March 4, 2009

Bad Ideas Commonly Believed to be Facts are Preventing Real Solutions

Reality is, by nature, more complex than any human understanding can be. Thus judgements in which we can have real confidence are limited to prescribed situations within systems of rules or simplifying constraints we have imposed. For instance, we can say 5 + 6 = 11 with real confidence, or that experience has shown repeatedly that a household paying more than about 1/3 of income on housing often experiences financial stress or unsustainable finances.

When we try to judge actions in a more complex system such as an entire economy -- for instance whether letting Lehman fail worsened the economic situation months later compared to what we think would have happened if Lehman had been in part bailed out and handled like Bear Stearns -- we are forced to gauge or ignore large numbers of variables, some of which we cannot find in limited time, and then choose what complexities to simplify and what guesses to make.

When our financial system sank into crisis more deeply after Lehman failed, some plausible simplifications suggested that the failure of Lehman must have worsened the crisis.

After all, when a dramatic event immediately proceeds a great change, its reasonable (and common) to imagine the event caused or influenced the change.

We often hear in the news that a wilderness fire was caused by a careless campfire or cigarette. We sometimes hear that these caused fires even in wilderness areas dry from years of drought.

We ignore the fact that a soaking rain a day or two earlier would have caused that same bit of flame to lead to nothing much at all.

Even a lightning strike is sometimes said to have caused a fire, like an unlucky accident.

It's as if we want to believe that fire itself is unnatural and out of place in nature.

A more sophisticated and realistic view, though, developed with the wisdom of time and experience, is to understand that wildfires arise naturally in response to cycles of rain and drought -- that fire is inevitable, sooner or later.

Occasionally, instead of blaming an individual or a lightning bolt, we rise to the more meaningful assessment that drought itself is a cause of a major wilderness fire, and sometimes even can admit the growth of underbrush due to past firefighting is a cause. We can then -- once we have this increased honesty and clear vision -- take valuable actions made possible through our better understanding.

We plan for fires once we achieve this higher level of clarity and knowledge. We can begin to have controlled fires in response to lingering dry conditions, in order to preempt the inevitable in a way that saves the property and homes we have in the area.

Just thinking more clearly changes the situation and allows us to do what later we see as simply the obvious.

There is a prejudice in favor of old ideas, no matter how poor and erroneous they are.

But honesty and clarity and bringing in more knowledge usually pay off. They improve the bottom line and the public outcome.


So, which factor intensified this financial and economic crisis -- letting Lehman fail...or continuing fallout of the unsustainable levels of debt and leverage and from stratospheric house prices leading to foreclosures?

In other words, if we had bailed out Lehman or sold it off as we did with Bear Stearns, would that have prevented any worsening of the financial "crisis" months later, as more and more mortgages went sour and revenue streams from mortgage-backed securities and their derivatives disappeared and foreclosures spiraled ever higher?

In other words, if we stopped one careless camper from starting a big fire....would that have guaranteed there would be no fire later?

If your common sense says no, I think you are on the right track.

Stopping one careless campfire in a dry woods does not prevent lightning from striking a month or two or three later.

Applying a similar sophistication of including more information in our estimations of complex situations helps to reveal several false or simplistic beliefs that are commonplace today.

I'd like to list a few of the oversimplifications that are obstructing our body politic from finding the best solutions to our economic predicament. We need to think more clearly in order to prevent another Great Depression.

So, here they are, in no particular order -- the worst popular beliefs of the day:


1. Letting Lehman fail worsened the financial and economic situation.

The financial and economic situation has progressively worsened because millions of homeowners can not afford to make the payments on their over-priced houses after the end of re-financing or equity withdrawal based on increasing prices, and are progressively, in an increasing accumulation of numbers, unable to pay. Lehman was only one of many inevitable results. ("If Lehman had been saved, at you and your children's expense, instead of at the expense of various investors, that would not have saved Washington Mutual (as an independent bank), IndyMac, Wachovia, Merrill Lynch, etc." -- more here)

What finally slowed the resulting inevitable financial crisis was only the massive blanket guarantees and money finally thrown by the Fed and Treasury into the banks. In effect, we have sprayed fire-slowing water across much of the entire dry financial wilderness in our area now. But there is a problem with the strategy -- significant stretches of forest are just temporarily dampened tinderboxes of essentially dry wood. We don't have the ability to truly make a heavy rain across the entire huge wilderness areas of dry forest. We need some controlled burns (aka some restructuring of some major banks and more widespread relief of impossible mortgage payments via foreclosure or write downs).

2. Foreclosures hurt everyone by driving down home prices in their neighborhoods.

Foreclosures are only making the inevitable more obvious.

House prices cannot be sustained at huge premiums above local rents and local incomes, because creative financing will eventually come to an end.

House prices inevitably will continue to come down after a housing speculation fever is gone, until they settle back to to their more normal price levels vs incomes and rents, which for the US will be similar to prices of circa 2000 or 2001 in many areas (based on Case-Shiller national prices), no matter what we do.

