Teaching Economics to the Post on JP Morgan

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Thursday, 24 October 2013 04:58

The Washington Post continues to be very upset that the government is spending time going after Wall Street banks. Its editorial today complained again about the Justice Department's lawsuit against JP Morgan.

Among other things, the piece complained that the homeowners who benefit from write-downs of mortgages ($4 billion of the $13 billion settlement) were not the victims of the bank's misrepresentations of mortgages sold in mortgage backed securities. It also argued that these write-downs could hurt the investors who were the victims of this misrepresentation.

Both parts of this story are not accurate. The misrepresentations were part of the wave of bad financing that pushed up house prices. As a result, many homebuyers bought homes at bubble inflated prices, paying far more than fundamentals of the market would dictate. On the other side, write-downs will often be in the interest of investors, since banks are virtually guaranteed to lose money on homes that go through the foreclosure process, which will happen with many underwater homes.

The piece is also wrong in complaining that this sort of suit does nothing to prevent future bubbles. It does provide some sanction against banks that were breaking the law in issuing and reselling fraudulent mortgages in their exuberance over the bubble. The lesson for banks in the future should be to follow the law. Of course criminal sanctions, with bank executives facing prison time, would be far more effective in accomplishing this goal.

Also, if we want to prevent bubbles in the future, it would be desirable to have intelligent life at the Fed. It would be good to have a chair and governors who were prepared to use the Fed's weight to counter the impact of a bubble, rather than cheer it on as Alan Greenspan did. This would mean documenting the fact that prices were out of line with fundamentals with Fed research and using its bully pulpit to publicize this research so that even the Washington Post editorial board would know about it.

The Fed could also use its substantial regulatory power to crack down on the abuses in the mortgage industry that were quite evident at the time (except to Alan Greenspan). And, it could convene meetings with other federal and state regulators to pressure them to similarly crack down on the abuses at the financial institutions under their jurisdiction.

The failure to pursue criminal actions against bank executives, and the continuing treatment of Alan Greenspan as a great authority on the economy, should raise concerns about the extent to which we are prepared to counter future bubbles.