Interdependence, Externalities and the “Credit Crunch.”

There is a silver lining around the dark cloud hanging over the U.S. economy recently. It should increase interest in your course. I don't know about where you work, but students and staff members around here are talking to me more frequently; even if it's in a light-hearted way.

But as I read and listen to news, commentary and conversations, I'm struck by one fact. There's an overarching view of "us" and "them"; and the "us" gets reparsed and redefined as often as the "them." But it is always in a way that the speaker is among the "us" and, more importantly feels put upon by the "thems", however defined. What seems to be missing is a sense or understanding of the concept of interdependence – we’re all "them" AND "us." Allow me to illustrate.

This article from The Washington Post is not atypical of a lot of recent coverage and commentary. There is a perception of outrage about the rescue plan being floated in Washington. I'll focus on the plan shortly, but I want to start by examining the perception. I am intrigued by some of the statements in the article. One person "lived within his means in an era of easy credit." Presumably, that is easier than living within one's means in an era of tight credit. Later the same person states he didn't buy an overly large house, and isn't behind on his payments. That's good. But to what extent is his success due to general growth in the economy? Did he benefit from the activity and decisions of others?

Another person in the article suggests this may take generations to unwind. That may or may not be true. I suspect it will affect how this and possibly the next generation make certain decisions - significant economic and financial events do that. But so do the rules and regulations that get put in place - that's why we have them. Still another person recalls a neighbor saying he didn't know how he afforded the house he bought, he "just signed." Evidently, those were the rules and incentives in place. The point is that none of the people interviewed seem to connect the situation we're in to the decisions and choices made by "us". Rather, there’s a tendency to recast the situation as created by "them." Some of us may have been concerned about housing and mortgages earlier in this decade, or even during the last. But we all benefitted because lower prices and financing for homes meant people could by more other stuff. "Us" was part of the "them."

Now, there is evidence that leads us to believe that the crisis may be restricted to a small (but very significant) segment of the financial industry. One of the terms bandied about recently is "credit crunch." But is there a credit crunch affecting Main Street? To me, that would imply a difficulty in finding credit. Yet, if we look at some data from the Federal Reserve Bank of St. Louis cited in the Marginal Revolution blog, credit continues to be available for consumer loans, commercial loans, and mortgages. So where's the problem? Blogger Alex Tabarok suggests it is in the area of short-term asset-backed securities. This would make sense as some of those investments were linked to mortgage loans of dubious origination. And if people doubt the value of the homes and the ability of borrowers to repay, everything resting on that foundation becomes shaky.

However, let's get back to the Post story. The subjects of the story are asking valid questions about their "role" in the bailout. This brings me to another concept. In economics, we often talk about externalities - benefits or costs that accrue to parties outside of a transaction. In the case of the proposed rescue, one could make a case that this is a case of huge negative externalities. Taxpayers are being asked to provide the funds to aid parties to transactions that did not directly involve them. Many of them did not purchase homes under questionable terms; and many did not purchase the derivative contracts that grew out of the housing boom. Consequently, the fall of housing prices and the ensuing collapse of the derivatives based on mortgages for those homes, sent ripples through the economy - negative externalities - costs that must be paid. But is the taxpayer the one who should pay for the externality? The question now becomes, was the taxpayer a beneficiary? One can argue that the average economic citizen benefited from a growing economy, stable financial environment and access to credit. To the extent that proposed plan maintains that condition, taxpayer involvement is appropriate. To the extent that taxpayers benefitted from “cheap and easy credit”, etc., it is also appropriate. Look at the past benefits, look at the present benefits, and consider the future costs.

This leads to a discussion about "them", or at least to one of the conveniently defined "thems". The rescue package is still being debated, so it is pointless address details. Nevertheless, one of the things the package will hopefully do (indeed I would submit it should be a major objective) is properly allocate costs, or as one of my econ teachers used to say "internalize the externalities." By that, he meant take the externalities and properly integrate them into the cost structure – who benefits and who pays?

