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Home Publications Blogs Beat the Press Leonhardt on Risk: BP, the Housing Bubble and Budget

Leonhardt on Risk: BP, the Housing Bubble and Budget

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Tuesday, 01 June 2010 19:42

David Leonhardt's magazine piece on mis-estimating risk gets the story of BP largely right. The top executives felt free to take big gambles with safety and the environment because it was entirely a one-sided bet for them. Large profits from increasing production could mean millions or even tens of millions of dollars in additional compensation each year. On the other hand, the downside from even the worst possible disaster carried little consequence for top executives (who will still be hugely rich) or even the company since Congress capped liability at $75 million.

However he gets the story of the housing bubble and the budget deficit almost completely wrong. He argues that Greenspan and Bernanke missed the fact that the economy faced a nationwide housing bubble because we had never seen one before. While that may be partially true, this comment also ignores the incentives facing the Fed chairs. Large financial companies like Goldman Sachs and Citigroup were making enormous profits from the financing that fueled the bubble. If Greenspan or Bernanke had tried to clamp down on the bubble they would have been confronted by the full force of this powerful industry. They may have found themselves ridiculed and pushed to the side as happened to Brooksley Born when she tried to regulate derivatives in 1998 as head of the Commodities and Futures Trading Commission.

In contrast, their decision not to clamp down on the bubble led to catastrophic results leading to the worst economic downturn in 70 years with tens of millions of people unemployed or underemployed. Yet, both Greenspan and Bernanke are still wealthy men and highly respected. In fact, Bernanke was reappointed to a second term as Fed chair in spite of his disastrous first term.

In short, the problem was not that they underestimated risk. The problem is that they face an entirely assymetric tradeoff structure. Clamping down on financial speculation was sure to have serious consequences for their careers, even if they were right. By contrast, failing to regulate properly did not seem to damage either man's wealth or stature in any major way even though it led to just about the most distrous possible outcome.

Leonhardt also gets the story of the risks from the budget deficit largely wrong.  He writes:

"The big financial risk is no longer a housing bubble. Instead, it may be the huge deficits that the growth of Medicare, Medicaid and Social Security will cause in coming years — and the possibility that lenders will eventually become nervous about extending credit to Washington. True, some economists and policy makers insist the country should not get worked up about this possibility, because lenders have never soured on the United States government before and show no signs of doing so now. But isn’t that reminiscent of the old Bernanke-Greenspan tune about the housing market?"

First, it is pecular to include Social Security in this list. Social Security is growing at a relatively slow pace. It is projected to grow less rapidly than interest on the government debt. Like interest on the government debt, Social Security benefits have already been paid for in advance by their beneficiaries. Wall Street tycoons like Peter Peterson have been desperate to gut Social Security for decades and have invented numerous stories (e.g. that the Trust Fund does not exist) to advance their agenda. However a responsible newspaper should not be advancing this agenda under the guise of news reporting.

The projected growth of Medicare and Medicaid, driven by the explosive growth of health care costs in the private sector, will impose strains on the budget. However, if the growth in health care costs really follows the path assumed in budget projections it will provide a much greater burden on the private sector than the public sector. It is difficult to imagine that the public will itself to be priced out of the market for health care rather than taking simple and obvious steps that challenge the industry's power and ability to continually jack up prices. The point is that this is first and foremost a health care problem. It is only the Peterson Wall Street gang that insists on discussing the issue as a budget problem.

The second reason why the discussion of the budget is not entirely right is that we have been here before. The country has had ratios of debt to GDP in excess of 100 percent following World War II. In spite of this debt burden, interest rates remained low and the economy grew rapidly. Other countries, like the UK and more recently Japan and Italy have sustained much larger debt to GDP ratios without seeing any financial panics.

Finally, unlike Greece, which does not control its own currency, the debt of the United States is in dollars and the United States can always print more dollars. This means that the actual risk is not insolvency, but inflation, since the country would presumably print money rather than face bankruptcy. An honest discussion of the debt problem in the United States would discuss the risk from inflation. In the current environment, this is extremely low. In fact, according to a recent paper by Olivier Blanchard, the IMF's chief economist, the United States would actually benefit from a somewhat higher inflation rate (3-4 percent) since it would reduce debt burdens and lower the real interest rate.