House prices will decline back to normal no matter what we do.

3. Increasing taxes on the richest Americans will hurt economic growth.

American economic history contradicts this idea several times, making it appear random. Once tax rates on the highest incomes come down below about 1/2 (50%), further reductions don't always correlate with better economic outcomes.

Be honest: if you were earning $300,000 or $500,000 a year, would you really work less because your marginal tax rate was 40% instead of 35%? The idea the 2011 rise in marginal rates will hurt the economy contradicts common sense as well as the actual history of economic growth in the U.S. Reducing taxes on the highest earners mattered when confiscatory rates well over 50% came down significantly. In contrast, Bush's 2003 tax cuts to lower top income tax rates from about 40% down to 35% and cut investment capital gains taxes even for the wealthiest can even be claimed to have backfired, correlating with less job and wage growth vs other periods which had higher tax rates. I think the most accurate conclusion is simply that once the top income tax rates are under 50% and top capital gains taxes under 30%, it does not matter much what they are, one way or the other, expect in terms of the benefits of balancing the federal budget and allowing the good forms of public investment to be funded.

4. Federal spending/investment is mostly wasteful and private investment is always better.

Some forms of public investment (federal spending) -- such as education, school lunch programs, and aid to families with children -- have huge payoffs, making us all wealthier in terms of future economic growth. It's common sense that spending a modest bit of the national wealth improving education and nutrition of our young will result in more productive capacity vs a situation where a large fraction of our population is handicapped for the long run by malnourishment and under-education. To consider interesting questions like public investment "crowding out" private investment see this.


What we need in America is less "debate" between simplistic extremes, and instead a more intelligent process of bringing in more information to refine our popular ideas.

Less conflict, and more refinement.

Cooperative refinement of ideas will win out over loud argument any day and any year and in any era.


  1. What makes you think that house prices ca 2000 or 2001 are reasonable? We bought our house in 1986 for $225K, which I thought then was outrageous for a 3 BR 1.5 BA on a city lot. Around 2000 it was valued at over $600K.

    I bought a 2 BR 1 BA bungalow in 1976 for $33K which I thought was reasonable. I sold it 11 years later for $110K which I thought was high.

    Prices need to go a lot lower than 2000 to be reasonable. Remember, wages have been essentially flat for 30 years, unlike house prices.

    Actually, I disagree about Lehman. I agree that bailing it out wouldn't have helped the situation in the long term. However, shoving it off a cliff DID significantly worsen the problem in the short term, because that single event froze the money market - which was one of the drivers of day-to-day business at ALL levels. Planet Money made it clear that after Lehman died, short term financing essentially vanished in the U.S. - it still is harder to get than it was.

  2. On average (for the nation as a whole), when prices have reached the neighborhood of circa 2001 or 2000, then in *many* places (not all!), the bubble in real house prices on the Case-Shiller national graph will have been wiped out in *real* terms. On average over time house prices on the Case-Shiller rise with inflation -- in other words about flat in real terms.

    But...we may then overshoot on the downside (national average). Some areas will certainly continue down! But for the national average, that remains to be seen.

    Arrayed against overshooting on the downside for the nation as a whole (as distinct from some areas which surely will) are a President, Democratic Congress and Fed determined to prevent a depression, and a Fed determined to prevent deflation. The Fed has unlimited ammunition. They can print money and buy securities.

    That all said, its certainly true that house prices have to be affordable for about 2/3 of household (the natural proportion of buyers), and that means pricisely that median house prices in an area must be below 3 x median household income of the would-like-to-buy population....except in areas which have natural constraints on available land, zoning, etc that force higher prices.

    I think that financing was going to progressively more scarce in every scenario. It was only a matter of time, just like with a dry forest. There isn't a way to maintain easy credit when securities buyers finally see that there was a credit bubble. See?

  3. Hedera, what's happened to wages is the elephant in the room often, in all the economic discussion (sometimes addressed ineffectively).

    Here's an interesting bit from Marketplace on that:

    Curious what you think.

  4. Paul Krugman repeats what looks to be an inconsistent argument about Lehman:

    "’re looking at some building, and you hear the fire alarm go off, and smoke starts trickling out the windows. Then a lot of fire trucks and firemen arrive — and only after that do flames start shooting out the top of the building.

    "Clearly, the fire department turned a small problem into a crisis."


    But....the whole problem is exactly that all the surrounding buildings (or forests) are bone dry (or momentarily dampened just a tad), and ready to explode into fire, as above.

    Here's the problem: if we can't be realistic about what "rescues" can accomplish, then we will continue to blunder our way into inevitable morass.

  5. To help clarify what I mean -- either just a few bank rescues, like for Lehman, and Citigroup, etc., will solve our problems and prevent the general fire....


    not....and then something else is needed, like "temporary nationalization".