To that end, a number of lessons are available to apply. As we see in this New York Times piece, (HT to blogger William Polley)Sweden underwent a mortgage-induced crisis in the early 1990s. The Swedish government intervened with a rescue package. But the Swedish government implemented some very strict conditions for intervention, among them: banks had to write down the losses before rescue. This means the losses had to be recognized on the books so that shareholder value was impacted first. Thus part of the externality was accounted for by the shareholders. Only then would the government intervene, taking stock warrants as collateral. This meant that if assets were later sold off above the price on the books, part of the profit went to repay the government. This is, if I understand correctly, part of what was done for AIG.

Now some are asking that banks be asked to do the same as AIG. But there is a subtle difference between what was done for AIG (and Freddie and Fannie) and what needs to be done for banks. This is because banks are...well, banks. The Federal Reserve System is already set up to deal with banks, providing liquidity through various channels, even taking debt as collateral. This is important. Generally when liquidating a firm, debt (liability) has a superior claim to assets over capital (owners), meaning the debt holders get paid first. While AIG was not a bank and therefore not in the normal procedures, banks can use existing channels to get money from the Fed. If the U.S. government or the Federal Reserve takes stock as collateral before a bank's losses are figured in; there is a risk of being last in line in case of liquidation. By taking debt, that should be less of a problem.

But there may be other ways of "internalizing the externalities". On the PBS program NewsHour on Tuesday, September 23, (HT to Greg Mankiw there was interview with a panel of economists about the proposed plan. All more or less agreed something needed to be done, but the consensus was that the plan needed modification. Of particular note were comments by Alan Meltzer of Carnegie-Mellon University. He suggested that the aid should be in the form of loans to be paid back with interest. (Indeed, if we look at some of the recent plans, loans not only are being made, but some of them have fairly steep interest rates – reflecting greater risk.) And that until the loans were paid back, dividends to stockholders would be suspended and bonuses to executives would also not be paid. (My initial reaction was "and don't let the executives jump ship until the loan is repaid." But I'm not sure having the same people steering the ship when it hit the iceberg is a good thing. Maybe you let them go without departure bonuses. To extend the analogy, this would be akin to setting them adrift in a lifeboat without the full complement of provisions.) Meltzer’s suggestion provides a certain incentive for the firms to mark down the losses, and then work quickly to restore profitability in order to pay off the loans. But that’s about "them", isn’t it?

We're still examining the "us" behind the rescue package. Even if the costs are properly shifted, there's still going to be some overhang. Who should pick that up? In the long-run, one could probably wait for a market solution, letting the losses hit various parties involved, whether culpable or not. That may not sit well with our sense of justice in some cases, and it may sit well in others. It depends on who is taking the specific hit. But one needs to look at the big picture. Fed Chairman Ben Bernanke, in his economic outlook delivered before Congress yesterday, pointed out that some things are being implemented that would reduce the potential loss to the taxpayer. The general situation is also causing reactions one would expect. "Nonconforming jumbo mortgages cannot be securitized and thus carry much higher interest rates" - so much for financing a big house on the cheap with little or no documentation. And he pointed out that the cases of Fannie and Freddie, while large and unusual, were largely the result of those organizations being government-sponsored, an issue that was addressed back in July.

Where does that leave us in the classroom? We've got lots of examples to use as explanations and illustrations when discussing externalities, incentives, the role of banks and credit, exotic financial instruments, and the role of the Fed (see last week's post). I also submit that, depending on the details of the rescue package, there is something to use when discussing institutions (the rules of the game) in the financial markets. Hopefully, the final package will not set up institutions that promote situations like this.

Overall, I am reminded of an anecdote an economist once shared with me after the savings & loan crisis of the late 1970s and early 80s. He was a guest on a radio call-in program and one irate caller said that “government got us into this; government should have to pay for it.” The economist then reminded everyone that we are the government. The "them" is "us". The same goes for the economy. The economy is merely the sum of all of our personal decisions. Our decisions are shaped, in part, by the rules we put in place (or allow to be put in place), and in part by our desire to improve our lot, our attempts to "get the most for the least." Whether we know that our actions are "right", whether rules are "correct", or whether the consumer/taxpayer ultimately gets the check, the economy is still of our making. We’re all on the same boat. That’s interdependence.

In the end, as the discussion on the bailout continues, and various constituencies jockey for their place at the payout window, I am reminded of something said by the French economist, Frederick Bastiat. To the best of my memory it was "we all look to live at the government’s expense, but we forget that the government lives at our expense." I look forward to your comments.