Barack John
Left and rights of passage
Black and whites of youth
Who can face the knowledge
that the truth is not the truth?
Obsolete Absolute

Ron Ralph
Cruising under your radar
Watching from the satellites
Take a page from the red book
and keep them in your sights
Red alert Red alert

USN

All six factors show up in Hayek's intertemporal coordination theory of credit-based business cycles. Why does nobody read Hayek?

It's my understanding that the investment firms were leveraged approximately 30:1 (the max allowed).

I'm no math genius. But it doesn't take a wiz to see that at 30:1.. it don't take much to go broke.

This may be a Joe Six Pack analysis, but if there's a shortage of loans isn't the usual solution a rise in the interest rate until demand for loans decreases or savings increase? I feel like the American people still have money they could lend.

Posner: I also agree that caps on the salaries of the executives of banks that participate in the bailout are dumb.

So if Bush had been paid more, he would have been smart enough to see the financial collapse coming and would have taken steps to prevent it?

The idea that leaders will make better decisions if they are paid more is a lot like the idea that medieval kings would make better decisions if they were allowed to build luxurious castles for themselves and eat off gold plates. At the end of the day, you don't attract better kings, you just attract people who like to eat off gold plates.

The key innovation of democracy was recognizing that you don't want decisions to be made by some single maximally "superior" person: you want the decisions to be made by a system. You don't want the king deciding whose head to chop off based on his "gut": you want a system of laws and judges and lawyers and juries.

If a company needs the assembly line to be more productive, it doesn't pay the workers more: it hires more workers. If a company needs to be making better business decisions then it should expand it's leadership staff to include more analysts and experts with the relevant expertise.

Excessive executive compensation is more the symptom (of a medieval approach to leadership) than the disease but it is ridiculous to claim that excessive levels of executive compensation serve some sort of useful purpose.

I am still not buying it. Six factors or sixty! Even if I accept the excessive risk model created by these factors, that is still risks, not failures! The cause of the failure (or loss) is due to the fact that we have loans that are bad. Tons of them. In good times or bad, there are always loan defaults. But the fact that the Congress had more or less beaten the banks into writing loans to people who have no prospects of servicing the loan was the real reason for the mess. The risk model amplifies and spreads the mess; that much is true.

Sure, Congress did not write laws that said that bank must loan money to those who could not pay it back. But when bank presidents were constantly threatened with legal actions or onerous regulations unless they could show they made as many loans to poor neighborhoods as in wealthy neighborhoods, could we expect anything different? Especially if you turn loose your mortgage salesmen and tell them to relax the lending criteria.

Sorry, Judge. You are still refusing to call the advocates of the liberal agenda to the carpet.

I also take issue with your defense of the Government taking equity stakes in "private" companies on a temporary basis, although your famous economic analysis seems to support the model. First, it creates a bad precedent. It is also not clear that any "exit strategy" will work. The government might end up finding itself unable to unload the equity because the business entity continues to be unattractive, but is always too large, or too government-involved, to fail. Sort of like the war in Iraq. This is not like the government is buying a few hundred shares…I have never seen a government-owned company make money. Anywhere. Ever.

I think the approx $12 trillion in US mortgages outstanding is backed by about $6 trillion in post-crisis home value. About 50%.

If this is true, than one inevitable purpose of the bailout is to allow the Gov't to choose which financial institutions will survive or not.

I would far prefer the gov't to be offering 50% of the last mortgage price for all foreclosed properties -- putting a floor under housing, and making the value of the MBS less uncertain.

Of course, most homeowners would be demanding a new, much lower mortgage. And they should.
The biggest failure of the bailout is that it doesn't push the banks to offer lower cost mortgages for the same houses that are now worth much less, if not worthless.

I'm gonna guess the judge's point about the UNwisdom of trying to legally limit exec comp at financial firms is that they already operate too much like a United Nations of Banana Republics for it to do any good. Like the old saw about the guy who spends $500K to run for a city council seat that pays $50K ABOVE the table, no telling how much below (til somebody snitches him out). That's one more risk the system doesn't need with $350 Bil in new cash to be sloshing around in a matter of weeks.

It is a political season, so I think so many people are looking for election-related answers to these questions. Posner is right, however, that government does not cause boom and bust. Thank God government does not control our economy. Capitalism is not smooth sailing; there will always be ups and downs; risks and rewards; fortunes made and fortunes lost; businesses born and businesses spectacularly fail. Governments are able to magnify or ease a crisis, but they rarely create them from scratch or prescribe a cure-all that makes the bust system go away.

I'm one of those who thinks Judge Posner wrong on government's role in causation. If the government agrees to insure all (or at least a sizable portion of) the bad paper you write in the express interest of achieving a political goal and succeeds, they are more than merely complicit. One must concede there's plenty of blame to go around both public and private, here. Nevertheless, to say that government encouragment of certain corporate (or quasi-corporate in this case) actions in pusuit of political aims does not cause those actions when they occur, is a kind of hairsplitting that, at least, borders disengenuousness.

In both 2003 and again I believe in 2005 the Bush administration (for which I have little love and almost no respect), claiming to be alarmed by the purported accounting irregularities that drove former management (Franklin Raines) out of Fannie Mae, did, to their credit, attempt to have Congress put the brakes on that runaway organization. The proposed legislation was killed in committee on strict party line votes both times. Demonstrating, once again, the incomptency of politicians in regulatory or commercial arenas.

And no one exonerates this market based on the failure of government to properly regulate it. Still, regulatory failure is a failure of government and a reason not to trust the government to solve a crisis they (at least in part) caused and failed to ameliorate by useful regulation.

Democratic governments should not own companies. Heavens knows they have a tough enough time finding concensus to govern. They will never find consensus to run the companies satisfactorilly and what consensus they will find will be political, not economic. Just like with Fannie Mae that they didn't even own, just performed "oversight functions". It is no solution to poor coprporate decision making (of which there's plenty in this current situation) to substitute even worse political decision making.

And it's OK if it's temporary? If it's a bad idea, it's a bad idea. Hanging is no less bad if you only do it for a short time. And what makes you think it'd be temporary? A bureaucracy would be created to manage these assets, no? And when, I ask you, in the entire history of human affairs, has any bureaucracy ever voluntarilly limited either it's scope or duration?

Learning from others:

> Suppose you were an idiot.
> And suppose you were a member of Congress....
> But then I repeat myself.
> -Mark Twain
>
> I contend that for a nation to try to tax itself into
> prosperity is like a man standing in a bucket and trying to lift
> himself up by the handle.
> Winston Churchill
>
> A government which robs Peter to pay Paul can always depend on
> the support of Paul.
> George Bernard Shaw
>
> Democracy must be something more than two wolves and a sheep
> voting on what to have for dinner.
> James Bovard, Civil Libertarian (1994)
>
> Foreign aid might be defined as a transfer of money from poor
> people in rich countries to rich people in poor countries.
> Douglas Casey, Classmate of Bill Clinton at Georgetown
> University
>
> Giving money and power to government is like giving whiskey and
> car keys to teenage boys.
> P.J. O'Rourke, Civil Libertarian
>
> Government is the great fiction, through which everybody
> endeavors to live at the expense of everybody else.
> Frederic Bastiat, French Economist (1801-1850)
> .
> I don't make jokes. I just watch the government and report the
facts.
> -Will Rogers

> If you think health care is expensive now, wait until you see
> what it costs when it's free!-

P.J. O'Rourke

> In general, the art of government consists of taking as much
> money as possible from one party of the citizens to give to the
> other.
> -Voltaire (1764)

> Just because you do not take an interest in politics doesn't
> mean politics won't take an interest in you!
> -Pericles (430 B.C.)

> No man's life, liberty, or property is safe while the
> legislature is in session.
> -Mark Twain (1866

)
> Talk is cheap...except when Congress does it.
> -Unknown

> The government is like a baby's alimentary canal, with a happy
> appetite at one end and no responsibility at the other.
> -Ronald Reagan

> The inherent vice of capitalism is the unequal sharing of the
> blessings. The inherent blessing of socialism is the equal sharing of
> misery.
> -Winston Churchill

> The only difference between a tax man and a taxidermist is that
> the taxidermist leaves the skin.
> -Mark Twain

> The ultimate result of shielding men from the effects of folly
> is to fill the world with fools.
> -Herbert Spencer, English Philosopher (1820-1903)

> There is no distinctly Native American criminal class...save
> Congress.
> -Mark Twain

> What this country needs are more unemployed politicians.
> -Edward Langley, Artist (1928 - 1995)

> A government big enough to give you everything you want, is
> strong enough to take everything you have.
> -Thomas Jefferson
>
>
>

Wonderful post, clear and neat explanation. I just hope that the people that think as Dr. Becker can understand this and open their mind a little broader from their free market fanatism.

