Systematic Risk Regulators and the Power of Arithmetic
The current craze in DC policy circles is to create a "systematic risk regulator" to make sure that the country never experiences another economic crisis like the current one. This push is part of a cover-up of what really went wrong and does absolutely nothing to address the underlying problem that led to this financial and economic collapse.
The key fact that everyone must always remember is that the story of the collapse was not complex. We did not need great minds sifting through endless reams of data and running incredibly complex computer simulations to discover the underlying problem in the economy. We just needed some people who understood the sort of arithmetic that most of us learned in 3rd grade.
If the people at the Fed, the Treasury, and in other key positions had mastered arithmetic, and were prepared to act on their knowledge, they would have taken steps to stem the growth of the housing bubble. They would have prevented the bubble from growing to the point where its inevitable collapse would bring down both the U.S. economy and the world economy.
Just to repeat the basic facts: house prices began to diverge sharply from a 100-year long trend in the mid-90s as wealth created by the stock bubble began to exert upward pressure on real estate prices. After having tracked the overall inflation rate for 100 years, house prices were substantially outpacing inflation.
There was no remotely plausible explanation on either the supply or demand side for the run-up in house prices. Income growth was good, but not extraordinary in the late 90s. In the current decade, incomes actually fell slightly after adjusting for inflation. On the supply side, we built houses at near record rates in 2002-2006 indicating that there were no substantial constraints on building.
As another tell-tale sign that we were seeing a bubble, inflation-adjusted rents were not rising, indicating that there was no underlying shortage of housing driving up prices. Finally, housing vacancy rates were hitting record levels as early as 2002.
At their peak in 2006, inflation-adjusted house prices had risen by more than 70 percent, creating over $8 trillion in housing bubble wealth. There was no way that the loss of this much wealth ($110,000 for every homeowner) would not lead to a severe a recession and create the sort of financial crisis that we are now seeing.
In normal times houses are highly leveraged with down payments rarely exceeding 20 percent. In the bubble years, it was common for homebuyers to borrow the full value of their home and sometimes even a few percent more. It should have been obvious to any serious economist or financial analyst that when the bubble burst, there would be hell to pay in the financial sector.
In short, all the evidence was right there for anyone who cared to see it. We didn't need some super-genius to solve the mystery. We just needed an economist who could breath and do arithmetic. But the DC policy crowd tells us that if only we had a systematic risk regulator this disaster could have been prevented.
Okay, let's do a thought experiment. Suppose we had our systematic risk regulator in 2002. Would this person have stood up to Alan Greenspan and said that the country is facing a huge housing bubble the collapse of which will sink the economy?
Remember, before the fall Greenspan was known as "the Maestro." Politicians, reporters and economists worshipped every pearl of wisdom that came out of his mouth. In fact, when he announced his plans to retire in 2005, many of the world's leading economists and central bankers gathered at Jackson Hole, Wyoming to debate whether Alan Greenspan was the greatest central banker of all time.
Alan Greenspan said that there was no housing bubble; everything was just fine. Would our systematic risk regulator have said that Greenspan was nuts and that the whole economy was a house of cards waiting to collapse?
Anyone who believes that a risk regulator would have challenged the great Greenspan knows nothing about the way Washington works. The government is run by people who first and foremost want to advance their careers.
And, the best way to advance your career in Washington is to go along with what everyone else is saying. If that was not completely obvious before the collapse of the housing bubble, it certainly should be obvious now.
How many people in government have lost their jobs because they failed to see the bubble? How many people even missed a promotion? In fact, the top financial officials in the Obama administration, without exception, completely missed the housing bubble. One might think it was a job requirement.
This lack of accountability among economists and economic analysts is the core problem that must be tackled. Unless these people are held accountable for their failures in the same way as custodians and dishwashers, there will never be any incentive to buck the crowd and point out looming disasters like the housing bubble.
The reality is that we have a systematic risk regulator. It is called the Federal Reserve Board. They blew it completely. We will do far more to prevent the next crisis by holding our current risk regulator accountable for its failure (fire people) than by pretending that we somehow had a gap in our regulatory structure and creating another worthless bureaucracy.
