Did Speculation Make the Economic Crisis Deeper or Shallower? Posner

Speculators have never been popular, and they have never been as unpopular as they are in the United States today. Increasingly they are blamed for the economic crisis. Probably they should be rewarded for making the crisis less grave than it would otherwise have been.

 

There is a wide range of speculative activities, but my focus will be on financial speculation, which I’ll define as a bet on the future price of some commodity or asset, which could be a house or a bond—to pick the two speculative assets centrally involved in the crisis. (Mortgage-backed securities and collateralized debt obligations, the specific financial instruments at the center of the crisis, are essentially bonds or bond clusters—debt obligations or packages of debt obligations that pay a contractually fixed interest rate or rates.) In the 2000s, until the crash, there was a great deal of speculation in housing prices, including by people who bought a house with a mortgage that they could afford only if the value of the house increased. They would buy the house with no down payment and very low (sometimes zero) interest rates usually for two years, after which the interest rate would be “reset” at a higher level—a level they could not afford unless their house appreciated significantly in value, in which event they would have equity in the house and could use it to refinance the house with a normal mortgage at a normal interest rate. So they wouldn’t have to pay the reset rate.

 

At the other end of the market from the speculating home buyer was the speculating investor. Buying MBSs (mortgage-backed securities) and CDOs (collateralized debt obligations, often an assemblage of the riskier slices of mortgage-backed securities) entailed speculating on future housing prices, because the direction of those prices—up or down—would affect the default rate on the mortgages in which the buyers of the securities were investing indirectly. If the default rate rose because housing prices cratered, the securities might not pay the agreed-on interest rate, and so their value would fall.

 

Some very smart, very unconventional people, though they were only a tiny minority of the financial community, began thinking, some as early as 2005, that housing prices might well crash, that the housing boom was a bubble—house prices were rising because house prices were rising, convincing people that they would keep on rising. The “contrarians”—the subject of Michael Lewis’s new book, The Big Short—wanted to put their money where their mouth was. But while it is easy to bet on a rise in the future price of some asset, simply by buying the asset, it is not so easy to bet on a fall in that price. If it is a stock (or other security, including a bond), you can borrow it and agree to sell the stock to someone at some specified date in the future at a specified price. If as you expect the price falls, you can buy the stock that you’ve agreed to sell at a price lower than the sale price, deliver the stock you borrowed to the buyer and be paid the agreed-on price, pocket the difference, and deliver the cheap stock you just bought to the person you borrowed the stock from for the speculation, thus completing the transaction. The process I have just described is selling short.

 

Selling short is risky, because the price of the stock may rise over the price specified in the short sale when you expected it to fall (which means you’ll have to buy at a price higher than the price specified in the sale contract the stock that you need in order to return stock equivalent to what you borrowed), and costly, because you have to pay interest to the person you borrowed the stock from.

 

As an alternative to short selling, you can buy a credit default swap, which is a form of insurance on debt—not necessarily your own debt. If there is a bond that you expect to go into default (it might be a bond backed by a collection of mortgages), you can buy insurance against the resulting loss in the bond’s value. So if there is a default, the issuer of the credit default swap pays you, and so you gain just as the short seller gains when the price of the stock or bond that he’s shorted falls.

 

Like other speculators, short sellers and buyers of credit default swaps that insure strangers’ debt are unpopular because they are trading on and therefore hoping for a future calamity. When the price of an asset falls as a result of speculative activity, the speculators are blamed. That’s like blaming a thermometer for a fall in temperature. Provided the speculators do not spread false rumors about the assets they’re hoping to see fall in price, or engage in other fraud, their activity is socially beneficial. It adds to the information in the market and by doing so tends to bring about a more rapid and complete alignment between prices and underlying values.

 

It’s hard to sell houses short, but one can speculate that housing prices will fall by selling mortgage-based bonds short, since as I said a housing crash will increase the mortgage default rate and thus reduce the value of bonds that are based on mortgages. Had there been rampant short selling of such bonds in the early 2000s, the price of those bonds would have fallen because a high level of short selling would have been a signal of widespread doubt that housing prices would continue to rise. When bond prices fall, yield rises, because the interest rate of a bond is a fixed percentage of the bond’s face value. (So if the value of a bond that pays 2 percent interest falls in half, the interest rate to buyers of the bond rises to 4 percent.) With interest rates on mortgage bonds higher and housing prices therefore lower (because mortgage interest is a major cost of buying a house), we might have been spared the housing bubble whose bursting triggered the economic crisis that the nation and the world are still struggling to climb out of.