This bailout is just one more example of the indivisible handjob stroking irresponsible CEOs and CFOs with billions so that they can run the American economy even further into the ground. So much for Keynesian economics. If the goal is to stimulate the economy, why not give the money directly to the American taxpayer? A bird in the hand is worth two in the bush administration.

Jim,

Thanks for that post. Man, I needed a laugh about this. Well done.

What I see as the key difference between free-market advocates who oppose the bailout and those who support it is focused on this passage from Posner's most recent post:

"The third point is the most important, and let me pause on it. The idea behind it is that the value of the "bad" assets that the banks hold is unnaturally depressed by the panic that has seized the financial industry. The bailout will dispel the panic and so restore the "bad" assets to their true, "good" value. The government will need only to hold the assets until their maturity and it will be able to sell them then at a price equal to or even higher than the "excess" price that it will have paid for them during the bailout."

I would argue that Judge Posner has it exactly backward. The prices have fallen to their real level after being artifically inflated. The bailout freezes the higher prices and misallocation of resources in place. Why do I say this?

Relying on the Austrian view of the business cycle (see F.A. Hayek's *Prices and Production,* 1931 and *The Pure Theory of Capital,* 1941) the Federal Reserve's artificially lowering the interest rate to stave off deflation (in the sense of the stock of money falling) in the earlier years of this decade induced an overinvestment in certain sectors of the economy. In our present situation, the money flowed to housing facilitated by governmental efforts to increase housing for low income minorities. There is no question that the Fed followed this policy.

Due to the overinvestment in housing, the price of real estate rose dramatically. The dynamics that drove up house prices that Judge Posner describes did occur. But it was brought on by the Fed's monetary policy leading investors to believe that there was sufficient real demand and real savings to support the upward movement in the housing market. According to Austrian theory, when the central bank takes on itself the responsibility to stimulate the economy without regard to real factors of demand and savings, the lower interest rate misleads investors to invest too much and produce the good at rates higher than can be sustained over time.

If Hayek's analysis were not accurate, why did so many skilled entrepreneurs and investors have such a terrible misperception of the market simultaneously when they have a track record of making sound judgements? I agree that the newer financial instruments made this problem worse. But I would argue that Judge Posner has again reversed relevant factors causing the crisis--here he has reversed the root cause and a contributing factor.

Of course, not bailing out the banks is likely to bring on a credit crunch and a recession.
With the bailout, we are likely to simply push the problems off into the future bringing us either inflation to pay off the debt or a recession when the inflation ends (if it did not end, then we would get hyper-inflation). We are already getting inflation now from the previous monetary expansion. We may get stuck in stagflation for a while--then either recession or inflation (due to either a constrictive monetary policy or an expansionist one to delay a downturn). The recession is coming no matter what. It is just when we want to take it.

The cause was not the market but the overexpansion of credit by the central bank. Some of the dynamics of the market exacerbated the misdirection of economic actors brought on by Alan Greenspan's fear of deflation ala Japan and the Great Depression. What monetarists overlook is that if the stock of money falls dramatically and prices are allowed to fall in a proportionate manner, then the economy will correct itself. Perhaps, we should listen to Dr. Phil instead of Dr. Greenspan when Dr. Phil says, "whatever you fear most, you will bring about."

"Cycles of boom and bust are intinsic to Capitalism". This sounds like Schumpeter and Kondratiev Wave Theory. Specifically, Long Wave Theory and it's modern development by Marchetti & Modis. It may very well be. Yet, we still need to minimize the impact on the Social order and population at large. Clearly, we can't depend on the Finacial Industry to take care of it. They're the ones in trouble, or Wall Street, they are not too far behind. So who's left? The U.S. Government. For better or worse.

As Robert E. Lee so aptly muttered at the beginning of Gettysburg, "God's Will".

Neilehat, I think you are on to the underlying problem more broadly conceived. We have turned away from God in the United States and Europe. We fail to see the rational order of the universe, both in the physical world and in the social world as evidence of the Divine. In fact, we can see it if we open our eyes and minds to what lies before us. Instead, we believe that we can defy the order God gave us and insulate ourselves from the fallout. We think we can control things and manipulate people as if they were objects in a room. Then when our own manipulations reach a breaking point as we defy the rational principles that God gave us to live by, we are left in confusion and in the wake of the destruction we set ourselves up for.

Below is a link to Frederick Hayek's Nobel Prize lecture, "The Pretense of Knowledge." I am afraid that the Chicago School monetarists have fallen into the hubris that Hayek discusses in his lecture. Certainly, the Keynesian Revolution did.

As Bernard Levy said mocking Nietzsche, "God is dead, Marx is dead, and I am not feeling so well myself." We can add Keynes and now Milton Friedman to Levy's roll call. When we found God to be irrelevant for modern man, something died inside us and the corpse is Western civilization.

General Lee pushed it too far at Gettysburg because he thought the Army of Northern Virginia was invincible. Perhaps God is speaking to us now in our failure as he did the South in defeat.

http://nobelprize.org/nobel_prizes/economics/laureates/1974/hayek-lecture.html

This is a rather disappointing post by Judge Posner. For example:


"It is possible that the banks' problem is not, or at least not only, undercapitalization because of the decline in the value of their assets, but lack of liquidity, which is different."


Declaring that declines in asset values and illiquidity are "different" ignores reality.

As a 23 year old law student about to enter this fledgling workforce, I feel that the source of this economic calamity goes much deeper than financial instruments or government (in)action. In my opinion, what got us to this point is not inaccurate interest rates or poorly regulated mortgages. Our mistake was in believing that "If we can just tweak interest rates or decrease inflation or blah blah blah," it will all balance out. Our mistake was in trusting that the hypercomplex jargon being tossed around by snakes in suits was valid simply because it seemed over our heads and their suits were nice. This country was founded by hardworking farmer folk with callused hands in home-stitched clothes. It was their dedication to community, justice and family values that took us from a newborn democracy to a global superpower in just two centuries. But we all agree that power can be a double-edged sword, and I feel we're just now starting to feel the cut from the other side of that sword. America would currently best be caricatured as a rich fat kid who lies around on the couch demanding global prominence without ever wanting to lift a finger. The financial industry is a perfect reflection of that - we don't want to have to create new things or contribute energy - we'd rather just lie around on the couch and "let our money work for us."

I believe the end of the 20th century produced a generation of snakes in suits who justify their own immorality as "the American way." As we speak, hundreds of millionaires who have never worked a day in their lives are slithering around Washington, STILL trying to tweak financial instruments so that the corporations who bought their Seat stay in the black. Maybe I'm naive, but I have a feeling that deep down inside each one of those snakes is a family man or woman who entered the public service arena to protect the interests of their loved ones. Somewhere along the line, they sold out to corporations in the mistaken belief that corporations have our best interests in mind. But a corporation (at least the 20th century version) only has one interest - BOTTOM LINE SHORT TERM PROFIT. So the snakes got what they wanted - bottom line short term profit. In the meantime, they've neglected the generations to come and in many cases the Constitution that gave them any power in the first place.

No, the changes that need to take place before this country ever restores itself to global prominence are not going to be found in the minds of Harvard Business grads. As phony as it sounds, the Best Bailout Plan we have lies in the hearts of every American who is only being further fattened by all of this government intervention. Washington is showing a grave lack of faith in the resilience of the American people by "saving" us from that looming D-word we're all so afraid to confront. Let us feel a depression. It may not be what's best for your kid's trust fund, but in the long run it will wake us up to how off course our system is. And somewhere in the heart of every fat rich kid on the couch is a fighting, innovative spirit that will one day "bail us out."

It doesn't take a Masters in Economics from Yale to know that you can't create capital out of thin air, which is precisely what all these complex financial instruments are designed to do. As a 23 year old, I'm part of a generation that just can't wait for the baby booming Gordon Gekkos to croak & turn over the keys to the White House. Thanks to information technology, our generation is more informed as young adults than those snakes in suits are in their old age. We understand the dynamics of the global economy, and as I wrote on the final page of a book I just self-published: "Intelligence - Surge. Disciplines - Merge. First Generation of Global Citizens - Emerge." So until the snakes in suits all clear out of Washington, we're just going to keep blaring our dirty rap music & communicating on MySpace. If you guys ever want our attention, us dumb poor kids who were once revered as the American people, just text us. Or do you know what that is?

