulation?

We ought to chop government down to a total of no more than 30% of GDP (including regulation costs). To do so will require a series of constitutional amendments on spending, borrowing, taxing, insurance and loan guarantees, and regulation costs.

That would double the income available to the private sector. As it is now, big government owns us and holds us in financial bondage, we no longer control the government.

The bubbles and crashes will continue until we remove big government from its dominant, incompetent role pretending it can micromanage our economy.

 
At 12/22/2010 11:35 AM, Blogger Hydra said...

"We ought to chop government down to a total of no more than 30% of GDP (including regulation costs).

.........

That would double the income available to the private sector. "

=================================

We've been through this before, and this argument is nonsense, unless you think the private sector can get an 800% rate of return on the the money saved and invested.

But, lets assume this nonsense is correct. You double the income to the private sector and tax revenues go up, substantially. What would you have big government do with all that new money?

Why, nothing. Government doesn't need that moey so we could cut taxes, of course.

 
At 12/22/2010 11:38 AM, Blogger Hydra said...

Ok, so which is it?

Icompetent government's failure to regulate effectively, or

Incompetent government successfully pullig off a huge market intervention that PE was powerless to recognize or stop?

 
At 12/22/2010 12:19 PM, Blogger morganovich said...

hydra-

incompetent does not mean unimpactful.

you framing of that question means nothing at all.

an incompetent electrician can burn your house down.

that a government can push through a terrible and unfundable policy that rains free goodies on people should hardly come as a surprise.

 
At 12/22/2010 12:21 PM, Blogger Benjamin said...

An interesting paper.

However, the fact that commercial real estate markets--without intervention by Fannie, Freddie--also buckled is interesting. It suggests real estate collapses can happen in largely free markets, and do and did recently in front of our faces.

In this case, it suggests the rating agencies, and the MBS market, and a global capital glut, were enough to boost commercial property values to a very high level, that tumbled when the general economy tumbled. As even a free market banking system involves leverage loans to real estate, this cayse huge losses, snowballing downhill.

So, the residential market might have suffered the same fate even without a Freddie or Fannie. Hard to know.

As for federal deposit insurance, it is in theory a bad idea. Yet, even as a relatively sophisticated fellow, I wonder if I would put deposits anywhere without insurance. Private insurance? And what if private insurer declares bankruptcy? AIG anyone?

And we know that free-market ratings agencies (S&P, Moodys, et al) were evidently easily corrupted by issuers. The issuers pay the ratings agencies (now, that could be changed by creating a pool into which issuers pay, and then the rating agency selected at random).

So, without FDIC, we may get disintermediation. I sure would not trust Countrywide, Merrill or any financial institution with my money, unless I knew officers would be executed if I lost money.

There is another problem in free markets, addressed at length by right-wing nutcases Redleaf/Vigilante in their book "Panic,", and that is that public shareholders exert very weak ownership. I wish the free market would evolve ways for shareholders to have much more effect, but it seems unlikely.

You can always choose not to own shares in companies with poor governance, and wow-wee that will change everything.

So it is quite possible for management of any institution to leverage up and bet the bank, knowing a win means vast wealth for management, and a loss means shareholders lose.

 
At 12/22/2010 3:43 PM, Blogger PeakTrader said...

The government promotes risk in the private sector, and when the inevitable failure takes place, the government blames the private sector.

The government brought down the whole economy, and put the economy in a position where we need the government to rescue the economy.

So, the free market bad, the government good.

 
At 12/22/2010 3:55 PM, Blogger Benjamin said...

Why did commercial property suffer the same boom-bust of residential property, despite completely different levels of federal involvement?

Commercial property rose nearly 90 p[ercent in value from 2002 to 2008, then got cut in half in the collapse. It is a mirror image of the residential market.

Peak Trader. In what bank would you park your money, without FDIC insurance?

 
At 12/22/2010 4:22 PM, Blogger morganovich said...

benji-

"Peak Trader. In what bank would you park your money, without FDIC insurance?" is the wrong kind of question.

if there were no fdic insurance, banks would be different and try to look stable as opposed to offer high interest payouts.

