Tuesday, August 28, 2007

The problem you throw money at 

Yves Smith (filling in for Felix Salmon) has an excellent post on how sometimes sensible people are arriving at nonsensical solutions to the subprime/credit crunch. The takeaway:
[T]he prospect of a 10% to 15% fall in house prices is being treated as if it would constitute the end of the world. Yet as we pointed out, quite a few economies have endured 25% or more housing price falls. They did not go into an economic black hole. They had short bad recessions.

The fear of recession in this country has gotten so bad that the Economist ran a story this week arguing that America needs a recession. I have no doubt they did that mainly to be provocative, but the horrified reactions from some quarters proves the point. This fear of recessions, and tendency to paint a recession in the dark colors of a depression, is dangerous and distorts policy decisions.

Fear of a recession is leading some to argue that we need to throw money at this problem, in the many variety of ways Smith elucidates. Fortune itself has an article in which Jerry Useem is calling for Washington to take on "the scarier role of leader" to avoid a panic, predicting dire consequences if we do not do something about.
a nebulous concern about income disparities, assets obtained with easy credit, the use of novel financial instruments that seep into the mainstream, and above all, the lack of what Henry James called the "imagination of disaster."
Yet that has been just what has been done: The Fed has acted in as close to a Bagehot-ine fashion as possible without yet firing all the bullets in its holster. It has certainly given the impression that it will use those bullets if needed. It has gone so far as to let banks borrow against sound collateral to finance their brokerage affiliates; some see this as a bad sign for the commercial paper market, but it does demonstrate that there has already been a robust response from Washington.

Fiscal solutions do what John Palmer fears: When you shield losers from losses while letting winners keep their gains, you encourage a greater-than-optimal amount of risktaking. Be it own to rent (helping borrowers) or expanding Fannie and Freddie into jumbos to help lenders as Larry Summers supports, or some other bailout like that Bill Gross suggests. In each case you are encouraging people with little financial cushion to purchase highly-leveraged assets.

Mark Thoma argues that heads do not need to roll to prevent this from happening again because it will happen again, and it does without anyone necessarily committing fraud. (Those who do, we agree, should be punished according to law.) Yet it is in the interest of a well-functioning market that people understand we live in a profit-and-loss system, and that those who do not appropriately treat and take precaution for the risk of their investments will not use scarce resources that could have gone to other, potentially more valuable investments. That is, a way to view this crisis is as an overinvestment in housing. While we may not be able to prevent overinvestment, that's no reason to encourage it.

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