And of course we should teach our economists arithmetic.
Thank you for saying it. The systematic risk regulator™ is just another way for the bureaucrats to say, 'It wasn't my fault".
May 6, 2009 9:17 PM | Reply | Permalink
As I was reading through this, I passed your post in the other column. And I thought what a great side by side couple of pieces. Yours and this. This one so simple - like for a third-grader. And yours like a poem.
So nice to see yours was the very first comment!
May 6, 2009 10:31 PM | Reply | Permalink
"We just needed some people who understood the sort of arithmetic that most of us learned in 3rd grade."
Yes. And we still do.
May 6, 2009 10:03 PM | Reply | Permalink
Well, OK. But that bubble, although it may lie at the core, seems to be a small fraction of the mega-bubble that grew up around it with these arcane "financial products" that constituted the catastrophic risk, and for which regulation is needed -- badly.
May 6, 2009 10:05 PM | Reply | Permalink
Do they do 3rd Grade at Harvard?
It seems many of the architects of the economic meltdown came from that esteemed institution.
May 6, 2009 10:12 PM | Reply | Permalink
One class of licensed real estate professionals is the appraisers. In California, at least, you have to pass a licensing exam, serve a sort of apprenticeship by working for a reputable appraiser for a certain period of time, and you are subject to review of your work to keep you professionally honest.
In spite of that real estate appraisals became nothing more than whatever number the bank wanted to get so they could justify writing a mortgage on a piece of property. Real estate appraisal classes were carefully training people to do appraisals based on: income generating ability of the property, replacement cost for the property, and current market "value" of the property. But, once employed, appraisers just got real estate brokers to tell them what comparable properties recently sold for, and that determined the "value" of the property.
If the system had worked then, these phony appraisals would have caused license suspensions and/or fines. And, if the system worked today, there would be massive openings for new appraisers to replace all of the suspended ones. I don't see any sign of that.
I see this as the "grass roots" of the real estate balloon problem.
May 6, 2009 11:11 PM | Reply | Permalink
"current market "value" of the property"
Like most things, the "Current market value" of anything is what someone is willing to pay for it and what someone is willing to sell it for.
Nothing more, nothing less.
May 7, 2009 12:04 AM | Reply | Permalink
The problem that you point to is due to the bundling and reselling of motgages (as has been pointed out ad nausium) taking the long term troubles away from the inital lender and passing them along to... the world.
The demise of the "local bank" can also be added into the mix. The closer it all stays to home the more prudent and responsible the actors will be. Can bank regulation at a federal level work as effectivly as the old state regulatory systems? So many of the woes we now face can be layed at the feet of loss of state level oversight when SCOTUS declared banking an interstate commerse issue.
Mr. Baker's rundown of this story is the clearest I have seen. I am of the oppion that any explanation of business and economy that can't be grasped by a third grader is poorly stated or hocum with an aim to perpetrate a fraud. And let's face it, Fraud is what has been done at all levels. All of these actors from Greenspan to the guy who wrote the loans knew it was going to crash. They just didn't want to be the ones holding the bag when it came down.
May 7, 2009 6:49 AM | Reply | Permalink
"The problem that you point to is due to the bundling and reselling of motgages (as has been pointed out ad nausium) taking the long term troubles away from the inital lender and passing them along to... the world."
This wouldn't be a problem at all if the buyers of those "bundles" were held accountable for their stupidity in making these purchases and were forced to take the losses they deserve instead of successfully passing those losses on to the US taxpayer.
.
May 7, 2009 11:24 PM | Reply | Permalink
It would've helped to have a halfway decent President who was sincerely committed to upholding the law in a good faith way.
Instead, we had Bush, whose buddies at Enron set the standard for how America would be destroyed.
May 7, 2009 3:22 AM | Reply | Permalink
A couple days ago, I was talking with a real estate broker, and he was telling me that my hometown of Charlottesville, Virginia has about 22 months of inventory of houses for sale. At the same time, he is amazed that prices have come down so little. I guess people around here think that if you have the proper breeding, you should not lower your price to fit the market.