- Taylor J. Simpson

Just when it all gets too depressing, a much needed laugh arrives:

http://www.youtube.com/watch?v=uZUXXSxZPhw

A funny song about the bailout.

Whether the government will or will not actually make money on these assets, I believe you underestimate the market problems created by the negative "animal spirits" out there w/r/t these assets. Many of these assets are trading far below what a simple discounted cash flow analysis would suggest is their value-- even assuming foreclosure rates substantially higher than likely.

That suggests that investors and managers of investments are showing the kind of avoidance of volatility and uncertainty that has been shown by Tversky and Kahneman.

Taylor, I take it you've never lived through, seen, experienced or studied Depressions and their impact on Social and Indvidual Psychology or the Socio-Economic Order in general. Wishing a Depression on someone is like wishing a Nuclear War on someone so that it will "toughen" them up.

That's the attitude the Nazi's and Japanese War Mongers had about us, not too mention Al Qaeda. Guess they found out differently. The majority of us are tough enough as it is. We certainly don't need a tough love program to make us stronger.

Now that you've finished Law School, welcome to the real world. Where you are about to have to re-learn "everything".

The medical profession or if you wish the healthcare industry has become so complex and post modern that the physicians have given over control of most of the process, input and output, to others by virtue of excessive division of labor. Perhaps not intended but a reality nonetheless. Perhaps the same dynamic is extant in our political and financial lives vis-a-vis the average citizen. Has anyone ever developed a curve to suggest that the relationship between complexity, division of labor and efficiency reaches a point of failure or inverse proportion? As an aside, I might also add that every modern ethicist, regardless of their theory or persuasion, would find those responsible for this mess utterly immoral.

Great post.
For further research it might be helpful to look at the way the Israeli Government delt with its banking crsis in the mid 80s (referring to the third point in the post). The Government offered to buy the stock from the shareholds in exchange for bonds - and made alot of money in the proccess. so buying the stock might not be such a bad idea after all.

Jim, good trial lawyers and able judges belly-ache every day about the civil justice system's exorbitant costs, inefficiencies, and diminishing returns. Corporate America is now spending more money to monitor and preserve electronically-recorded information that might become discoverable in a lawsuit than on product/service improvement and compliance aimed at averting litigation.

Q1. Why isn't the financial crisis on Wall Street palpable on Main Street? Although financiers, journalists and politicians have been warning of a major financial crisis, as big as the Great Depression, since August 2007 (some economists have been warning for several years now), normal economic activity seems unaffected, or at least the common man does not seems to feel any impending doom. Why is this so?

A. To a large extent, the current financial crisis does not involve the working capital of the American economy. The funds available with the commercial banks, community credit unions and credit card companies have been sufficient to keep business investments, payrolls and consumer spending going on in the near-term. Sure enough, the persistent gloomy predictions on the economy seen in the newspapers and television channels, throughout the year 2008, would have had a negative effect on the confidence of the consumers and the business entrepreneurs. This would have led to cutbacks in production plans, tightening of credit, mark-down of inventories and penny-pinching of family budgets. But, on the whole, the real economy has shown unexpected and prolonged resilience. No doubt the action of the US Federal Reserve Bank to pump over one trillion dollars into the economy for over-night and short-term lending has also eased the flow of money. But, the main reason for the disconnect between Main Street and Wall Street is that the financial crisis is concerned with the accumulated capital (as opposed to working capital) of the American economy.

The term accumulated capital refers to the capital held by (i) pension funds which hold the life-time savings of Americans, (ii) reserve funds which hold the accumulated profits of large corporations and private companies, (iii) mutual funds and money-market funds, which hold savings of individuals that are in excess of mandatory life-time savings like social security, and are more freely invested in the markets expecting a better return than from treasury bonds, (iv) endowment funds, held by private trusts, which are collected through charities and donations, (v) hedge funds and private equity, (vi) any other entity that holds capital that has accrued through the savings of individuals, or the profits of private organizations, or the surplus of state, local and federal governments, and is not needed as immediate investment for the day-to-day functioning of the economy.

To provide a perspective on accumulated capital, one may note that the financial wealth in the American economy is estimated to be $40 trillion (ref: Wall Street Journal Oct 1, 2008 article by Professor Edmund Phelps). Wikipedia states that the world-wide value of all pension funds are in excess of $20 trillion; mutual funds total more than $26 trillion. Please note that it is possible that some of the pension funds are invested in mutual funds. Also, I am not aware of what is the exact total sizes of pension funds, mutual funds and other constituents of accumulated capital within America per se, but I would assume that they add up at least to $10 trillion (which, I suppose, is included in the $40 trillion quoted above). In additions, hedge funds have about $1.5 trillion under their management totally, all of which is investments from individuals of high net worth.

Q2. Aren't saving for retirement, insurance and pension systems old phenomena? Why did they bring down Wall Street this time?

A. Yes, pension and insurance systems were already well-developed in the industrial economies of 19th century Europe. There are two major differences this time around. Demographically, the senior citizens of 19th century Europe retained close ties to the younger generations because of genetic, ethnic and racial homogeneity. As a result, the pension amounts received by the retired people were substantially supplemented by contributions from inter-generational and intra-family transfers of wealth. If we go back a hundred or more years, old people lived with their families and helped to bring up their grandchildren. Moreover, hereditary transfer of wealth was still as important as creation of new wealth in the industrial economies of the 19th century. These factors served as economic incentives for the working adult population to provide old-age care for their parents, which supplemented the parents' income from pension. The second difference is that the dichotomy between an empire and a democracy was far more prominent among the nations of 19th century Europe. People felt assured that the social infrastructure provided by an empire would safeguard their standard of living through their old age. Examples of the social infrastructure of an empire during 19th century Europe are the establishment of universal heath care, the administration of the pension and life insurance systems, and subsidized public transport and postal systems. As an aside, it may also be mentioned here that the development of the modern university was pioneered in Germany during the 19th century.

Thus the fundamental reason for the current financial crisis is the time value of money. To maintain the standard of living that people who are close to retirement or have already retired would expect, the income from their pensions have to be substantially larger, in view of the reasons discussed above, than what a senior citizen in 19th century Europe would have received, even after adjusting for inflation and GDP growth. This enhanced pension income would have to come from interest on investments, because the senior citizens who receive them could not possibly compensate for this income with active work. Thus the managers of pension funds found it imperative to look for high returns on their investments. At the same time, since these funds were so huge and so critical to the lives of many millions of people, their investment strategy had to exercise the utmost caution. Diversification served as the compromise in this situation. The managers of these huge funds would invest the major part of their portfolio safely, for example, in treasury securities. A smaller part would be put under the stewardship of the Wall Street firms for more risky investments in the expectation of high returns. Over a period of two or three decades, such unreasonable expectations on Wall Street to keep generating high returns on capital took its toll.

Q3. How exactly did unreasonable expectations bring down Wall Street?

A. When one refers to Wall Street, it is important to keep two types of people in mind. The first type is the senior executives who have gained their credentials through many years of involvement in the traditional roles of investment banking, beginning in the 1950s or later. The conventional wisdom among these people places a lot of importance on trust-worthiness, reputation, people-skills and management techniques as the path to career-success. Advising industrial firms in mergers & acquisitions, underwriting the issuance of company stocks and bonds to the public, helping the government finance a deficit through the purchase of treasury securities for their clients, and trading in securities on behalf of their clients were the main activities of Wall Street firms before the 90s. We note that all these activities required trust-worthiness primarily, and moreover they didn't require much of the firms' own capital. The second type is the smart, innovative PhDs who have arrived on Wall Street starting from the 1980s. These people have helped build the massive computational infrastructure on Wall Street along with the development of financial innovation. Their most valued skills are quantitative and they are quite tech-savvy. On the downside, many of the senior executives making up the first type have come to exercise a lot of political influence which could be illegitimate sometimes. For their part, the tech-savvy 'quants' of the second type have grown-up with post-modern, anti-heroic sensibilities that has no use for honor or reputation, as defined conventionally. However, in spite of their differing attitudes towards reputation and the 'word on the street', when it comes to compensation, both the types would like to cash in on their professional worth right away with large bonuses.