 
At 12/22/2010 5:18 PM, Blogger PeakTrader said...

I don't like overpaying for insurance, because I don't have $250,000 or more in the bank.

Government should complement, not compete, with the free market.

Do we really want government to micromanage our lives?

 
At 12/22/2010 5:20 PM, Blogger Benjamin said...

Morgan-

in some respects I agree. But all banks are leveraged on deposits.

Can you name a bank you would trust your money with, sans FDIC insurance?

I can't think of one. Disintermediation might becoe a problem with every scare--worsening scares. Bank runs, depression etc.

It can't happen here, except it already did.

 
At 12/22/2010 5:22 PM, Blogger PeakTrader said...

All government workers, including politicians, should work part-time at real jobs :)

 
At 12/22/2010 5:55 PM, Blogger PeakTrader said...

All government workers, including politicians, should work part-time at real jobs:

Obama could work as a manager at 7-11, Bernie Sanders could be a VP at Walmart, Sara Palin could run a shooting range or work in a rodeo, Joe Lieberman could be the backup voice for Elmer Fudd, John McCain could not only teach skydiving and parachuting, but lead by example, Nancy Pelosi would fit in at the front desk of a nursing home, particularly in Cuba, Mitch McConnell would be an excellent auctioneer.

 
At 12/22/2010 5:57 PM, Blogger Michael Smith said...

Benjamin wrote:

However, the fact that commercial real estate markets--without intervention by Fannie, Freddie--also buckled is interesting. It suggests real estate collapses can happen in largely free markets, and do and did recently in front of our faces.

The commercial real estate market is hardly "largely free". It is forced to use the same fiat money as every other market in the U.S. -- which means, it suffers from the same inflationary effects and the same interest rate effects of all other markets using that fiat money.

In a truly free market, operating on a gold standard, an increase in demand for loans to purchase commercial property (or to purchase residential housing for that matter) would, all other things being equal, cause a rise in interest rates which would serve to put a break on the purchase of said properties and thereby curtail any rise in their prices.

But with fiat money under the Fed's control, this mechanism does not exist -- the Fed can, and did, cause interest rates to fall even in the face for increased demand for loans, said low interest rates then serving only to fuel an additional increase in demand for loans. This is the mechanism by which the Fed inflates asset price bubbles -- which are inevitably popped when the Fed realizes it must raise rates back to more reasonable levels and when demand for the asset declines back to its pre-low interest rate level.

Indeed, the entire phenomena of continuously rising asset prices is an artifact of statist interventions in the economy, primarily in the form of inflating a fiat money supply. For absent such inflation, the prices of assets like commercial structures and housing should fall over time, due to the immense productivity improvements that have been made in the construction trades and in the industries that supply materials for the construction trades. Building a single family residence today takes a fraction of the labor it took 30 years ago -- yet housing prices have rising enormously over that time, mostly as a result of inflating the money supply. Increased government regulations have also caused prices to rise.

There is nothing in the nature of a truly free market to cause a sudden, sustained increase in the demand for certain assets, thereby causing a long, sustained increase in their prices and inducing companies supplying those assets to increase production capacity and employment -- followed by a sudden, sustained decrease for those same assets, resulting in layoffs and now-useless capacity in those same industries. It takes a Federal Reserve and fiat money to accomplish that.

 
At 12/22/2010 6:35 PM, Blogger morganovich said...

benji-

i can think of banks i'd trust, but most are small private banking firms and do not take "retail" accounts. pictet and cie are impeccable.

i would also trust goldman sachs and JP morgan to be around. JP in particular has excellent private banking.

but if you take away the FDIC, banks will change. they are as they are because they have guarantees. they'd compete for those looking for safety if they had to. people would also shift into other assets than savings account cash.

i already keep most of my money (90%+) in places that are not insured for anything (hedge funds, private equity funds, private companies, etc) frankly, the disappearance of the fdic would do little to change my view about my economic risk.

granted, you have to be a great deal more careful going into such investments, but it's not really that difficult to find appropriate risk reward without any kind of regulatory backstop.

it may even be that the lack of regulation/financial guarantees makes them safer. hedge funds did much better than mutual funds over the 2008-9 period.

