Monday, August 25, 2008

Malpass Didn't Just Wreck Bear Stearns

Paul Krugman correctly points out that the illusion by many American households that capital gains should be treated as equivalent to savings wasn't as he puts it,"a delusion of the great unwashed", it was a doctrine promoted by the pro-Republican supply-side cheerleaders of the housing bubble. Most notable among these were David Malpass, known as chief economist at Bear Stearns, who repeatedly argued (see for example here)the case for treating capital gains as savings. The conclusions from this theory, and the rest of his analysis, were that there was nothing wrong with the housing boom or the American economy.

It was probably not coincidental that he was chief economist at Bear Stearns, a company whose fate is all too well known. The conclusions of his analysis, that there was nothing wrong with the housing boom, of course prepared the way for the decisions of Bear Stearns management and investment strategies to invest heavily in the U.S. housing market. This later led to the collapse of that company.

Moreover, as Malpass went out of his way to spread this message in interviews and op-ed columns and as this in turn led other pundits to spread that message, and as some probably acted on that analysis, this also contributed to lowering actual savings (although to be fair, his role in that respect was far more modest than his role in wrecking Bear Stearns).


Blogger Danny said...

Your blame is far too narrow here. This isn't a problem that can be blamed on Malpass alone, nor should he even get most of the blame. I am going to copy this from the Marginal Revolution comments, as I can't put it any better:

"2. Second, one important false market signal was that people thought rising asset prices could substitute for savings out of disposable income. That is not the Misesian or Hayekian scenario."

This is just plain wrong. In both his Theory of Money and Credit and his Human Action, Mises emphasized the pivotal role played by the "illusory" profits generated by the falsification of accounting that occurs during the boom stage of the business cycle. (He also recognized, unlike Tyler, that since assets are alienable, saving via a rise in asset prices is indistinguishable from saving out of so-called "disposable income.") These false accounting profits result in capital consumption (i.e., a reduction in real saving) among all income classes in the economy, in particular as a result of "the in rise prices of stocks and real estate." As a result, businessmen, stock jobbers, wage earners--all "feel lucky and become openhanded in spending and enjoying life." (HA pp. 546-47).

Hayek too recognized the increase of asset prices as identical with an increase in current profits, that is, disposable income. In pointing out an error of Keynes, he wrote: "But these two functions [of capitalist and entrepreneur] cannot be absolutely separated even in theory, because the essential function of the entrepreneurs, that of assuming risks, necessarily implies the ownership of capital. Moreover, any new chance to make entrepreneurs’ profits is identical with a change in the opportunities to invest capital, and will always be reflected in the earnings (and value) of capital invested" (Hayek, “Reflections of the Pure Theory of Money of Mr. J. M. Keynes.” Part I. Economica, No. 33 (August) p. 277.

made by the commenter cleric

It wasn't just Malpass, and I don't think he should get the blame. All of modern economics should get the blame, as apparently, it is against their doctrine to recognize asset bubbles.

11:26 PM  
Blogger stefankarlsson said...

Danny, you're right that Malpass shouldn't get most of the blame for the overall U.S. housing crisis. Which is why I wrote in the end that his role was far more modest in that compared to his specific role in Bear Stearns. In Bear Stearns too, others deserve a lot of blame too, but in that company his role was quite significant.

7:43 AM  
Blogger Danny said...

Ah, I didn't focus enough on your last statement. Agreed, he was prominent in his role in the downfall of BSC, but he was a product of a system that taught what he preached. I see almost no Austrians on Wall St, the one exception might be Kasriel at Northern Trust, who, not coincidentally, has been ranked among the best for years. Add Roach and Rosenberg as mainstream economists with common sense, and neither of them apparently had much influence on their own firms practices.

3:21 PM  
Blogger stefankarlsson said...

I don't know how much influence particular chief economists have had on their firm's behavior, but given that Bear Stearn's behavior was consistent with Malpass' analysis, it indicates a role of that analysis in that company's trouble.

It should BTW be noticed that Northern Trust seems to be relatively unaffected by the crisis. Unlike many other financial companies they aren't losing money or even seeing its profit decline. That would perhaps indicate that they listened to Kasriel's bearish outlook on housing.

7:13 PM  
Blogger Danny said...

Growing up in Chicago, Northern Trust has been the bank that my family and its businesses have used for years. Lots of great, smart people. I have a feeling that Chicago is going to catch up very quickly with New York as the main business center in the US. The CME's recent purchase of the NYMEX is case in point. I think the commodity bull has years to run, even if it has a rough couple years between the global slowdown and the leveraged speculators getting kneecapped. We just have to hope that Congress doesn't decide to hyper-regulate, and drive market actors out of the US to newer commodity pits.

3:56 AM  

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