The advent of computers transformed the industrial economy into an information-based economy. This meant that smart people who could devise intelligent strategies to take quick advantage of the flow of information could expect to make large profits, especially from financial investments. Thus, starting in the early 80s, Wall Street investment banks began to make huge profits, aided by their large investments in computers and their new army of smart PhDs. Over the course of the 80s and 90s, the capital in the 'bulge-bracket' investment banks grew from a few tens of millions to one or two dozen billions dollars. The capital in the smaller investment banks and hedge funds on Wall Street produced similar returns. Thus Wall Street turned into a sleek and mean money-making machine. It was for its massive returns on capital that the managers of pension funds and other sources of accumulated capital had been turning steadily to Wall Street. The boom in the technology stocks during the 90s turned the trickle of capital to Wall Street from these fund-managers into a flood. Now, as history would have it, the technology sector went bust in 2000 with the NASDAQ composite index losing more than 60% of its value between 2000 and 2003. This drastic loss of wealth exposed an inability of modern finance theory to figure out how to determine the proper economic value of technological progress. There was a big question about how Wall Street could continue to churn out its massive profits. It was in this scenario, that the smart PhDs on Wall Street stumbled on the great innovation to direct the huge sources of accumulated capital in America and the rest of the world towards solving the long-term demographic incongruities in America. This was how Wall Street came to trade in mortgage-backed securities. In the process, they found a way to keep the money-machine that is Wall Street hum along smoothly for another 8 years.

Now, the smart PhDs that form the second type came up with a lot of innovations to carefully control the risk involved in turning a housing mortgage loan into a hierarchy of claims on payments, called tranches. For their part, the senior executives that form the first type, who had built up a reputation for trust-worthiness over several decades, could borrow money from the pension funds and other sources at leverage ratios of 25 to 30 -- far in excess of the reserve ratios expected from the commercial banks under the regulations of the Glass-Steagal act. This unlikely marriage of old wise-heads and smart innovators on Wall Street was sanctified by the Federal Reserve which kept interest rates low to avoid a slowdown in economic activity, given the tragedy of 9/11. However, from 2007 onwards, cracks in the marriage began to appear one by one, and it became apparent that the party had gone on too long. The smart PhDs had not take into account that the process of securitization separates the property rights on mortgaged homes from the investments on mortgage securities. The home-owner lives under the threat of foreclosure. So, his/her property rights are compromised. The security-owner bears liquidity risk and credit risk. So, his/her income is uncertain. It is plausible that left to themselves the smart PhDs would have, in due course of time, overcome their error by devising a market-based solution that would mutually alleviate the grievances of the home-owner and the security-owner. However, the Wall Street money-machine was on high-gear by then, and it was not designed to slowdown for any eventuality. The senior executives, who were more comfortable with people-to-people communications rather than arcane finance theory, ran to their long-established connections in the political establishment and the media. Moreover, these senior executives decided to play smart. They used the very same unreasonable expectations that society had placed on Wall Street as a bargaining chip to hold society to ransom. Their constant chants were "Bail-out Wall Street, for otherwise there is the 'systemic risk' of a financial meltdown". "It's going to be armageddon, so raise FDIC insurance to $ one million" (CNBC's Jim Cramer). "We're going to see a repeat of the Great Depression's bank runs". Unfortunately, the long sage of bail-outs starting with Bear Stearns in March 2008, then Fannie Mae, Freddie Mac and AIG in September 2008 and finally the $700 billion bill passed now have not stemmed the financial crisis, and the reputation of Wall Street is in tatters. Thus Wall Street was brought down by unreasonable expectations.

Q4. So what about the billions of losses due to mark-to-market accounting rule? Could these losses lead to financial meltdown? Also, why is de-leveraging cited as a reason for the huge losses? Why is re-capitalization of the banks necessary?

A. In view of the explanations above, it is far simpler to think of the situation as follows. The 'bulge-bracket' Wall Street investment banks (that have now been converted into bank-holding companies or have gone bankrupt) had about $20 to $30 billion of capital each. Wall Street was so used to annual returns of 20% or more on capital before the collapse of the technology sector in 2000. To maintain this high rate of return after 2000, the investment banks resorted to leverage ratios of 25 to 30 in their investments on mortgage securities. This means that each of them borrowed about $750 to $900 billion from the pension funds and other sources. The reader might ask what is the collateral for this borrowing? The investment banks would purchase mortgage securities with this borrowing and submit these same mortgage securities as collateral to the pension funds. The payments received from the home-owners on these mortgage securities would be used to first pay the interest on the borrowings from the pension funds, and the rest would be the profits of the investment bank. In view of the leverage ratio of 25 to 30, a net difference of only about 0.8% in the interest rate received from the home-owner and the interest rate paid to the pension funds would ensure a rate of return of 20% or more for the investment bank. However, the problem with this scheme is that the pension funds only had the trust-worthiness of the investment bankers and the mortgage securities as assurance against the money they lent out. Of course, they also had the enticement that only the Wall Street money-machine could provide them the rate of return adequate to keep up with their large pension payments to senior citizens.

With a fall in the house prices, there would be a corresponding fall in the mortgage securities due to the risk of foreclosures. Moreover, these mortgage securities were structured in such a way that foreclosures of mortgaged homes would be reflected in increasing degrees as one went lower down the tranches. Thus the lowest tranches would lose value very quickly in the event of a fall in house prices. So, the pension funds and mutual funds would need to assess the value of the mortgage securities in their accounting books periodically, say once every quarter, to safeguard their interests. For this, they would need refer to the market value of these securities (mark-to-market), and to request the investment bank to replenish the collateral, if there is a drop in the market value of the mortgage securities. Unfortunately, since the leverage was so high, an average drop of 3% in the market value of the mortgage securities could mean that after the pension fund's collateral was replenished, the whole amount of the capital of the investment bank ($20 to $30 billion) would have to be replaced. This was what led to the bankruptcy of some of the large investment banks. The story with smaller investment banks and the hedge funds is similar. Now, if the pension funds simply didn't insist on mark-to-market accounting, then the investment banks would receive regular payments on the mortgage securities from the home-owners. Over time, the pension funds would recover the full amount of their investment along with the rate of interest that the they had expected, with the only risk being that of foreclosures. There would be no risk that the prices of the mortgage securities would fall due to illiquidity in the markets. Thus financial meltdown would be avoided, with or without the existence of the Wall Street firms.

However, this argument turned out to be the Achilles' heel of the investment banks. Working in their old trust-based mentality, they thought they could ride through this financial crisis if they simply convinced their creditors to rescind the mark-to-market rule and give them more time. They didn't find it necessary to sell off the risky mortgage securities and cut their losses, nor were they seriously looking to raise new capital. And they were caught by surprise when the end came. For the same reasons cited above, the investment banks and hedge funds that survived found that their capital had been seriously eroded by this need to replenish their creditors' collateral. Hence the banks need to be re-capitalized. However, it is not clear that the government should do this re-capitalization through its $700 billion bill. Moreover, the surviving investment banks and hedge funds have realized that such high leverage ratios are not sustainable. So they would like to sell off the mortgage security and pay off some of their borrowings to the pension funds. But since they are all looking to sell off in the short-term, the prices of the mortgage securities are lower, which again requires further de-leveraging. This phenomenon is called the 'paradox of de-leveraging'. However, the real economy on Main Street need not wait for Wall Street to de-leverage. As I mentioned above, the financial meltdown would be avoided with or without the existence of the Wall Street firms. De-leveraging is solely Wall Street's problem, and it is highly unprofessional for Wall Street executives to keep sending out predictions of impending doom in the media.

Q5. Why have the markets for mortgage securities continued to remain illiquid?

A. The main reason that the markets for mortgage securities have been illiquid for a prolonged period of time is that the home-owner who is the only party with a credible and serious interest as a buyer of the mortgage securities has been shut out of the market. Instead of directly involving the home-owner, Wall Street has been peddling bizarre theories about risk management that has resulted in this huge mis-allocation of this $700 billion recently. By providing the information for a direct match-up of the home-owners on Main Street and the security-owners on Wall Street, the government could implement a low-cost eBay-type bidding system that would enable the home-owners to bid for the various tranches in the mortgage securities issued on their homes -- those tranches that the banks want to get rid of. This way the home-owners stand to benefit from a reduction in their debt obligations. The security-owners gets a floor on the prices of the mortgage securities and because of the decent prices, their capital gets replenished. Moreover, the home-owners' debt reduction can be structured in a way that encourages good behavior, and timely re-payment of the rest of the mortgage loan. This process would cost less than $1 billion for the government and achieves the objectives of liquidity and re-capitalization stated in the $700 billion bill. In addition, this direct match-up plan reduces foreclosures by reducing the home-owner's debt. Professor Martin Feldstein has also proposed a plan to reduce foreclosures. In his plan the government re-negotiates the home-owners' loans to provide debt reduction through low-interest loans, in return for enhanced claims on the home-owner. In my plan, the government's role is solely to provide reliable information.