Comments

[Jack]

Chris: I'm not sure how long a time we'd need to say, the proof is in the pudding, and I don't know then entire history of the Fed, but from what I've seen and read about I haven't seen any real blunders. Consider, we got through WWII with little inflation. The housing boom of the 50's went off with low interest. The devaluation/leaving the "gold standard" behind was not the fault of the Fed, but as today, heavily influenced by trying to hide, at least, the monetary costs of unpopular wars.

Today? While I might hurl a brickbat or so at the Fed for over-tightening at the end of the Clinton admin, and Repubs might hurl a few during the curious tightening at the end of HW's term, neither would deserve more than a few lightweight brickbats.

2. As for the fraud and utter corruption of our?? banking system from top to bottom, I think it would be very difficult to make a case that the Fed had eased too much. For all I know the source of what (actual) funds were being flung out may well have been recycled dollars coming back from China, India or a host of others holding surpluses from our trade deficit. Corruption is simply corruption as we saw with the S&L scam that went on for nearly a decade after being spotted, the Enron affair, and the current mess.

3. Well, I suppose he'd have to argue with those who are just as certain that an expanding, modern economy requires a somewhat steady increase in the money supply along with the occasional tap on the brake.

The alternative it seems, and the reason we and most advanced nations have a central bank, would be wild swings between feast or famine that would destroy viable enterprises that lacked the depth to survive even a short drought and a waste of manpower. As no one can work "twice as hard" the best use of labor is a fairly stable economy that allows folks steady employment.

Consider: Just now our biggest "cost" is the lost productivity of 15 million un- or under-employed working folk. Tally up the wages, and as every job produces more than the wage cost which is then profit and operating overhead for their employer and it's a big number.

[Jack]

Chris: I'm not sure how long a time we'd need to say, the proof is in the pudding, and I don't know then entire history of the Fed, but from what I've seen and read about I haven't seen any real blunders. Consider, we got through WWII with little inflation. The housing boom of the 50's went off with low interest. The devaluation/leaving the "gold standard" behind was not the fault of the Fed, but as today, heavily influenced by trying to hide, at least, the monetary costs of unpopular wars.

Today? While I might hurl a brickbat or so at the Fed for over-tightening at the end of the Clinton admin, and Repubs might hurl a few during the curious tightening at the end of HW's term, neither would deserve more than a few lightweight brickbats.

2. As for the fraud and utter corruption of our?? banking system from top to bottom, I think it would be very difficult to make a case that the Fed had eased too much. For all I know the source of what (actual) funds were being flung out may well have been recycled dollars coming back from China, India or a host of others holding surpluses from our trade deficit. Corruption is simply corruption as we saw with the S&L scam that went on for nearly a decade after being spotted, the Enron affair, and the current mess.

3. Well, I suppose he'd have to argue with those who are just as certain that an expanding, modern economy requires a somewhat steady increase in the money supply along with the occasional tap on the brake.

The alternative it seems, and the reason we and most advanced nations have a central bank, would be wild swings between feast or famine that would destroy viable enterprises that lacked the depth to survive even a short drought and a waste of manpower. As no one can work "twice as hard" the best use of labor is a fairly stable economy that allows folks steady employment.

Consider: Just now our biggest "cost" is the lost productivity of 15 million un- or under-employed working folk. Tally up the wages, and as every job produces more than the wage cost which is then profit and operating overhead for their employer and it's a big number.

[Chris Graves]

Jack, as for your comments just above characterizing Hayek and Mises' theories parroting their line to the point that their views have become mindless or even lies, such a response is simply an ad hominem attack. It fails to deal with the substance of Hayek's analysis.

Thanks for your reference to Steele's work on Hayek and Keynes' views on capital. I shall take a look at it when I can locate a copy of it. If you take a look at G.R. Steele's discussion of Hayek's theory of capital, his criticism of Keynes' views on capital seem to bear out my comments above. Here is a link to Steele's discussion (see page 13 and thereafter):

http://www.lancs.ac.uk/staff/ecagrs/hptc.pdf

As Hayek said of Keynes' *General Theory*: "Beyond its contribution to the overall level of expenditure, capital is an unwelcome intruder into the analysis portrayed as a General Theory. All is reduced to the multiplier, with all its attendant problems."

