Economics post!!

It was requested that I do a post about the tanking economy, and so here goes. Please God, don't let my professors be reading my blog. If you're a prof of mine and you're reading this, it wasn't me who wrote this, it was a guy who works for a hedge fund.

OK, so what's happening now with the economy? What's this whole "crisis" about?

First of all, I recommend anyone who wants a better summary than this one to read Brad DeLong's blog.

OK, you're a financial institution - basically, you borrow money in the short-term (if you're a bank, you don't have to pay very high interest) and invest it for the long-term (to get a higher rate of return), preferably in some asset you know will grow fast, like a business, but maybe in some risky long-term thing like a subprime mortgage. Now what if those long-term investments (for example, subprime mortgage bonds) go bad? Just borrow more money and make more long-term investments, and it'll get better. No worries. But what happens if you can't borrow more money, because everyone made the same bad bets, so everyone's calling in their debts at the same time? You're out of luck, son! That's what's called a "liquidity crisis." If that happens just as your investments go bad, you're in a world of hurt. And that's exactly what just happened to our financial institutions last year, when housing prices fell and everyone's subprime mortgages went bust at the same time. Oops.

But how did we get into this crisis?

Don't banks know that this can happen? Won't they avoid making risky investments, to avoid just this kind of crisis? Well, here's the thing - if the banks tank, the economy tanks, because businesses need banks and other financial institutions to loan them money so they can expand their businesses, or even keep them going, etc. If the banks are broke, the gears grind to a halt. So the government backs up banks - the Fed can lower interest rates (which sometimes, but not always, makes it cheaper for banks to borrow that short-term money), or do a bunch of other stuff like the Fed is doing now, or if things get too extreme the government can just take over banks (like we did this week when the Fed made Bear Stearns sell itself for less than the price of its office building), or bail them out with txpayer money (like we did back in the Savings & Loan crisis). The government needs to keep the financial system running at any cost. Of course, the finance people know this. So, knowing that the government basically gives them free insurance, they take more risk. That's called "moral hazard". It makes markets not work.

But don't we regulate banks to make sure this thing doesn't happen? Ever since the Great Depression, you bet we do. But here's the thing - there's a bunch of other financial institutions out there that we don't heavily regulate, like hedge funds (or those Savings & Loans back in the 80s). Even banks themselves can get around the regulations, by using things called "conduits" or "SIVs". Basically these are unregulated shadow companies that banks invest money in. They're controlled by the banks, but they don't have to obey most government regulations, and their activities don't appear on the banks' balance sheets. After this crisis, you can bet we'll regulate hedge funds and "conduits" more, but you can also bet that finance people will find a new way around the new regulations.

There's two other causes of this crisis besides "moral hazard." One is that the compensation system for hedge funds was incredibly badly designed, and basically paid people to make really bad bets. Oops.

The other reason is that China bought a shit-ton of American bonds. That made it really really cheap for the U.S. - our government, our banks, and our homeowners - to borrow money, since China's government was there to lend out as much as we wanted at stupidly low rates. Which meant that our government borrowed money too cheaply ("deficits don't matter"), our homeowners borrowed money too cheaply (subprime, etc.), and our banks borrowed money too cheaply. And the thing is, we can sort-of "default" on that debt by just printing money, even though that causes inflation and hurts our economy (remember all those jokes in the 90s about pesos? Guess what, Mexico did what we're doing now). As my prof Jing Zhang has shown, if you lend another country money without any way to make them pay you back, they typically won't. China knew we could and would stiff them. They were therefore very stupid to lend us all that money. Why did they do it? Short answer: I don't know. Oops.

So how do we get out of the crisis?

The Fed can lower interest rates, but that takes a long time to work, and the closer the rates get to zero the less of an effect rate cuts have anyway. For reasons that are too complicated to explain here, a bunch of bank failures can lower the economy to a very bad long-term situation (as happened in the Depression). In that case, the only thing for the government is to "print money and buy stuff," as my prof Miles Kimball puts it. The main thing to buy would be those crappy subprime mortgages. Paul Krugman and Brad DeLong agree that this is the thing to do. That would keep banks from losing too much money and pump cheap money into the economy at the same time. It's a big, drastic step, though, and it'll cause inflation, and the dollar will crash even more. Whatever we do, the economy is going to seriously suck for the next two years at least. The last time this kind of shit-storm happened was in the late 80s and early 90s, and that lasted for 4 years or so. People say this crisis is even worse. Who knows.

So what do we do to prevent this kind of thing in the future?

Well, improve regulation of financial institutions, of course. That won't work forever, but it'll work for a while. Also, fix the compensation system for finance people, so you can't get paid hundreds of millions to do crap work. Hopefully the industry will do this on its own, but a little government intervention probably wouldn't hurt. Finally, we need to stop China and other foreign governments from accumulating massive stockpiles of U.S. bonds at cut-rate prices. That means balancing our federal budget, and also finding some way to force China and other export powerhouses (but mostly China) to drop their exchange rate pegs. We tried to ask them nicely to do it, but they didn't, and even if they had it would have been years too late. Next time, we should be a little more forceful.

So, to summarize:
* China lends us cheap money
* Finance people get paid to make stupid bets
* Finance companies know the govt. will bail them out if they lose money
* All the bad bets go bad at the same time, and the banks have to stop lending so they can pay back their debts, so the economy seizes up
* There goes your pension, but the hedge fund guys made out like bandits
* The Fed and Congress can fix things, but it'll take a while and we'll have inflation in the meantime
* Better regulation in the future will help, but not cure the problem

The basic point here is that markets may be better than communism, but they ain't perfect - they have some systematic flaws, and these periodic crises are one of them. There will be another financial crisis. And another, and another. This has all happened before, and it will all happen again. Last time it happened to a bunch of 80s guys with bad haircuts. This time, it happened to you and me. Oops.

In any case, the long-term outlook (i.e., 5+ years in the future) for America's economy is probably fine. We still have a growing and relatively young population, a strong business culture, great universities with lots of smart researchers, and a relatively un-corrupt government (I know it may be hard to believe, but sadly it's actually true...remember that I said relatively). The main threat in the long-term is peak oil. If you think things are bad now, just wait til we run out of energy. That will be the shit-storm to end all shit-storms.

Oops.