Is Preventing Asset Bubbles Worse For The Economy? Reprint Of My December 2009 Post

The following is a reprint of my blog post of December 14, 2009, "Is Preventing Asset Bubbles Worse For The Economy?"

Monday, December 14, 2009

Is Preventing Asset Bubbles Worse For The Economy?

Posted By Milton Recht

But would we have destroyed Amazon.com, Ebay and Google to name a few very successful internet companies in the process of controlling the internet bubble? Will the long term effect of a remedy for controlling asset bubbles, destroy future industries? Wasn't Holland's tulip industry the result of tulip bulb mania, a bubble?

How does government distinguish from innovation and asset bubbles? Innovation and new industry result in a rush of new investment, asset price increases, financial collapse of many participants, asset declines and survival of a few big winners that go on to create new opportunities and economic growth. Can we distinguish innovation from so-called bubbles, which have no positive economic and social welfare effect?

By preventing bubbles, we prevent major investment in new technologies, processes and industries. We will create a world with very little economic growth, a world without structural shifts in technologies, if our goal is to prevent new bubbles.

If we believe in increasing asset price bubbles and want to prevent them from occurring, shouldn't we also believe in decreasing asset price bubbles, where prices collapse too far and too fast and want to prevent price declines also? Isn't preventing bubbles really just an alternative way of saying we do not want major price changes? Wouldn't prevention of price movements substantially distort the world's economies and lead to worse results than any asset bubble?

Isn't it is better to figure out remedies for the occasional negative effects of bubbles than to try to prevent them from happening?

And of course, there is always a possibility that asset price bubbles and eventual collapse are a rational response to economic events at the time that we are too ill informed to understand correctly.

My comment to "Using a hammer or a wrench to pop asset price bubbles?" by Antonio Fatás posted on the Antonio Fatas and Ilian Mihov on the Global Economy blog.

Bank Leverage Is A Red Herring: Reprint of My 2009 Blog Post

The following is a reprint of my blog post of June 17, 2009, "Bank Leverage Is A Red Herring."

Wednesday, June 17, 2009

Bank Leverage Is A Red Herring

Posted By Milton Recht

Many offer higher capital and lower leverage requirements as a solution to the problem of the recent banking crisis. However, it is a risk preference problem and it is not a capital or leverage problem. As anyone familiar with financial theory knows, leverage can be placed anywhere in the investment chain to create a higher risk level. Higher leverage is just a way to increase risk and the potential return.

So, if capital is increased at the bank level (lower leverage and lower risk), banks will either invest in riskier products or make safer investment products riskier by incorporating leverage into the product directly or implicitly, such as through embedded options, etc.

Using residential mortgages as an example, their risk is increased by going from 80 percent loan to value to 100 percent loan to value. Additional risk is created by lending to lower credit worthy borrowers.

When the mortgages are packaged as investment products, borrowed funds can be used to increase the value of mortgages in the product so that the total mortgage value exceeds the equity investment in the product, which increases their riskiness. The investors in these leveraged products can borrow funds themselves to increase their equity investment in the leverage products, further increasing the risk to the investors.

The investor's risk preference ultimately determines the amount of risk in the invested products. There are too many ways to increase risk. Regulations and regulatory supervision will not stop excessive risk from occurring if that is what the bank or any other investor desires.

It is a rehash of the old Modigliani-Miller problem about the optimal capital structure. A bank with low leverage can invest in riskier products to achieve the same total institutional risk that higher leverage would achieve. Despite the regulators' attempt to prevent increased risk, an institution with a higher risk tolerance will find ways to invest in products that match its risk profile. The risk to the institution will not be lower with higher capital amounts.

As Arnold Kling stated, "the problem was not a gap in regulatory structure." What would cause financial institutions to take on so much risk that the continued existence of the entire institution was in jeopardy?

Moral hazard and incentive compensation themselves cannot explain the institutional behavior. Participants, many of whom had restricted company stock, risked too much of their own personal wealth, careers and reputations for the bonus compensation structure to be the answer. Furthermore, many of the investors, including the investment and commercial banks, are too sophisticated not to have understood the risk, despite the credit rating agencies' stamp of approval and their post mortem statements.

While there are many "expert" answers proffered, none offer an adequate explanation of why institutions took on so much risk. Many sophisticated investors and financial institutions either misread the risk in the market or intended to take on excessive risk. Both are troubling and not easily fixed.

Addendum

The recent 2023 Silicon Valley Bank, Signature Bank, and First Republic Bank failures show that the management of these banks was willing to take on the added risks of interest rate increases and volatility, asset sheet valuation losses, and deposit withdrawals. The bank asset-liability management systems and analyses would have revealed to banks' management the danger of the maturity mismatch and cash flow risks of the long-term US Treasury investments funded by short-term deposits that created the run of the banks' deposits.