Construction was a major part of the economy. Can anyone identify another "foundation" (how do you like that pun?) for economic recovery?
Bob Spencer
May 7, 2009 7:05 AM | Reply | Permalink
Bob:
Have you considered that the reason Charlottesville, Virginia has about 22 months of inventory of houses for sale is because the asking prices are way above what anyone is willing to pay?
When it becomes necessary to sell a house, those prices will drop.
May 7, 2009 11:18 PM | Reply | Permalink
I forgot to mention that I asked the broker if he had seen Dean Baker's handy calculator for comparing the cost of buying compared to renting. It says that the houses in Charlottesville are overpriced by 48%. He said that he did not know who that Baker guy is, but his calculations are probably correct.
Bob Spencer
May 7, 2009 7:17 AM | Reply | Permalink
Those who do not learn from history are condemned to repeat it.
What is being done to correct the underlying problems? Not a thing that I can see. We are gonna allow these corporations to operate in a 1990's-2008 'business as usual' sense and take extreme risk again. I want to know what is being done at the SEC to bolster their ranks and put some teeth back into oversight of the financial sector. Seriously, nothing is being done except throwing tons of taxpayer money at the financial sector in the hope that'll do the trick and Happy Days will be here again...of course until the next crisis. Where the financial sector will say 'show us the taxpayer money' again. Irresponsible economic behavior is being rewarded...and encouraged. Pray tell what is the difference between Trickle Down Economics and what is going on now...everything is still predicated on the rich doing well. And history shows where that got us...the only thing that 'trickled down' was the bill the taxpayers were given.
May 7, 2009 11:04 AM | Reply | Permalink
Step 1: Dismantling of any corporation which currently holds the label' Too big to fail'.
May 7, 2009 11:11 AM | Reply | Permalink
Yes, yes, yes! If any "X" is too big to be allowed to fail, it is too big. If something is too big, make it smaller. I think this is Einstein's Particular Theory of Relativity?
Back when men were rational, and women....well, whatever, we determined that when a business was too big, it was a violation of the anti trust laws, and it was made smaller. Look backwards!
May 7, 2009 9:57 PM | Reply | Permalink
Ma Bell is a great example.
May 7, 2009 11:42 PM | Reply | Permalink
What is consistently being ignored in this financial crises and bailouts is that the world's finances are a closed system. When money is given to banks, financial institutions, auto companies, and anyone else, it must come from somewhere.
Printing it only dilutes the money supply and is called inflation.
Borrowing it requires paying it back, usually by borrowing more money in order to repay the original debt and the interest on that debt.
Doing both at the same time is basically cheating since the money used to pay off the debt and interest is worth less than the money borrowed. At some point, the lenders get wise to this and interest rates skyrocket.
This, by definition, is a ponzi scheme and is being perpetrated by the US government.
May 7, 2009 11:13 AM | Reply | Permalink
Oddly, I find myself agreeing with Baker. I, too, see the in-crowd's (yeah, I'm looking at you, Sheila Bair) call for a "systemic risk regulator" as a cover-up -- a Hoocoodanode moment in elitist politics. But Baker goes further ---
Alan Greenspan said that there was no housing bubble; everything was just fine. Would our systematic risk regulator have said that Greenspan was nuts and that the whole economy was a house of cards waiting to collapse? Dean Baker
If the proposed "systemic risk regulator" had identified the housing price bubble, he or she need not have challenged Greenspan (or a future Federal Reserve Chairman) on the question of whether there was or wasn't a bubble. Such a regulator could call for 1) adherence to standards of sound banking and insurance and 2) such legislative changes which would advance sound practices:
For example, a "systemic risk regulator" might have required and/or demanded
1) that ratings agencies' algorithms be stress tested,
2) that the writers of private derivatives and the monolines maintain adequate reserves,
3) that securitizers have the underlying loan files audited by outsiders,
4) that "to big to fail" financial institutions bring their SIVs and SPVs back on their balance sheets and restrict their leverage,
5) that GSEs not buy or insure a mortgage or a MBS in the absence of full documentation of the underlying loans,
6) that borrowers have reasonable "skin in the game."