So, the supposed threat from the deficits has been seriously misrepresented by the Wall Street deficit hawks. It is hardly irrational to disregard threats that are incoherent.

 

 

Comments (12)Add Comment
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written by izzatzo, June 01, 2010 11:03
In short, the problem was not that they (Bernanke, Greenspan) underestimated risk. The problem is that they face an entirely assymetric tradeoff structure. Clamping down on financial speculation was sure to have serious consequences for their careers, even if they were right. By contrast, failing to regulate properly did not seem to damage either man's wealth or stature in any major way even though it led to just about the most distrous possible outcome.


Obama's Dept of Interior was the counterpart to the Fed in regard to the BP spill and faced the same assymetric tradeoff, which is practically the same as underestimating risk as a matter of intent to ignore the law by the regulator, rather than a flawed decision by BP to underestimate risk. BP didn't underestimate risk, it just exploited it and the coin flipped the wrong way.

That Greenspan and Bernanke got off scot free shouldn't imply that most associated with the BP spill won't either, including the regulators. Most will. It'll be like the financial backlash, lots of posturing and investigations but nothing seriously punitive. BP doesn't have a Madoff who can be hung in the public square.

Had Obama's Dept of Interior cracked down on BP and enforced the regulations in place necessary to avoid the spill, they would have faced the same attacks directed at Greenspan or Bernanke had they tried to stop the bubble, so it was assymetric tradeoff in both cases, not underestimated risk.

Everyone on both sides knew what the risks were all along for the spill and the bubble. It was just a matter of socializing them so they could extract the privatized gains.
...
written by broggler, June 02, 2010 4:02
assymetric --> asymmetric
Right On!
written by Eric Yendall, June 02, 2010 9:50
"Clamping down on financial speculation was sure to have serious consequences for their careers, even if they were right. By contrast, failing to regulate properly did not seem to damage either man's wealth or stature in any major way even though it led to just about the most distrous possible outcome."

There is no percentage in being the only sane man in an insane world. No-one had the courage to say the Emperor had no clothes. No one would listen and the consequences were all negative. How do we create a regulatory system where the regulators are expected and encouraged not to bend before the wind, but to act without fear or favour. Regulatory bodies should be treated as part of the legal system and free from political interference, not as the playthings of the Administration and of Congress.
Wrong on BP
written by John Smith, June 02, 2010 10:30

Sounds to me like David Leonhardt got the story on BP largely WRONG. First, he assumes that BP's senior executives somehow encouraged taking unnecessary risks in order to boost their own compensation. He says that they did this because there was no downside to them as they are already "hugely rich". So the executives simultaneously want to make more money (through risk taking) and yet don't care if they don't make money (since they are already "hugely rich"). Doesn't make sense.

He then says that BP's liability is capped at $75m. Well BP has already paid out nearly $1B in this spill so this is nonsense. BP stands to lose tens of billions here. Not exactly "no downside".

I can't understand why no-one seems able to grasp the concept that this event was an ACCIDENt. Like almost every accident before it was largely the result of human error. But you can be sure that no-one wanted it to happen and probably no-one had any idea of the risks they were taking.



Taxes, taxes, taxes
written by skeptonomist, June 02, 2010 10:40
Another thing that prevented Greenspan and Bernanke from taking action against the bubble is that it would have been an admission that their own strategy had backfired. Boosting housing was the main thing that their policy did to ameliorate the recession of 2001 - it was not likely that they would admit that this had also created a bubble.

