RSS Feed MenuPaul Krugman comments on something I said on TV this past weekend:
I don’t always agree with Naomi Klein, and I don’t always disagree with David Frum, but Klein wins this one hands down: Frum worries that financial regulation might crush “the creativity of the system,” Klein counters that “we could all do with them being a little less creative.”
This is usually framed, less colorfully, in terms of “financial innovation”, but the point needs to be repeated again and again: at this point, there is no reason to take it on faith that cleverness in the financial industry is a net social good. Unless you can provide some clear evidence of productive innovations since regulation began to unravel — and ATMs don’t count — the balance of the evidence suggests that smart people have been devising ingenious ways to concentrate risk and direct capital to the wrong uses.
John Bogle of Vanguard offers one answer to this challenge in today’s Wall Street Journal: the index fund. (Although Bogle has many other severe things to say about the financial services industry.)
Here’s another: the interest-only mortgage. A generation ago, the interest-only mortgage was a rarified device typically available only to the super-wealthy clients of institutions like Banker’s Trust. In the 1990s and 2000s, the interest-only mortgage was democratized: today about 1 in 10 American mortgage-holders has one.
Interest-only mortgages are often grouped with low-down-payment mortgages as culprits in the housing meltdown.
But used responsibly, they can be a beneficial tool. Once a homeowner has reached a satisfactory level of equity in his or her dwelling, it does not necessarily make sense to concentrate further saving into the principal residence. It might make more sense to accumulate other kinds of assets – or, for a small business owner, to direct capital into the business instead.
More broadly: Yes of course looking back on any period in economic history, you’ll find many examples of smart people directing capital to the wrong uses. Way too many railway lines were built in the 19th century; the sodbusters opened too much western land; nobody wanted the Hupmobile and the Stanley Steamer; the skyscrapers of the 1920s did not hit full occupancy for a generation; Silicon Valley went nuts in the 1990s.
But directing capital to the wrong uses is a necessary part of the process of directing capital to the right uses. It’s a point that has been made by thinkers from Frederic Bastiat to Virginia Postrel: the defense of free markets is not only a defense of what has been accomplished – it is a defense of possibilities as yet unaccomplished. Economists and statisticians can calculate in retrospect what went wrong and went right in the 2000s. Trying to raise the home ownership rate over 64%? Bad idea. Technology to enable people to upload video of kittens to the Internet? Good idea.
Discerning the good and bad ideas in advance, however, is a rather more testing undertaking. And if you think it’s risky to allow markets to guess – just what till you see what happens when you order markets to stop.
Kanzeon // Jan 19, 2010 at 4:02 pm
There may be other examples of useful financial innovation that don’t encourage speculation, but the residential interest only mortgage isn’t one.
The interest only mortage is useful in commercial transactions for those who are speculating – often a developer will seek extremely low payments to fund construction, with the thought that reward will come through the increased value of the property. Sale or refinance would follow once construction is complete.
I suppose, theoretically, an economy could exist in which it would be, as a general rule, responsible for a homeowner to obtain an interest only mortgage – but the general profile is someone buying more house than they can afford, gambling on a rise in value, just as the developer. Housing typically has increased in value, and the homeowner receives a deduction for interest. Historically, it was difficult to compete with housing as an investment vehicle for the average person. If someone wanted to invest in the next Microsoft or their small business, they could always stretch themselves through a home equity loan.
blowtorch_bob // Jan 19, 2010 at 4:47 pm
So David you think this is just an issue of directing capital to the wrong use? It’s much more than this. It’s about “funny money” and get rich quick schemes, a mentality which has taken over Wall Street.
It’s a poker game right. You play with the cards you’re dealth with. You’re dealt a few bad hands, make a few big bets and you loose all your money and you can’t go home. You just can’t reach out your pocket and drag out your monopoly money. Let’s see how far that gets you in the real world.
Come on David, it’s time to cut the bull crap and put these frat boys on Wall Street in their place. Bring back the Glass-Steagall Act!
mlloyd // Jan 19, 2010 at 4:48 pm
Respectfully, David, I think you’re missing the point a bit. The point is, finance has grown to be a much, much larger proportion of our economy than a few decades ago. And for what? Paul Volcker is of the view that the ATM is the only useful innovation in that period.
http://www.ritholtz.com/blog/2009/12/volcker-only-financial-innovation-has-been-atm-machines/
Now, no one wants to ban innovation (least of all globalization defender Paul Krugman!), they’re just talking about enforcing regulations that were universally regarded as commonsensical in the Reagan and Bush Sr eras, ie, restricting the amount of leverage of financial institutions.