The issue was not whether there was a housing price bubble but rather what was causing it -- a mountain of worldwide savings looking for a home (Greenspan and Bernanke's explanation) or fraud and excessive risk taking on the part of financial institutions (NOBODY -- and that includes Dean).
May 7, 2009 12:09 PM | Reply | Permalink
Ellen, you're assuming that anyone would listen to a systemic regulator. Any system that relies on some kind of godlike being to make people do what they refuse to do under normal circumstances isn't going to get very far.
May 7, 2009 1:12 PM | Reply | Permalink
Agreed.
Too bad Greenspan's old; he'd be the perfect appointment to be the first systemic risk regulator.
No irony intended.
May 7, 2009 1:29 PM | Reply | Permalink
I find myself agreeing with Baker
Take me now, Jesus--I have lived to see everything.
May 7, 2009 1:42 PM | Reply | Permalink
Perhaps what we really need is to bring back the Court Jester. http://en.wikipedia.org/wiki/Jester
May 7, 2009 1:50 PM | Reply | Permalink
Our misfortune -- Greenspan, who should have been the "licensed fool," turned out to be nothing but a "natural fool."
That is, he failed to recognize the agency dilemma* or its effects on the financial markets he was hired to oversee.
* ". . . those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief." Greenspan 10/24/2008 Testimony
May 7, 2009 2:22 PM | Reply | Permalink
:sigh: Yes, Greenspan certainly disappointed.
I was really half serious in my comment about a Court Jester. If we somehow were able to incorporate the role of a person playing professional devil's advocate into our financial system, we'd be a lot better for it. But even Court Jesters, according to the wiki, knew they could only go so far. Members of the press, who were supposed to play the role, sure aren't meeting their own responsibilities anymore.
Maybe questions about what happened when we repealed Glass-Steagal, and the reasons it was passed in the first place, need to be made a required part of high school kids curriculum, with no graduation unless they are able to answer them.
May 7, 2009 2:50 PM | Reply | Permalink
Krugman?
Fools, like Oracles, too often speak in riddles.
May 7, 2009 3:34 PM | Reply | Permalink
I thought that the Jester was Jon Stewart.
May 7, 2009 3:16 PM | Reply | Permalink
Heh...yeah, I thought of Stewart myself sometime after logging off earlier today. He does fit the job description pretty well, but I don't seem to recall that he warned of an impending housing crisis, which is what I would have wanted in a jester. In his defense, we were all pretty focused on Iraq during the time in question.
May 7, 2009 9:06 PM | Reply | Permalink
Not all calls for a systemic regulator intend to hide from what Ellen seems to consider the core problem. But I would agree that addressing only the "systemic" aspects could leave other aspects free to fester and grow again. I also wonder if systemic=systematic for Baker, or if he's trying to talk about something else or perhaps to point out another aspect.
Let's indeed look at causal agents (of the housing bubble and collapse with somewhat consequent problems - inflation, peaking, collapse). Here is a list of suspects:
Too much money/profits looking for a job or nest (many houses being bought as speculative investments or havens for loose real money).
A debt bubble often misnamed a "credit bubble" inflating the general economy (low current rates, lending on faith instead of good credit/collateral, non-cyclical consumer borrowing, problematic financial and producer debt).
Lax to possibly perverse regulation (SEC, mortgage origination, Fed, Treasury, OTC instruments,...).
Problematic social policy (Ownership Society).
Gambling (shorts and other contracts such as 'insurance').
Frauds and criminal activity (in mortgages and in markets, rent-seeking).
May 7, 2009 1:12 PM | Reply | Permalink
Leaving aside the question of whether the new regulator would obscure, rather than shine a light on, the problems that led to the housing bubble in the first place, wouldn't a systemic risk regulator succeed if the government invested quite a bit of credibility in the office itself? In other words, if the government promoted the office in such a way that people would listen? It would seem to me that if we were honest with ourselves about the propensity of financial types to be very greedy, and the risks of that, then we would be more inclined to recognize developing problems before they grew to bubble-size.
