(Cross-posted over at Economic Thought.)
The Ludwig von Mises Institute of Canada re-publishes my review of Jeffrey Friedman’s and Wladimir Kraus’ Engineering the Financial Crisis. I call the book “undoubtedly one of the best books written yet on the causes of the Great Recession” — simply stated, there are few scholars who have done the amount of historical research Friedman and Kraus committed themselves to (that being said, much of the book’s thesis, admittedly, is based on a number of journal articles published in a special 2009 issue on the financial crisis in the Critical Review journal).
The authors may not consider themselves “Austrian,” or at least may not necessarily sympathize with the entire corpus of Austrian theory, but Engineering the Financial Crisis is extremely compatible with the broader Austrian theory of intertemporal discoordination (malinvestment). The authors also borrow from and develop a particularly Austrian insight: radical uncertainty. Both Friedman and Kraus vehemently believe that, generally speaking, bankers had no idea that their assets would collapse, and thus discard the possibility that the financial crisis was caused by malintentioned financiers.
The authors blame regulation. They bring to the table evidence which suggests that regulations — specifically, capital minima regulations set by the recourse rule — provided bankers an incentive to overconcentrate their investments into the mortgage market. The method of risk pooling adopted by the recourse rule (and the Basel II accords agreed upon by foreign governments) created an artificial preference for mortgage-backed securities over other types of investments, including business loans, since it lowered the capital reserve minima banks were required to maintain (i.e. these types of loans came with a lower cost).
The one major flaw, as I point out in my review, is what I perceive to be an inadequate reasoning for why these assets were so poorly rated. Here, I think, Friedman and Kraus drop the “radical uncertainty” thesis, and instead suggest that it was a product of a lack of competition. They do bring up that there is a broad industry of private investment firms who were coming out with their own ratings, but can only give one example of such a firm that sold its investments in mortgage-backed securities before the crisis. If Friedman’s and Kraus’ thesis was incorporated into the Austrian story of a distorted pricing process (i.e. price signals which falsely convey consumer preferences and cause discoordination) it would be a much stronger and more comprehensive one.
Engineering the Financial Crisis is primarily a history book — it deals with empirical data relating to the pattern of investments which characterized the boom period. As a piece of historical research, it is an invaluable contribution to economic history. It can be easily incorporated into the Austrian narrative (and even, in some ways, bolster the Austrian story), and I think that anybody interested in the topic would be deeply rewarded by reading the book.
{ 24 comments }
This crisis can be blamed on the FED lowering interest rates to 1% in 2003 and raising them to 5.5% in 2007 – no need for any other actors.
… The next crisis can be blamed on the FED lowering rates to close to 0% and keeping them there – again, no other actors necessary.
Broadly speaking, you are absolutely correct. How the crisis took its form (why a housing crisis?), though, is something that is more complicated to explain.
As a result of the FED lowering interests rates to 1%, many large investors required to invest in fixed income securities lost the option of investing in treasuries unless, as Jim Grant aptly put it “they wanted return free risk!”.
The jumbo mortgage market was a prime target for these investors. Also, tax preferences,, given the mortgages and home appreciation encouraged consumers to buy houses. Securitization was a natural way to make a large number of investment grade securities available.
Ninja loans, greed,Fannie and Freddy buying jumbo loans and all the other media reasons were just a natural consequence of the initial conditions.
I think it would be worth it for you to actually read the book. I’m not saying that much of what you’re saying isn’t right, but I think there’s more to it than you think you already know.
Jonathan:
I actually read your whole review – very good articlek.
I agree with nearly all of what you wrote.
I would add the following comments about the credit rating agencies.
1) Credit ratings are not static – they change over time.
2) Credit agencies use a quantitative model that forecasts probability of loss and
severity of loss. The parameters fed into these models involved future assumptions that ultimately turned out to be false – housing prices would continue to increase at 5%, the FED would keep interest rates close to 1%. Default rates on adjustable rate mortgages were based on historic numbers, where there had never been any time in the past where 5 year ARM rates had not reset to a lower rate.
