Posted by: erichosemann | September 20, 2009

Trail of Tears

In my last post I wondered about when and how free market economists decide to start tracing the trail of decisions leading to severe discrepancies between human expectations and market abilities to satisfy them.

In my inexperience and naiveté, I spoke too soon.

Audio of Russ Roberts and Arnold Kling giving their interpretations of the sequence of events leading to the crisis can be found here.

I can’t wait to listen to the whole thing again.  A few points I took from my first listen:

1) From Arnold: the mortgage backed securities marked is a creature of the government–I had no idea of this.

2) From Russ: a vicious circle of speculation with borrowed money had a lot to with the scale of the crisis.  He likened it to a poker game in which the players keep lending each other money as they up the ante.

3) Arnold used a rock and roll analogy in critiquing the media’s ham-handed descriptions of the crisis.

4) Russ’s description of what the government actually does when “saving” “too big too fail” institutions is really interesting.

Russ’s description of the speculative circle is compelling, but I keep wanting to think that such a phenomenon can only be stoked by outside factors.  I know nothing about poker, but presumably, if each player in a poker game lends to his buddy, and keeps lending to him, there must be some factor outside of the money on the table that each lender is considering.  There must be something on each lender’s balance sheet that makes him more willing to lend money.  Part of the reason he’s lending could be that he knows his bank account is getting bigger for some reason; maybe his wife works and just got a huge promotion; maybe he’s on the cusp of selling off some assets, etc., etc.  It doesn’t seem logical to me that the lending circle’s own animal spirits would stoke themselves—not that Russ was implying that, and not the furors or frenzies don’t ever stoke themselves.  I don’t want to absolve Wall Street completely from any “guilt,” but I’m a libertarian, and thus my first instinct is to believe government just as likely an exogenous factor encouraging speculation as any other, such as predicted shortages or surpluses of resources.  Could the belief in some implicit guarantee of Fannie and Freddie assets have been the thing causing the poker players to believe their bank accounts had greater protection against risk?  Russ says the literature pertaining to Fannie and Freddie was very explicit about there being no real “implicit” government guarantee on their assets.  But he also mentions the Wall Street adage: “When the music’s playing, you gotta dance.”

I think Arnold’s highlighting the government origins of the mortgage backed securities market fits in there somewhere, but I’m too green and uninitiated in financial arcana to connect the dots.  It’s more like an inkling of my animal spirits sort of thing.

I thought Arnold’s rock and roll analogy was apt but a little unfair, too.  It went something like this: In 1964, the media coined the term “British Invasion” to describe the wave of British bands hitting the America charts. The media, and much of the public were unaware that the chief musical influence on these bands was African-American rhythm and blues.  The media missed the deeper details of the British Invasion’s roots.  Likewise, Arnold claims the media missed the deeper details of the causes of the financial crisis. Their coverage might have been a mile wide but only a few inches deep.

That sounds right but I don’t see it ever changing.  This isn’t my suspicion of the mainstream media talking, though that has something to do with it, I’m sure.  The reality is that the media miss the deeper details of almost every story; if they were to include the deeper details they would never get a story out!   (That kind of delay could be a good in and of itself—but that’s another story for another time.)  It’s a rational ignorance kind of thing writ a little larger than the individual.  Rational ignorance in media gets dissipated in the long term (think Dateline NBC or 20/20 or 60 Minutes), but then again it never goes away entirely.  In other words, the media can’t help it—deadlines and competing outlets make it essential to establish the narrative with whatever “facts” you’ve got.  The resultant gaps are where guys like Arnold and Russ come in.

Do yourself a favor and listen to this talk.  It’s not esoteric and the jargon quotient is small.  Both men speak in an approachable style that frees the topic up for informed general debate.

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