 
At 12/22/2010 6:42 PM, Blogger morganovich said...

"For absent such inflation, the prices of assets like commercial structures and housing should fall over time, due to the immense productivity improvements that have been made in the construction trades and in the industries that supply materials for the construction trades. "

you are leaving out the price of the land and the relative scarcity of housing.

if population increases, housing will get bid up for any given amount of supply) as demand increases. most americans live in places where there is no more buildable land open. sure, you can get a deal on south dakaota high plains, but few want to live there. in manhattan or san francisco or chicago, the story is very different.

house prices went up under the gold standard too, and there was a great deal more open buildable land then.

 
At 12/22/2010 6:52 PM, Blogger Benjamin said...

Michael Smith:

Okay, suppose you and I are a couple dudes with no money (gold). You say, "I will help you dig that ditch on your property, if you help me plant my trees."

I say yes. After a while, we start issuing scrip to each other, worth one hour of labor.

After a longer while, you take your scrip to a store, and say, "Sell me a Pepsi. This scrip means Benjamin will sweep up for you for one hour." The storeowner says okay....

You get the picture.
Of course, to avoid counterfeiting and assure wide acceptability, we have to have "real" money printed by a government agency.

Right now, we are emergig from a terrible global recession. It is natural to look for faults (blame Obama, blame Bush jr.)

But on a broad scale, since 1970, much of the world has emerged from poverty. Indeed, where there is poverty, it is not because of money or gold, it is because of chronic corruption and laziness (Africa, parts of Latin America, Burma etc).

Real food production, manufacturing etc is soaring globally, as are expected lifespans etc. This all happened with the world off the gold standard. Life is getting much better all the time all around the world. This has been a fact for 40 years running.

One place going in reverse is Japan, and they keep a very tight money supply there.

I just don't see a case for gold, or Austrian economics. One recession does not mean 40 years of progress is meaningless.

 
At 12/22/2010 7:32 PM, Blogger morganovich said...

there is one flaw in your logic benji-

you have to have hours of work to back up your money. as you get more skilled, they even appreciate.

your "labor money" is still convertible.

the dollar isn't. it has no hard peg to any good or service. the fed can print infinite amounts and keep rates low at the same time, whereas the "benji-buck" would rapidly stop being accepted if you had so many out that you could not do the work. the dollar's role as a reserve currency has shielded us from a great deal of the consequences of our massive money supply growth, but even that comes to an end eventually.

 
At 12/22/2010 9:44 PM, Blogger W.E. Heasley said...

“Today we see how utterly mistaken was the Milton Friedman notion that a market system can regulate itself. We see how silly the Ronald Reagan slogan was that government is the problem, not the solution . . . I wish Friedman were still alive so he could witness how his extremism led to the defeat of his own ideas.”

— Economist Paul Samuelson (January 2009)


“Everybody loves to argue with Milton, particularly when he isn't there.” - George Shultz

 
At 12/23/2010 4:43 AM, Blogger sethstorm said...

This comment has been removed by the author.

 
At 12/23/2010 4:44 AM, Blogger sethstorm said...

The private sector decided to not work with in the rules. They had every chance to choose to act in a manner that would result in prosperity from that policy. However, in their decision to oppose the policy in every way, participants decided to purposefully trigger failure.



it may even be that the lack of regulation/financial guarantees makes them safer


Actually, no. Stability is what makes things safe, and regulation/guarantees provide that.



but if you take away the FDIC, banks will change. they are as they are because they have guarantees. they'd compete for those looking for safety if they had to.


Or try to drop it in a way that says "safety for me, but not for thee". Yay, now my bank account gets to be like stocks - NOT.

 
At 12/23/2010 7:34 AM, Blogger geoih said...

