I wish to recommend to one and all Jim Hamilton's reports and commentaries over the last several days on the meeting at Jackson Hole for the Kansas City Fed annual do, where they are all going on about the sub-prime mortgage problem and its many implications. Jim has them up at econbrowser at http://www.econbrowser.com, and he presented a paper there as well as being a very up-the-middle and fair-minded commentator on the proceedings, which have included speeches or papers by Bernanke, Gramlich, Mishkin, Taylor, Shiller, Leamer, Richard Green, and Susan Wachter. Hamilton is not a pessmist like Dean Baker or Nouriel Roubini who have been predicting a recession for some time out of all this, but does critique the more pollyannaish of the speakers there, with Fed Governor (and author of the most widely used money and banking text) Frederick Mishkin fitting that bill. Despite some stabilization of the financial markets two weeks ago, Hamilton sees ongoing problems due to the opacity and "where is the garbage?" of the derivatives and CDOs with all the sub-prime crud in them still out there. The other problem, emphasized by Baker and Roubini, is that as long as housing prices continue to fall, more mortgages can turn into garbage and ultimately the economy can be pushed into recession. There is the added wiggle that foreclosures and bankruptcies can dump more houses onto the market, thereby exacerbating the downward trend in prices.
Regarding the opacity mess, this has been warned about for some time in connection with the huge expansion and increased complexity of newer derivative instruments for some time, even before the sub-prime mortgage problem reared its ugly head. Almost a year ago, New York Fed President, Timothy W. Geithner, rather cautiously warned about it in a widely noted speech, "Hedge Funds and Derivatives and their Implications for teh Financial System," http://www.ny.fed.org/newsevents/speeches/2006/gei060914.html. The combination of this problem with all the opacity and repackagings of the sub-prime garbage have been very much at the heart of the current flocking of the black swan unknown unknowns along Keynesian/Knightian uncertainty lines that have spooked the global financial markets.
Regarding the potential dynamic for declining housing prices to trigger sales that push further declines, this is like the mechanism behind a crash that happens on a stock or other markets where margin calls force sales on liquidity-constrained investors which then further push down the prices further triggering the margin calls. This Minskyan mechanism is at the heart of a paper by me with Mauro Gallegati and Antonio Palestrini, available on my website at http://cob.jmu.edu/rosserjb, "The Period of Financial Distress in Speculative Markets: Interacting Heterogeneous Agents and Financial Constraints." Beyond what I have already said, I shall not drag you all through the technicalities of this paper, but I do note that it is the first paper ever to provide a mathematical model for the "period of financial distress," described by both Hyman Minsky and also Charles Kindleberger in his magisterial, _Manias, Panics, and Crashes_. According to him there are three patterns of speculative bubbles and their endings: a peak followed by a sudden crash, a peak followed by a slow decline, and by far the most common with the vast majority of historical bubbles following it: a peak followed by a period of slow decline (known as the "period of financial distress") then followed by a crash.
So, the question is, were the events of two weeks ago the peak or a crash? Is it over, as Mishkin thinks, or are the ongoing declines in housing prices the sign of a period of financial distress that will erupt sometime coming up in a much more serious crash with much more serious consequences for the world macroeconomy?
19 comments:
I apologize that the link to Geithner's speech does not seem to work. You can find it by googling "Geithner derivatives speech 2006" or some variation thereof.
Replace "ny.fed.org" in the link provided with "newyorkfed.org," and the link will take you to the speech.
So you like JDH and the other half of the site Menzie Chinn is good too.
Me? You are growing on me Rosser, ep with lines like this:
Is it over, as Mishkin thinks, or are the ongoing declines in housing prices the sign of a period of financial distress that will erupt sometime coming up in a much more serious crash with much more serious consequences for the world macroeconomy?
Ok, pacification is not your long suit because unlike Mish, your vested interests are closer to your neighborhood and not the offices of the Fed.
Is this what's wrong with this august governance --no representation from the people they purport to represent?
calmo thinks Mish is about to lose some more credibility.
shane,
Thanks. I tried to change it in the post, but was not able to do so. Still getting used to this software. Anyway, I guess people know from you how to get Geithner's speech, if they are interested.
Anonymous,
Yes, I like Menzie Chinn. He is a bit more political and anti-Bush compared to Jim Hamilton. Tends to cover more international finance stuff, kind of like brad setser, whom I also like.
Isn't this concern about opacity the same #$%#$% speech everyone made 15 years ago or so? Seems to me that the nature of derivatives is to become as opaque as the market will bear, because it's exactly the (believed or real) issues of asymmetric information that make them so profitable.
And that under, um, interesting conditions the should become opaque to everyone rather than just the rubes is pretty much an obvious consequence of what the futurist types call the Singularity. (Or perhaps not -- perhaps more a consequence of the usual implicit assumption that computational tractability implies some kind of correctness.)
Your interesting comment on Dean Baker's site drew my attention. Perhaps I have the benefit of living in a Bubble state, but for me it's been a question of when, not if. The reason's simple.
In CA. housing prices have tripled over the last ten years, from a level that was already considerably higher than most of the country. During the same period wages barely moved. Who's left to buy homes at these lofty levels, especially if they are now required to show work history & a down payment to qualify for a loan? Last year in CA almost 40% of homebuyers were investors & 2nd home buyers. And, let's not forget, as home prices rise so do property taxes and that presents an additional out of pocket burden.
