Stiglitz: How to Prevent a Repeat of this Financial Crisis

Nobel Laureate Joseph Stiglitz gives his prescription for preventing this type of crisis from happening again:

This is not the first crisis in our financial system, not the first time that those who believe in free and unregulated markets have come running to the government for bail-outs. There is a pattern here, one that suggests deep systemic problems — and a variety of solutions:

1. We need first to correct incentives for executives, reducing the scope for conflicts of interest and improving shareholder information about dilution in share value as a result of stock options. We should mitigate the incentives for excessive risk-taking and the short-term focus that has so long prevailed, for instance, by requiring bonuses to be paid on the basis of, say, five-year returns, rather than annual returns.

2. Secondly, we need to create a financial product safety commission, to make sure that products bought and sold by banks, pension funds, etc. are safe for "human consumption." Consenting adults should be given great freedom to do whatever they want, but that does not mean they should gamble with other people's money. Some may worry that this may stifle innovation. But that may be a good thing considering the kind of innovation we had — attempting to subvert accounting and regulations. What we need is more innovation addressing the needs of ordinary Americans, so they can stay in their homes when economic conditions change.

3. We need to create a financial systems stability commission to take an overview of the entire financial system, recognizing the interrelations among the various parts, and to prevent the excessive systemic leveraging that we have just experienced.

4. We need to impose other regulations to improve the safety and soundness of our financial system, such as "speed bumps" to limit borrowing. Historically, rapid expansion of lending has been responsible for a large fraction of crises and this crisis is no exception.

5. We need better consumer protection laws, including laws that prevent predatory lending.

6. We need better competition laws. The financial institutions have been able to prey on consumers through credit cards partly because of the absence of competition. But even more importantly, we should not be in situations where a firm is "too big to fail." If it is that big, it should be broken up.

These reforms will not guarantee that we will not have another crisis. The ingenuity of those in the financial markets is impressive. Eventually, they will figure out how to circumvent whatever regulations are imposed. But these reforms will make another crisis of this kind less likely, and, should it occur, make it less severe than it otherwise would be.

U.S. Learns from Japan's Lesson

The Wall Street Journal says that the U.S. is making sure not to repeat the mistakes Japan made when its banking system ran into trouble.

When Japan was mired in economic crisis, the U.S. urged it to take decisive action to deal with its ailing banks. Japan didn't follow the advice and the crisis dragged on for years. Now, it is the U.S. that is mired in crisis and facing the prospect of swallowing the bitter medicine it once proffered. ...

"One of the lessons we took from Japan was the hesitation and refusal to own up to the problem was a disaster," says University of Chicago Graduate School of Business economist Anil Kashyap.

U.S. financial firms, too, have struggled with owning up to the extent of their credit losses, partly because those losses are a moving target. A year ago, Bear Stearns Cos. was reluctant to sell mortgage-related credit at a loss. That decision came back to haunt the firm as declining home prices continued to pummel mortgages, and Bear ended up in a government-backed fire sale to J.P. Morgan Chase & Co. Meanwhile, Merrill Lynch & Co. Chief Executive John Thain said in a January interview that the firm's troubles were "for the most part behind us" — but in July the firm agreed to sell more than $30 billion in mortgage-related assets at a large loss.

Still, U.S. financial firms have been much quicker to acknowledge losses than their Japanese counterparts were. While the slicing and dicing of mortgages into tradable securities played a part in the mortgage mess, accounting rules make it difficult for firms to ignore losses on those securities, says Princeton University economist Hyun Song Shin. In contrast, by continuing to extend credit to bad borrowers, Japanese banks were able to put off recognizing the extent of their debt problems.

"The denial strategy is harder to pull off — it will catch up to you in the accounting," says Mr. Shin. "That's one of the more encouraging and hopeful signs in the U.S." ...

Just as Federal Reserve Chairman Ben Bernanke has been intent on not repeating the Fed's Depression-era mistakes, Treasury Secretary Henry Paulson is intent on not repeating Japan's mistakes in the 1990s, says Brad DeLong, an economic historian at the University of California at Berkeley.

Do We Even Need Fannie and Freddie?

Does the United States even need organizations like Fannie Mae and Freddie Mac? Most developed countries don't have such organizations. Why do Americans assume they are necessary for a functioning mortgage market? Professor Richard Green ponders, "What has been the real benefit of Fannie and Freddie?"

It is almost certainly not homeowning, and it is almost certainly not funnelling money into underserved neighborhoods or toward underserved borrowers.

Rather, is has been the transfer of interest rate risk from households to investors. So far as I know, the US is the only country in the world with long-term, fixed-rate, 95 percent LTV loans that do not have prepayment penalties. When interest rates rise, borrowers are protected; when they fall, they are not made immobile by yield-maintenance and lockout clauses. The low down payments (and five percent equity seems to be OK) effectively give households with modest incomes access to capital markets. I have written elsewhere that I believe that the peculiar structure of Fannie and Freddie has helped bring about the unique American mortage.