Again, apart from the financial debacle, the reason deficits look so bad in the future is that tax rates on higher income people have been repeatedly slashed, not because of entitlements, certainly not SS. There is no rational or "honest" reason why discussion of raising rates, or real tax reform such as eliminating special treatment for capital gains and dividends, should be taboo among economists. If the government is going to provide more services - and Republicans apparently agree that it is since they passed Medicare Part D - taxes must go up (though in fact takeover of health insurance by the government would unquestionably decrease costs). And again, the historical evidence is that if higher marginal rates have any effect on the economy it is beneficial, not detrimental. Economists allow politicians and others to argue - and even argue themselves sometimes - on the basis of completely counter-historical "theoretical" ideas about the effect of raising marginal tax rates.
...
written by skeptonomist, June 02, 2010 10:56
The greatest danger over the short to medium term is probably that of another financial bubble. The masters of the financial world have scarcely been reined in at all, in contrast to what happened after 1929, and as we speak are plotting ways to game the system, and to profit through inflation of another bubble (though they probably regard anything they can get away with as beneficial according to the basic philosophy of laissez-faire capitalism).
...
written by Nick B in DC, June 02, 2010 12:12
Really enjoyed this post Dean, thanks for the brief lesson!

In regards to inflation, why are their so many inflation fear mongers who want to see the Fed push interest rates up? If anything, at this point we are more likely to face disinflation, or deflation than inflation in this current climate. Who stands to gain from such policies? Why is the "mainstream" media and talking points so backwards with regards to monetary policy right now?
...
written by Queen of Sheba, June 02, 2010 1:23
JohnSmith:
"I can't understand why no-one seems able to grasp the concept that this event was an ACCIDENt. Like almost every accident before it was largely the result of human error. But you can be sure that no-one wanted it to happen and probably no-one had any idea of the risks they were taking."

I agree that no one wanted this "accident" to happen (and I won't believe it was an accident until all the evidence is in on what shortcuts or hurried decisions were made that allowed it to happen). But there is an argument to be made that if BP had been forced to file a full risk evealuation, and particularly a detailed plan for how the company would handle a spill should one occur - paperwork that is required by the MMS paperwork but waived by Ken Salazar for BP for the Deepwater Horizon - that such filing might have at least given the MMS regulators pause before issuing the drilling permit. Alas, it seems that "regulatory capture" extends much further than the late Bush administration.

It disappointed me greatly to hear in Obama's press conference two days ago that he still has faith in Ken Salazar and has no plans to review his performance as Sec. of Interior. Considering Salazar's past cheerleading for offshore drilling in general - and his outspoken personal push for BP and the Deepwater Horizon project in particular - Obama's statements of support were disappointing indeed.
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written by liberal, June 02, 2010 1:41
John Smith wrote, I can't understand why no-one seems able to grasp the concept that this event was an ACCIDENt. Like almost every accident before it was largely the result of human error. But you can be sure that no-one wanted it to happen and probably no-one had any idea of the risks they were taking.

Nonsense. You can take measures to mitigate the impact of human error. The problem is that those measures cost money. Those are the costs that BP wasn't willing to pay.
...
written by Roberto Carrillo A., June 02, 2010 3:17
The economic and financial problem of the US are its socialistic creatures: SS, Medicare-Aid, Freddie et all. Nobody says these creatures created over the last 70 years should stay. What people needs now are jobs, security (health, housing, retirement are nice but not mandatory). We can not wait until un-employment is 20% and no kid has a meaningful job.

To the following statement is very strong:
"The big financial risk is no longer a housing bubble. Instead, it may be the huge deficits that the growth of Medicare, Medicaid and Social Security will cause in coming years........"
But I would add the Housing Monsters of Freddy et all. If we do nothing and interest rates remain at zero, the cost US$ 100BB a year to the federal deficit. With Fed Funds at 4% (their long term average) the contribution to Freddy will be in the trillions of dollars. That will be a greek "comedy".
Best regards,
Roberto
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written by John Emerson, June 02, 2010 4:37
Isn't Leonhardt's opening "in retrospect" wrong? I'm sure there were a lot of people who knew that at the time, it's just that Leonhardt and others didn't listen.

Same as everything else, of course.
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written by John Emerson, June 02, 2010 4:49
No, it wasn't an "ACCIDENt", John Smith. BP executives deliberately cause the spill. I saw them. They all were laughing maniacally and smoking big cigars.

Jesus, I get sick of these crap arguments. Why bother? The game is lost. The morons have won. Did you know that the BP oil spill was caused by excessive regulation? Fact. Do you know that racism would be gone in this country, except for the Civil Rights Law? Fact.


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Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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