We’ve just had a decade of diminished regulations, and a decade of zero growth. Also, the economy just about melted down because of excessive, incautious risk-taking by financial institutions. The evidence suggests that the regulations were good for growth.
balconesfault // Jan 19, 2010 at 5:02 pm
In a country where large corporations didn’t hold so much sway over what was broadcast over the airwaves, by now anyone uttering the phrase “innovative financial instrument” would be held in the same regard as someone saying “to each according to their needs”.
Interest only mortgages might be relatively new in popularity – but they’re not particularly innovative or complex. Everyone can understand them.
Massive financial institutions leveraging and at the same time buying puts on derivatives are, I believe, the sort of things that Krugmann is discussing. Financial instruments that are so esoteric, so far removed from the original source of material value, that we’re really just running a casino where a lot of very smart, very rich guys were trying to bilk a lot of other very smart, very rich guys, all with the attitude that they were playing with house money.
What we need today is a single financial regulatory entity. No more allowing investment houses to jurisdiction shop their wares, trying to find cracks in the system where they can saddle society with enormous downside risk in exchange for they themselves having personal high upside risk.
As a start, I’d use the leverage that the government has thanks to the seeming de facto presumption that has now arisen – that the government will always step in to guarantee the downside.
Instead, Obama should announce a maximum size institution that he will be willing to bail out in the future, and a code of conduct that sets the expectations for any firms that would be eligible to receive TARP funds in the future.
In other words – play chicken with the sharks. If they don’t break up their institutions into smaller entities that pose less risk to our economy … and don’t play by the code of conduct … conservative investors are going to be far less likely to put their money in them.
It’s sad that it has come to this, but the ratings firms obviously did not do their job in the last decade. Let’s move to a KISS principle. Which of course, means – “innovative financial instrument” should be a dirty word.
hormelmeatco // Jan 19, 2010 at 6:37 pm
“And if you think it’s risky to allow markets to guess – just what till you see what happens when you order markets to stop.”
That’s one type of lost decade. The other type is the decade we just lived through: 8-9 years of growth wiped out by a calamity.
Deregulation isn’t a convincing economic program any more…
advocatusdiaboli // Jan 19, 2010 at 10:23 pm
Most of us read “financial regulation is danger to innovation” as the dissembling propaganda of the financial industry it is after experiencing the calamity financial deregulation brought us in less than a decade. The facts and history are against you David, give it up. Or are you queueing up the mantra of the privatization of social security that followed GW Bush and Graham’s deregulation. Let’s se a show of hands–how many think, in retrospect, that was a great idea? Didn’t think so.
sinz54 // Jan 20, 2010 at 10:57 am
I do not agree with Volcker–because times change.
Creative financing vehicles like Adjustable Rate Mortgages and even Graduated Payment Mortgages became popular in the late 1970s. These enabled young Americans like I was back then to buy real estate at a time when prices were rising steadily (making real estate a good investment) while interest rates were still too high to make a fixed-rate mortgage affordable. When interest rates on fixed-rate mortgages hit 20%, nobody could afford a home with such mortgages. Creative financing became necessary.
In today’s environment, virtually the opposite of that one, it’s easy to forget why such creative financing can be necessary.
It’s always tempting to look at CURRENT economic conditions and say “We don’t need this” or “We don’t need that.” Everybody tries to extrapolate too far from where we are now.
Some day, we’ll be back to the 1970s: Interest rates will be high, inflation will be accelerating, and real estate prices will rise sharply as an inflation hedge. And then creative financing will have its day again.
communists-basher // Jan 20, 2010 at 12:29 pm
The simplest solution:
-leave the Capitalism Alone!
-close Feds, return to Gold Standard!
This has to be done in several steps:
1. Admit that the last crisis was caused by artificial relaxing of the lending standards, forced upon us by Radical Liberal Fascists Socialists.
2. Admit that the crisis was needed to smear Capitalism and to initiate transformation to Socialism.
3. Admit that most Economic professors/scholars in the US are pro-Socialism and remove them.
4. Admit that the US Government is to big to fail, and needs to be returned to its minimum size.
5. Admit that the Federal Reserve, Department of Education, EPA, FCC and other Control mechanisms were created by Progressive Socialist Fascist Liberals (on the right and on the left) for one reason only, to rob the poor and to discredit Capitalist Ideology.
6. Admit that the US media is mainly Progressive Liberal Socialist (ABC, NBC, CBS) and Fascist (MSNBC) and is partially responsible for the last crisis.