[Chris Graves]

Correction to my last post. It should have been addressed to NEH.

[NEH]

Chris, As for "theoretical development", all theories develop in fits and starts (better known as the logic or illogic of theoretical development). There has never been a theory that was born full and complete from the mind of Man. This applies equally well to Newtonian Physics vis a vis Quantum Physics, the Theory of Relativity and the development of a Universal theory of Physics through to a "General Theory of Economics". As for Hayek's comment, this was but an observation on the impact of the variable of "Capital" within the framework of the "General Theory". Now, this "argument" by Hayek does not eliminate the "General Theory" per se, but requires a modification to the "General Theory". Such as the positions postulated by the Neo-Keynesians. Read Steele.

[Jack]

Chris: I think we end up again at the tension between intervention by our representative government and leaving all, (in my view -- being enslaved by) "the market". I'd certainly agree that most often "government" is too slow and perhaps too mindful, or not enough, of political pressures to respond to small or short term problems.

Let's consider one "market" for a moment. Oil for most of oil's history has been plentiful and had so little market power to increase price that OPEC was created. Until very recently oil remained in the $20 range that represents a reasonable profit for existing oil and might fall a bit short in terms of the costs of developing new oil. In short, we've never had to bid for oil in short supply. I don't know if the price of four times the $20 is a result of beginning to bid against actual supply shortages, but let's assume for the moment that is the case or soon will be the case. IF, it is the case, oil is likely to soar over a relatively short time -- a decade or less.

The problem of course is that of a nation, and world, so dependent on oil, needing perhaps 50 years to respond to either a shortfall or prices in the 100's.

We received our first wake up call when President Carter was in office. The warnings included America no longer being the captain of the ship in terms of producing one of its most crucial economic inputs. At that time we had 30-50 years to respond.

During the crisis we did respond with some intelligence with CAFE standards, lower speed limits and at least an attempt to put a small, demand limiting tax on gasoline. But the price of oil crashed and "the market" told us to waste our time opportunity and instead build the biggest fleet of gashogging SUV's and oversized P/U's the world has ever seen along with 50 million energy wasting homes, shopping centers and buildings.

Human intelligence of the 70's could have and did predict that, if not "peak oil" for the world, that the lines between supply and demand would sharply diverge at some time in the intermediate future and we could have and should have responded. Were America a corporation a CEO would be consider negligent not to assure future supplies of their number one resource for production.

Instead, we took our orders from "the market" and while the market will send us signals, in the case of oil it will come far too late for an orderly response.

That's why, instead of a VAT tax that would put a chill on all consumption of goods and services, I'd begin with an oil, BTU, or carbon tax. As we've legions of unemployed craftsmen, I'd intervene even further with direct employment to improve the energy efficiency of all of OUR government buildings, and offer strong incentives to do the same in the private sector.

I'm CERTAIN that I'd rile Hayek, but hey, he lived in an era a bbl of oil cost about 2 hours of min wage and we'd not even begun to address air pollution........... which, of course was begun, not by "the market" but by democratic action.

[awfrey]

Along those same lines, it should be noted that there should be some responsibility placed on the media, which tends to stir the pot with sensational language (in my opinion).

Check out this article from Fisher Investments analyst Mike Hanson: http://investingiq.wordpress.com/2010/04/19/sensational-economics/

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[Shelia]

simply stimulating demand in the aggregate too little or too much is not the main concern if we are interested in stable and sustained economic growth as much as it is preventing the distortions in the production process as well as misallocation of resources among various markets. These distortions that give rise to bubbles that by their very nature cannot be sustained are precipitated by the central bank tinkering with the supply of money. If the money supply grows at predictable rates, then the price system is more likely to send reliable information to producers and to consumers about which goods and services are needed coupled with information about their continued availability.

[Shelia]

I'd have to disagree that derivatives are a "natural" outgrowth of anything, other than the schemes of those unwittingly or purposefully constructing the latest greatest Ponzi.

Looking back at what seemed to happen after we went off the gold standard (ha! when we could not own gold bullion or coins) with inflation and oil going through the roof, we might long for the good old days. But, it was a combo of WWII and Vietnam costs "hidden away" that made it impossible to maintain gold at $35/oz. In short going off the GS was a devaluation.

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