Parentonomics (US Version)

Amazon.com have posted a pre-publication link for Parentonomics: An Economist Dad Looks at Parenting to be published by MIT Press in April 2009. Click here to sign up for notification when it is actually available. Interestingly, it is different to Parentonomics: An Economist Dad's Parenting Experiences published by New South in both subtitle and also in language. The international version adopts a US style. So expect diapers rather than nappies and various other things like that.

Unforgetable Concerts

The key is to watch the kids ...

Bankruptcy, not bailout

At cnn.com economist Jeffrey A. Miron argues that Bankruptcy, not bailout, is the right answer to the current problems in the US financial markets. Miron is senior lecturer in economics at Harvard University ands one of 166 academic economists who signed a letter to congressional leaders last week opposing the government bailout plan. In this article Miron explains why the plan is a bad idea.

He opens his piece by noting

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.

Once housing prices declined and economic conditions worsened, defaults and delinquencies soared, leaving the industry holding large amounts of severely depreciated mortgage assets.

Miron argues that any response to the crisis should eliminate the conditions that created the problems in the first place. What such a response shouldn't do is attempt to fix bad government with even more government. He writes

The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.

But keep in mind that bankruptcy doesn't mean the company disappears. What happens is that the firm is now owned by someone new. Importantly bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable. Contrast this with the bailout plan which transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending.

Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This "moral hazard" generates enormous distortions in an economy's allocation of its financial resources.

Many of the more thoughtful advocates of the bailout will concede the moral hazard point, but will still argue that a bailout is necessary to prevent economic collapse. Their argument is that lenders are not making loans, even for worthwhile projects, simply because they cannot the capital to do so. Miron accepts that there is a grain of truth in this and that if the bailout does not occur, more bankruptcies are possible and credit conditions may worsen for a time. He goes on to note, however, that

Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.

Miron further notes that the current credit freeze may well be due to Wall Street's hope of getting a bailout. Bankers will not sell their toxic assets for 20 cents on the dollar if the government might pay more than that.

Anticipation of the bailout will engender strategic behavior by Wall Street institutions as they shuffle their assets and position their balance sheets to maximize their take. The bailout will open the door to further federal meddling in financial markets.

So what should be done? Miron's answer is,

Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay. This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.

He ends by saying,

The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that. That someone should not be, and does not need to be, the U.S. taxpayer.

A must read for Matt McCarten ... and others (updated)

Steven Horwitz, Department of Economics, St. Lawrence University, has written An Open Letter to my Friends on the Left to do with the financial crisis in the US. The letter attempts to persuade those on the left that the current financial mess is not the product of free markets but a whole variety of government interventions. It also makes an attempt to persuade them that, for reasons they might share, solutions that bailout the lenders and ask for more regulations will be counter-productive.

At one point Horwitz writes,

One of the biggest confusions in the current mess is the claim that it is the result of greed. The problem with that explanation is that greed is always a feature of human interaction. It always has been. Why, all of a sudden, has greed produced so much harm? And why only in one sector of the economy? After all, isn't there plenty of greed elsewhere? Firms are indeed profit seekers. And they will seek after profit where the institutional incentives are such that profit is available. In a free market, firms profit by providing the goods that consumers want at prices they are willing to pay. (My friends, don't stop reading there even if you disagree - now you know how I feel when you claim this mess is a failure of free markets - at least finish this paragraph.) However, regulations and policies and even the rhetoric of powerful political actors can change the incentives to profit. Regulations can make it harder for firms to minimize their risk by requiring that they make loans to marginal borrowers. Government institutions can encourage banks to take on extra risk by offering an implicit government guarantee if those risks fail. Policies can direct self-interest into activities that only serve corporate profits, not the public.

The whole letter is worth taking the time to read.

(HT: The Austrian Economists)

Update: The visible hand in economics asks Does the credit crisis indicate the failure of the “free market”. Matt sees the issue as one of asymmetric information, which must be to a degree true. But I'm not sure it is one of the primary causes of the current mess. I think a lot of people knew what they are trading and traded anyway due to the incentives provided by the government or its agencies. So I see the causes as more to do with incentives than information.

More on General Motors-Fisher Body

The seemingly never ending debate about the General Motors-Fisher Body vertical integration has taken another step towards not ending with the publication of two new papers on aspects of the issue.

