A less flippant post

This post is my response to Gaurav's and Kunal's comments on Kunal's post on Amit Varma and Ottoman.

From a first principles stand point I suppose everyone opposes the bail-out. You will be hard pressed to find a person out there who says that he/she supports the bail out cheerfully and without any qualms. It is not hard to discern that whichever way you look at it, the taxpayers are being dished out a raw deal here.

Most are in a catch-22 situation. Or a better analogy would be a Vikram Vetal situation. While they shoulder the burden of the Wall Street fat cats' greed and ponder what their response should be, Wall Street keeps whispering sinister questions in their ear about whether Damocles' sword will fall on them if they cut off the financial thread with which it is hanging on. However, if the taxpayer bails them out then it is a moral hazard and then the Vetal is free to do his shaitani again. Maybe not immediately, but when the memory of the crisis has receded. So you have taxpayers cornered. Not everyone knows economics and its not just lobbyist and Wall Street playing doomsayers but a variety of experts from varying ideological spectrum who think this is a once in a century crisis.


The point I am trying to make is it is futile to talk about this from a first principles standpoint. If we start arguing from that angle then it precludes all discussion. You guys win hands down. Because you will always talk about how things would have been different in an ideal situation where markets were truly free. That has never happened, hadn't happened leading up to the crisis and as such an honest discussion about whether or not your ideology's prescriptions were at least partially responsible for the cause of the crisis can never take place.

A doctor cannot make the argument that the drugs he prescribed to treat a patient for healing a wound did not work because the patient also had diabetes. Especially given that the patient had informed him before hand that he is a diabetic. Similarly, in spite of knowing the areas where there was or there would have been government intervention and voter pressure, if you prescribed policies that proved to be ineffective then you have to accept responsibility.

You cannot shy away from the fact that these were one of the best years for your ideology in terms of favourable public opinion, political muscle and policy backing for your ideological prescriptions. Even if the prescriptions weren't implemented enough to your liking, they were still incrementally better implemented than in previous years. So now to take umbrage under the guise that it was no fault whatsoever of the ideological prescriptions since they were not implemented in their entirety is disingenuous.

When these prescriptions were being advocated you guys knew exactly what the situation on the ground was. It was not as if libertarians were unaware of Fannie and Freddie's existence or the CRA or for that matter of government's agenda for promoting housing for the poor before Greenspan decided to keep the interest rate low or let the markets mess up before any corrective action could be taken. This, purportedly, to avoid unintended consequences. (As an aside. Could you explain why you think the unintended consequences of not increasing interest rates or letting the housing bubble inflate despite knowing that it is a bubble would have been worse than the unintended consequences of letting the market take its own course and now spending trillions to repair the mess. And if possible try to avoid getting into a discussion on how it is impossible to know a bubble before it bursts. There were many voices who were talking about this bubble before it burst.)

Regarding deregulation: Yes, it isn't entirely deregulation's fault as Democrats are shouting from the roof tops. But to deny that lack of regulation played no role in the crisis is not true either. Libertarians keep harping about the fact that banks are the most regulated entities. This is a complete non-sequitor. The crisis didn't happen because of the everyday regulated business of the banks. Rather it happened in the derivatives and credit default swaps markets which were entirely unregulated. There is absolutely no way of knowing what these contracts are, how many of these are there, what their value is, or whether the contracts could be fulfilled. All these because there was no regulation. Isn't transparency in contracts better for capitalism? Or has the defensive position you have to adopt wiped out the memory of your agenda to save capitalism from capitalists?

Another place where you guys need to take a hard look at is the idea that market players can come up with a self-regulatory mechanism because it is in their interest to do so. Well, the rating agencies were supposed to do just that. But we all saw what happened when Moody's and S&P gave triple A ratings to risky mortgage backed securities. So what happened to the libertarian argument here?

Just like Democrats are blaming deregulation free marketers are blaming Fannie and Freddie. Don't even get me started on the whining about how government forced sub-prime lending. Obviously, the banks didn't lend money to the poor out of any government pressure or out of any benevolence. They thought they could earn a hefty profit through sub-prime lending since the risk would be distributed owing to the trading in mortgage backed securities and derivatives.

I don't get it. I mean how can Freddie and Fannie be solely responsible for this crisis? Partly, yes. They did add fuel to fire by starting to deal with sub prime mortgages since 2004 on the suggestion of Congress. But essentially they were buying up mortgages from the banks, freeing their capital and then bundling a lot of these mortgages together and selling it in the secondary market where Investment Bankers and Hedge Funds were placing speculative bets on their prices. In fact, Fannie and Freddie claim in their defense that it was not just the Congress but market conditions that forced them into dealing with sub prime mortgages because the mortgage lending firms like Countrywide were threatening to take their business lock stock and barrel to the investment bankers who were more than willing to buy sub-prime mortgages and bundle them their selves and sell it in the secondary market. This would have meant a loss in profits for Fannie and Freddie who were answerable to shareholders despite being quasi government entities. It was the secondary market, and the swaps market that was built upon this secondary market to cover the risk of a credit event that has frozen the financial pipes. Fannie and Freddie had an agenda which was known to everybody in the market and that was to inject capital in the markets and aid affordable housing. The fact that they had a government guarantee was known. Yes, they distorted the market. But I would assume the market to be efficient enough to warp around this distortion and in fact leverage it to their advantage. There are several different equilibriums/equilibria where the markets can stabilize, right? This is exactly what the markets had been doing from 1968 since the formation of Fannie Mae. Why wasn't there a crisis before this. It wasn't Fannie or Freddie's agenda that changed but the market's gambling on the securities and the derivatives that changed the game.

One other gnawing issue is banker's compensation. Even Martin Wolf and Raghuram Rajan are writing about how the way the industry designs its compensation plans and bonus, results in perverse incentives to take the kind of short term risks that lead to crises like these. The banks know this is a problem as this has led to many crisis in the past. However, markets haven't come up with self-regulation to correct this. Banks have never changed their pay structure. Partly because if one bank does it and the other bank doesn't, the competitor might steal their best talent. But weren't the markets supposed to learn from their mistakes? This is a situation where no one wants to go first. Yes, you can say that it is the fault of the governments who keep bailing the banks out each time. But given that this (bail-out of banks after crisis) is bound to happen again and again with no change in the structure of compensation from the banks' side, should we just sit and watch repeated crisis unfold as leftists blame banker's greed and free marketers blame the government bailout?

Gaurav your point about boom and bust cycles would have been well taken had the boom been experienced by the general economy. During the Bush years the middle class wages had stagnated. Of course, middle class did benefit in absolute terms because market innovations led to price declines in most items which might have been considered luxuries some time back. I am not disputing that. But when you have financial elite whose wealth grows exponentially, which instead of trickling down gives a semblance of trickling up while the regular Joe does not see his income rise, it is bound to raise questions about whether there really was a boom. The boom benefitted the rich disproportionately because of Bush's tax cuts which libertarians support. And now you find the regular Joe is having to bail out these same fat cats who enjoyed the boom to avoid a bust for themselves.

The real question I think is whether it is better to digest a slight drop in growth with timely government intervention, despite its obvious inefficiencies and unintended consequences or let the growth be unhindered in spite of warning signs and then let everyone bear a massive hangover even though many didn't even get drunk. You guys' have always argued that the latter approach is better. Now in light of this crises I think the onus is on you to explain how and why?