Today in "Economists Are NOT Totally Clueless" (Part 3 of 4)

Pete Davis:

Treasury Secretary Hank Paulson initially sold Congress in the fall of 2008 on emergency intervention to purchase “toxic assets,” but quickly reversed course in favor of direct capital injections. Those favored financial institutions revived more quickly than most thought possible and most of those injections have already been paid back. However, most of the toxic assets remain on bank balance sheets, impeding new lending. [emphases mine]

At the end of the last post, I was ready to discuss “deadweight loss.” But a brief detour seems in order.

We used to talk a lot at this blog about DSGE models. Economists talk a lot about Equilibrium, even if they don’t fully understand it. At its core, saying “equilibrium” is saying “this is the best of all possible worlds.”  You can’t improve on equilibrium unless you choose a non-Pareto-optimal solution (i.e., a solution in which at least one person is affected negatively).

Equilibrium doesn’t mean you have achieved ideal social welfare. (Anyone who has looked at Game Theory for more than a minute can tell you that.)  But it does mean that things are “hitting on all cylinders.”  Or, more accurately, if the economy is not at equilibrium, the odds are better that people making choices will make mistakes.

Which is why I pointed to Brenda Rosser and especially this

“The way out of this thing is a shift in the way we treat the LDC debt,” Coldwell argued. “The banks would have to take a big hit on their balance sheets, but then it’s over. If you give them a definitive hit, then they could say it’s behind us. If you get down to a crisis stage, the banks would accept that. They would have no choice.” — William Greider. ‘The Secrets of the Temple – How the Federal Reserve Runs the Country’ Touchstone 1989. Page 549

If the banks take that hit, we’re back at equilibrium.  If they don’t, they continue to make suboptimal choices.  Which brings us back to the graphic.

There were several good suggestions for refinement in the comments, none of which can I do at the moment, since I’m working solely from FRED data. (General response: those acquisitions, especially WaMu, were made on terms that were agreeable to all acquiring parties. Which doesn’t mean those acquisitions may not be affecting the flow, but it’s likely more a question of acceleration than velocity, especially given the relative sizes of the institutions.)

But the FRED data is damning enough.  The risk management procedures at larger institutions were significantly worse than they were at smaller ones.  And the bigger they are, the worse they are becoming:

With several waves of doubt still to come, we are (choose one) (a) far from equilibrium or (b) still making suboptimal choices.

So let’s do a finger exercise.

Mortgages Outstanding approx. $11 trillion (Q4 2008)

Amount at risk (SWAG)25%

Expected Losses $2.75T

Fed Holdings (TARP, TALF, CPLF, etc.) approx. $2.2 T

Remaining Balance Sheet Exposuren approx. $550B

25% at risk seems about right.  Slightly over 10% of that $11T was Home Equity Loans, and the outstanding household debt at that time was about 123% of national income while equity was around 40%.

But note that this assumes that all of the special facilities remain in place. For instance, per Hamilton’s graphic, the Fed now owns about $1T worth of MBSes. CR notes that this program “is scheduled to be complete by the end of Q1.”

Of course, there are some cures that would be worse than the disease.  Via alea’s Twitter feed, I see that either the headline writer or the speaker made a slip yesterday:

“There ought to be government-backed ABS,” said Fed economist Wayne Passmore in a presentation to the American Economic Association.

Note that the quote is not (just) MBS but ABS—asset-backed securities, including credit-card receivables, car loans, basically any form of consumer (or other) debt that can be securitized.  The result of this would be that your tax dollars would pay a bank for your default on a credit card that charged you 30% interest, despite the risk-free rate being something near 0%—and almost always in the 5-8% range.

The reason we like equilibrium is that people who make mistakes do so because they are “being irrational.” When we’re not at equilibrium, we realize that they make irrational decisions all the time.  In what I hope will be the last of this series, we’ll look at irrational and rational decisions—and why irrationality may be the best survival strategy.

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