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March 17, 2010

Latest Posts from Economist's View

Latest Posts from Economist's View

"Shrinking Detroit Back to Greatness"

Posted: 17 Mar 2010 01:49 AM PDT

Ed Glaeser on "right-sizing" Detroit:

Shrinking Detroit Back to Greatness, by Edward L. Glaeser, Economix: Can Detroit shrink to greatness? After decades of betting that white elephant projects, like the city's monorail, would reverse decline, Detroit's remarkable mayor, Dave Bing, a former N.B.A. All-Star and successful steel entrepreneur, has focused on right-sizing his city and its government. ...
But what does it mean to right-size a city? As cities lose people and tax revenues decline, it often makes economic sense to close a public structure, like a school. Kansas City has put itself in the forefront of this trend by choosing to close 28 of its 61 schools to meet the reality of declining enrollments and limited funds, which is a little odd since Kansas City's population has been quite stable for two decades.
Closing schools, or any public facility, is never easy, but it is hard to argue that a cash-strapped municipality isn't within its rights if it chooses to cut costs by reducing the number of public facilities. ...
A second strategy, proposed by Mayor Bing, goes beyond closing a few schools, and eliminates the provision of public services to some parts of a city.
Detroit has a large number of communities that are dominated by empty lots and vacant homes. Mayor Bing has spoken of providing incentives for the people still living in such areas to relocate...
For a big-city mayor to warn that some areas will be no-service zones is radical, but our country is filled with less populated areas that lack public trash removal, bus service and water provision. ... Of course, one might hope ... he would also cut their property tax bill.
The third, and most extreme, approach is to bulldoze buildings and turn them over to some alternative use, like parks or agriculture. Razing empty, dilapidated, hazardous structures is fairly uncontroversial, but more questions must be raised if the mayor is going to forcibly move significant amounts of people in order to physically reshape large land areas.
If the residents of largely empty areas aren't willing to sell and move, then we are back in the same quandary that always faces large public changes in urban land use... To what extent should a city put perceived citywide interests ahead of the wishes of individual property-owners?
If removing a largely vacant neighborhood really generates significant gains, then some sizable fraction of those gains can be given to the citizens who will have to give up their homes. If generous payments, rather than eminent domain, are used to move the remaining residents, then right-sizing can be win-win.
But if Mayor Bing tries to do too much, too quickly, without giving enough to the residents who have to move, then right-sizing will justly be seen as yet another example of the public insensitivity and folly that has unfortunately marred too many past efforts at dealing with urban distress.

"Questions and Answers about the Financial Crisis"

Posted: 17 Mar 2010 01:25 AM PDT

Here is the beginning and end of a (much longer) Q&A with Gary Gorton discussing the financial crisis. He explains how the crisis was generated by a bank run much like past bank runs, but in a different type of asset and in a different segment of the banking system. 

Rather than a run by individual depositors on demand deposits held in traditional banks (or, further in the past, private bank notes), this run involved firms and institutional investors and it was on repo held in the shadow banking system:

Questions and Answers about the Financial Crisis, Prepared for the U.S. Financial Crisis Inquiry Commission, by Gary Gorton[open link]: 1. Introduction ... Yes, we have been through this before, tragically many times. U.S. financial history is replete with banking crises and the predictable political responses. Most people are unaware of this history, which we are repeating. A basic point of this note is that there is a fundamental, structural, feature of banking, which if not guarded against leads to such crises. Banks create money, which allows the holder to withdraw cash on demand. The problem is not that we have banking; we need banks and banking. And we need this type of bank product. But, as the world grows and changes, this money feature of banking reappears in different forms. The current crisis, far from being unique, is another manifestation of this problem. The problem then is structural.
In this note, I pose and try to answer what I think are the most relevant questions about the crisis. I focus on the systemic crisis, not other attendant issues. I do not have all the answers by any means. But, I know enough to see that the level of public discourse is politically motivated and based on a lack of understanding, as it has been in the past, as the opening quotations indicate. The goal of this note is to help raise the level of discourse.
2. Questions and Answers
Q. What happened?
A. This question, though the most basic and fundamental of all, seems very difficult for most people to answer. They can point to the effects of the crisis, namely the failures of some large firms and the rescues of others. People can point to the amounts of money invested by the government in keeping some firms running. But they can't explain what actually happened, what caused these firms to get into trouble. Where and how were losses actually realized? What actually happened? The remainder of this short note will address these questions. I start with an overview.
There was a banking panic, starting August 9, 2007. In a banking panic, depositors rush en masse to their banks and demand their money back. The banking system cannot possibly honor these demands because they have lent the money out or they are holding long-term bonds. To honor the demands of depositors, banks must sell assets. But only the Federal Reserve is large enough to be a significant buyer of assets.