Quote from Benjamin: "I say yes. After a while, we start issuing scrip to each other, worth one hour of labor."

Your "script" is still worthless paper. Why would a store owner or anybody accept it in exchange for something tangible. This is pure fantasy.

The reason people developed money was because the money had value in and of itself. Grain, salt, metals, etc., are all tangible commodities. Paper with writing on it may be tangible, but it has little if any intrinsic value and can be created virtually out of thin air. In today's modern electronic banking, it can literally be created out of thin air. It's value is an illusion, a fiction in your mind, only perpectuated by the thugocracy created to force its use on others.

We're now witnessing what happens when the illusion ends. It has happened over and over again through history. It makes no difference whether the illusion is from physical debasement of coins, private inflation through fractional reserve banking, or government fiat money. Your 40 year boom is an inflated bubble of malinvestment driven by corrupted market signals due to interferance with the money supply and the market by the state. Reality is returning, the only question is how much violence will be perpetrated in order to keep the illusion going.

 
At 12/23/2010 7:49 AM, Blogger Michael Smith said...

morganovich wrote:

you are leaving out the price of the land and the relative scarcity of housing.

We are nowhere near a scarcity of land in most places (provided one gets rid of zoning regulations) and where we are, such as in densely populated cities, one builds up, vertically, and not out.

But the larger point is that such a scarcity of land -- in and of itself -- would not produce a boom and bust bubble asset price phenomena that causes significant over-investment, over-capacity and over-employment in major sectors of the economy. The land doesn't suddenly get more scarce for a period of time and then drastically less scarce for another period of time. Hence, it would not produce a boom and bust phenomena such as we have just seen in housing.

I repeat: There is nothing in the nature of a laissez-faire free market to cause such massive shifts in demand leading to massive misallocations of capital and wide-spread unemployment as we continue to see under our Fed-manipulated fiat money.

 
At 12/23/2010 8:00 AM, Blogger Michael Smith said...

Benjamin wrote:

I just don't see a case for gold, or Austrian economics. One recession does not mean 40 years of progress is meaningless.

We haven't had merely "one recession" -- we've had a series of booms and busts, all brought on by the fact that since the Fed was created, the value of the dollar has been decreased by 95% -- 95%!.

What's utterly lacking in any justification is the notion that it is proper and necessary to have a government agency authorized to continuously loot the value of my earnings and savings by any amount it arbitrarily chooses whenever it arbitrarily chooses. You'd never consider it justified for me to steal whatever amount of your income I wished whenever I wished -- so what on earth makes you think it is justified for Fed to steal it via inflation?

 
At 12/23/2010 8:06 AM, Blogger Michael Smith said...

sethstorm wrote:

The private sector decided to not work with in the rules.

Your comment, like all of your comments that I've seen, is nothing but a collection of unsupported claims -- such as the above.

Pray, tell us in detail what "rules" the private sector broke. Give us some evidence, data, reasons or logic to support your claims. "Because I said so" is not persuasive.

 
At 12/23/2010 9:21 AM, Blogger morganovich said...

michael-

i think you are still missing the point - as ia said, sure, there's lots of prairie in the dakotas, but no one want to live there.

building up in cities is expensive. the land underneath goes way up in value. even the price of virtually all suburban land trends up, and always had, fiat currency or no.

and can you seriously be arguing that you cannot get asset bubbles and busts under a free market system? that's ridiculous. they are a persistent feature of markets. i don't view that as a reason to regulate, but there is no denying that asset bubbles are a feature of markets.

i recommend you read chancellors "devil take the hindmost" on the topic.

the .com bubble was not caused by regulation any more than tulipmania was or the south sea bubble or emerging market debt or even property in the 20's. the japanese property bubble was not driven by regulation nor is the one going on in shanghai now. (though you could argue that shanghai is being fueled by money being too cheap)

this is not to say that you cannot create a bubble through regulation, clearly you can, but it's also undeniably true that you do not need regulation to create bubbles.

you do not need an asset to become suddenly scarce to drive a bubble either. .com stocks were anything but scarce, their supply increased astonishingly, but it only fueled the bubble. all you need for a bubble is popular perception that prices will rise and access to capital.

greater fool speculative behavior is a feature of humanity and cannot be removed from an institution as utterly human as a market. even, an in the .com bubble, when virtually everyone believed that it was a bubble, they continued on anyway. the rewards if you time it right are just too high and it is too difficult to watch others making so much money while sitting on your hands.

