Most Government Involvement Since the Great Depression

Rick Wagoner, the chairman at General Motors, has resigned, apparently forced out by the Obama Administration. According to a New York Times article, the decision caught both Detroit and Washington by surprise and also indicated , "...a level of government involvement in business not seen since the Great Depression."
My first blog posting had to do with all the times we hear today about the "worst since the Great Depression." We may now get other phrases in connection with the last part--since the Great Depression. It seems clear that the new administration wants government involvement at greater levels that we have seen, at least since Reagan's election. (Robert Reich had a recent opinion piece in which he argues that Obamanomics isn't about big government, but I don't find his arguments persuasive.)
A question remains as to how involved the government will be in operations and strategies of GM given that GM has asked for and received federal money. To hear some politicians, including Obama while a candidate and Rep. Pelosi on numerous occasions, the auto firms just need to become more green and profits will return. How to do so remains a bit of a mystery. Ronald Coase, a Noble-winning economist, described how as a student he and classmates were discussing policy in the oil industry, and how wasteful American oil firms were. (This was in 1930). Arnold Plant, the professor of the class, led them through a discussion that implied that the government knew more about running an oil firm than the executives of the oil firms, and further, that they as students knew more about running oil firms than the executives knew. Coase notes that the foolishness of the implications were obvious at that point. (See R. H. Coase, "The Nature of the Firm: Origin," Journal of Law, Economics, & Organization, 4 (Spring 1988), p. 6.)
GM has made a lot of mistakes, and perhaps it deserves to fail. But if GM had followed the path Pelosi or other politicians opt for, that failure would have come even sooner.

Two Views on PPIP

I admit to being skeptical about the new plan to recapitalize the banking system. But, can a plan that both Robert Reich and Paul Krugman hate be all that bad? (For article, see here.) Perhaps I should take a closer look. Joe Nocera, in today's New York Times, said he took a closer look and he thinks it may work. I hope Nocera is correct.

Reregulation II

Treasury Secretary Geithner testified before the House Committee on Financial Services, calling for new regulations. His prepared statement can be found here.

We Are Moving into a Time of Reregulation

One of the reasons given for the current financial crisis is deregulation, which permitted greedy Wall-Street-types to earn huge incomes by taking excessive risk. We can expect to see an increase in regulation in the near future. Treasury Secretary Geithner is calling for increased regulation in the financial sector.

While I will not argue that some changes in regulation may be needed, I fear that the changes that will be implemented will not lead to a better financial system. Why? For several reasons. First, when the consensus of policymakers is that we are in a crisis, the likelihood of passage of poorly conceived and poorly thought out laws and regulations is high. At least some of the deregulation movement in the past developed because deficiencies in the regulations that existed at the time had become apparent. Second, regulation tends to be reactive--reacting to the perceived shortcomings of the situation without knowing the effects of the regulations when the economic environment is different. This reflects the general concern economists have for the unintended consequences of government actions. Third, between government officials and the press, one could think that regulators will be wise, impartial, selfless public officials, and they can oversee the selfish, risky actions of the people working in finance. But all are human beings. All lack omniscence; all lack perfect foresight.

Economists who work in the economics of regulation long ago gave up the idea that regulation was done in the public interest. Instead, it is recognized that regulators are impacted by interest groups. Further, interest groups include, but are not limited to, those in the industry that is regulated. As we examine the current situation and the politicians who are key figures of key committees in the House and the Senate, can we not expect that those interest groups that Barney Frank and Christopher Dodd pay attention to will have more influence in the outcome of legislation than other groups? (I use the two men only as an example and am not accusing them of nefarious behavior. This is how our system of representative government works.)

A Few Recommendations

I am facing a tight time constraint today, so am limiting my blog to a few recommendations from elsewhere:

Victor Claar has a good discussion of monetizing debt.

Casey Mulligan has a piece on home prices.

Financial Times on the credit markets response to the new Treasury Plan.

Finally, in the news today is a report from Great Britain that the CPI for Britain increased 3.2%. That helps reduce worries about deflation but the concerns about inflation that some economists have may be real.

Securitization and the Financial Crisis

A major component of the current financial crisis involves the "toxic assets" on the balance sheets of many banks. These assets include derivatives that were manufactured to reduce and spread risk. There is an interesting article in the newest Journal of Economic Perspectives entitled, "The Economics of Structured Finance" and was written by Joshua Coval, Jakub Jurek, and Erik Stafford. They illustrate how the collatorized debt obligations (CDOs) could be created such that a lower level of risk is attached to one of the obligations. I illustrate with an example they use in their article.
Suppose there are two identical bonds and each has a probablitity of default equal to 10%. Let the bonds each pay $1 if there is no default and $0 if there is a default. Combine the two securities into a portfolio and create two tranches, each of which pays $1. But one of the tranches--the junior tranche--bears the first $1 of losses to the porfolio while the other--the senior trance--bears a loss only if the capital of the junior tranche has been wiped out. To determine the expected cash flow for the senior tranche, we need to know the likelihood of observing both bonds defaulting. That depends on whether the probabilities of default for the two bonds are correlated. If they are uncorrelated, then the probability of default for the senior tranche is 1%. The senior tranche will sell for a higher price than the junior tranche. If the probabilities of default are correlated, then the risk associated with the senior tranch will be greater than 1%.
The authors then develop a simulation study involving more complex securities with different assumptions about the correlation of risks associated with the underlying assets. They show two things in their simulations. First, they find that small errors in assessing the riskiness of an asset are magnified by the collateralized debt obligations structure. Second, structured securities experience more exposure to systmatic risk. They state, "Unlike traditional corporate bonds, whose fortunes are primarily driven by firm-specific considerations, the performance of securities created by tranching large asset pools is strongly affected by the performance of the economy as a whole." (p. 23).
As housing prices fell and defaults increased, the system-wide problems became obvious and the prices of CDOs fell. In the extreme, no one is willing to buy some of these assets because they do not know the actual risk associated with them.

Recession and Protectionism

Whenever national economies slow down there are calls for reducing foreign competition in order to protect domestic jobs. The current global recession is no different. Many economists were concerned with the "But American" feature of the stimulus plan, although it was watered down somewhat. For the rest of the world, when the long-term proponent of free trade backs away from it, it is easier for them to back away also. An article in today's New York Times outlines some of the countries that are increasing protection for domestic industries. Does anyone remember the Smoot-Hawley Tariff Act?