The bailout: Hayek's revenge

Markets are bigger and more complex than any one set of regulators can comprehend, even Henry Paulson, as this WSJ story makes clear:

• Fannie/Freddie bonds are selling off because the bank guarantee is better, which of course undercuts the Fannie/Freddie rescue.
• The bailout increases government debt, also increasing interest rates, which makes mortgages harder to get, which was the problem that drove all this.
• Government backing for short-term debt pulled money away from corporations and European banks. . . .
• So the government had to loan directly to corporations and overseas banks with US branches. . .
• Which further increases government debt, further raising interest (including mortgage) rates, leading again back to square one.
• And increased bank deposit insurance may lure funds there, away from money market funds, which will then buy less short term debt, undercutting government relief of that market.

All this is well summarized by one person quoted in the article:

"You have unintended consequences that spark government actions, that create other unintended consequences," said David Kotok, chairman at money managers Cumberland Advisors.

Comments

[T L Holaday]

I know that to attempt to map physics to economics is to enter a state of sin, but I must ask:

Does economics have the concept of turbulence?

[Marcus]

Concerning the 2nd item: increased government debt, increased interest rates. Can you explain this one to me? I understand the relationship, I get that. But I'm looking at Treasury yields and I'm not seeing it. Not in short term rates anyway.

Short term Treasury yields are so low people are practically paying Uncle Sam to hold their money (and they ARE if you consider inflation).

Perhaps the effect is seen in long term Treasuries? But in the latest leg of this crisis they have all gone down too.

Mortgages have gone up a bit in the last month but not alarmingly so. My explanation to that though would be that everybody has their money in Treasuries making less money available for mortgages.

So, I'm not able to grasp the connection here with the 2nd point.

[Kevin]

Marcus the yield on the 10-year is up 60 basis points in the last week.

[Marcus]

Marcus the yield on the 10-year is up 60 basis points in the last week.

Ah, you're right! My mistake. Thank you.

[Dan]

The price of Treasuries (government debt) is determined by supply and demand. The price of bonds is inversely related to its interest rate (a lower price means a better return on face value).

When government goes deeper into debt, it issues more Treasuries. This increases the supply of Treasuries and reduces the price, raising the interest rate. However, this could potentially be offset by a large increase in demand. People are probably moving into short-term Treasuries to escape the risk in a volatile market. Long-term debt, as Marcus pointed out, is going up.

[Bailout Law Blogger]

As described, these effects seem to be second-order relative to what we've been seeing in the recent past. Of course, the propagation has only started as pointed out.

[Tommy M.]

For those of you who can't read the WSJ article in its entirety, a little more is found at this link.

http://boards.fool.com/Message.asp?mid=27100969&sort=postdate

[Leith]

RE: Turbulence

I haven't seen anything that formalizes the idea of economic turbulence. It falls more in the area of decision science than economics.

The primary difference between the two ideas is one of adaptation. My understanding is that fluid turbulence has increasing positive feedback, while economic turbulence has short-term positive and long-term negative feedback. This is caused by the impact of fixed cost capacity investments (education, research, machinery, software) and bounded rationality constraints that limit the rate and nature of adjustments.

People tend to focus on the financial leveraging process, however organizational and decision leveraging is also at work. That is to say, businesses focus their resources and structure themselves to succeed in the current environment rather than uncertain future ones. The more stable their environment the less resistant to shocks they become.

[John David Galt]

Interest rates on mortgages may be undesirably high right now as a result of the current banking "crisis", but too-high interest rates certainly did not cause the "crisis". Too-low rates (and too-low standards on the part of lenders) did.

[durban]

Explanation for (2). The interest on a 15-year $100K mortgage can be thought of as the amount of money the lender charges the borrower to use the $100K for 15 years. The interest is primarily determined by (1) the lender's willingness to part with this money for this period (more willing implies lower rates), and (2) the riskiness of the borrower (less risky implies lower rates).

Government bonds are seen as a "risk free" investment, so whenever there more 15 year government bonds are issued, many lenders buy them up, giving the government the use of their money. Unfortunately, this means that there are fewer funds available on the loan market for private borrowers. Private borrowers who still want loans will need to offer to pay more interest to ensure that they get some of the remaining funds. In agreeing to do this, they bid up the market interest rate (e.g. the interest rate required to borrow for a 15 year mortgage) higher.