Since Obama's style is so different than Bush's, and of the ideological far right, it seems that now would be a good time to set up such an office and imbue it with credibility. If there had been such an office in the past, it might have raised an alarm when Congress first contemplated repeal of Glass-Steagal, for instance.
I seem to recall noticing myself that the housing industry was responsible for what seemed like an unusually large proportion of the GDP way back in...what was it? 2002? 2003? I don't have an economic background, but I do have a background in basic ecological principles and presumed economics worked in a similar way: any time there is a domination of one sector (species), the system becomes vulnerable to a crash. It strikes me that if I could sense a looming problem, someone else, say at the Fed or Treasury, surely should have.
But while just about everyone says that nobody noticed it, the wiki on the housing bubble says otherwise:
Perhaps rather than saying that nobody noticed it, we should be saying that nobody paid attention to those who noticed it. I guess that's part of what Baker is saying. It does seem that we need someone playing the role of the little boy who said the (financial) Emperor has no clothes.
One thing I've wondered is whether in the climate that occurred after 9/11 (remember Bush's exhortations to spend, spend, spend?), maybe those in government who were supposed to be paying attention to these things did notice it, but decided to ignore it for reasons related to the need for bubble-generated tax revenues to finance the Iraq War. This, however, is total speculation.
I suppose the problem with a systemic risk regulator, going forward, will be that once the Republicans return to power (assuming they'll return in the future to being a viable party), they may see risks in a very different way, and so the regulator could turn out to be someone who has a vested interest in not seeing approaching crises.
May 7, 2009 1:36 PM | Reply | Permalink
"Fools, like Oracles, too often speak in riddles."
The problem with a systemic risk regulator is that you need to define "systemic risk" in operational and political terms, and do so quite clearly. Otherwise you merely add another layer of foolish bureaucracy to the system.
The better option is to design, or redo, the system in such a way that no entity can be too big to fail in the perverse sense. This is the basic idea of the old Internet, many unimportant nodes which can adapt traffic flow to get around node failures. Of course consolidation runs antithetical to that principle too. But if finance is largely about liquidity of risk and capital, maybe it should work like the old Internet -- many little guys working cooperatively with distributed contracts which cannot exceed leverage limits.
May 7, 2009 3:45 PM | Reply | Permalink
eds: I never thought about the internet in ecological terms before, but it appears that you're really saying that it, and the financial system, needs to work like a successful ecosystem.
May 7, 2009 9:14 PM | Reply | Permalink
Would you care to expand on that idea?
I don't see the nodal nature of the net as being all that close to a biological ecosystem, but maybe you can bring the two closer together for me.
May 8, 2009 12:13 AM | Reply | Permalink
OK, it's late and I'm a little fuzzy, but here goes. When you mentioned this:
I was reminded of a basic characteristic of a successful ecosystem: diversity. In a successful ecosystem, each species occupies it's own niche, and no one species tends to dominate to the detriment of the others (this is very simplified, but for the purposes of this example and of brevity that's the best I can do).
The reason diversity creates a successful ecosystem is much like what you describe above. Since there is a variety of species, if there is a failure of any one of them, the system will be able to adapt.
It seems to me this similarity also applies to financial systems. Our problem now is that certain companies, through acquisitions and other forms of super-heated growth became "too big to fail," which is analogous to an ecosystem in which one species becomes invasive and drives out other species, creating a lack of diversity and therefore making the entire system very vulnerable and at much higher risk for a crash. At least that's how this non-economist tends to view the problem.
May 8, 2009 1:37 AM | Reply | Permalink
I do see elements of diversity in a net, there are many possible paths. If a possible path is a species, then there would be many species. It feels awkward to me, but maybe it works fine for others. I'm thinking more in terms of simple redundancy of pathways in both the Internet and finance systems.
ecosystem - "a system formed by the interaction of a community of organisms with their environment."
Of course ISPs etc. (and banks etc.) do form a sort of non-biological economic ecosystem, or part of a larger one ("the economy"). Do people become the environment of the finanicial or routing "organisms"?