Q6. What exactly is this great innovation of directing accumulated capital towards solving demographic problems that Wall Street has achieved?

A. Throughout history poor people have lived in subsistence conditions. Due to shorter life expectations than exist today, a poor man would have had to work for a living all his life. As mentioned above, the industrial economies of the 19th century Europe enabled the rise of a broad middle class with the means of hereditary wealth transfer and of supporting retired lifestyles. Contemporary times have raised the possibility that this access to wealth of a middle class standard could be further broadened to the whole of the population. Over the course of the 20th century, home-ownership had come to be a fundamental middle class aspiration throughout the world. In his "Lectures on Economic Growth", Professor Robert Lucas cites the travails of the characters in Sir V. S. Naipaul's "A House for Mr. Biswas" as the model for growth and development. Of course, I should also mention that Professor Lucas is more directly concerned with developing human capital rather than with home-ownership in his lectures quoted above.

Historically, massive accumulations of capital that are unrequited, have always been problematic. In addition, accumulation of capital has also resulted in the military-industrial complex. Professor Jeffry Frieden's "Global Capitalism: Its Fall and Rise in the Twentieth Century" is an excellent narration of how promises of global capitalism at the beginning of the 20th century quickly unraveled into the two World Wars. Thus matching the culturally and racially homogeneous retirement age population with the more diverse and younger home-owner population finds a gainful investment for the accumulated capital.

Q7. If Wall Street has been achieving all these great feats, where did it go wrong?

A. When concerns about the mortgage securities surfaced last year, many Wall Street investment firms claimed to be safe because they had not invested in sub-prime mortgages. This created a fear psychosis whence people began to consider these sub-prime mortgages as 'toxic'. The prime mortgage is one which meets the eligibility criterion for purchase by Fannie Mae and Freddie Mac. This includes a 20% down payment and good credit score. Those mortgages that don't meet this criterion were called sub-prime. Gradually, Fannie Mae and Freddie Mac also began to deal with these sub-prime mortgages. So, it didn't make sense to be denigrating sub-prime mortgages. Wall Street wasted a lot of time in late 2007 and early 2008 trying to discredit the sub-prime mortgages. In the modern economy, every single participant is beset with economic insecurity. So, the distinction between the prime and the sub-prime borrower, while it exists, is not really that great. Moreover, it is the sub-prime borrower who stands to gain the most by way of the development of human capital that Professor Lucas discusses in his "Lectures on Economic Growth". So, the sub-prime borrower would be the most willing, in the long-term, to highly value the inter-generational trade of wealth to support the senior citizens. Thus to discredit the sub-prime borrower has been the single major mistake that led to the financial crisis on Wall Street.

Q8. What are the lessons that can be drawn from the current financial crisis for government involvement?

A. Government's role is very important for avoiding crises, like the current one, in the future. The government should ensure that public transportation is available from home-owner colonies to their places of work. Most of the new single family homes are built in colonies of 100 or so, with whole neighbourhoods of new homes developed together. These new home colonies form suburban communities around cities and they are the symbols of affluence near towns. Because of their distance from the business districts, millions of these new home-owners drive their own cars to work. For example, it is not uncommon for software engineers and other professionals living near the Washington beltway to spend two or three hours on the road every working day, by way of commuting to work. Many of these new home colonies do not have frequent public transportation service. If the government would ensure that convenient and timely public transportation to their place of work is available, then this would save billions of dollars in oil expenses for America. Moreover, this way, the automobile would be seen as a luxury product, to be used in the evenings and in the weekends for entertainment, rather than as a necessity to get to work. This way the market for higher-end automobiles would benefit.

For people buying new homes, the government should ensure that they are fully informed about the economic and financial aspects of their investment. Equally importantly, they should not be overloaded with irrelevant, unreliable and unnecessary information. The best step would be ensure that the new home buyers are aware of the Case-Shiller Home Price Index. Currently this index is available only for 20 major American cities, and the data is collected for repeat sale homes, not new homes. But, being aware of this index is the best way new home-owners can be equipped for making financial decisions about their homes. The government should assist the managers of this price index financially so that they can gather empirical data for the prices of homes in all residential communities in America, not just on the 20 major cities. Apart from this, the government should ensure that low income people who are vulnerable to predatory lending are properly educated about the risks involved in sophisticated financial products, like adjustable rate mortgages.

Q9. What is the role of the Chairman of the US Federal Reserve Bank in finding a solution for this crisis?

A. As far as the Federal Reserve Bank is concerned, the most important and pressing need, at present, is for its Chairman, Professor Benjamin Bernanke to give a well-thought public speech that demonstrates that he understands the problems he is encountering in the markets. (I am still studying his speech given at National Association of Business Economists today. I would have more to say after I have studied his speech carefully). He has done a good job in injecting more than $1 trillion into the economy by way of short-term funds to provide liquidity. Moreover, I had given him high marks for his speech at Jackson Hole in August 22, 2008 in my "Update 3: Fire-sales, Bazookas and Hospitals" (dt. 8 Sep., 2008). It still seems that he is the only person in government who is thinking seriously about the current crisis. However, it appears that he has let himself be sidelined by the Secretary of the Treasury, Henry Paulson, who has exacerbated the crisis to global proportions through his Bazooka theory. The best service that Professor Bernanke can do for America is to recommend to the United States Congress that the spending of the $700 billion be postponed by three months.

The Federal Reserve would be well advised to restrict its actions solely to providing liquidity in the global financial system. In particular, changes in the Fed's interest rate are not advisable until a new government is sworn in. In this respect, one should note that one explanation for the persistent spread between the treasury yields and the inter-bank lending rates (TED spread) could be that the private banks, unlike the Fed, are not willing to lend money at real interest rates that are negative. This is a legitimate point, and it suggests that in fact it could be the Federal Reserve that has read the interest rate situation wrong. Then again, buying of commercial paper, as announced today (October 7) is ill-advised. More importantly, it is nearly a dereliction of duty to have approached the United States Congress for permission to spend $700 billion six weeks before a Presidential election. Professor Benjamin Bernanke had disassociated himself from this plan during his Congressional testimony, in fact, going to the extent of saying that he is just a college Professor, and has not worked on Wall Street and does not have any personal connections in the finance industry. The consensus among academic economists (as expressed by Professor Kenneth Rogoff) seems to be that the United States has a lot of money to spend, perhaps referring to the fact that countries in the rest of the world had their currencies seriously devalued in comparable situations like the East Asia crisis, the Russian crisis, Mexican crisis and the Latin American crisis. But, I should point out that $700 billion is about 5% of the annual GDP of the United States.

Q10. What is really ailing the American financial system? Doesn't the government need to intervene to salvage the situation?

A. The real problem is that the common man and the individual investor expect an honest and trust-worthy functioning of government. As I mentioned in my "Update 3: Fire-sales, Bazookas and Hospitals" (dt. 8 Sep., 2008), 'What the taxpayers (and the voters) within the United States, along with investors all over the world, most need to see, at this moment, is that there is a functioning legal (and legitimate) framework within which the financial markets play the role of enabling the process of economic decision-making towards optimal allocations of scarce resources'. At present, decision making at the government level has been taken over by vested interests. Both the Presidential candidates have promised to curtail the greed on Wall Street. The democrats have been complaining about executive compensation for many years now, and they have proposed government regulations of the finance industry in the future. The Republican candidate, Senator John McCain has openly called for the firing of the SEC Chairman Christopher Cox, and for prosecuting any fraudulent activities on Wall Street. This situation has given great jitters to Wall Street. So, the power mandarins on Wall Street have figured that they need to get the most they can before the current administration goes out of office at the end of the year. This seems to be the most credible explanation for their political activities of the last two months. However, I am no expert in political science, and I am just making my own conclusions based on my reading the news. The reader should consult a Political Science Professor on this question. My own point is that the government authorities have very little credibility, especially after the hilarious testimony to the US Congress two weeks ago. What is really ailing the American financial system, it seems to me, is a vacuum in the political leadership. Thus the role of the government in the current financial crisis should be minimized as much as possible until a new government is sworn in. The world runs on democratic principles much more than it does on fear of bazookas.

