Frog Blog

How do we get out of the current financial mess?

“Do whatever you can to allow the start of new businesses,” said 2002 Economic Nobel Laureate Vernon L. Smith, who spoke Thursday night (10/28/2010) at Indiana University.

In the history of recessions here and around the world, bubbles in the housing market are regularly more devastating to financial institutions and other parts of the economy than even larger disruptions elsewhere according to Smith, Professor of Economics at Chapman University.

Over the past few years I’ve been frustrated by simplified explanations of our recent financial crisis that place all blame on a single element of our system rather than dealing with what is a rather complex and intermixed systemic failure. Smith’s background in experimental microeconomics and long experience with bubbles led him and his associate, Dr. Steven Gjerstad, to study historic recessions and try to identify the differences that lead to more widespread disruptions. This is a great review of the major and less severe recessions since  the great depression as well as a primer into the importance of housing.

“Why housing?” is a significant question especially when you realize that the tech stock bubble early this decade wiped out significantly more wealth initially than the housing decline, and yet for the most part, financial institutions survived.

Price bubbles are common in lab experiments surrounding durable assets (items that we can expect to retain value and possibly be resold). When buyers are taking into account the future value of an item they regularly bid up the price into bubble territory. This was true of college students and stock pickers alike according to Smith. Bubbles are exacerbated when there is more cash available to participants or when there is significant room to buy on margin.

Smith identified several points that started the formation of the housing bubble including: Laws passed in the 90’s tying the rating of mortgage companies to low income loans and regulations and laws in the 90’s directing funds to lower income borrowers; 1997 tax relief act that raised home exemptions to $500k; The increasing US trade deficit causing a strong inflow of capital.

The bubble was sustained by easy monetary policy, continued capital inflows and my favorite target, CDS Derivatives that were not collaterized.

The key is that EVERY institution had a hand in creating and sustaining the bubble. It was a matter of law, government regulation, unwise trading in the financial community, unwise buying by homeowners.  The bad guy was all of us. And unfortunately it takes all of us to get ourselves out of the mess.

Later in the evening I was able to ask Dr. Smith about the parallels in housing seen between the extended great depression and our current situation. Like today, in the 30’s states tried to stop and slow foreclosures possibly extending the amount of time it took to get debt ratios back in line. He said that getting households past their current over-levered position is a key step to moving forward.  He said it was hard for him to believe he was saying it, but he actually felt that a restatement of mortgages might be the answer. (Saying that he did not feel it was a good answer, but maybe the best answer we had when all we have are bad answers.)

His key point of the evening comes back to the importance of moderating the impact of bubbles.  (He does not feel they are possible to prevent, given human nature.) A key way of moderating the impact would be to make sure buyers had to put more ‘skin in the game’ and make sure that CDS derivatives were collateralized. In other words put cash buffers through out the system so that shocks will be absorbed rather than toppling institutions like dominoes. In many ways the market worked this way from the Great Depression through the mid-90′s when reserves were reduced and money down requirements were reduced. Then the institutions ‘forgot’ what they new and set us up for catastrophe.

Complicated solutions to complicated problems requiring discussion that our 140 character political system doesn’t encourage very well.

But while the reforms and regulations, banking best practices and housing prices get worked out by those we vote for and those who have the money to lobby effectively – he left the solution to our mess in the hands of us.  Entrepreneurship has been and is something within reach of every person and will be what drives us finally out of the current mess.