Banking means creating short-term trading or transaction securities backed by longer term assets. Checking accounts (demand deposits) are the leading example of such securities. The fundamental business of banking creates a vulnerability to panic because the banks' trading securities are short term and need not be renewed; depositors can withdraw their money. But, panic can be prevented with intelligent policies. What happened in August 2007 involved a different form of bank liability, one unfamiliar to regulators. Regulators and academics were not aware of the size or vulnerability of the new bank liabilities.

In fact, the bank liabilities that we will focus on are actually very old, but have not been quantitatively important historically. The liabilities of interest are sale and repurchase agreements, called the "repo" market. Before the crisis trillions of dollars were traded in the repo market. The market was a very liquid market like another very liquid market, the one where goods are exchanged for checks (demand deposits). Repo and checks are both forms of money. (This is not a controversial statement.) There have always been difficulties creating private money (like demand deposits) and this time around was no different.

The panic in 2007 was not observed by anyone other than those trading or otherwise involved in the capital markets because the repo market does not involve regular people, but firms and institutional investors. So, the panic in 2007 was not like the previous panics in American history (like the Panic of 1907, shown below, or that of 1837, 1857, 1873 and so on) in that it was not a mass run on banks by individual depositors, but instead was a run by firms and institutional investors on financial firms. The fact that the run was not observed by regulators, politicians, the media, or ordinary Americans has made the events particularly hard to understand. It has opened the door to spurious, superficial, and politically expedient "explanations" and demagoguery. ...

The Panic of 1907

3. Summary
The important points are:
• As traditional banking became unprofitable in the 1980s, due to competition from, most importantly, money market mutual funds and junk bonds, securitization developed. Regulation Q that limited the interest rate on bank deposits was lifted, as well. Bank funding became much more expensive. Banks could no longer afford to hold passive cash flows on their balance sheets. Securitization is an efficient, cheaper, way to fund the traditional banking system. Securitization became sizable.
• The amount of money under management by institutional investors has grown enormously. These investors and non‐financial firms have a need for a short-term, safe, interest-earning, transaction account like demand deposits: repo. Repo also grew enormously, and came to use securitization as an important source of collateral.
• Repo is money. It was counted in M3 by the Federal Reserve System, until M3 was discontinued in 2006. But, like other privately-created bank money, it is vulnerable to a shock, which may cause depositors to rationally withdraw en masse, an event which the banking system – in this case the shadow banking system—cannot withstand alone. Forced by the withdrawals to sell assets, bond prices plummeted and firms failed or were bailed out with government money.
• In a bank panic, banks are forced to sell assets, which causes prices to go down, reflecting the large amounts being dumped on the market. Fire sales cause losses. The fundamentals of subprime were not bad enough by themselves to have created trillions in losses globally. The mechanism of the panic triggers the fire sales. As a matter of policy, such firm failures should not be caused by fire sales.
• The crisis was not a one-time, unique, event. The problem is structural. The explanation for the crisis lies in the structure of private transaction securities that are created by banks. This structure, while very important for the economy, is subject to periodic panics if there are shocks that cause concerns about counterparty default. There have been banking panics throughout U.S. history, with private bank notes, with demand deposits, and now with repo. The economy needs banks and banking. But bank liabilities have a vulnerability.
Update: See also HTML clipboardWhat Really Went Wrong?, BY Steve Landsburg.

links for 2010-03-17

Posted: 17 Mar 2010 12:01 AM PDT

FOMC Meeting: Rates Steady for an Extended Period, Asset Purchase Programs to End

Posted: 16 Mar 2010 12:39 PM PDT

I have a quick reaction to the Press Release from today's FOMC meeting at MoneyWatch:

FOMC Meeting: Rates Steady for an Extended Period, Asset Purchase Programs to End

Chinese Currency Manipulation: The Case for Change in U.S.Policy

Posted: 16 Mar 2010 10:23 AM PDT

Panelists: Paul Krugman, C. Fred Bergsten, Robert E. Scott

This posting includes an audio/video/photo media file: Download Now

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