Wednesday, September 12, 2007

All for the Want of a Nail

I’m going to pick on Jeff Miron again, and in this case my only source is a couple of paragraphs in Monday’s Harvard Crimson (hat tip: Mark Thoma), so I won’t pretend that I’m really being fair to him, but I think these paragraphs are representative of a point of view that is in need of attack:
Miron...expressed less sympathy than others for the subprime lenders and borrowers, who he suggested are playing the roles of both perpetrator and victim in the current crisis.

"The subprime event is not that big a deal. It’s a small part of the economy. There will be some foreclosures, banks will lose money. That’s life. That’s capitalism. They took risks, and they lost. Policy should not bail out people for greed and stupidity, or their risk taking."
As it happens, I do think that we should have some compassion for subprime borrowers and lenders, not necessarily out of general compassion but for the reasons I discussed here. But I see that compassion as a minor issue. The fact that interest rate cuts (for example) would help these people, is one additional pebble in the balance that weighs toward my advocacy of interest rate cuts, but by itself this factor is not enough to make 25 basis points worth of difference in my opinion on the federal funds rate target. Is it possible that this factor – and the associated “moral hazard” issue – weighs 25 basis points worth (or more) against interest rate cuts for some people? It seems like it does, and that seems foolish to me, but let’s get to the main issue:
The subprime event is not that big a deal. It’s a small part of the economy.
Quantitatively speaking, it’s certainly true that the volume of subprime loans is small compared to the size of the economy. But does that observation justify the conclusion that “the subprime event is not that big a deal”? To me, it seems that the question should be rhetorical, because the obvious answer is “no,” but apparently others don’t find that answer to be obvious. And (assuming that the Crimson quoted him correctly and that he intended those two propositions to be logically connected) I’d have to say that, from my point of view, Jeff Miron doesn’t seem to understand what’s going on.

I’ll allow that Mr. Miron was quoted out of context (by both the Crimson and me); that the reporter probably surprised him when he was thinking about something else, and he didn’t get a chance to think through his answer; that he probably didn’t feel he needed to be too careful about his words when he was talking to the college paper. But when we take into account indirect effects, the subprime event is a very big deal. Subprime may be “a small part of the economy,” but LIBOR – which rose about 35 basis points because of the subprime fallout (in spite of a large drop in T-bill yields at similar maturities) – is not small: as far as short-term lending is concerned, LIBOR is most of the economy.

If it were just a matter of a few institutions that made subprime loans and had to recognize some losses because defaults were higher than they had planned, that would have been a virtual non-event in the grand scheme of things. But the subprime risk is not concentrated in a few institutions – or, to be more precise, maybe it is; we just don’t know where the hell it is, and that’s the problem. Can one say that walking across a minefield is “not that big a deal” because the actual mines underlie only a small fraction of the total area? When you suddenly find that institutions in France and Germany are close to toppling because of a small problem in the US, you’ve got a big problem, because people start to lose confidence in the whole global financial system.

And that’s just the beginning. Another effect of the subprime crisis has been diminished confidence in the bond rating agencies. When investors don’t know which bonds are safe and which aren’t, it becomes hard to borrow money by selling bonds. This has not been a big problem for traditional investment-grade corporate bonds outside the financial sector, but it has been a big problem for lower-rated bonds, and it has been a huge problem for just about any kind of asset-backed security that doesn’t seem to have a government guarantee. One of the results is that it has now become difficult and expensive – even for prime borrowers – to get a mortgage for any property that doesn’t conform to the requirements of government agencies or government-sponsored enterprises. (A particular case in point is the oversized “jumbo” loans that are now required to purchase even many mid-level houses in the post-boom coastal areas.)

And then there is the liquidity crisis. With all the uncertainty about the quality of loans and institutions, the institutions themselves face increased withdrawals of capital and increased uncertainty about withdrawals. At the same time, with all the uncertainty about the quality of bonds and other assets, these assets become more difficult to sell. Leverage is forcibly unwound. Failures cascade. Many of the failures occur outside the banking system and therefore outside the direct influence of central banks. Assets deflate. Otherwise solvent institutions become insolvent. Disintermediation further weakens the financial system.

Job losses in construction, finance, and home furnishings also have multiplier effects. In the financial chaos, with even prime borrowers facing difficulties in purchasing new houses, house prices could fall below fundamental value, and households will be bound by more stringent liquidity constraints and forced to curtail consumption. Financial problems abroad can be expected to dampen improvements in the US trade balance. Damn, I’m really talking myself into forecasting a recession now. Anyhow, to reiterate my original point, even though the subprime problem is a small part of the economy, it is a big deal.

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