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December 8, 2007

Who Should Pay the Price for the Popped Real Estate Bubble?

I want to make a simple point in response to so many people calling for heads to roll over the turmoil in financial markets, and to suggestions that the Fed should not cut rates if doing so bails out financial markets and prevents participants from fully realizing the costs associated with past behavior.

Recessions, popped bubbles and the like do not have to be somebody's fault and, as such, we don't necessarily have to extract blood from anyone to avoid it happening again. Perfectly reasonable actions a priori - in the sense of responding to the economic incentives that are in place - can still lead to bad ex-post outcomes. The people acting in the economic environment didn't write the rules, they're simply maximizing given the rules that are in place, so why punish them?

I don't mean to absolve those who committed fraud, etc., nor do I mean to absolve those who did fall down on the job - the rule makers and the ratings agencies - from any responsibility for the outcome. But I doubt that the people writing the rules intended to cause a meltdown, and it's possible they did the very best they could with the information they had. And it can be argued, credibly, that ratings agencies simply responded to the economic incentives that were in place (i.e. responded as expected to being paid by those they were rating).

We made mistakes in the regulatory environment, no doubt about it, and I hope we learn and fix the problems, but this Victorian call for someone to pay the price if there are problems seems overwrought, and it's getting in the way of talking about how to help people.

Here's something by Paul Krugman on this issue that I've posted before, and is worth repeating:

The Hangover Theory, by Paul Krugman: A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the "Austrian theory" of the business cycle--a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire. Oh well. But the incident set me thinking--not so much about that particular theory as about the general worldview behind it. Call it the overinvestment theory of recessions, or "liquidationism," or just call it the "hangover theory." It is the idea that slumps are the price we pay for booms, that the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion.

The hangover theory is perversely seductive--not because it offers an easy way out, but because it doesn't. It turns the wiggles on our charts into a morality play, a tale of hubris and downfall. And it offers adherents the special pleasure of dispensing painful advice with a clear conscience, secure in the belief that they are not heartless but merely practicing tough love.

Powerful as these seductions may be, they must be resisted--for the hangover theory is disastrously wrongheaded. Recessions are not necessary consequences of booms. They can and should be fought, not with austerity but with liberality--with policies that encourage people to spend more, not less. Nor is this merely an academic argument: The hangover theory can do real harm. Liquidationist views played an important role in the spread of the Great Depression--with Austrian theorists such as Friedrich von Hayek and Joseph Schumpeter strenuously arguing, in the very depths of that depression, against any attempt to restore "sham" prosperity by expanding credit and the money supply. And these same views are doing their bit to inhibit recovery in the world's depressed economies at this very moment.

The many variants of the hangover theory all go something like this: In the beginning, an investment boom gets out of hand. Maybe excessive money creation or reckless bank lending drives it, maybe it is simply a matter of irrational exuberance on the part of entrepreneurs. Whatever the reason, all that investment leads to the creation of too much capacity--of factories that cannot find markets, of office buildings that cannot find tenants. Since construction projects take time to complete, however, the boom can proceed for a while before its unsoundness becomes apparent. Eventually, however, reality strikes--investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off, prices and wages fall from their excessive boom levels, and only then is the economy ready to recover. ...

The hangover theory ... turns out to be intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present. Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives, who can't stand the thought that positive action by governments (let alone--horrors!--printing money) can ever be a good idea. Some libertarians extol the Austrian theory, not because they have really thought that theory through, but because they feel the need for some prestigious alternative to the perceived statist implications of Keynesianism. ... But moderates and liberals are not immune to the theory's seductive charms--especially when it gives them a chance to lecture others...

We don't need a recession. If the Fed determines an interest rate cut is needed to keep the economy moving toward full employment, then it shouldn't hesitate to implement the policy because it believes it would send the wrong signal to financial market participants. I hope we don't get so caught up in our zeal to make sure people learn the right lessons from all of this that we allow "bad investments in the past" to bring about "the unemployment of good workers in the present."

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