Finance Professor Rafghuram Rajan wrote in his book Fault Lines that the GSEs and the Fed’s low interest rates helped cause the housing bubble, so Paul Krugman “reviewed” it, trotting out his inaccurate analysis that the GSEs had little to do with it.

Rajan responsed to the review by showing why the GSEs and the Fed’s interest rates policy did contribute. Well written and well argued.

Arnold Kling discusses the use of experts by government to control certain sectors:

We live in an increasingly complex world. We depend on experts more than ever. Yet experts are prone to failure, and there are no perfect experts.

Given the complexity of the world, it is tempting to combine expertise with power, by having government delegate power to experts. However, concentration of power makes our society more brittle, because the mistakes made by government experts propagate widely and are difficult to correct.

It is unlikely that we will be able to greatly improve the quality of government experts.

Instead, if we wish to reduce the knowledgepower discrepancy, we need to be willing to allow private-sector experts to grope toward solutions to problems, rather than place unwarranted faith in experts backed by the power of the state.

This is a fascinating use to Hayek’s basic argument that markets are the spontaneous order created by the interconnection of knowledge distributed throughout many minds, and it is impossible for any one person or group to have all knowledge necessary to make the same decisions a market makes through these interconnections (e.g. the price of lead).

Kling’s addition is that this dispersion of knowledge is accelerating, so this is getting even more difficult than before, but there is a parallel trend of government putting experts in certain fields in charge of controlling some part of that field. Kling’s argument is that it is fallacious to assume they can make those judgments, and as time passes it only becomes less viable.

This trend troubles me, too, because the premise underlying it is that these experts (the ones chosen) know so much that they can make legally-binding decisions for everyone else. If we accept this, then we also accept that others should be making decisions for how we live our lives that we have no choice in. If we accept that, than why shouldn’t we also accept a planned society?

Home sales declined precipitously in July:

Economists and forecasters were predicting an awful 13% decline in existing home sales for July, to 4.65 million units.  This, we were told solemnly, would be the worst since 2009.

In hindsight, those making the predictions seem to have been the sort of wild-eyed optimists whose sunny belief in the strength of the housing market got us into this mess in the first place.  The actual figure for home sales, according to the National Association of Realtors, was 3.83 million–a 27% decline.

The home buyers tax credit ended in April and this is the result. The credit didn’t create new demand—it took existing demand and artificially compressed it into a smaller period of time. In this way, it inflated demand while it was in effect and inflated housing prices as well, and thus put off (but didn’t avoid) a necessary contraction after the 1997-2006 housing bubble. We will now live through that contraction.

We could have suffered through it earlier, but we decided to delay the pain.

Arnold Kling:

The suddenly unsustainable housing and mortgage boom comes atop the ongoing obsolescence of various patterns of specialization, as the Internet and globalization continue to foster new forms of organization and competition. The result of the boom-bust cycle superimposed on the ongoing obsolescence is to overload the market’s ability to reconfigure production patterns so that workers are fully employed.

The market needs to undertake a recalculation in order to deploy workers in a new, sustainable pattern of specialization and trade. The process involves gradual, decentralized trial and error. Firms need to be launched by entrepreneurs, who will make risky investments in employees. The failure rate will be high, but eventually the successes will have a cumulative effect that brings about more economic activity.

Fabulous article.

Insightful:

I would compare those who advocate such outright borrowing without committing to credibly repay at maturity to people who fall for teaser mortgage rates and are rather negatively surprised to see the rate adjust later. It is interesting though that there seems to be a large positive correlation between people who advocate government borrowing because rates are low NOW, and those who call for protecting consumers against reckless lenders who tease them with a low temporary rate. To quote a famous Canadian singer, Isn’t it ironic?

John Taylor:

The low interest rates added fuel to the housing boom, which in turn led to risk taking in housing finance and eventually a sharp increase in delinquencies, foreclosures, and the deterioration of the balance sheets of many financial institutions as toxic assets grew rapidly. To test the connection between the low interest rates and the housing boom I built a simple model relating the federal funds rate to housing construction. My research showed that a higher federal funds rate would have avoided much of the boom and bust.

And:

Others might say that my research ignores mistakes in the private sector. Of course there were market problems of various sorts. Mortgages were originated without sufficient documentation or with overly optimistic underwriting assumptions, and then sold off in complex derivative securities which credit rating agencies rated too highly. Individuals and institutions took highly risky positions either through a lack of diversification or excessive leverage ratios. But such mistakes do not normally become systemic, and in my view, the government actions tended to convert non-systemic mistakes into systemic risks.

The link is to a PDF, but if you have any interest in politics or the economy at all, you should read it. And then read it again.

Placing the Federal Reserve’s awesome power in the hands of men is dangerous no matter how it is managed, but we would be in a much better position if the Fed followed Taylor’s recommendations.

Keith Hennessey nicely breaks down the different positions on fiscal stimulus.

It’s well done and a good way of framing the debate. For what it’s worth, I’m in the first group.

Russ Roberts has a nice, succinct overview of what F.A. Hayek argued. Hayek was a brilliant man.

(The article is gated, so you’ll have to click through from Google. The above link is to Google News–just click on the first link.)

Gregory Mankiw considers the administration’s response to the failure of their stimulus models:

The trouble is, we have no way of knowing for sure if the model was in fact correct. To react to a model’s failure to predict events accurately by insisting that the model was nonetheless right — as Obama’s economic advisors have done — is hardly the most obvious course. Careful economists should instead respond with humility. When their predictions fail — as they often do — they should not dig in their heels, but should instead be willing to go back to their starting assumptions and question their validity.

