I take some pride, but little satisfaction, from having tried to fix several of the systemic flaws that ultimately led to the financial crisis. I also was fortunate to spend that time serving under Senate Banking Committee leadership that was more often right than wrong. But I’m only human and did miss a few things. In the spirit of the new year, here is my, far from exhaustive, list of things I missed:

1. The extent of house price declines. While I never bought the housing industry line “prices never go down”, my sense back in 2005 was that we’d see something like a 10 to 15 percent decline. It was well known before the bubble that inflation-adjusted home prices have declined nationally on several occasions.

2. Growth of strategic default. In previous housing busts, the percent of borrowers who simply walked away only because of their negative equity position was small. Boston Fed economists have estimated 6% during the last bust. We are likely between 20 and 30% this time around.

3. There’s no substitute for a downpayment. I served as the primary drafter of the American Dream Downpayment Act. While small in impact, it did offer an experiment in downpayment assistance. Its results have not been good in my view. That bill was a mistake.

4. Bailouts for everyone. Don’t believe the spin, the rescues of AIG, Bear, Fannie, Freddie, the autos were all bailouts of choice. While I had serious reservations about Paulson, Bernanke and Geithner, I underestimated their willingness to just throw money at every problem. Accordingly I now have far less trust in the discretion of regulators (not that I had much before).

5. Receivership doesn’t end too-big-to-fail. The primary reason that Democrats, and some Republicans, opposed GSE reform beginning in 2004 was over the creation of a receivership (bankruptcy) mechanism for Fannie/​Freddie. Such a mechanism was finally put into place in July 2008. It was ignored and the GSEs were rescued. It is partly for this reason that I don’t see the receivership authority in Dodd-Frank as very credible. If we won’t wind down Fannie, why would we wind down Citi.

6. GSE role in the re-po market. While banks regulators did nothing to reduce the exposure of the banking system to GSE debt, they at least knew about it. What was less understood was that about a third of the collateral in the overnight re-purchase market (called by some “shadow-banking”) was GSE debt. When hair-cuts on GSE debt expanded in 2008, liquidity in the re-po market contracted.

7. Level of Pure Speculation in the Housing Market. Setting aside that every home purchase entails a degree of speculation, the amount of pure investor sales as a percent of single family home sales turns out to be about double what I had thought back in 2005-06.

 Obviously this doesn’t cover the things that caused the crisis which I did see coming. And perhaps an even bigger surprise to me was the degree during, and since, the crisis that many continue to hold onto certain beliefs even in the face of compelling evidence otherwise. For instance, it seemed clear to me as early as 2007 that “exploding adjustable rate mortgages” were not the primary driver of default. Anyway, we could all use a little more modesty when it comes to discussing the financial crisis.

A powerful trend in today’s more globalized world is the growing competition among nations to attract and keep human capital — people with the skills and education necessary to make a modern, open, market economy hum.

Nobody has done a better job of describing this phenomenon than British journalist Robert Guest in his new book, Borderless Economics: Chinese Sea Turtles, Indian Fridges, and the New Fruits of Global Capitalism, just out from Palgrave Macmillan.

Guest is the business editor of the Economist magazine. He’s traveled widely in the United States and across the world. He has a keen understanding of the market forces shaping the global economy today, as well as a reporter’s eye for interesting people, places, and companies that tell the story.

The author summarized Borderless Economics in a recent Wall Street Journal op-ed, and the book was favorably reviewed in the same newspaper this week. The reviewer, Katherine Mangu-Ward of Reason magazine, highlighted an immediate application of the book’s thesis to U.S. immigration policy:

Mr. Guest notes that the U.S. annually awards only 85,000 H‑1B visas for highly skilled workers; more than that number have been known to apply on the first day that applications can be submitted. America is strong because it has long been the nation richest in the resource that matters most: talent. Yet the U.S. government every year turns away tens of thousands of the most talented, motivated people in the world.

The Cato Institute hosted a book forum for Robert Guest in November, with comments from Edward Alden of the Council on Foreign Relations. You can view the event here.

If you missed it, The Economist has a useful contribution on the renewed interest among many Americans in adopting the loser-pays principle in civil litigation, which most countries around the world have long embraced in light of its fairness and practicality. I’ve been writing in favor of the idea since my first book, The Litigation Explosion (more links here) and Cato has spotlighted Marie Gryphon’s important recent work on the topic. Mississippi governor-elect Phil Bryant “has already expressed support” for the concept, according to this recent report in the Jackson Clarion-Ledger.

Despite strong interest in liability reform over the past two decades, no state has joined Alaska (which has had the principle since territorial days) in adopting an across-the-board loser-pays principle. Why is that? The opposition of some plaintiff’s lawyers and legal academics is hardly a full explanation. The fact is that loser-pays reform remains perpetually sidelined because much of organized big business quietly or not-so-quietly opposes it. In fact, some D.C.-based business lobbyists even roam the country attempting to squelch outbursts of enthusiasm for loser-pays among state legislators and others close to the grass roots.