 
At 12/23/2010 9:36 AM, Blogger PeakTrader said...

The role of the Fed has been underappreciated to some. Would the U.S. have been better off with a depression in the 1970s, similar to the depressions in the 1870s and 1930s. Of course not.

The Fed has helped smooth-out both long-wave and short-term business cycles to improve economic growth. Therefore, the U.S. also had one of the greatest eras of prosperity from 1982-07, greater than the Industrial Revolution a hundred years ago.

 
At 12/23/2010 9:48 AM, Blogger morganovich said...

michael-

so what do you make of the fact that many of the worst US depressions, including the great depression, occurred under metal standards?

1807, 1815, 1873, 1893, the panic of 1907, 1920 (18% deflation!), and then, of course, the great depression whose deflation finally drove us off the gold standard.

while much of what you say about the risks of a fiat currency is true, you seem to be putting gold forth as some kind of panacea and ignoring the severe flaws in such a system and the fact that we had speculative booms just as severe under gold (1929 consumer debt to gdp was higher than 2008) as well as much deeper and more severe depressions and recessions.

1893 saw unemployment over 10% for 5 years.

1920 saw 18% deflation and was perhaps the sharpest contraction in US history.

the rampant credit boom of the 20's and the subsequent decade long bust took place and began and deepened respectively under gold.

i think you have a rosier view of gold than is warranted by the facts. it too is a system with deep flaws.

you claim that "There is nothing in the nature of a laissez-faire free market to cause such massive shifts in demand leading to massive misallocations of capital and wide-spread unemployment as we continue to see under our Fed-manipulated fiat money."

is simply unsupportable by fact.

there were numerous examples every bit as egregious under gold and before the fed.

 
At 12/23/2010 12:48 PM, Blogger Jason said...

Great article, Prof. Perry.

I often wonder why people would think that the market didn't work exactly the way it was supposed to. Perhaps the result was different from the intended, but it is not the fault of the market participants that bad, ill-conceived legislation was passed.

An pretty highly regarded electrical engineer, Bob Pease, once wrote, "A circuit works exactly the way it is supposed to." Similarly, the market, designed by the US Government, worked exactly the way it was supposed to.

 
At 12/23/2010 2:13 PM, Blogger morganovich said...

jason-

i'm not convinced that that comment about circuits working as they are supposed to actually means anything at all.

if you mean that they work in accordance with physical laws, well then yes, but so does every single other thing in the universe. if everyhting "works as it is supposed to" it means nothing to say that such is true about any given thing.

if you mean "works at it was intended to or designed to" then the statement is clearly false. ask any engineering student. lots of circuits don't work as they were intended or designed.

you are also leaving out the possibility that an outside actor impacts a working circuit by shorting it or a market by skewing it by regulatory fiat.

i have no idea why you think the governess designed the market, much less that their intervention had the effects they desired. it's pretty obvious that they were not trying to cause a subprime crisis and wipe out the personal balance sheets of millions of low income americans. intended effect and actually effect can be quite divergent and again, depending on what you take "supposed to" to mean, it's either a useless generality or an obvious falsehood.


as a result, i don't really understand what you are trying to say.

 
At 12/23/2010 2:47 PM, Blogger Hydra said...

hydra-

incompetent does not mean unimpactful.

===============================

Yes, but Im not the one that thinks government is entirely incompetent.


Some people think the government is incompetent becasue it failed to regulate enough.

Some people think the government is so crafty it is able to pull offf a giant conspiracy, which however failed because of goverment incompetence.

The second explanation has an internal problem, so I preer the first.

