Clive Crook - A system overwhelmed by innovation

In an interesting article in the Financial Times, Clive Crook mulls over the long-term prospects for the financial system and for regulation of the overall economy.

Sorting out the details of the response will be messy but the principles are now clear and policy is forming around them. First, address illiquidity in the market for mortgage-backed securities. Second, inject public capital on a huge scale, drawing in new private capital at the same time. Third, revive the inter-bank market with temporary guarantees. Fourth, especially in the US, step up efforts to slow mortgage foreclosures, to relieve the distress and stop house prices undershooting.

Financial Risk, Safe Bike Lanes

Here's an interesting mix. Real Time Economics summarizes Fed Governor Kroszner's words encouraging the financial sector to take risk into account. At the same time, Streetsblog summarizes some research that indicates that increasing the availability of safe bike lanes increases the number of people who bike.

Perhaps it isn't so much that bankers don't take into account risk per se, but as a result of the structure of incentives we've built up. Perhaps, to make an analogy, there aren't very many safe bike routes.

We have either highly padded and regulated cars (the commercial banking sector). Many accidents occur not because of lack of regulation but perhaps because of an "excess" it, which encourages drivers to stop paying attention to risk (I have a huge amount of metal surrounding me, I can't feel the wind, I have a nice, cushy seat and a seat belt and air bags, etc.). Lots of car accidents aren't really terrible, but a few are.

The idea of increasing the awareness of risk in bank management by adding indicators and reports is like adding an extra gauge in one's car that indicates the level of risk at which one is driving. I bet most people might pay attention to it the first day or two, and then just go back to the old ways ... because the incentives haven't changed at all. I know driving 20 miles above the speed limit is pretty stupid. But I haven't died yet, and I'm in a hurry.

On the other hand, bikers (and motorbikers) are exposed to huge amounts of risk if they interact with cars. Those who ride end up being highly risk-taking (who'd ride a bike in his right mind?).

What we want is a more innovative financial system that is, at the same time, not a danger to our health. We also want the environmental, health, and aesthetic benefits of biking (and, sure, the added flexibility), without the risk. Indeed, biking is in itself safer (who has ever heard of anyone dying from a bike collision).

Making safe bike lanes available increases the likelihood that people will bike rather than drive because now it's no longer just the highly risk-taking who drive. A "safe bike lane" is one in which the car-bike interaction is minimal. My analogy would point to creating areas of the financial system that in themselves are completely unregulated but which have no interaction with the rest of the financial system and in which collisions aren't very damaging.

The analogous group might be financial institutions that offer checking accounts, savings accounts, and perhaps CDs, but no more on the liability side (nothing fancy, nothing with very much leverage at all, nor very much return -- very solid stuff for people who have very simple needs and little sophistication), and very simple, very plain-vanilla assets that everyone understands easily and that are directly connected to some tangible backing.

These institutions would have to have access to liquidity in case of localized widespread defaults or liquidity needs (perhaps through the discount window and a network of similar financial institutions across the country), perhaps also full FDIC backing, etc., but would not be allowed to interact with the more sophisticated sectors of the financial system.

Perhaps what all this is leading to is a return of Glass-Steagall.

Housing Markets that May be Ready for a Turnaround

According to this article, these cities may be ready for an improved housing market:

• Philadelphia
• Raleigh
• Seattle
• Des Moines
• Birmingham
• Salt Lake City
• Denver

In October 2005, near the peak of the boom, the median sales price for a U.S. home reached 7.3 times per capita income; by this May it had fallen to 5.7, in line with historical norms. Nationally, the rate of decline in sales is slowing, and in some regions sales numbers have actually perked up. "The indicators are starting to look better," says Adam York, an economic analyst with Wachovia.
Why the disconnect? For starters, the national sales figures that get so much attention -- and remain depressing -- are brought down by boom-and-bust markets like Las Vegas, Miami and Phoenix. David Berson, chief economist with mortgage insurance firm The PMI Group, says that if hard-hit states like California, Arizona, Nevada and Florida are taken out of the statistical mix, the picture is much more promising.