Brian,

Precisely my point. We might call it the "Tower of Babel" principle under which arrogance and lack of adherence to basic principles lead to cessation of progress.

In response to Taylor’s post from a day ago, I think you are on to something. I would suggest a few points to consider in forming your understanding of economic and social policies that have shaped American history. First, I would refer you to the link just above your post where I refer to the Nobel Prize lecture, "The Pretense of Knowledge," by Friedrich Hayek (I carelessly referred to him as Frederick Hayek in my previous post) where he makes a similar point to yours on the government or central bank arrogantly believing they can fine-tune the economy.

http://nobelprize.org/nobel_prizes/economics/laureates/1974/hayek-lecture.html

I would also suggest Douglass North’s Nobel Prize lecture on how we have overlooked the importance of time and institutions in our highly formalized economic models.

http://nobelprize.org/nobel_prizes/economics/laureates/1993/north-lecture.html

North’s discussion here is not only similar to Hayek’s but also resembles the historical analysis of conservative icon, Edmund Burke, who argued that “ the individual is foolish but the species is wise.” What he meant was that individuals cannot gain and consciously process the full array of information relevant to good decision-making. According to Burke, there is an accumulation of knowledge that culture builds up over generations that can be accessed by living individuals through tradition, habit, and prejudice. We have to reconsider exactly what rationality entails on the Burkean view. These issues are relevant to today’s crisis since much of the problem that we now face is a lack of personal trust in institutions and individuals who are cut off from institutional ties that facilitate trust. We also have to reconsider global capitalism since it may very well break down these trusted institutions leaving us lost in a maze of derivatives and econometric studies to guide us. This is a danger that Marx appreciated in capitalism, viz. its tendency to destroy traditional, face-to-face ways of life.

Second, I like your point about the history of the United States being built from hard work of common people governed by face-to-face relationships and common sense. On this point, hangs a fight that goes back to the founding of the country, the conflicting visions of Jefferson and Hamilton. The frenetic, impersonal quality of life in much of America today can be traced to the state capitalism of the Hamiltonian vision. The credit crisis was exacerbated by this dynamic where people thought they could lie and cheat themselves to prosperity. Impersonal, ungrounded institutions facilitated these abuses. Even the hectic pace of life with money being the sole basis for achievement, recognition, respect, and social status set the stage for the bubble developing. Here is a link to a discussion by Marxist historian Eric Foner on the differences between Jefferson and Hamilton's social and economic visions for America. Previous to his discussion of Hamilton and Jefferson, Foner contrasts what he terms a Jacobin and a Jeffersonian social and political philosophy. Later in this piece, Foner identifies Hamilton as carrying on the Jacobin vision. Foner characterizes the Jacobin as supporting collectivism, the unitary, and statism. He sees the Jeffersonian as requiring voluntary assent, pluralism, and individualism. The moves we are currently making in this bailout is a move back to the Hamiltonian/Jacobin philosophy.

http://oll.libertyfund.org/index.php?option=com_content&task=view&id=175&Itemid=259#LF-0353-1978v3-Essay01lev1sec005

The two sections of particular interest in Foner's discussion are "Jeffersonian Republicanism and Land Ownership" and "Hamilton's State Capitalism vs. Jefferson's Market Capitalism." They are listed at the top of the page and you can click on them to read them.

Another discussion that sheds light on this current controversy is Foner ‘s discussion of the Locofoco movement in the New York Democratic Party in the 19th Century. The Locofoco supported President Andrew Jackson’s abolition of the Second National Bank as they considered a central bank issuing fiat money without restraint as inimical to liberty. That discussion is within the section entitled “Workingmen's Movement: Equal Rights vs. Special Privileges.” Even the title of this section of the essay sounds as if it were written today.

Your point about having to delay gratification and earn gains in income, wealth, status is well-taken. Daniel Bell accurately describes the moral decline America, and other developed countries, in his *The Cultural Contradictions of Capitalism.* The unwillingness to delay our urges has led to the credit crisis as Americans take out loans and "max" out their credit cards as they save less set the stage for this crisis as well as a general moral decline. John Maynard Keynes understanding of the business cycle as rooted in underconsumption and his policy prescription of the State encouraging consumption and denigrating saving contributes to the irresponsible mindset that lies at the base of the overextension of credit.

In contrast to the Hamiltonian/Keynesian corporate/state capitalism is the Austrian view of interest, savings, and production. I would refer you to the Austrian theory of the accumulation of capital termed the "Roundabout Method of Production" where future increases in productivity due to improvements in technology are founded on current sacrifices to make the necessary improvements to make future gains possible. The Roundabout Method bears out your insight of having to work for gains in productivity and wealth rather than simply manipulating the system to get what we desire. Here is a link to a discussion of Austrian Capital theory. I would also suggest the economic writings of Friedrich Hayek that I mentioned above.

http://www.lancs.ac.uk/staff/ecagrs/hptc.pdf see page 3 for roundaboutness

http://mises.org/story/2364

I also agree that a Depression is likely to be necessary to remove the dross from the system that has contaminated the economy by years of artificial stimulation and misdirection by the Federal government and the Federal Reserve Bank. If prices were allowed to fall freely, then the fall in the stock of money should only create a temporary downturn, although it could be severe. As I suggested above, depending on the policies pursued by the Congress and the Fed, we will be in for a recession and/or stagflation in any case. We humans tend to flee crisis at all costs as Alan Greenspan and Ben Bernanke have in the economic realm.

But if we consider the crisis at the level of the individual, we can see that while an existentialist crisis is by its very nature intensely painful, such a crisis can serve as a turning point in a person's life that can lead to growth and development. The same can be true of crisis in scientific paradigms, as Thomas Kuhn has shown. As one paradigm fails, another can replace it that deals more adequately with the current trials and challenges facing the scientist. Of course, Joseph Schumpeter observed this tendency in capitalism and applauded it.

A depression should not be avoided at all costs just as the existentialist crisis and the scientific crisis should not be denied. If we do not face our mistakes now and accept responsibility for them we not only continue to live in bad faith, but we will be doomed to repeat this cycle at a higher cost each go around until we reach a point of no return.

I think you are right to raise these issues that range out farther than narrow economic policies. There is a lot more at stake here than we realize.

Perhaps a few of the circuits should consider budgeting for additional clerks next year -- with an emphasis on hiring people with bankruptcy/white collar/corporate backgrounds?

I really can't believe that people are so blind as to think that allowing a Depression to occur is vital to "clear the dross" from an Economic System. If one looks at the history and life cycle of Depressions, one will find that invariably a War has occured and is the prime stimulus that drags the economy out of it. A little War anyone (good or bad is unimportant)?

As for the National Banks, it was governmental response to trying to establish a stable and accepted currency. And hence stimulate Commerce and Industry across State and National Boundries. As a businessman in New York, Paris, London or Berlin I'm certainly not about to accept "Arizona Rials" from John Magoo's Bank of Nowhere as legal tender. Which was also a contributor to Bust and Depression problems in early America. Thank God for the Federal Reserve and Treasury, it's better than the Freedom of Anarchy.

As for moral decline and consumerism, What else can one do with it? Eat it. Money has no intrinsic value except for what it can be exchanged for in the market place. Perhaps the Roman Ethicists had it it right when they said, "Private austerity - Public Magnificence"

On Saturday I will post a 30+ minute telephone interview with Judge Posner where he answers the "Four Fundamental Questions of the Crisis": what is it? what caused it? what is its impact?; and can it be fixed?

James Reese
www.RadioEconomics.com

Let us assume, for purposes of discussion, that the stock market goes to 0.00 and that 50% of the stockholders had liquidated at some point above 0.00. At that point their cash under the mattress would be worthless, companies would be worthless, there would be no jobs or goods. The only system left would be barter. We would probably be ruled by a dictatorship and we would be living in a third world country. Could that happen?

Go to Wikipedia and check out Romulus Augustus.

My new Craig's list entry:
Anyone out there willing to lend me some rags for shoes. If we can negotiate, I might be willing to let you borrow my mule and plow for three days.

Neilehat, has the Federal Reserve with its discretionary monetary policy prevent the current credit crisis we are in? Did it prevent the S& L crisis in the 1980's? Did it prevent the Great Depression? Did it prevent the near runaway inflation of the late 1970's? Did it prevent the stagflation of the early 1970's? In fact, didn't the Fed with its discretionary policy not only fail to prevent these problems, but did they not cause each of these economic maladies?