Victor P. Goldberg has a paper in the journal Industrial and Corporate Change, Volume 17, Number 5, pp. 1071–1084 in which he argues that the 1919 General Motors–Fisher Body contract was legally unenforceable. The abstract of his paper, Lawyers asleep at the wheel? The GM–Fisher Body contract, reads

In the analysis of vertical integration by contract versus ownership, one event has dominated the discussion—General Motors’ (GM) merger with Fisher Body in 1926. The debates have all been premised on the assumption that the 10-year contract between the parties signed in 1919 was a legally enforceable agreement.However, it was not. Because Fisher’s promise was illusory the contract lacked consideration. This note suggests that GM’s counsel must have known this. It raises a significant question in transactional engineering: what is the function of an agreement that is not legally enforceable?

In a note on the Goldberg paper, Benjamin Klein argues that even if Goldberg’s contract law conclusion were correct, and Klein argues they are not, it is economically irrelevant. The abstract of the Klein piece, The enforceability of the GM–Fisher Body contract: comment on Goldberg, reads,

Goldberg unconvincingly claims that the General Motors (GM)–Fisher Body contract was in fact legally unenforceable. But even if Goldberg’s contract law conclusion were correct, it is economically irrelevant. It is clear from the actions of Fisher and GM and from the testimonial and other contemporaneous evidence that both transactors considered the contract legally binding and behaved accordingly. Therefore, proper economic analysis of the Fisher–GM case should continue to assume contract enforceability, and the economic determinants of organizational structure illustrated by the case remain fully valid.

(HT: Organizations and Markets)

Will Wilkinson interviews Arnold Kling

This video comes from Bloggingheads.tv. Wilkinson and Kling talk about the current financial problems in the US and the Paulson plan to deal with it.

Principles of Parentonomics

Recently, I recorded a lecture in which I tries to illustrate the 10 Lessons of Economics (from the Australian version of Mankiw's textbook) with parenting examples. It was a challenge but I made it. That said, in watching this I realised that I make typos as I speak. Hopefully no one will transcribe it. (YouTube below or full version here).

Understanding Crisis in the Markets: A Panel of Harvard Experts

The following link is to a video for "Understanding Crisis in the Markets: A Panel of Harvard Experts" which occurred on September 25, 2008. The panel of experts included

• Robert Kaplan, Professor of Management Practice
• Jay Light, Dwight P. Robinson, Jr. Professor of Business Administration and Dean of the Faculty of Business Administration
• Gregory Mankiw, Robert M. Beren Professor of Economics
• Robert Merton, John and Natty McArthur University Professor
• Kenneth Rogoff, Thomas D. Cabot Professor of Public Policy
• Elizabeth Warren, Leo Gottlieb Professor of Law

Arnold Kling recommends listening to three of the panel in particular,

Greg Mankiw (starts about minute 44) said that chapter 26 of his textbook explains the importance of the financial sector. [...]

Ken Rogoff (starts about minute 57) says that the financial sector needs to shrink. He's been writing that, and I've incorporated his views into my criticism of the Paulson plan.

Please listen to Ken, who is a respected policymaker as well as a leading academic. He calls the financial sector bloated, and he draws out the same implications that I do. In particular, rather than being a trigger for a new depression, the shrinkage of the financial sector is part of a necessary adjustment. But hear how he tells it.

Ken also describes our international position as precarious. He will drive Don Boudreaux crazy, because he sees this in terms of currency values and "our" trade deficit. But I think that the point that our government may suddenly find itself facing higher borrowing costs is certainly worthy of emphasis.

[Robert] Merton (right after Rogoff, but you don't want to skip Rogoff) is one of those speakers whose mind produces so many thoughts that all you get to hear are excerpts. One point he makes is that there has been a large real loss of wealth in housing, amounting to trillions of dollars.

Alex Tabarrok at Marginal Revolution has a short summary, by Elizabeth Warren of Credit Slips, of Ken Rogoff's discussion,

Any liquidity crisis is caused by the promise of a government bailout. Ken said that his many friends in investment banking said that there is plenty of money to invest in financial services, but right now it is "sitting on the sidelines." Why? Because the financial services industry does not want to pay the terms required to get that money back in circulation (e.g., give up equity). As he put it, why do business with Warren Buffett who will negotiate a tough deal, if you believe that the government will ride in soon with cheaper cash?

Ken also talked about the need to shrink the financial services sector. He thinks it is good that the investment banking houses are failing and many people on Wall Street are losing their jobs because, in his view, we have an oversupply in that sector and our economy just can't support it.

Ken's background with the IMF and on the Board of the Federal Reserve add a certain credibility to his assessment of conditions on Wall Street. If he is right, the $700 bailout is saving some investment bankers' jobs in the short term, but overall it is just making the financial system worse.