Tyler Cowen gets Fisked

What is a credit crunch? At first, I thought when people were using this term they meant credit markets weren’t in equilibrium. There was no market for credit. Then when people started talking about the increasing TED spread — basically the price of very short term loans — I thought they meant a credit crunch was a contraction of credit supply. You know banks were all of a sudden more risk averse and they weren’t extending credit that should be extended.

But then someone said, “hey, volumes of credit are actually increasing!” Basically, if supply is decreasing, we’d expect increasing prices, e.g. an increase in the TED spread, but also decreases in quantities, e.g. lower volumes. If volumes are up and prices are up, this is consistent with increasing demand.

To which Tyler Cowen replies with this weirdness. Basically, he’s saying a credit crunch is an impending decrease in supply (or demand even) for credit. Why is this weird? A commenter on that post explains:

“As for the current financial crisis, my view of the data is that many borrowers have been drawing on their pre-existing lines of credit like crazy, for fear that their chances to borrow may be drying up. “

So, your view of the data is that an increase in the amount of loans and credit available is a sign of a freezing of credit and an unwillingness for banks to lend. This is a very convenient position to take. A reduction of loans and credit is a sign of a credit crunch and an increase in loans and credit is also a sign of a credit crunch. This is like the game of flipping a coin where if you flip heads you win and if you flip tails I lose.

“Even now it remains unclear whether these options will be replenished and of course if they are not that means trouble.”

I see…so, we are not in trouble yet, but because in the future we might possibly have a reduction in loans and credit, that definitely means we are in a credit crunch now.

“It does not necessarily show up in current period credit flow data and in fact it may show up counterintuitively as a spike in borrowing.”

A spike in borrowing also means a spike in lending from the banks. But a credit crunch is where banks are unwilling to lend. Now, with new Orwellian double speak, a credit crunch is when banks are willing to lend to everyone and his brother. Some credit crunch.

“I am puzzled by Alex’a admission that there is a recession; no matter which way you assign the causality, doesn’t that mean credit should be contracting?”

Causality does matter. If borrowers choose not to borrow this is not a credit crunch. A reduction in demand for loans due to a recession would not be considered a credit crunch. The credit crunch would have to originate on the supply side. Banks would have to be unwilling to lend to borrowers for there to be a credit crunch. A reduction in loans and credit is a necessary but not sufficient condition for there to be a credit crunch.

Investments are the most volitile component of national income. When GDP is high, investment goes really high and when GDP is low, investment is really low. We’d expect, if we’re entering a recession, to see investment and thus the demand for credit go down. Its hard to call this normal contraction of demand for credit a credit crunch.

The data aren’t telling us we’re in a credit crunch, given a half-way meaningful definition of the phrase “credit crunch”. In fact, the data are consistent with increases in demand for credit and so increases in investment.

Emailing Senior Ambrosini

I got this email from my dad:

Ok, you are the trained expert on this. In 100 words or less please explain what the hell is going on with the market and what will be the final outcome. (ps: your inheritance just went down over [30%] in the last seven days!)
J. William Ambrosini CPA

My reply which I hope is wrong in the “you can’t get all the details right in a short essay” sense and not a “what the hell is he talking about” sense:

What the hell is going on?

Prices in houses have decreased a lot because we were in a housing bubble. This means a lot more people are delinquent and defaulting on their mortgages because credit ratings algorithms were attuned to an environment of ever-increasing home prices. This may have been prevented if banks didn’t move to score based credit ratings in the 90’s and if people with poor credit weren’t encouraged to buy homes… but who knows what would prevent asset bubbles.

What’s the effect?