We have a proven track record from the Fed using such policies that you seem to defend, and we do not have to speculate whether discretionary policy is effective--it ain't.

We also have a clear track record on bailouts. Continual bailouts not only freeze misallocations of resources in place, punish the innocent and protect the irresponsible, but they encourage future bubbles that we keep falling into with all their attendant consequences for all of us. For Judge Posner to say, " Moral hazard considerations aside..." is like asking, " Mrs. Lincoln aside from the assassination, how did you enjoy the play?"

(Continued on October 9, 2008)

Q11. What about the co-ordinated rate cut of 1/2 percentage point that the US Federal Reserve carried out along with several European banks announcing rate cuts all at the same time on Wednesday, October 8, 2008? Was it a good idea? What about the IMF/World Bank meeting this weekend of October 10 - 12, 2008, and the G7/G8 Finance Ministers' meeting on this Friday, October 9, 2008? Should they decide to take joint action?

A. As I have already mentioned in my answer to Q9, there is no further role for the US Federal Reserve in this crisis. I do recognize the crucial contribution made by the Federal Reserve to provide liquidity in the global financial system. However, the crisis is no longer a financial one. Throughout 2007 and the first half of 2008, people talked about a Mortgage Crisis. Then sometime during this summer, the focus shifted to a Financial Crisis. But now, it is clear that the experts in modern finance would not be able to solve this crisis. It is now an Economic Crisis. However, it is definitely important for the Federal Reserve to consult and communicate with the central banks in the rest of the world. But, to go beyond professional consultations and to try to cut rates in a co-ordinated fashion is quite ill-advised. The main reason for this is that the current crisis is hitting the global financial system at varying degrees at different times. So the same response at the same time from all the central banks would be spreading the resources at their disposal very thin. They definitely need to consult with each other to keep themselves informed about how the shock in the financial system is spreading across the globe, but they would have to figure out their responses individually.

Regarding the G7/G8 Finance Ministers' meeting, there is a group of 18 financial economists who have written a 38-page document (http://www.voxeu.org/index.php?q=node/2327) asking the finance ministers to take joint action like (1) quick bank re-capitalization with global co-ordination, (2) guarantee of deposits and/or loans with global co-ordination, (3) co-ordinated macro-economic stimulus. This is just very bad advice. I hope that respected economists would come forward to advise against this recipe for unmitigated disaster. As I said before, this crisis can no longer be solved by modern finance theory. There are no quick-fix solutions with rate cuts and reverse auctions. In this regard, there was a perception that a two-pronged strategy to address the short-term and the long-term should be employed. Unfortunately, this well-meaning approach has played into the hands of the loose canons, who proposed a $700 billion plan for the short-term. It is very encouraging to see that highly respected economists have weighed in that the doomsday predictions are wrong, and that there are no easy, quick-fix solutions (ref: Wall Street Journal articles, "We're Not Headed for a Depression" on October 7, 2008 by Professor Gary Becker and "There's No Easy Way Out of the Bubble" on October 9, 2008 by Professor Vernon Smith. Also, Professor Joseph Stiglitz had expressed dissatisfaction with the design of the $700 billion dollar bill and has called for its revision after its passing in the US Congress into an Emergency act). As I have explained in my answer to Q1, we have to look at macro-economic phenomena, like accumulated capital and time value of money, to come up with the proper solution for this crisis. And indeed, from a macro-economic perspective, this current crisis is quite within manageable proportions. To illustrate this point, I quote from Professor Edmund Phelps' Wall Street Journal article of October 1, 2008, "Among most economists, it came as a surprise that the banking industry, and, indeed, most of the financial sector, was so devoted to houses. ... ... And we didn't foresee that a trillion or two of losses in an economy with $40 trillion of financial wealth could bring high anxiety and, two weeks ago, near panic".

Q12. Why are you so much against the further involvement of the US Federal Reserve Bank and of the US government in solving this crisis that you want to call an Economic Crisis? Just because you think that the $700 billion plan was a bad idea, do you want to conclude that nothing should be done in the short term? Also, there are frequent reports that the losses in the stock markets and in the house prices amount to several trillions of dollars of loss in wealth. Shouldn't the government do something to stem these losses?

A. Well, first of all, no serious mathematician would pretend to know any theory that explains the day-to-day price changes in the stock markets. Moreover, I have already expressed my disappointments in my "Update 3-2: A Mathematician's Apology" (dt. September 21, 2008) about the failure of mathematical theories of economics to adequately capture the subtle issues in the economic reality of the day. That said, I would like to point out the much bigger losses in having an out-of-control Treasury Department and a dysfunctional Federal Reserve -- their misguided and arbitrary meddling in the functioning of the markets have effectively nullified a century's worth of intellectual capital. Price theory, Growth theory, Economic of Asymmetric Information, Econometrics and Behavioral Psychology are all areas of modern economics that have many deep insights to make about the current financial crisis. However they have all been rendered ineffective, because of the treasury's buffoonry -- it has been claiming expertise in pricing mortgage securities that no one knows how to price.

The main issue to note is that in spite of all that has been written about this current financial crisis and the earlier mortgage crisis, it is still not clear why there was a bubble in the house prices. Professor Robert Shiller's "Irrational Exuberance" is the classic reference for the tech bubble of the late 90s. The methods of econometrics and psychology employed in this book provide a convincing explanation for the tech bubble. The valuations of the tech stocks were very arbitrary and each tech stock could rise or fall by 100% or more within a week during the euphoric times of the late 90s. However, it is not completely transparent why there was a housing bubble during 1998 -- 2006. A convincing explanation of this phenomena would take years in my judgment. So, it is not advisable to skirt or short-circuit the political process to rush through quick-fix proposals that would supposedly solve the crisis.

Chris, You've missed one little detail, Regulation has not been the responsibility of either the Federal Reserve or Treasury, but is the responsibility of the Securities and Exchange Commission and Congress. And where have they been? Asleep at the wheel.

As for "bailouts", better to attempt one than to "be dragged by the tiger into the abyss" like the Hoover Administration allowed to happen and helped create the Great Depression. Anyone for a little Boom, Bust and War?

As I have mentioned on numerous occasions, The Federal Reserve, Treasury, S.E.C. are anachronisms in this modern age and Congress clearly needs to revise the Nations Economic Control System. Otherwise, the invisible hand will continue to slap us in the face with amazing regularity.

what evidence is there that paying higher wages to CEOs results in more competent CEOs?

what evidence is there that paying higher wages to CEOs results in more competent CEOs?

Actually I am a little surprised that Judge Posner wasn't more stern in his comments about this MESS. I mean really Judge...can you fathom this happening? Did you ever when a student at Harvard Law think something of this magnitude would happen in the USA? I am sure our grandparents are rolling in their graves...John Adams is gagging. Thanks Jim for timely quotes...I wonder if non-snake-suited-rich are to be reduced to peons, turned into a military operation, promised to be fed if performing, like in North Korea. Whether or not designer towels are correctly placed in the guest bath, located in our foreclosed house, will be moot.

Hey, what time is www.radioeconomics.com going to broadcast Judge Posner on Saturday, October 11, 2008? (It is Friday night at 10:40, west coast...so hurry and post...thanks)

Hi Neilehat,
Thanks for your reply. I agree that the regulations that we have should have been enforced more effectively. I would also argue that the repeal of Glass-Stegall Act in 1999 set the framework for securitization, which spread the contagion of shaky sub-prime loans all over the world. I am not opposed to all regulation by any means especially when there is the reality of bailouts. Deposit insurance and bailouts dramatically increase moral hazard. In the banking system, this is playing with fire due to fractional reserve banking as you know. When we deregulate, there must be an equivalent move to hold players more personally responsible for their actions. We have not done that. Even with a more consistent system of deregulation where players are held responsible, there must be government oversight to prevent fraud.

I disagree with your characterization of President Hoover as a champion of laissez-faire. He may have seemed to be a non-interventionist in light of the dramatic and much more far-reaching intervention by his successor, President Roosevelt. But Hoover did intervene in a much more robust way than previous presidents had in the face of financial panics. Hoover made the mistake we are falling into today by attempting to hold prices up as the stock of money falls. The deflation of the money supply coupled with the policy of preventing prices from adjusting will cause business failures, unemployment, and prevent the dross from being burned off, to return to my previous metaphor. In the 1920's, people and resources had been misdirected by the overexpansion of credit by the Fed as has happened in recent years setting us up for a major correction. To prevent the correction from occurring is a mistake. It will only make matters worse in the long-run--and we are not all dead at the same time in the long-run.