Post Binge World

Post Binge World
http://www.nytimes.com/2008/10/12/opinion/12friedman.html?_r=1&ref=opinion&oref=slogin

Economic crisis Web site BaselineScenario.com
http://www.washingtonpost.com/wp-dyn/content/article/2008/10/10/AR2008101002441_pf.html

http://www.newsweek.com/id/163449/page/1
The financial industry itself is likely to shrink, and that's not a bad thing, either. It has ballooned dramatically in size. Curry points out that "30 percent of S&P 500 profits last year were earned by financial firms, and U.S. consumers were spending $800 billion more than they earned every year. As a result, most of our top math Ph.D.s were being pulled into nonproductive financial engineering instead of biotech research and fuel technology. Capital expenditures went into retail construction instead of critical infrastructure." The crisis will stop the misallocation of human and financial resources and redirect them in more-productive ways. If some of the smart people now on Wall Street end up building better models of energy usage and efficiency, that would be a net gain for the economy.

There Is No Reason to Panic

Casey Mulligan in The New York Times
An Op-Ed piece by Casey Mulligan in the New York Times. He very clearly lays out economic arguments as to why things are just not that bad.
He concludes as follows:

So, if you are not employed by the financial industry (94 percent of you are
not), don’t worry. The current unemployment rate of 6.1 percent is not alarming,
and we should reconsider whether it is worth it to spend $700 billion to bring
it down to 5.9 percent.

Excellent discussion of likely Fed policy

By Tim Duy, via the Economist's View

It is impossible to rule out a rate cut, and it seems like a cut should be the baseline case. Indeed, the case for a rate cut should be a slam dunk, expect for a.) rates are already low and b.) we haven’t seen a rate cut yet. ... The Fed may simply have already moved well beyond rate cuts in searching for solutions to the current crisis. And outright asset purchases is looking like that next move.

Paying interest on reserves (banks' deposits at the Fed) puts a floor on the Fed Funds rate. Suppose, as is the case, that the Fed flooded the market with liquidity (through the TAF, temporary auction facilities - which, now that there's an actual schedule, don't look too temporary). The increase in the supply of excess reserves should lower the Fed Funds rate, say from 2% to 1.5% But if the Fed keeps the interest rate to be paid on deposits at the Fed at, say, 2%, then those excess reserves will be borrowed at 1.5% and flow back into the Fed, as deposits, at 2% - this will keep going on until the Fed Funds rate returns to 2%.

So why do this? The problem of the TAF is that it provides liquidity a little too broadly. Not every institution that gets liquidity needs it equally badly. Suppose an institution that doesn't need liquidity gets it: since it didn't need it to pay its liabilities, and since keeping it as excess reserves earns income, the institution will "park" the excess reserves at the Fed, effectively "mopping up" the excess liquidity. Suppose an institution does need liquidity. It will use it to pay its depositors, suppliers, employees, creditors, etc., because its need for liquidity will exceed the interest on the Fed's deposits. So we get a happy situation in which the people that spend the Fed's cheap cash are the people who actually need it.

WSJ: Obama's Lead Widens in New WSJ/NBC Poll

Presenting himself as a man of action, it seems, was not terribly attractive to independents

Independent voters are starting to swing behind Barack Obama and Joe Biden, who continue to benefit from economic turmoil and the public response to their debate performances, according to a new Wall Street Journal/NBC News poll. The survey gives the Democrats a six-point edge over John McCain and Sarah Palin, 49% to 43% with a margin of error of plus or minus 3.8 percentage points. That's up from a slim two-point advantage from the last Journal poll two weeks ago, and parallels other recent national polls.

The new poll is full of good news for the Democratic ticket. Obama increased his advantage over McCain when voters were asked which one they prefer to handle conomic issues, as a growing percentage of voters said that was their top concern heading into the election. More voters said they're "more reassured" by how Obama was responding to the financial crisis than by McCain.