What is there to say about the credit crunch?

(This is sort of a round-up of comment on the economics news. I don't have much to say about it yet.)

It would appear that the economy has just gone from bad to really bad, although if you wanted to be technical it was probably bad already. Prices just hadn't fallen to reflect the true magnitude of that badness until recently. Take the now-to-be-bought Bear Stearns. It's price was 70 dollars two weeks ago and about 170 a year ago. Did that market value simply vanish over two weeks? I rather doubt it. (Particularly considering that their New York office building is supposedly worth more than what J.P. Morgan is paying to buy them. This of course ignores any debt that they may have accumulated that we don't know about.)

There are two questions I feel on everyone's mind.

The first is whether such a credit bubble was predictable. The "maestro" -- depending on your point of view -- of either creating this mess or delaying it during his tenure, Alan Greenspan, attributes it to unnamed factors in our econometric equations:

I do not say that the current systems of risk management or econometric forecasting are not in large measure soundly rooted in the real world. The exploration of the benefits of diversification in risk-management models is unquestionably sound and the use of an elaborate macroeconometric model does enforce forecasting discipline. It requires, for example, that saving equal investment, that the marginal propensity to consume be positive, and that inventories be non-negative. These restraints, among others, eliminated most of the distressing inconsistencies of the unsophisticated forecasting world of a half century ago.

But these models do not fully capture what I believe has been, to date, only a peripheral addendum to business-cycle and financial modelling -- the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve. Asset-price bubbles build and burst today as they have since the early 18th century, when modern competitive markets evolved. To be sure, we tend to label such behavioural responses as non-rational. But forecasters' concerns should be not whether human response is rational or irrational, only that it is observable and systematic.

This, to me, is the large missing "explanatory variable" in both risk-management and macroeconometric models. Current practice is to introduce notions of "animal spirits", as John Maynard Keynes put it, through "add factors". That is, we arbitrarily change the outcome of our model's equations. Add-factoring, however, is an implicit recognition that models, as we currently employ them, are structurally deficient; it does not sufficiently address the problem of the missing variable.

On the other hand, if you follow Austrian business cycle theory, they would argue that such a breakdown is the direct and logical thing consequence of excess liquidity injected into the market. Austrian business cycle theory posits that when the government lowers interest rates to increase economic growth it creates a greater incentive to invest than the ability of those investments to create productive capacity in fact. The government gives away cheap money creating more production (or production in different sectors) than consumers will demand. In their terms, it creates a disconnect between the time preference of consumption and producers understanding of that time preference. Austrian business cycle theory states that bubbles are caused by misallocated production. (The theory is explained in greater detail here.)

The Austrians would argue that the "unnamed factor" in economic equations that caused this credit bubble wasn't the animal forces of irrational economic exuberance but rather Fed policy shoving money down the market's throat.

The debate here is not so much as over the irrationality of investors and consumers. Rather the issue is whether -- granting that human beings are very often irrational -- you are going to let them be irrational with the government's (and by extension your) money. On this ground, I am inclined to agree with the Austrians. You can't will productive capacity or consumer demand into existence, and this credit bubble is the logical consequence of us trying to do just that.

The second question is what to do about it.

Here the Austrians suggest that you have to let bad enterprises fail. Only through the failure of bad enterprises does the disconnect between productive capacity that consumers want and productive capacity that they don't be rectified. Failure to do so only results in the end in a wider and more prolonged economic collapse.

In contrast, the Fed has decided to bail out Bear Stearns on the rationale that it is "too big to fail" and that the repercussions of such a failure would be simply to severe. The Austrians would predict that this may work over the short-term, but over the long-term you are just turning a danger of one bank collapsing into a chance that all will collapse at once. John Quiggin at Crooked Timber calls this the "Wonderful One Hoss-Shay" approach, after the poem by Oliver Wendell Holmes Sr. (Man do I wish that I had thought of that.)

What do you think the parson found,

When he got up and stared around?

The poor old chaise in a heap or mound,

As if it had been to the mill and ground!

You see, of course, if you're not a dunce,

How it went to pieces all at once, --

All at once, and nothing first, --

Just as bubbles do when they burst.

End of the wonderful one-hoss shay.
Logic is logic. That's all I say.

Megan McArdle differs slightly. She argues that we shouldn't let the firm fail, but we should make it hurt:

As with the people who took out unwise mortgages, I am in favor of having the government make strategic interventions to shore up the markets, but I think that they should make it hurt. No one who took excessively risky behavior--even if they honestly didn't realize it was excessively risky behavior--should escape without getting spanked, hard. Pain is nature's way of saying "Don't do that!", a lesson that apparently a lot of us needed to learn.

There will still be some sort of moral hazard, I think..., in that bankers will not be as cautious about systemic risk as they should be. Alas, we live in an imperfect world, and the price of preventing catastrophes is that you will have more of them to prevent. Ultimately, that's a price I'm willing to pay. And I think you should be too. The people screaming that we ought to let the banks fail don't seem to realize that they, too, can be thrown out of work in the resulting hideous recession.

I guess I agree, though I fail to see how a bail out at a small fraction of firms previous value is any different than liquidating it and letting the eligible investors get their money from the FDIC. Bear Stearns as it had previously existed is no more. Whether you call it a bail out or not doesn't seem to matter much.

This whole business strikes me as just sad at this point. Bernanke and the Fed look like they are spinning their wheels trying to make things better, but -- particularly at this point -- I simply doubt their ability to turn this thing around. It seems like a better idea to me to try and limit the duration of the impending recession than trying to avert it.

UPDATE: More from the Economist:

Bear's shareholders will not benefit from the Fed's largesse. Bear, a firm known in the past for its canny risk management, failed badly in its mortgage business and investors will take the full hit. Regulators are desperate to avoid a situation where shareholders bank private profits but losses are borne by the taxpayer. And the Fed has perhaps learned that it is better to act swiftly rather than dither. The British government earned deserved criticism for its failure to act speedily and decisively over the collapse of Northern Rock.

The Fed's decision to introduce loans to brokers as well as regulated banks marks a significant shift in policy, and raises the question of whether the former should now be subject to more stringent regulation in return. But the Fed's widening role is a sign of its fears that other pins might fall. Merrill Lynch looks decidedly wobbly. Lehman has lots of toxic mortgage securities on its books. Lehman's shares plunged on Monday morning but it is not the only one facing trouble. All the other big investment banks will be under intense funding pressure in the coming days. And when trading partners start to pull away, a rapid chain reaction can begin. In effect, with Bear Stearns being sold for such a low price, including its valuable office property, the price of the securities portfolio is zero.