First, in the banking sector, this newly discovered risk is spreading like ripples in a pond. Mortgages were repackaged as “mortgage backed securities” and sold and resold. This had the effect of spreading risk (a good thing) but it spread it in a way people can’t account for. We’re in a situation now where we know a lot of assets are worth less than we thought, because they have more risk than we thought, but we don’t know exactly which assets. People are nervous to buy anything related to mortgage assets, even good assets, because they’re afraid they might actually be bad. That’s why these assets are called “toxic”. Nobody wants to touch them. People don’t even want to touch banks that had positions in these types of assets (which are most banks).

Second, in the “real” economy the credit expansion caused by high house prices led to over-expansion of capital so now we have a lot of excess capacity. This isn’t covered as much in the press but I think its may be as much of a problem as the financial stuff. Basically, people were borrowing against the inflated value of their homes and consuming a lot. This extra consumption prompted businesses to increase capacity — to expand their business. But this extra consumption dried up when the house prices tanked and businesses are stuck with a lot more capacity than they need. This means investment that would have happened, even without the housing bubble induced consumption, won’t happen now.

What am I worried about?

I’m worried about the effect this all will have on the “real” economy. As banks struggle to get rid of these bad assets they’re reluctant to make normal loans to businesses. This makes it harder for companies to make payroll or to get loans in order to expand capacity. This is how the “paper” economy has an effect on the “real” economy and this is why this financial mess may cause a recession. Also, over capacity means businesses will have less demand for capital goods, there will be less investment and this may mean the recession will be protracted. The good news is that China and the world economy in general are expanding like gang-busters. This “over” capacity might not be.

What am I really worried about?

The government screwing things up worse. The great depression was really a bad recession that the government made much, much worse. Government made a lot of mistakes, but the biggest was in its attempts to control prices. President Hoover basically had a deal with big business to keep wages high at their current level. Because wages couldn’t drop as they needed to, unemployment was high (if you can’t reduce your employees wages, you have to fire them) and so aggregate demand was low (people didn’t have jobs so they weren’t keen to spend money). There’s two ways to deal with low aggregate demand: increase government expenditures and let prices/wages adjust back to the full employment level. Increasing government expenditure is a good short term solution but it has to be paid for eventually. Letting prices adjust, on the other hand is painful in the short run (the employed people have to live with wage decreases), but its the only solution that works in the long run. Eventually, prices have to adjust. During the depression, government didn’t let wages adjust down for nearly a decade and we had a depression for… you guessed it, nearly a decade.

Anyway, this is more than 100 words. But this is my sense of what’s happening. I expect a short recession as the banking sector reorganizes unless there’s lots of over-capacity. But if you see politicians making a lot of noise about controlling prices, we’re in a world of hurt.

J. William Ambrosini Jr.

PS – Short term movements in the stock market get the headlines but they convey no useful information. If stock prices represent discounted future cash flows, I find it inconceivable that future cash flows will be 30% less than they were a month ago (before the 30% decrease in stock prices). Even if we have Depression 2.0, I can’t imagine future profits will take that big of a hit even in discounted terms. In other words, my inheritance took no such hit!

Just a tad over 100 words… by the way, a point similar to the one I made about over-capacity was made by Prof. Phelps the other day (via The Economist).

VSL is BS?

Gabriel wants to talk about SVL or “statistical value of life” (aka VSL). Where would we be without acronyms.

First, why should we have such a thing? Isn’t putting money value on human life too icky to contemplate? If we have such a value, wouldn’t it suggest Bill Gates could buy our lives? Would it be condoning slavery?

Answers: because we have to, yes but someone’s got to do it, no and really no. Simply put: there’s no way to know how much money to spend on life preserving/extending goods and services if we don’t have a sense of how much its worth to us to preserve that life. “Life is priceless” is a nice sentiment, but taking it literally, and via a sufficiently snarky reductio ad absurdum, this refrain would suggest we spend infinite resources making sure people don’t get the slightest owies. See how absurdum that reductio would be?