7. Announce Government intentions to Support Capitalism only.
8. Stop printing money.
9. Return to Gold Standard to support the US Dollar.
10. Return to Capitalism.
11. Now work on health-care and other reforms, while following the principals of Capitalism (not Socialism)
MildlyAmused // Jan 20, 2010 at 12:30 pm
It is simple, folks, let the markets work, in BOTH directions. If an individual wants to take the risk of an interest only loan and a lending institution wants to make such a loan, let THEM. However, don’t do a damn thing when the housing market crashes and both parties are screwed. There should be no limit on the upside but also NO government intervention on the downside. If that means, banks and finance companies fail, then so be it. “Too big to fail” is a myth. Eventually the market will correct for too much risk taking. The other practice that MUST stop is the availability of federal money at little to no interest to financial institutions. If banks need to borrow money from the taxpayers, they should pay the prevailing commercial rate. Any blithering idiot can borrow money from the taxpayers for next to nothing and then lend it back to the same taxpayers at 8% and make money. That is a fraudulent scheme that needs to be stopped immediately.
Kanzeon // Jan 20, 2010 at 1:21 pm
sinz54:
Volker’s comment that the only useful thing banks have invented in 20 years is the atm isn’t exactly undermined by discussing 35 year old innovations.
communists-basher // Jan 20, 2010 at 1:37 pm
I wish someone in the White House would have guts to stand up and demand to Outlaw Socialism/Marxism/Maoism. I’m sure he’ll get an overwhelming support.
Just think about it … who would be openly for these failed radical ideologies … no one.
This will instantly resolve multitude of issues the US is facing.
communists-basher // Jan 20, 2010 at 1:43 pm
Just like the drug use is illegal in the US, these failed ideologies must become illegal too.
Then the Capitalism will flourish and so the level of living for an average American will be improving daily. This is what the pro-America Americans need to fight for …
kevin47 // Jan 20, 2010 at 1:48 pm
“Let’s se a show of hands–how many think, in retrospect, that was a great idea? ”
*raises hand*
It was an excellent idea, and almost anyone who would have qualified for the program would be buying low in the stock market right now. The program provided an outlet (as does any sensible investment strategy) for reducing risk as retirement nears.
As it stands now, workers are losing money in the system, or will be once taxes increase to forestall Social Security’s impending collapse. People who think that markets don’t have a role in savings or economic growth simply don’t understand what markets are or how they function.
As it relates to the housing market, there were several innovations that worked, and the prevalence of interest-only mortgages was one of them. They worked because mortgage interest is tax deductible, and because there was a provision to begin making principal payments. Keep in mind that the majority of people profited off of housing speculation.
Those who did not profit, should have been left with a house. The problem is that interest-only mortgages were paired with pick-a-payment plans, one-month ARMS with skyrocketing interest rates. These were piggybacked onto houses that were overvalued by shady appraisers, and s0ld to people who didn’t know what they were buying into.
Worse, these practices were accompanied by bait-and-switch tactics (promising one loan, but providing different documentation at closing) which were technically legal, but certainly unethical. On top of this, many mortgage lenders were encouraging straw-buying, which is not at all legal, and put numerous properties into the hands of a single buyer.
The solution, then, would have been to accrue fiduciary responsibility to the mortgage broker and lender by law (no more bait-and-switch), while urging the feds to aggressively pursue straw-buyers. We haven’t done that, in part because Countrywide bought Sen. Dodd, and in part because there is no ideological incentive for congressional Democrats to worry about mortgage brokers.
blowtorch_bob // Jan 20, 2010 at 1:59 pm
In summation, if I may be so bold to summerize the general sentiment expressed in this forum, you can’t trust Wall Street any more than you can trust a convicted pedophile in a schoolyard.
Bring back the Glass-Steagall Act!
communists-basher // Jan 20, 2010 at 2:08 pm
“We haven’t done that, in part because Countrywide bought Sen. Dodd, and in part because there is no ideological incentive for congressional Democrats to worry about mortgage brokers”
kevin47 has logic upside down exposing himself as a Radical troll: Sen. Dodd and other Progressive Socialist Liberal Fascists are the ones who influenced Countrywide to loosen their lending criterion’s thus causing the crisis. They must be jailed. It’s irresponsible to think that a Capitalist mortgage company would put itself in danger by taking such high risks as lending $400K to an a Latino grass cutter making $5 an hour. Countrywide was forced to do it by Radicals.
Sen. Dodd is one of the most Radical in Senate: he has been working on Consumer Protection Agency and Sustainable Living Communities legislations, both reflecting the far reaching agenda of Progressive Radical Socialists Fascists to install more Socialist controls in the US, copied from Denmark.
communists-basher // Jan 20, 2010 at 2:13 pm
Ah, the Glass-Steagall Act, the FDIC …. more Socialist Controls that need to be removed. The 1930’s is exactly when America has started to loose its ways … and slowly submerged into the Socialism nightmare …
blowtorch_bob is another Radical troll.