Effects of US Federal Policies on Electric Vehicle Demand and the Supply of Charging: CBO Projections

From CBO, "Projecting the Effects of U.S. Federal Policies on Electric Vehicle Demand and the Supply of Charging Stations" Presentation by David H. Austin, an analyst in CBO’s Microeconomic Studies Division, at ICEX España Exportación e Inversiones, November 16, 2023:

Projecting the Effects of U.S. Federal Policies on Electric Vehicle Demand and the Supply of Charging Stations from Congressional Budget Office

Housing Inflation Is the Worst

From The Wall Street Journal, "While All Inflation Feels Bad, Housing Inflation Is the Worst: For some, unaffordable homes undercut the American dream even more than high gasoline and food prices" by Greg Ip:

Housing is an entirely different matter. The Bureau of Labor Statistics, which compiles the CPI, doesn’t measure the cost of homeownership with home prices. Rather, it estimates what a homeowner would pay to rent their own house. This “owners’ equivalent rent” tends to track rents rather than houses and is up 17% since the start of 2021.

But if you’re actually in the market, what matters is the price of a home and the mortgage rate. Since January 2021, home prices, despite a late 2022 dip, have risen 29%, according to the S&P/Case-Shiller national home price index, and mortgage rates have nearly tripled. The buyer of the typical home thus faces a monthly principal and interest payment of nearly $2,200, more than double the level of early 2021, the National Association of Realtors calculates. No wonder the net share of consumers telling the University of Michigan it is a good time to buy a home is the lowest since 1982. 

Source: Wall Street Journal

CBO’s Analysis of the 30-Year Long-Term US Budgetary Outlook

From CBO’s "Analysis of the Long-Term Budgetary Outlook," November 16, 2023, Presentation by Molly Dahl, CBO’s Long-Term Analysis Unit Chief, at the University of Michigan’s 71st Annual Economic Outlook Conference:

CBO’s Analysis of the Long-Term Budgetary Outlook from Congressional Budget Office

The Last Line of Defense By Bari Weiss: Barbara K Olson Memorial Lecture: Federalist Society: Video

"The Last Line of Defense" by Bari Weiss, from The Free Press, Barbara K. Olson Memorial Lecture at The Federalist Society, November 10, 2023:

Bari Weiss is the founder and editor of The Free Press and host of the podcast Honestly. From 2017 to 2020 Weiss was an opinion writer and editor at The New York Times. Before that, she was an op-ed and book review editor at The Wall Street Journal and a senior editor at Tablet Magazine.
[Source: Bari Weiss Bio]

US Population Will Stop Growing By 2080 And Shrink By 2100: Census Bureau Projections

From The Wall Street Journal, "America’s Population Projected to Shrink by 2100, Census Figures Show: Declining birthrates and higher death rates are making the U.S. more reliant on immigration for growth" by Paul Overberg and Rosie Ettenheim:

Census Bureau projections released Thursday show that, under the most likely scenario, the U.S. will stop growing by 2080 and shrink slightly by 2100.

It is the first time that the bureau has projected a population decline as part of its main outlook for the coming decades. The only time the U.S. has recorded a population decline was in 1918, when the flu pandemic and deployment abroad of more than one million troops produced a small drop in the estimated population.

Slowing growth would produce a peak U.S. population of almost 370 million before an ebb to 366 million in the final years of the century, according to the bureau.

Halloween Trick Or Treat Kids Created Wealth By Trading Candy

From THE BEACON, "How Do Your Kids Create Wealth by Trading Halloween Candy?" by Art Carden:

The kids were creating wealth even though they weren’t making any new candy. How? They were getting candy they preferred for candy they didn’t like as much.

My daughter, for example, mentioned that she doesn’t actually like candy with caramel in it (I was surprised to learn this). This means Snickers, Twix, Milky Ways, and a whole host of other delicious candies are out.

If trade isn’t an option, she’s simply stuck with a lot of candy she doesn’t want to eat. With access to a market consisting, in this case, of her brothers and friends, she is able to swap the caramel-containing candies she doesn’t want for non-caramel-containing candies she does. She is better off. Her trading partners are better off. There’s an important lesson here: by getting candy into the hands of those who value it most highly, the kids are creating wealth.

It’s a mistake to think that wealth consists of stuff. Wealth, rather, is whatever people value. For someone who likes Snickers bars, Snickers bars are wealth. For someone who doesn’t like Snickers bars, they aren’t wealth—unless they can be traded. If they can, the excess Snickers bars become wealth because they can then be swapped for something better.