The administration predicted that without stimulus the economy would suffer 9 percent unemployment, and with stimulus it would not rise above 8 percent. The unemployment rate for May was 9.7 percent. Their conclusion is that the stimulus wasn’t large enough, rather than questioning their initial assumptions.

Mankiw’s piece is excellent, and looks at one of the assumptions they should have re-considered—that government spending’s multiplier is 1.5, while for tax cuts it is 0.99¹, and that this is the sole criterion for deciding what kind of stimulus should be used.

1. The multiplier is how much effect one dollar will have on GDP. So, for a dollar of government spending (with the 1.5x multiplier), GDP would increase by $1.50. [↩]

Columbia professor Ang Yuen Yuen thinks China’s cheap labor advantage is slipping away:

Apparel production is a prime example of China’s declining competiveness in markets dependent on low-cost labor. According to a study by the US consulting firm Jassin O’Rourke, labor costs in China are higher than in seven other Asian countries. The average cost for a worker is $1.08 per hour in China’s coastal provinces and $0.55-0.80 in the inland provinces. India was in seventh place, at $0.51 per hour. Bangladesh offers the lowest cost, only one-fifth the price of locations like Shanghai and Suzhou.

That’s how developing markets work: an economy based on cheap labor leads to rising standards of living and wages, and that advantage erodes over time. The economy must then shift to different economic advantages, or higher up the supply chain, as Ang says.

James Surowiecki comments on market volatility created by increasing (and erratic) government intervention in the economy:

As a result, investors have a vast range of new things to worry about, like voter sentiment in Westphalia. They have to try to figure out whether policymakers will do things they shouldn’t, like slash spending during a downturn, and not do what they should, which is to intervene promptly when systemic crises appear.

He’s right that government intervention is creating uncertainty in the market, but his solution–that governments intervene “promptly” during crises–is exactly wrong.

Bubbles certainly are inherent to markets, but systemic crashes are not. The financial crisis we experienced in 2008 was a result of a housing bubble that the federal government (1) funded through low interest rates and the GSEs (Fannie Mae and Freddie Mac) and (2) encouraged through prior bailouts of ailing banks. This created an environment where risks were not properly considered precisely because of what Surowiecki recommends: Government would intervene if the bubble burst. And that’s precisely what they did.

We shouldn’t be creating standardized and routine government intervention in the economy to protect failing institutions. We should do the opposite: make clear government will not save failing firms nor their creditors. Government protecting firms and creditors makes Washington, D.C.’s whim, and not a company’s own fundamentals, ultimately responsible for a company’s success.

That isn’t capitalism. It’s authoritarianism, with markets merely serving the government’s desires.

Arnold Kling comments on the European Union’s bailout of debt-ridden members:

My take is that this is like TARP in that it treats the European debt crisis as a liquidity problem, when at least in part it is a solvency problem. Lately, I have seen several writers argue that a Greek default is inevitable, and no one seems to argue otherwise.

Suppose that banks had to write down the value of their Greek debt by 30 percent or more. At the very least, this would eat significantly into their capital, and they would have to curtail lending. This in turn would make funds scarce for other sovereign debtors. In some sense, this is what should happen–interest rates should rise, and financial intermediation should contract.

As he points out, the problem is this isn’t simply a liquidity issue (e.g. banks have stopped lending, but the country’s finances are actually strong). This is a solvency issue. These countries are in terrible shape financially.

Like TARP and the nationalizing of Fannie Mae and Freddie Mac here, this only extends the inevitable. These countries still need to fix their fundamental problem, and this is just prolonging the pain.

Russell Roberts, professor of economics at George Mason University, wrote a fantastic paper on the causes of the financial crisis.

The most culpable policy has been the systematic encouragement of imprudent borrowing and lending. That encouragement came not from capitalism or markets, but from crony capitalism, the mutual aid society where Washington takes care of Wall Street and Wall Street returns the favor.9 Over the last three decades, public policy has systematically reduced the risk of making bad loans to risky investors. Over the last three decades, when large financial institutions have gotten into trouble, the government has almost always rescued their bondholders and creditors. These policies have created incentives both to borrow and to lend recklessly.

Former acting CBO director Donald B. Marron has a fabulous look at why why our public debt is so dangerous, and what should be done about it:

First, once our economy is back on its feet, prolonged deficits and mounting debt will inevitably undermine economic growth. Americans simply do not save enough both to lend the government everything it needs to finance persistent deficits and to continue investing in the growth of the private sector. Future government borrowing will therefore require either more borrowing from abroad or significantly less domestic investment. If we reduce our domestic investment — building fewer factories, cutting back on research and development, and generating fewer innovations — our nation’s future earnings prospects will dim, and our future living standards will suffer. And while borrowing more from foreign lenders enables us to afford more investment today, that money (plus substantial interest) will eventually have to be repaid. As a result, more of our future income will have to be sent overseas — and again, our living standards will decline. Sometimes economics can be painfully simple: The more money we borrow now, the less we will have in the future.

Read the entire thing. We must reduce our debt to sustainable levels, and that means a significant reduction in spending and, unfortunately, tax increases.

This is precisely why the healthcare reform passed is so monumentally dangerous: our current spending and debt is unsustainable, yet we’ve decided to (1) tack on $100-200 billion in new spending a year, and (2) use up valuable means of cutting the budget.

A conversation with Gay Becker:

Mr. Becker places his hands behind his head. Once again, he reflects, then smiles wryly. “Of course that doesn’t mean there isn’t any systematic bias toward bad policy,” he says. “There’s one bias that we’re up against all the time: Markets are hard to appreciate.”