May 8, 2009 4:59 AM | Reply | Permalink
eds: Perhaps redundancy is a better way to conceptualize it. I think redundancy is exactly what makes the two similar. Maybe diversity is only a way that redundancy is achieved.
Perhaps it's not necessary to find an exact equivalency between elements of a biological ecosystem and the early internet's nodes if one instead considers both as subsumed under the larger umbrella of systems theory, with the redundancy being a common feature of successful systems in general. Does that make more sense?
I have to thank you for asking these questions. It's been a very long time since I studied either ecological systems, or systems theory in general, and as a result of the questions you've asked, I've spent and enjoyable hour or so now browsing around the net, reading things about systems (Brain food! Gets the synapses firing!). I know I've seen a table of the common characteristics of systems somewhere, but alas, I haven't been able to find it, and my internet interlude is at an end for the morning. Thanks for an interesting conversation.
May 8, 2009 11:34 AM | Reply | Permalink
"Does that make more sense?"
It makes sense metaphorically, but one man's effective metaphor is some woman's annoyance. :-)
The value of more direct equivalency is that you get a more accurate illustration. We can look at clouds and "see" familiar shapes. That's projection. Or we can find analogies between systems and then use the rules from a known system to hypothesize about the lesser known system.
Usually we think of organisms in an environment. That would be people in an economy (or on the internet). But my closing remark suggests turning that around backwards, that the people and "real world" are the environment for the nodes of the internet or the banks as nodes in finance. Finance is about cash flow between organisms. The internet is about data flow...
Thanks to you too!
May 8, 2009 2:09 PM | Reply | Permalink
Here is your Systemic Risk Regulator: De-couple insurance and finance. Make financial deals stand on their own merit like they used to. If a deal is so risky it needs insurance, chances are they won't be made without it.
The current system is like me taking out insurance for a Las Vegas gambling trip. I'll pay someone $150 to insure my $1,000 at the tables. Anyone want to take me up on that? I think you'll have better odds than AIG got.
And I agree, anti-trust laws need to be enforced. If they are too big to fail, they are too big to exist.
May 7, 2009 4:06 PM | Reply | Permalink
At the risk of revealing my naivite on all matters economic, has anyone suggested that requiring the person who sells the product (mortgage, whatever) to stand behind it - make good on it should it turn out to be worthless - out of the realm of possibility?
(And then there's all those 401K holders who contributed good money to them for years to be told, sorry, they're worthless, is outrageous.)
It just seems to me that the 'problem' is more easily solved from the bottom up rather than the top down.
May 7, 2009 4:36 PM | Reply | Permalink
The main tenet of Capitalism is: "Let the Buyer Beware".
Therefore, the seller in a capitalist system is not required to guarantee that what is being sold and bought has any value at all. It is the buyer's responsibility to not purchase anything which is worthless.
However, once a purchase is made, it is the buyer who assumes the risk if it turns out that whatever was bought turns out to be worthless.
That is the part which is missing in this financial crisis. The buyers are successfully transferring the risk to the taxpayer.
That is not capitalism, it is privitization of profits at the expense of socializing the losses and guaranteeing that there will be losses by transferring wealth out of the financial companies as fast as it comes in.
Expect the banks to recalculate their balance sheets to reflect the new reality that they are to big to fail and will therefore continue to show losses in the future that the taxpayers will have to absorb over and over again.
May 7, 2009 11:40 PM | Reply | Permalink
Caveat emptor is not about capitalism, and modern trade includes warranties and guarantees etc.
"The buyers are successfully transferring the risk to the taxpayer."
That needs unpacking. The banks were buyers AND sellers. They are not transferring risk so much as they are transferring losses, but in some cases some risk transfer is occuring (but it might help to be clear about which parts you mean to discuss).
Borrowers and home sellers made out like bandits. Investors got the shaft. Now investors and banks are scrambling to get what they can besides properties at very depressed prices and non-existent cash flows.
May 8, 2009 12:20 AM | Reply | Permalink