Here is a link to a different take on Hoover and Depressions by Austrian economist Murray Rothbard for you to consider.

http://www.mises.org/rothbard/agd/chapter7.asp

Historians have found that Hoover was an interventionist. Even though the panics were more numerous before the Fed, they did not last as long. The intervention by the Congress and President to hold prices high and to limit competition as well as inept Fed policies is why the Depression lasted so long.

I think you are right that the Invisible Hand is slapping us right now. If we do not wake up from delusions that we can control the economic world, then we are doomed to repeat the failures of the past.

Why no discussion of the short seller market? The University of Washington ordered the Northern Trust to stop lending the shares the Northern held as custodian for the university's endowment, on the theory that the short sellers were using the university's assets to drive down the value of its endowment.
It seems to me that the problem was one of pricing; as demand for lent shares went up, the price of their loan should have increased. It did not and I don't know why; perhaps the custodians were dumb or imprudent or just did't know how to price them. A hedge fund theory might have worked: if you make x dollars on the loan of shares, we get half. That would have halved the endowment's loss.

Perhaps the problem was fear of the anti-trust laws, since a single lender of shares has no market power, raising the price does not work unless other lenders do the same. Some transparency or a market for lending shares would cure this. It should take about a day to create one; that is the value of the internet in increasing the flow of information.

Oddly, the problem is the reverse of the problem Roscoe Steffan talked about the first day of Agency class in l951. He had just returned from Washington, having lost the goverment's antitrust suit against the investment bankers for their stabilization actions during the period of a stock offering. Now we need an anti-trust suit against the short sellers for rigging the market to keep down the price of shares they borrow but never buy.

Why no discussion of the short seller market? The University of Washington ordered the Northern Trust to stop lending the shares the Northern held as custodian for the university's endowment, on the theory that the short sellers were using the university's assets to drive down the value of its endowment.
It seems to me that the problem was one of pricing; as demand for lent shares went up, the price of their loan should have increased. It did not and I don't know why; perhaps the custodians were dumb or imprudent or just did't know how to price them. A hedge fund theory might have worked: if you make x dollars on the loan of shares, we get half. That would have halved the endowment's loss.

Perhaps the problem was fear of the anti-trust laws, since a single lender of shares has no market power, raising the price does not work unless other lenders do the same. Some transparency or a market for lending shares would cure this. It should take about a day to create one; that is the value of the internet in increasing the flow of information.

Oddly, the problem is the reverse of the problem Roscoe Steffan talked about the first day of Agency class in l951. He had just returned from Washington, having lost the goverment's antitrust suit against the investment bankers for their stabilization actions during the period of a stock offering. Now we need an anti-trust suit against the short sellers for rigging the market to keep down the price of shares they borrow but never buy.

Why no discussion of the short seller market? The University of Washington ordered the Northern Trust to stop lending the shares the Northern held as custodian for the university's endowment, on the theory that the short sellers were using the university's assets to drive down the value of its endowment.
It seems to me that the problem was one of pricing; as demand for lent shares went up, the price of their loan should have increased. It did not and I don't know why; perhaps the custodians were dumb or imprudent or just did't know how to price them. A hedge fund theory might have worked: if you make x dollars on the loan of shares, we get half. That would have halved the endowment's loss.

Perhaps the problem was fear of the anti-trust laws, since a single lender of shares has no market power, raising the price does not work unless other lenders do the same. Some transparency or a market for lending shares would cure this. It should take about a day to create one; that is the value of the internet in increasing the flow of information.

Oddly, the problem is the reverse of the problem Roscoe Steffan talked about the first day of Agency class in l951. He had just returned from Washington, having lost the goverment's antitrust suit against the investment bankers for their stabilization actions during the period of a stock offering. Now we need an anti-trust suit against the short sellers for rigging the market to keep down the price of shares they borrow but never buy.

Why no discussion of the short seller market? The University of Washington ordered the Northern Trust to stop lending the shares the Northern held as custodian for the university's endowment, on the theory that the short sellers were using the university's assets to drive down the value of its endowment.
It seems to me that the problem was one of pricing; as demand for lent shares went up, the price of their loan should have increased. It did not and I don't know why; perhaps the custodians were dumb or imprudent or just did't know how to price them. A hedge fund theory might have worked: if you make x dollars on the loan of shares, we get half. That would have halved the endowment's loss.

Perhaps the problem was fear of the anti-trust laws, since a single lender of shares has no market power, raising the price does not work unless other lenders do the same. Some transparency or a market for lending shares would cure this. It should take about a day to create one; that is the value of the internet in increasing the flow of information.

Oddly, the problem is the reverse of the problem Roscoe Steffan talked about the first day of Agency class in l951. He had just returned from Washington, having lost the goverment's antitrust suit against the investment bankers for their stabilization actions during the period of a stock offering. Now we need an anti-trust suit against the short sellers for rigging the market to keep down the price of shares they borrow but never buy.

Chris, Just one question. When did the Securities and Exchange Commission come into existence? As a response to the failures of the Hoover Administration, I might add. All of this clearly points to a lack of knowldge and insight about Economic Process's and the design and development of adequate control systems.

Where I am about to take you is far beyond the meager knowledge and insight that passes for economic understanding today. I take it you agree that what we are witnessing and experiencing today is the result of regularly occuring process's. Posner's, "Cycles of Boom and Bust are intrinsic ..." if you will. There is a newer field of economics that is being developed out side of most Economic schools of thought these days, that is merging the disciplines of Economics, Physics, Mathematics, and Engineering. In Physcis and Engineering it is a well known fact that any regularly occuring phenomena can be adequately modeled Mathematically. In Engineering we call this, the "first principle" of Advanced Automatic Process Control Theory. Of which, Kondratiev Wave Theory provides the link to Economic phenomena, along with other links. So we have now established a bridge between the "Scientific" disciplines of Physicis, Mathematics, Engineering and the less than "scientific" Economics.

The second principle of Advanced Process Control Theory states, That any regularly occuring process phenomenon that can be modeled can also be controlled. In this case, both the frequency and amplitude of the Kondratiev Wave phenomenon of the cycle of "Boom & Busts".

So you see, the "Invisible Hand School" and "God Will's It - allow it to run its course School" of Economics; have essentially turned their backs on Science/Engineering and the benefits that it brings to Humanity. But in order to allow this New School of Economics to bring the methodolgy to the fore, it will require a "Paradigm Shift" in thinking. Not only at the Academic level, but also at the Socio-Political organization level.

With respect, I disagree with many of your points:
1. cheap global capitol. Central banks low interest rates to keep the economies 'stimulated' to avoid a downturn are at least partially to blame. Avoidance of a necessary correction has led to a blowout instead.
2. housing bubble low interest rates (see #1 above) and aggressive lending. The aggressive lending was only possible because the lenders did not retain the loans but securitized them, thereby passing the risks along to everyone else. If institutions had to hold their own mortgages, they would have been more careful to ensure that the borrowers could pay them. Instead, everyone took a fee as they passed the bad debt along to the next guy.
3. new financial instruments that ostensibly lower risk - some folks tried to point out that the quants risk models were faulty and had definite limits. Management didn't listen because this knowledge would have spoiled the party. Management's interests were completely short term as they took massive salaries and bonuses from fees and only cared to make as much as possible for as long as possible.
4. Hard to sell a 'conservative' strategy. This is true but it should be noted that Warren Buffett was able to sell such a strategy to his fellow share holders.
5. Uncertainty. If management would only be rewarded for LONG TERM good performance, then this uncertainty would have produced much more conservative practises.
6. boards of directors failed in their oversight. YES Now we begin to get at the heart of the matter.
Add the fact that culturally, winning is respected over ethics, morality and contributions to either company or country and you pretty well have it. None of these rich bankers will be shut out of the company and respect of their peers because they are all equally greedy and morally bankrupt.
Fortunately, there are still many responsible, morally decent citizens. They have to use their talent to select leaders who have both ethics and brains to lead us out of this mess. The moral impact of these citizens, though, can only be expressed in better regulation by government which I hope will be the outcome of this mess.

Judge Posner,

You said: "The third was new financial instruments that businessmen believed reduced borrowing risks and so increased optimal leverage." It's these derivatives that are breaking the banks, not the mortgages.