AlVeerhoff // Jan 20, 2010 at 2:37 pm
Someone has to maintain an orderly marketplace, because those in the market are not going to do it hemselves. A business that cuts corners to make a profit is not more likely to lose in the long run but rather to be copied by other businesses, to state the obvious. Someone must protect the public interest just as the outside directors are expected to represent investors in corporations. Market oversight is bound to lead to inefficiencies and possibly to rescue businesses that should be allowed to fail, but we have to recognize this and constantly balance the cost of regulation with the risk of diluting it. What I am positing is a more nimble and responsive regulatory environment, and I think such a thing is possible.
askwhy // Jan 20, 2010 at 2:39 pm
Mr Frum, Because your blog is so difficult to navigate I will attempt to address some issues here. You have suggested that people who object to “Free” trade and other moves toward Globilism are some how whacked out! You sir are a perfect example of what is wrong with the Republican Party! You and your type are nothing more than elitist progressives who believe the American people are just to stupid to figure things out. I want to say to you this. You sir are the STUPID one. You simply do not get it! A Large segment of the American people are certainly PISSED OFF! Our jobs have been sent overseas, our borders are essentially unsecured and our way of life and soverighnty are under attack and you suggest we are just decending into Anger and Paranoia and so therefore irrational! You sir are why people are PISSED OFF! You and your former boss are the ones who just DO NOT GET IT! I would suggest you get off your butt get out from behind your computer in your cozy home or wherever the heck you are and get out and talk to average Americans. Long before the recent economic collapse people were really upset! Now they are just PISSED OFF! And peple like you are adding fuel to the FOREST FIRE!
kevin47 // Jan 20, 2010 at 3:23 pm
a) We can’t trust banks.
b) therefore any regulation is beneficial
I don’t find the above syllogism to be at all compelling. Re-introducing Glass-Steagall is the sort of Monday morning quarterbacking that Congress loves to do, and which is always met with unintended consequences (think SarbOx).
Can someone explain what, specifically, the Glass-Steagall act will do to keep banks in check, and why it will be effective in improving the economy?
balconesfault // Jan 20, 2010 at 3:57 pm
12 communists-basher // Jan 20, 2010 at 1:43 pm
Just like the drug use is illegal in the US, these failed ideologies must become illegal too.
OK, I am officially conviced that communists-basher is a spoof.
balconesfault // Jan 20, 2010 at 4:47 pm
askwhy: You have suggested that people who object to “Free” trade and other moves toward Globilism are some how whacked out! You sir are a perfect example of what is wrong with the Republican Party! You and your type are nothing more than elitist progressives who believe the American people are just to stupid to figure things out.
The whole “elitist” and “believe the American people are just to stupid to figure things out” charge falls apart when someone is calling for protectionism – which is the opposite of free trade.
What protectionism says is that the American people are too stupid to not buy cheaper goods from overseas even when those individual decisions end up causing the jobs of fellow American to be sent abroad.
Unfettered free trade isn’t elitism … but rather, protectionism is.
It’s just that some forms of elitism are actually useful in protecting American interests.
blowtorch_bob // Jan 21, 2010 at 12:43 am
Kevin, off the top of the head the Glass-Steagall Act was enacted in the 1930’s, a direct consequence of the 1929 market crash and the Great Depression that followed. It was supposed to keep the banks from taking depositers money and investing it in wild and crazy investment schemes.
The Glass-Steagall was repealed back in 1999 by the Clinton gang and things have gone downhill from there. There is talk of reinstating this law but Wall Street are massing their PR machines to block any attempt.
kevin47 // Jan 21, 2010 at 3:46 am
“Kevin, off the top of the head the Glass-Steagall Act was enacted in the 1930’s, a direct consequence of the 1929 market crash and the Great Depression that followed. It was supposed to keep the banks from taking depositers money and investing it in wild and crazy investment schemes. ”
I understand the intent, but what does it actually accomplish? Ideally, shouldn’t we encourage banks to spread their risk between different industries? If we were to retroactively enact glass-steagall, and back-date legislation to 1999, I suppose we could avert some measure of this catastrophe.
However, the housing market responded to existing regulation. Mortgage brokers played games with the laws on the books, and will continue to do so, regardless of what laws are on the books.
I’m just curious as to why people think that Glass-Steagall represents the correct “fix”, insofar as there is a correct fix. If fraud was rampant during the housing boom (and my goodness was it ever) , why wouldn’t the bad eggs simply exploit the banks. In fact, wouldn’t brokers play an even larger role in determining how banks accrue risk?
I do not intend these as rhetorical questions. I don’t know the answer. But I do want to know what regulation will accomplish here.