"Never ascribe to conspiracy that for which a sufficent cause is stupidity."

 
At 12/23/2010 2:51 PM, Blogger Hydra said...

All government workers, including politicians, should work part-time at real jobs :)

And every engineer should work half time as a repair man on crap he designs.

 
At 12/23/2010 2:57 PM, Blogger Michael Smith said...

morganovich wrote:

so what do you make of the fact that many of the worst US depressions, including the great depression, occurred under metal standards?

1807, 1815, 1873, 1893, the panic of 1907, 1920 (18% deflation!), and then, of course, the great depression whose deflation finally drove us off the gold standard.

We were not under a true gold standard during any of those periods. A gold standard is not merely maintaining some tie between the value of paper money and a quantity of gold -- a gold standard is a completely free, unregulated banking system, which did not exist in the U.S. at the time of those problems.

For one thing, laws prohibited branch and interstate banking, which greatly limited banks' ability to move currency around as needed. Remember, prior to the 1920s we were a much more agrarian economy, and the demand for cash varied tremendously between harvest and planting seasons. The limits on banking resulted in repeated currency crises. Note that Canada, which had no such restrictions on branch and interstate banking, did not experience any of those economic problems.

So all of your arguments about the economic problems that happened "under gold" are invalid -- they were all caused by various government interventions in the economy.

You also wrote:

and can you seriously be arguing that you cannot get asset bubbles and busts under a free market system? that's ridiculous. they are a persistent feature of markets.

Nonsense. If bubbles were "a persistent feature of markets", then we would see such bubbles in all markets. I see no bubbles in consumer electronics prices or automobile prices or clothing prices or any of hundreds of other markets.

 
At 12/23/2010 3:28 PM, Blogger morganovich said...

hydra-

i have no idea to what conspiracy you are referring. i am ascribing this failure to governmental stupidity, cronyism, and (at best) an inability to foresee consequences or (at worst) a failure to care.

it doesn't take any kind of skill for an incompetent to wreck something. imagine all the incompetents you would not like to have "fix" your computer.

 
At 12/23/2010 3:43 PM, Blogger P.K. said...

Whatever the financial markets wanted, they got from the government.

5 yrs. ago -- "With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. . . . Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending . . . fostering constructive innovation that is both responsive to market demand and beneficial to consumers." -Alan Greenspan (At the Federal Reserve System’s Fourth Annual Community Affairs Research Conference, Washington, D.C. April 8, 2005)

Now--Representative Spencer T. Bachus of Alabama, the incoming chairman of the Financial Services Committee--“my view is that Washington and the regulators are there to serve the banks.”

 
At 12/23/2010 3:50 PM, Blogger morganovich said...

micheal-

the "completely free, unregulated" banking you refer to did nothing to hinder the effects you seek to avoid. look at the booms, busts, bubbles, and runs that took place in england.

you have not "invalidated" any arguments at all, merely referred once more to a system that failed over and over.

the railroad bubbles and the credit bubble of the 20's had nothing whatsoever to do with the inability to move money. that's totally orthogonal straw man. the inability to move money should have made them less severe and less widespread, quite the opposite of what happened. the massive deflation of 1920 was a direct consequence of gold.

gold as a medium of exchange is inherently deflationary in a growing economy. it tends to intensify every current crisis and make downturns deeper and more difficult to recover from.

can you show me any example at all of this "banking utopia" you describe? i doubt you can point to any examples of gold and private money having the effects you imagine.

we do see bubbles in all markets. your argument is a ridiculous straw man. remember what happened to walkman prices early on when supply was short? cabbage patch kids? how many times have you heard stories about parents paying up to get the hot toy for christmas?

you have seen hundreds of real estate bubbles, debt bubbles, equity bubbles, commodity bubbles, and even employment bubbles (remember 2000?).

you toss out 2 erroneous examples and purport to have refuted centuries of history which is flawed both logically and factually.

logically, just because there has never been a bubble in boisie muni bond says nothing about the existence of bubbles in all bond markets.