One could argue that the current environment shows that none of this has been worth it. But I would disagree with that argument.

More on Financial Speculation and Oil Prices

Two new reports contradict each other regarding whether financial speculation was behind the rising price of oil earlier this year.

Conventional wisdom in Washington holds that speculative money flooding into the market from index funds pushed up oil prices earlier this year.

But a regulatory report released Thursday shows that those funds actually were cutting their stake in the oil market as prices were soaring.

That data, based on private trading data gathered by market regulators, contradicts parts of a report released by Washington lawmakers on Wednesday.

That earlier report, by Michael W. Masters and Alan K. White, blamed high commodity prices on the growing role of institutional investors, specifically index funds. It was cited by several lawmakers as proof that new rules were needed to curb the impact of speculation on commodity prices.

But the new 69-page study, by the Commodity Futures Trading Commission, shows that, rather than rising, the stake of index funds in the oil market actually declined in the first half of this year.

Regarding the Masters report, you should know that Princeton economist Paul Krugman has taken Michael Masters to task in the past:

Some correspondents have asked me what I think about the Congressional testimony of Michael Masters, who told a Senate subcommittee that “index speculators” — institutions that buy commodity futures as an investment — are responsible for the price surge.

The short answer is that I think his testimony is just stupid. Here’s what he says:

Index Speculators’ trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits.

That quote pretty much epitomizes what’s wrong with a lot of what people say about speculation. Buying a futures contract for oil does not reduce the quantity of oil available for consumption; there’s no such thing as "virtual hoarding".

And Masters really is confused about the difference between paper contracts and physical stuff. He compares the growth in the futures market with increased consumption from China, and says

The increase in demand from Index Speculators is almost equal to the increase in demand from China!

Again, the fact that someone bought a futures contract (which means that someone else sold one) doesn’t reduce the amount of oil available to consume.

I’m willing to listen to serious arguments about how speculation might be affecting the price, but you do see a lot of dumb stuff. And this is really, really dumb.

Krugman attacked Michael Masters' reasoning in a bit more detail here.

Fannie and Freddie: A Lot Has Changed in 6 Months

Six months ago, Fannie Mae and Freddie Mac were supposed to be the saviors of the housing market. Congress even placed them at greater financial risk by raising the conforming loan limit, so they could help rescue the California housing market. These housing market superheroes don't look so super anymore.

From The New York Times:

The seizure of Fannie and Freddie is all the more surprising because, as recently as late March, Washington viewed the companies as saviors of the housing market and the economy, rather than as risks to them. Instead of requiring Fannie and Freddie to scale back, regulators gave them a green light to buy and guarantee more and bigger mortgages.

On March 19, James B. Lockhart, their chief regulator, dismissed swirling rumors about their financial health. “The actions we’re taking today,” Mr. Lockhart declared, referring to a decision to ease restrictions on how much capital they were required to hold, “make the idea of a bailout nonsense in my mind. The companies are safe and sound, and they will continue to be safe and sound.”

Why Fannie and Freddie Failed

Dean Baker on why Fannie Mae and Freddie Mac failed:

These mortgage giants went under because they were somehow unable to recognise the housing bubble and to adjust their lending to protect themselves against the inevitable crash. Fannie and Freddie are very far from innocent victims. It is their job to know the housing market and to recognise a bubble. Furthermore, if Fannie and Freddie had begun to tighten credit five or six years ago, when house prices were already clearly out of line, they could have stopped the growth of the bubble before it reached such dangerous proportions.

Dividend Taxes Cause Over-Investment in Housing

Harvard economist Greg Mankiw says taxes on dividends "induce people to invest too much in housing and too little in businesses":

Before 2003, when a person received dividends from his stock holdings, this income was taxed at ordinary income tax rates. That is, a dollar of dividends generated the same individual income tax liability as did a dollar of wages.

But many economists have long argued against taxing dividends this way. Dividends are a stockholder’s payment from corporate profits, and these profits have already been subject to the corporate income tax. Any tax on dividends represents a second tax on essentially the same income.

One can question whether this double taxation of income from corporate capital is fair. But fairness aside, there is also the problem of incentives. Taxing dividends twice substantially raises the overall tax burden on this form of income and distorts various decisions. Whenever taxes, rather than true costs and benefits, drive the allocation of resources, the economy shrinks below its potential.

Here are five ways a heavy tax on dividends messes things up:

CONSUMPTION VS. SAVING When the tax system depresses the return on a major asset class like corporate equities, households have less incentive to save for the future. Reduced saving means less funds for capital accumulation, which in turn impedes economic growth.

HOUSING VS. BUSINESS CAPITAL Wealth invested in your own home has several tax advantages. These include the mortgage interest deduction and the absence of any tax on imputed rent (the value that homeowners earn implicitly by getting a place to live). By taxing business capital highly, the tax laws induce people to invest too much in housing and too little in businesses.

