Tuesday, November 17, 2009

Where's Wenzel?

I'd like to start this post by writing a review of Dr. Wenzel's presentation last week.

His talk was entitled "Dorks with Bow Ties", just kidding, it was "Interest Rate, Caffeine and Fuzzy Signals: Making sense of the Recession."

Dr. Wenzel began by reminding us that the recession didn't start out as a recession. It didn't even start out as a financial crisis. The recession actually started as a booming economy! Well, what looked like a booming economy was actually the beginning of a housing bubble. A housing bubble that turned into a financial crisis. And a financial crisis that blew up into a full grown recession.

Dr. Wenzel mentioned that the causes of the recession were probably counter-intuitive, and most likely contrary to most of the proposed causes that we've heard. He said that basically if you want to understand the macro, you have to understand the micro. That was because the recession had macro consequences from micro causes.

‭At this point he broke off into a rosy-cheeked ode to the famous autobiography, "I Pencil" As a personal side note: We get it! We understand "I pencil"! I'm not convinced that its particularly useful as an analogy anyway, but I digress.

Basically, Dr. Wenzel went on, one of the main reasons we are in this whole recession mess is because the Price System broke down. Specifically the price of money, as signaled by the interest rate set by the Federal Reserve. For those of you playing at home, the Price System is a mechanism used by the market to allocate scarce resources. Dr. Wenzel explained it like this: Demand Curves slope downward. Decrease the price of something, and the quantity demanded of it goes up. This is just a basic fact of economics. There was also one other basic micro cause Dr. Wenzel mentioned: Incentives Matter. (Even if you don't believe in them.) The final piece of the puzzle was the concept of a Moral Hazard. It goes like this: If you're protected from the consequences of your risk, you WILL engage in riskier behavior. It's basically a really simple thing. If the following things happen, you will eventually get an economic problem on your hands.

  • Price System Breaks Down (Or sends false signals)
  • People are inappropriately protected from risk

In Dr. Wenzel's presentation, the monetary policy of the Federal Reserve was discussed in detail. Basically, if I understand it correctly, the Fed lowered the price of money artifically, and kept the price artifically low for a period of YEARS! I believe the Fed did this to try and avoid a reduction in economic growth in the early 2000's. This sent a false signal to the economy about the actual cost of money. (That cost determines how much money would be borrowed and loaned, and remember cheaper money equals more demand for loans.)

As a result of all this 'free money' flooding the market, people were looking for a place to put it all. That's where the Moral Hazard came into play. As a result of deliberate sustained government policy, banks were encouraged to make home loans available to high risk individuals. The regulatory environment set up over a period of years really went a long way toward turning a surplus of 'free money' directly into a housing bubble. Specific examples Dr. Wenzel gave were: FHA reducing down payment requirements, Freddie Mac, and Fannie Mae greatly expanding federal insurance on housing loans, and the Community Reinvestment Act targeting the highest risk potential home owners and pushing money their way. The Community Reinvestment Act actually forced banks to make sub-prime loans to risky prospective home owners.

Dr. Wenzel then explained a little bit about Ludwig Von Mises' concept of the Dynamics of Intervention. It basically states that once a government starts intervening in the free market, it can't help itself. It starts intervening more and more in various different areas of the free market. It's like Pringles: once you pop, you can't stop.

As I'm looking back over my notes, I have a question highlighted on my last page: Where was Dr. Wenzel 5 years ago!!!! Couldn't he have done something to prevent this crisis from happening? Well, that's where this week's Russell Roberts' article comes into play. If the president can't really effect the economy, deliberately one way or the other, what hope does Dr. Wenzel have?

Think of what would have happened if George Bush got on the phone to Greenspan in the early 2000's and said he would send him to gitmo if he didn't raise the interest rate! Are you crazy? Greenspan would have replied. I have to keep this rate low to prevent a future economic crisis! Don't you understand our economy was just attacked by terrorists last September? The best Fed policy would be one that let's the interest rate signal the actual price of money in the economy... If we let the rate be adjusted by the invisible hand of the market, then what good is having the Fed at all? (Dr. Wenzel probably knows, but I don't.) We've given our government control of the economy in a way that gives them breaks and a gas pedal, but no steering wheel! YIKES.

Consider what would have happened to poor Dr. Wenzel if he tried to get the Community Reinvestment Act dialed back or even repealed. He'd be called a racist to start, and it would get worse from there. We want people to own their risk. That would theoretically make them act more carefully, but if we were to do anything to dial back the home ownership moral hazard created by government policy, we'd be committing political suicide.

It seems to me, that it's more likely that any government attempts to fix the economy will most likely end up hurting it. Maybe if we started trying to calculate our GNH instead...


  1. Please let us not try to calculate GNH I would argue that it would be an inefficient use of resources (besides I think Wang Chuck of Bhutan stole his questioners from health insurance companies)

  2. Did.....you just agree with an economist, Udo? Or perhaps I misread your article. ;)