Economics & Finance

Testing Economic Hypotheses

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Watching people blame the free market for the housing crisis is like watching the jocks that trip nerds in the hallway mock the nerds for their clumsiness. The commercial real-estate markets demonstrate what a nerd can do if left unmolested.  

Leftists have to answer a   question: if greedy, irresponsible, unregulated etc. capitalism caused the housing bubble, why didn’t we see a similar bubble in commercial real-estate markets which operate under even less regulation than the residential markets? Why does the politically neglected and unregulated commercial real-estate market exhibit much milder swings?  

 

I dislike economics as a science due to its lack of  empiricism. You usually can’t test any of the ideas in economics beyond looking at the historical record and squinting until your pet hypothesis snaps into clear focus. Then you argue with other people who don’t squint the same way you do.  I am a libertarian/classical-liberal due to my understanding of the limits of economic knowledge. I know that people who claim to  possess  predictive economic models delude themselves and that any attempt to forcibly alter people’s economic behavior based on such delusional models will end badly.  

Every once in a while, though, we get lucky. The differences between residential and commercial real estate provide the means to test the hypothesis that government intervention or the lack thereof caused the housing bubble and subsequent collapse of the financial system. We can compare the two markets because the same institutions ultimately make residential and commercial loans. They make loans in the same communities and regions. Changes in the economy affect both types of real estate at the same time and to the same rough degree. The only major difference between the two markets lies in the degree of government intervention.  

Some might argue that the differences in financial sophistication between residential and commercial borrowers explains the difference. They argue that predatory lenders exploit naive borrowers in the residential market whereas they can not do the same for more-sophisticated commercial borrowers. We can dismiss this idea because in the free market financially sophisticated people assume the risk of lending for both residential and commercial mortgages.  

Lenders make money on loans in two ways: (1) they either hold the mortgage itself for 20, 30, 40 years and take their profit long-term off the interest, or (2) they sell the mortgage in the secondary market. In both cases, financially sophisticated individuals judge whether the borrower can repay the loan. If the initial lender exploits unsophisticated borrowers, he suffers long-term if he holds the loan himself. If he tries to sell the mortgage the sophisticated secondary buyer will refuse to purchase it. In either case, no one in the system has an incentive to make predatory loans because anyone who does will directly bear the consequences of doing so.  

Clearly, the problem lies in the way government actions sever the relationship between issuing risky residential mortgages and suffering the consequences of doing so. This not only allows predatory lending but also makes it difficult for lenders of good faith to judge when they make too many risky loans.  

More than any other policy, the creation of Freddie Mac and Fanny May distorted the residential mortgage market in a way that the commercial market escaped. The FMs exist solely to induce lenders to make residential loans that the free market judged too risky. The FMs buy up residential mortgages from primary lenders and bundle them together in securities. They do so precisely in order to short-circuit the free-market feedback system that communicates to banks when the financial system as a whole has lent out as much money as it safely can. That feedback system worked like a governor on an engine. It kept the system from running away and lending more money than it could recoup, but also prevented people with poorer credit from getting loans.  

Politicians who wanted the engine to run faster created the FMs to bypass the governor in order to get higher performance in the short run. Since the FMs would buy up almost any mortgage, lenders could make riskier and riskier loans without suffering any negative consequence. The FMs replaced the self-interested secondary-market buyers with people playing with government money and a mandate to induce more and more lending. Special dodgy accounting rules allowed the FMs to hide the risk behind the securitized mortgages they sold.  

Tellingly, no such intervention occurred in commercial markets. The FMs’ charters expressly prevented them from buying commercial mortgages. As a result, the commercial mortgage market functioned with a free-market governor. When lenders made too many risky loans, free-market secondary buyers stopped buying their mortgages and the system cooled down. As a result, commercial markets saw no runaway boom and subsequent colossal bust.  

The differences in the two markets proves as much as any observation can that political interference in the residential mortgage market ultimately caused the financial collapse. Had we been content with levels of home ownership that the market supported, and had we not tried to get something for nothing by blinding the financial markets, we would not be facing a crisis of this degree now.  

Sadly, experience suggests that mere  empiricism  has no place in political economics.  

[update (2009-2-12-9:52am): Rent control provides another dramatic example of the effect that government intervention in the free-market has on the residential housing supply versus  commercial building supply. In places with rent control, residential housing is almost always in short supply while at the same time  commercial  space is  abundant.]  

Dear Bill O’Reilly:

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If the stock market tanks in response to widespread concerns about incompetent national business and political leadership, this actually means that “the gangsters on Wall Street” are accountable.

Thanks for your attention.

Leaving a Trillion on the Table

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(I originally posted this in 2006. With the current push toward top-down micromanagement of virtually all aspects of the economy, it seems worth posting again. I should also note that a trillion is probably way too small a number to use for an estimate of the economic value of this technology)

The invention of the transistor was an event of tremendous economic importance. Although there was already a substantial electronics industry, based on the vacuum tube, the transistor gave the field a powerful shot of adrenaline and brought about the creation of vast amounts of new wealth.

As almost everyone knows, the transistor was invented by John Bardeen, Walter Brattain, and William Shockley, all researchers at Bell Laboratories, in 1946. But a recent article in Spectrum suggests that the true history of the transistor is more complex…and interesting not only from the standpoint of the history of technology, but also from the standpoint of economic policy.

The story begins in Germany, during World War II. Owing to short-sighted decisions by the Nazi leadership, Germany’s position in radar technology had fallen behind the capabilities of Britain and of the United States. (Reacting the the prospect of airborne radar, Herman Goering had said “My pilots do not need a cinema on board!”)

But by 1943, even the dullest Nazi could see the advantages that the Allies were obtaining from radar. In February of that year, Goering ordered an intensification of radar research efforts. One of the scientists assigned to radar research was Herbert Matare, who had been an electronics experimenter as a teenager and had gone on the earn a doctorate.

Read more

Trade War 2009?

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From the Telegraph:

The EU trade commissioner vowed to fight back after the bill passed in the House of Representatives late on Wednesday included a ban on most purchases of foreign steel and iron used in infrastructure projects.

The Senate’s version of the legislation, which will be debated early next week, goes even further, requiring that any projects related to the stimulus use only American-made equipment and goods.

The inclusion of protectionist measures has quickly raised hackles in Europe.

Catherine Ashton, the EU trade commissioner, said: “We are looking at the situation. The one thing we can be absolutely certain about, is if a bill is passed which prohibits the sale or purchase of European goods on American territory, that is something we will not stand idly by and ignore.”

Back in the USA, Bill Lane, who is the government affairs director for Caterpillar, is very concerned about the implications of protectionist legislation:

“We are the first to recognise that if the US embraces Buy American then the whole notion of buying national will mestastasize and limit our ability to take part in overseas projects. We are students of history. A major reason a very deep recession turned into the Great Depression was the fact that countries turned inward.”

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“We would be a primary beneficiary of any type of infrastructure project in the US, but at the same time we are one of the country’s largest exporters”

Caterpillar is of course not the only company for which exports are extremely important. At firms ranging from Boeing (airliners) and GE (locomotives, power turbines, medical equipment) to small manufacturing enterprises, there are millions of jobs which are dependent on the willingness of other countries to buy American products. Too often, politicians portray international trade as something we do almost as a favor to other countries, ignoring the very real benefits that Americans derive from trade.

I believe that manufacturing is very important to this country, and would support rational policy initiatives to help make American manufacturing more competitive. Starting a trade war, though, is not the answer to the problems either of American manufacturing or of the American economy as a whole.

(via PowerLine)