Many of the banks who purchased the MBS’s did not originate them. When banks originated their own loans they had certain rules (such as you need 25% to qualify for a rental property loan or a “Ninja” loan). However, when they bought MBS’s from a third party, they were unaware of what loans were actually in the securitized package. (The rating agencies were fully aware of this and required extra over-collateralization to rate the various tranches.)
Most of the loans issued in California were Jumbo and Super Jumbo loans. This was mostly a new market.
Jonathan:
The mention of Basel jogged my memory onto a comment the Per Karowski made at a Cato conference shown on C-Span. He raises the issue of the purpose of the banking system – should it only make loans that are perceived to be safe? Should Banking Regulations allow 62.5 to 1 leverage for “so-called safe loans” while only allowing 12.5 to 1 leverage for loans carrying risk. Is this one of the reasons why we still have a stagnant economy. Here is one on Per’s videos.
http://subprimeregulations.blogspot.com/2011/05/our-crazy-bank-regulations-explained-in.html
Note that this is referring to the next crisis rather than the last!
I think the idea of having different leverage ratios for liabilities of different perceived risk makes sense. I don’t think it makes sense to leave deciding these ratios to government, rather I think banks would make the effort themselves as a means of preventing bankruptcy.
If banks are private companies, then their purpose is to make a profit. However, under Bushism or Obamunism, banks fulfill a social function – hence the need for the government to bail them out and regulate them when they make bad investment decisions.
However, what Per is saying is that the banking regulations are incompatible with banks fulfilling the social function of lending to small business. Currently, it would appear that the banks are merely intermediate straw men – they buy US treasuries and repo them back to the FED. This effectively, allows the FED to buy the treasuries that it is auctioning off.
When all is said and done, it is the Congress that needs to be regulated financially.
Walt,
Again, I don’t disagree. That doesn’t mean banks wouldn’t privately leverage liabilities of different risk at different ratios.
Jonathan:
The problem is where do the banks get the money to leverage from? In the US, this is controlled by the FED. So it is the person who does the lending that determines how much certain assets can be leveraged, not the banks themselves. (For the FED you can find out how much margin is required for each type of collateral here.
http://www.frbdiscountwindow.org/discountmargins.cfm?hdrID=21?genid=22&desc=Collateral%20Margins%20Table&url=discountmargins.cfm?hdrID=21
).
Could a bank decide to make commercial loans to small business? Yes. However, the interest rate they would have to charge, to compete with their other option of buying US Treasuries leveraged 100 to 1 with no risk, would be prohibitive.
Isn’t Kraus an Austrian? I remember he’s quite the fan of Dr Reisman.
Yes, his economics have been most influenced by Reisman. However, Kraus rejects austrian business cycle theory and price theory.
This book no doubt (I haven’t read it and rely only on the limited summary in the article) makes the same mistake as most other commentators – the crisis is viewed only through the the lens of finance. I am not sure why this is so. In fact resource constraints (especially oil) were probably the the underlying reason behind the crisis and this remains the underlying issue that continues to impact the US and Europe. It should be noted that oil production (crude and condensate) has not increased since 2004, despite the highest prices ever. So long as oil production does not increase global growth will be limited to efficiency gains in the use of what oil actually is available. It should also be noted that oil is a fungible global commodity (obvious really). In the same period (ie since 2004) global net exports of oil have actually declined as the producing countries economies have boomed and their own oil use has outstripped their ability to produce more oil. This reduction is around 6.5% or 3m barrels per day. More concerning is the what I shall define as Available Net Exports – ie Global Net Exports less imports by China and India. Here the figures are even bleaker – the quantum of oil available to all other importing countries has declined by over 5m barrels per day or over 12%. The US alone has borne around 4m barrels per day of this cut and the impact in its economy is clear.