factually, there have been innumerable bubbles in every asset class you can name. you should have tried to buy a porsche in 1999 if you wanted to see an auto bubble. in a year, they went from 10-20% over invoice to 10-20% under. it has happened with gaming platforms, and any number of other items.

but again, you are missing a key element to what makes bubbles.

bubbles are driven by speculation. people do not speculate in (most) cars or most clothing or stereos. those are not assets that you buy and resell expecting to make money by holding them. even retailers that corner hot markets as was done in true religion jeans eventually get hosed because they wound up overpaying for exclusive inventory.

if bubbles are not a feature of markets, then why have they shown up in every asset under every kind of political and monetary system in history?

 
At 12/23/2010 3:54 PM, Blogger morganovich said...

that last line should say "asset class"

 
At 12/23/2010 4:04 PM, Blogger morganovich said...

also:

you definition of "gold standard" is not only not a standard one, but also internally inconsistent.

you describe as "gold standard" a system with no government regulation in the banking system, which goes a great deal beyond the standard definition of gold standard.

you then go on to presume that such a standard would be based on gold.

according to whom?

if banks are freed of all regulation, why need they be tied to gold at all? they are free to do as they choose including the issuance of currency backed by anything they like be it cowrie shells or pounds of carrots. they are also free to issue fiat currencies.

hence, your construct is untenable as either banks are regulated and required to use gold, or are not regulated and free not to which means there is no standard.

you seem to be advocating 2 incompatible goals.

 
At 12/23/2010 5:02 PM, Blogger Jason said...

Morgan, the quote is an ironic one. Systems always work the way they are supposeed to, not necessarily the way they are intended to. System designers, (and to be clear, I believe our government is a system designer) always wage war against unintended, unknown or poorly considered effects of their designs.

How the system actually functions is a direct result of the work and preparation in creating it. To that, my point is: The entire financial system is, has and shall operate EXACTLY the way it was designed to.

If we desire different outcomes, then we must put the work and preparation into creating a new design. Or eliminating a number of the features entirely, as Professor Perry may suggest, based on his article.

 
At 12/23/2010 5:11 PM, Blogger Jason said...

Morgan, one additional thing regarding circuits. It's a very funny thing to me when a fellow engineer comes to me for advice about a circuit and says "it's not designed to do that." My reply is always: "It has to be, why else would it be doing what it is doing?"

 
At 12/23/2010 6:01 PM, Blogger morganovich said...

""it's not designed to do that." My reply is always: "It has to be, why else would it be doing what it is doing?""

i still think you are confusing intent with outcome. i realize that it's intended to be a bit tongue in cheek, but "designed" implies intention. how would one design without intention?

you don't design a circuit to short and catch fire, but some do, in accordance with physical laws.

you also don't design a coat hanger to be a back scratcher, but it may be a perfectly good one.

 
At 12/23/2010 8:05 PM, Blogger Jason said...

Morgan, great point about the coat hanger/back scratcher. But I think that might fall into the misuse category. Misuse is always a tricky thing when you design anything. For complex items you try to limit the bad things that can happen under misuse.

But the disconnect here is "breadth of intention." Just because you didn't intend for something to happen doesn't absolve a designer from responsibility when it does.

To use your example of a circuit catching on fire, it had better not have occurred because the design did not account for overloading and over temperature. And then there should be a good system description of how the circuit should be used and what it's limitations are. The breadth of intention in design MUST account for all use and mis-use. Otherwise you'll get all the problems you should learn to expect.

With regards to the financial system and crisis, mis-use would have to result in broken laws, as the laws are supposed to apply to everyone without exception. So if laws weren't broken, then the system design didn't account for all the consequences and/or use cases. Understand lack of design is still design, so I contend the system did exactly what it was supposed to.

There are a lot of lessons here, but the most important one, and most topical to me, is how legislators are increasingly putting in place more complicated (and not robust) systems to shape or regulate different industries and systems. And after the inevitable crisis we always hear things like: "This is not what the system is supposed to do."

 

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