It's time for an Economist or two to do the math. What's the probability we'll have to revert to '02 home prices (that'll be a 33% drop) to clear current inventory? That will be enormous because a lot of homeowners who didn't buy, did cash out refinances. Only then will we be in a better position to talk about the economy, i.e. all our local gov'ts. that spend every nickle they get as they receive it & whether homeowners will slow down their spending patterns as they retrench.
How about offering a few of your students extra credit for setting the odds of a serious retracement in our bubble states? Bailey
paul,
What is different between 15 years ago and now is that 15 years ago the opacity was asymmetric. One side knew what was going on and the other did not. Now the deriviatives are so complicated that even the people issuing do not know what are in them or what they are doing or what they are. It is universal ignorance and idiocy, rather than a one-sided ripoff. Then at least somebody knew something. Now, sub-primes in the US start blowing and major banks in Europe start crashing.
anonymous,
Your point about price to income ratios is telling. Two years ago, in the second editon of his Irrational Exuberance, Robert Shiller, one of the speakers at Jackson Hole, added a chapter on the real estate bubble. He gathered an original data set on real estate values in the US, going back to the 1800s. What he found was that in 2005 both the price to income and price to rent ratios were at all time highs in US history. While some financial folks claimed that all this was justified by the then low interest rates, well, the interest rates have gone up, and pretty much anybody with any brains knew that this was unsustainable. Indeed, it was just a matter of time.
"Hedge Funds and Derivatives and their Implications for teh Financial System"
You are teh awesome...
Geithner: "..[derivatives ] should improve the overall functioning of markets. In most circumstances, increased trading and participation contributes to market liquidity and makes markets less volatile. The ultimate benefit should be lower risks for all market participants. This in turn should reduce the risk premia associated with holding financial assets, and ultimately reduce the cost of capital.."
This reminds me of why I am so happy to be out of the public service. To be reading such empty non-sensical/illogical aspirational statements, yet again. Vacuous words to justify what is happening anyway. To dampen down any prospect of genuine concern about what is going on.
Geithner: ".. For the present, however, our hierarchy of priorities should focus on improving supervisory incentives to make counterparty discipline more effective and to strengthen the resilience of the core institutions to more adverse economic and financial conditions."
We all clear now on what needs to be done? Let's go to it!
brenda, THAT starts my day off with a smile.
neither 'peak' or 'crash' two weeks ago - mishkin is wrong to believe it's over, though i'm not clear on which 'it' is referred to.
over the last decades, a qualitatively new and very global financial system has been created and at least since the mid-1990s it has been based on progressively more debt production, which is the problem being rectified. that this appeared most strongly in u.s. subprime only indicates the most recent weak link and, on a spreads basis, became evident in feb. though the seeming paradox of housing overproduction combined with rising unaffordability has been pretty clear for quite a bit longer.
in short, there are limits to financialization; we have a global debt crisis which will end only after risk exposure becomes fully recognized and reduced. lowering official interest rate targets such as the fed funds rate cannot overcome this.
but of course, not just risk but also uncertainty.
so, for an unknown period we have what i tend to think of as a centerless uncontrollability that, as i believe barkley either said or implied, should not be thought of as strictly subprime (but an entire spectrum of 'asset' types).
too much fictitious capital relative to both itself and real economy surplus.
'have you looked at your libor today'
oh, forgot to add that anyone interested in years of at least partially disaggregated credit/debt data might look over doug noland's weekly 'credit bubble bulletins'.
Hi Barkley,
The press reports today that a 'panic' is developing around the credit crunch in London. I believe that is related to the growth of hedge funds in England. Also Carlyle group was hit hard by their own hedge fund. Their wealthy investors had to put several hundred million down to keep the fund afloat. Sounds to me like the crunch is going to require a great deal more persuasion from central banks and governments to calm down. I can't say how far this will go, but it definitely seems to be growing, not contained.
Doyle
I would note first that the speech by Geithner needs to be read between the lines. Managers of major central banks or their arms do not go around spreading alarm or questioning economic orthodoxy. So, there are all kinds of reassuring and apparently naive statements.
But, there are also a bunch of ones that rather carefully indicate that he was already losing a whole lot of sleep over the explosion of derivatives so complicated he could not figure them out. After all, he was very aware that back in 1998 when things nearly blew up with LTCM, it was his predecessor as NY Fed prez who got in that room with a bunch of bankers and traders and cut the deals that kept things afloat. It was easier then because they knew what was going on. By last fall, Geithner had already figured out that he would not be able to do that if a similar crisis hit, and it certainly has been and may get a whole lot worse, as Doyle Saylor indicates.
Barkley,
I had read Geithner's speech at the time and, yes, it seemed clear that he had become more than merely concerned and that he knew that a LTCM arrangement would not work.
Doyle,
I don't think that central banks and governments have been and will be able to accomplish much more than periods of 'calm'. Every punctuation should make even this progressively more difficult.
Barkley Rosser said:
I would note first that the speech by Geithner needs to be read between the lines. Managers of major central banks or their arms do not go around spreading alarm or questioning economic orthodoxy. So, there are all kinds of reassuring and apparently naive statements.
Indeed. If you jump down to the subheading Challenges, you will find the discussion of opacity.
I am glad to see many of the Max Speak gang at the new site.
Hi, eleanor,
In talks that I gave this past year that dealt with financial markets and prior to these recent upheavals, I would refer to Geithner's speech as his "Insomnia." "Challenges" indeed...
I note that Edward Gramlich just died, former Fed Governor, who had remarks read for him at the Jackson Hole meeting.
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