So long as oil production (C+C) fails to grow, so economies, especially oil inefficient economies like the US, will struggle to grow. In fact if (when) oil production actually starts to decline economies will not just fail to grow, but will actually start to contract; and quite sharply too. Of course all this does play out in finance and so it is easy to misinterpret what is actually happening as purely financial. And that is what this book no doubt does.
The more “oil efficient” (i.e. extremely highly taxed) economies of Europe and Japan are having just as difficult a time as the USA, or even worse.
“This book no doubt (I haven’t read it and rely only on the limited summary in the article) makes the same mistake as most other commentators – the crisis is viewed only through the the lens of finance. ”
Because you have to be blind and slightly stupid to ignore the elephant in the room. Cheap credit hastens resource depletion in conjunction with policies favouring incumbent methods of energy production (as well uneconomic as-of-yet alternatives.) You cannot isolate developments in energy markets (including higher prices) from credit expansion, especially since it makes debt financing viable, which in turn drives Chinese exports. So finance is at the heart of it.
Oil is “money” – it is a lot easier for Ben Bernanke to create $1 trillion out of thin air than it is for him to create 1 million ounces of gold out of thin air or 100 billion barrels of oil out of thin air.
That book is a huge pile of … and I want my money back. Every time I read that “radical ignorance,” radical stupidity, radical lack of knowledge I just want to get a moment to talk with that wise, enlightened, radically knowledgeable author and ask him “tell me the price of oil two weeks from now” and if he gets it wrong, just sue him out of existence.
That book has o meaning, has not beef, has no intelligence in it, but a lot of noise and air.
My two cents.
Niko,
I think you misunderstood Friedman’s “radical ignorance.” Radical knowledge refers only to the unknown unknown; not, that there are “radically stupid” people. It’s not a comment on a level of intelligence, rather a comment on the fact that some knowledge is just unknown to market agents.
I don’t think it was what they didn’t know that caused the problems. For the most part bankers knew there are going to be problems. We would like to think of them as stupid people, but they aren’t. Some banks even got out of the game rather early, in 2005, and so missed another year or two of the bubble. As a matter of fact the only people who didn’t know anything were the economist, (almost) all of them were shocked. Hell, Fama was saying that bubbles aren’t possible.
But all those people also knew they were going to be saved, that there are all kind of government institutions with the sole purpose to protect them from their mistakes.
It is not what they didn’t know about the future, but what they did know what would happen in the future. And they were right: for the most part they were bailed out, accounting rules were changed so that they wont have to recognize loses and so on.
Friedman and the other guy just try to look smart or something, but this book is not the one to do that. Just saying “ignorance” three times, adding “radical” here and there and a small doze of nihilism doesn’t explain anything.
Niko,
Please, actually read the book.
” Hell, Fama was saying that bubbles aren’t possible.”
… and people are still waiting for real estate prices to rebound to the pre-crash “normal levels”.
I have friends who were senior executives at Countrywide. When Bear Stearns got into trouble and the music stopped, they were as shocked as anyone else. They lost millions of dollars in their pension funds when Countrywide stock fell from $40 to $4. Of the people I know in the industry, only on friend who was an senior executive at Merrill Lynch correctly forecast what was going to happen.
“(i.e. price signals which falsely convey consumer preferences and cause discoordination)”
Do prices give “signals”, or do prices just permit “calculation”?
https://mises.org/journals/rae/pdf/R91_7.PDF
mises.org/journals/rae/pdf/RAE9_1_8.pdf
https://mises.org/journals/rae/pdf/R72_6.pdf
mises.org/journals/rae/pdf/RAE9_1_9.pdf
Why shouldn’t it be both? Any particular set of prices allows for calculation, and tell us something about the state of the market at that time. Prices give signals in how they change over time, information not available by a static set of prices at one particular point in time.
Here’s a thought, maybe we don’t any Austrian theory. People bought overpriced assets because they were stupid.
They thought for sure they’d be smart enough to get out before any bubble collapsed. End of story.
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