Why are these businesses opposed? Some fear that any new set of rules will be interpreted to their disfavor, or prefer not to rock the boat for fear of unpredictable consequences; others delegate the issue to outside lawyers who may see the issue through the lens of their own professional biases; and yet other businesses recognize and (as perennial defendants) fear the tendency of loser-pays systems to vindicate many strong small plaintiff’s claims better than does our current system. With an open public debate and careful drafting of reform proposals, I think most of these fears would be assuaged: for example, most big American firms also operate in Canada, Europe, and other countries where loser-pays is accepted as a normal feature of the legal landscape. In the mean time, I wish someone would organize a group called “Business Leaders for Loser-Pays.”

John Stossel takes a look back at 2011 tonight at 10 on Fox Business Network. Jeff Miron and I will be on, along with Nick Gillespie and Katherine Mangu-Ward of Reason, legendary MTV VJs Kurt Loder and Kennedy, and more. Many people think of politics when they think of 2011, but not John Stossel. He’s a policy guy. So expect plenty of discussion of Iraq, the Arab Spring, the economy, the Fed, the debt, the nanny state, gay marriage, and more — but nary a candidate’s name.

And if you don’t get Fox Business, well, call a friend in a different cable monopoly jurisdiction and ask if you can come over.

December 28, 2011

Editor
The New York Times

Sir,

As you claim that Ron Paul’s belief that the Federal Reserve should be abolished disqualifies him for the presidency (“Mr. Paul’s Discredited Campaign,” December 27), and thereby appear to be convinced that no alternative to the Fed could possibly do better, we wish to alert you to our recent research reaching the opposite conclusion (“Has the Fed Been a Failure?” Cato Institute Working Paper no. 2, forthcoming in the Journal of Macroeconomics). We wonder as well about the grounds, apart from mere a priori convictions, for your contrary opinion.

Sincerely,

George Selgin, professor of economics, the University of Georgia;
William Lastrapes, professor of economics, the University of Georgia;
Lawrence H. White, professor of economics, George Mason University.

The U.S. Treasury Department finally released its overdue semiannual “Report to Congress on International Economic and Exchange Rate Policies” yesterday. I’ve been reading through the informative report this morning so you won’t need to. Two quick comments:

First, the report declined, once again, to brand China a “currency manipulator,” and for good reason. The term is needlessly confrontational. As the report documents, while the Chinese currency is probably still undervalued, the Chinese government has been taking concrete steps toward a more flexible exchange-rate regime. Since it began its currency reforms in July 2005, the renminbi has appreciated 40 percent on a real (inflation-adjusted) basis against the U.S. dollar. And 40 percent just happens to be the upper range of the revaluation that was demanded by Sen. Chuck Schumer (D‑NY) and other critics of China trade back then. They should declare victory and move on to more pressing economic problems, such as cutting federal spending and promoting private-sector growth.

Second, the report repeats the common but false assumption that a shrinking trade deficit is necessarily good for economic growth, and a rising deficit bad. From p. 6 of the report, we read:

Trade was also a bright spot in the third quarter [of 2011], as exports once again grew faster than imports. The resulting decline in the net export deficit contributed 0.4 percentage point to real GDP growth.

This reflects the simplistic Keynesian assumption that rising imports are a drag on growth because they merely replace domestic production. The truth is almost exactly the opposite, as I documented in my Cato study earlier this year titled, “The Trade-Balance Creed: Debunking the Belief that Imports and Trade Deficits Are a ‘Drag on Growth’.”

The truth, in theory as well as practice, is that a rising level of imports typically reflects rising domestic demand by both consumers and industry. Imports fuel U.S. production by supplying more raw materials, intermediate supplies, and capital machinery at competitive prices. That is why the U.S. economy has typically grown much faster during periods of rising trade deficits compared to periods of shrinking deficits. True to form, the first three quarters of 2011 saw declining GDP growth even though, according to the Keynesian creed, the decline in the trade deficit was a supposed “bright spot.”

As much as I have trouble believing it, there seems to be a portion of the public that will immediately dismiss anything Cato has to say on the financial crisis. So as much as I try to reach anyone willing to listen, there are just many unwilling to do so. Given the importance of understanding the financial crisis, it is essential that we have some intelligent, thoughtful voices on the Left. Perhaps the best of those is MIT’s Simon Johnson.

While I am nowhere near 100% agreement with Simon, a recent EconTalk podcast on the financial crisis illustrates that he is generally more right than wrong. From the podcast, Simon clearly sees central banking as an ultimate source of moral hazard in the financial sector. His discussion of the Aldrich-Brandeis views on the founding of the Federal Reserve alone make the podcast a worthwhile listen.

His core message is one of regulatory capture in the financial system, going as far as calling himself “a follower of George Stigler.” This is certainly a point where progressives and libertarians can agree. It is perhaps on the cures that we disagree.

So if you are frustrated that some of your friends seem to be getting all their (mis)information on the financial crisis from the likes of Paul Krugman, then point them towards this podcast. 

While Simon has apparently covered much of this in his book, 13 Bankers, I have to admit to not having read it. I’ve largely put it off because as a regular reader of Johnson’s blog, I find his co-author/blogger to be excessively partisan, not to mention lacking an understanding of what free-market proponents are actually advocating.