NONCORPORATE VS. CORPORATE Because noncorporate businesses like partnerships are taxed only once, they have an advantage over twice-taxed corporations. As a result, too much of the economy’s capital stock ends up in the noncorporate sector.

DEBT VS. EQUITY FINANCE Because interest payments on corporate debt are deductible for corporate income tax calculations, this capital income is taxed only once. This asymmetric treatment of debt and equity finance induces companies to issue more debt than they otherwise would, increasing leverage and the economy’s financial fragility.

RETAINED EARNINGS VS. DIVIDENDS Companies can avoid the dividend tax by retaining earnings rather than paying dividends. Excessive retained earnings, however, impede the movement of capital from older cash-generating companies to newer ones with better prospects.

Bond Fund Manager Bill Gross Calls for a Mortgage Bailout

Bill Gross, manager of the world's largest bond fund, asks for a government bailout of the mortgage market:

Bond manager Bill Gross wants to spread the bailout wealth. Gross says in a commentary posted on the Pimco Web site Thursday that the government must “open up the balance sheet of the U.S. Treasury” to support Fannie Mae (FNM), Freddie Mac (FRE) and, in a new twist, “Mom and Pop on Main Street U.S.A.” as well.

Gross has previously said he believes the Treasury will have to assist Fannie and Freddie in any efforts to raise new capital. His Pimco Total Return bond fund has major positions in mortgage-backed bonds issued by the government-sponsored enterprises, so it’s no surprise that he sees it that way. But now he’s calling on Treasury Secretary Henry Paulson to use federal funds to buy more housing-related assets, in the name of preventing asset-price deflation from spiraling out of control.

Gross writes that the government should be more aggressively issuing subsidized home loans and creating funds to buy distressed properties, to help inject cash into U.S. households and slow the plunge in home prices. He writes that federal assistance is required because the deleveraging sweeping the financial sector has moved from asset liquidiation to debt liquidation — a process, he writes, that “can turn a campfire into a forest fire, a mild asset bear market into a destructive financial tsunami.”

Gross argues that Paulson and other policymakers must overcome their unwillingness to offer relief to households, after a decade in which Americans went on a record spending spree using borrowed money. He says that regardless of the source of the problem, plunging asset prices will only become more intractable as time marches on.

“The bill for our collective speculative profligacy, obvious in the deflating asset markets, can be paid now or it can be paid later,” Gross wrote. “The tab will be less if paid up front, than if swept under a rug of moral umbrage intent on seeking retribution for any and all of those responsible.”

When Will the Housing Decline End?

Economist Irwin Kellner gives his opinion:

Three years ago, the housing bubble burst. That set the stage for a pullback in new-home construction and consumer spending as home sales and prices began to fall.

When it became apparent that many home loans were not held by the banks, but turned into securities and sold, a financial crisis developed, since holders of these securities had no way of knowing their value. This led to a credit crunch, and a severe pullback in bank lending. ...

Since this whole mess started with housing becoming irrationally exuberant, it must end with a return to sanity in this key sector of our economy. And in spite of what you may have read or heard about the "unprecedented" decline in home prices, normal housing prices are still beyond the horizon.

According to the latest data from the Census Bureau and the National Association of Realtors, median home prices in July equaled 3.6 times median household incomes. This may be down from the peak of four times incomes set back in 2005, but it is still far above the 2.9 times of the 1980s — when housing was more affordable and sales and construction grew at a steady pace.

In the halcyon days of the early 1970s, when home sales and construction were at their peaks both in absolute terms and relative to the size of the population, the ratio of home prices to incomes was less than 2.5.

To get back to the average of the 1980s, home prices would have to fall another 20%, on average. Add another 10 percentage points decline for housing to be as affordable as it was in the 1970s.

These numbers are for the U.S. as a whole. The declines needed in bubble markets would be greater. The declines needed in non-bubble markets would be less.

Fed President Hoenig Says Financial Institutions Must be Allowed to Fail

From Bloomberg:

Federal Reserve Bank of Kansas City President Thomas Hoenig said for economies to work best, institutions must be allowed to 'fail.'

Economies must "find a balance between financial stability and a stable price environment and in doing so must be able to allow individual institutions to fail," Hoenig said in a speech today in Buenos Aires. ...

"Financial crises will occur despite our best efforts to prevent them," Hoenig said in prepared remarks at an event hosted by Argentina's central bank. "The 'Too Big to Fail' issue will only grow in importance as the consolidation of the financial industry grows in both size and scope in future decades." ...

Hoenig, 61, dissented from a rate cut on Oct. 31 because of inflation concerns. Hoenig doesn't vote this year and will vote next in 2010. Dallas Fed President Richard Fisher has dissented from Federal Open Market Committee votes five times this year, preferring to raise interest rates last month.