Anyway, how much I spend on air bags for my bicycle or how much time I spend indoors instead of braving the mean streets of Davis ((Bikers don’t think they need to follow road rules.)) reflects the value I give to my life. If I value my life more, I’ll spend more time in bed. Usually, I don’t spend all my time in bed so I can’t have an infinite value for my life. If I value my life less, I’ll spend more time sky-diving. Because I’m not spending all my time jumping out of perfectly good airplanes, the value I give to my life can’t be zero. Somewhere between zero and infinity, then, you’ll find the value of my life. The things between zero and infinity are called numbers and that’s all economists are doing when they assign a money value to life; they’re assigning a number to that subjective value we all have in our heads anyway.

There’s a couple of things we’d expect to be true about that number:

  1. It shouldn’t vary too much between different types of people
  2. To the extent it does vary, it should do so primarily because of the underlying difference in risk preferences of individuals
  3. It shouldn’t vary too much by age except in the last moments of life
  4. It should be big in any case. It would be really disappointing (and unbelievable) if economists said lives were worth pocket change (even, or especially, for the infirm) .

With my limited imagination, I can think of two ways to put a dollar value on a human life. The first is to use lifetime income or the slight variant, the income yet to be earned. In other words, just add up pay checks. This breaks a bunch of the rules listed above, but mostly it violates #2 and #3.

Another way to come up with a dollar figure is to look at how much money people spend on safety equipment (willingness to pay) or how much extra money they earn doing dangerous jobs (compensating differentials) relative to mortality rates. The fancy folks down the hall that specialize in Public economics call this the value of a statistical life (emphasis on the “statistical”).

There’s lots of estimates of this value, but most put it between $4m and $9m ((see Viscusi and Aldy. They find safety is a normal good, unions are associated with higher hazard pay and VSL declines with age.)). This method does an OK job not breaking any of the above rules. Take for example the estimates showing a 10% increase in income leads to a 5% increase in VSL. This may seem disturbing at first, but assuming I’ve done my marginal effects calculations right, this values Americans at the poverty line at $2.5m or so ((and Bill Gates at $1.5B, but he may be slightly out of sample)).

Learn some economics, be entertained… (part IV)

Light bulbs. When I teach growth theory, I just keep talking about the difference between out of steady-state growth and steady-state growth until I see light bulbs. It seems esoteric at first, this distinction.

Capital accumulation explains growth up until the economy gets to the steady-state. Every economy eventually gets to the steady-state. Economies don’t stop growing.

“What the hell is the steady-state!?” you hear their expressions saying (when they’re not scribbling notes furiously as “this will be on the test”).

Capital has diminishing returns — the pizza joint only needs so many ovens — but it breaks at a constant rate — pizza guy expects to repair 10% of his oven every year (or he expects to replace his oven every 10 years). This means as additional bits of capital are added to the economy, less and less of them add to the total stock of capital and more and more of it is used to replace broken capital.


“Ack! ‘diminishing returns’! That’s definitely going to be on the final!” Scribble, scribble.

If more of that investment is going to adding new capital than is being used to replace old capital, more capital is being added to the economy. More capital means more output.


“Wait. Investment? I thought we were talking about savings.” (At which point, I hope the Smart Kid ™ asks about why we can assume savings is constant over all income levels. He doesn’t.)

Eventually, this sort of income growth peters out as we get closer to the level of capital where the amount of new capital exactly equals the amount of capital that is breaking; the steady state. Fingers, hands, arms, pants, backpack and that woman’s coat get a fine coat of chalk dust as I inch my way through the dynamics on the Solow diagram.

*bing* *pong*

The first question comes, “what’s that line on the diagram mean?” (Doh!… but I use the opportunity to repeat the dynamics story, trying to emphasize the diminishing role of capital in growth… there’s a singular level of capital the economy is headed towards.)

more *binging* *ponging* and *dinging*

The next and next questions give me the opportunity to try to explain the story in different words, from different angles. Rinse and repeat ((not kidding, during last quarter’s final review session, the same question was asked 5 different times in succession by different people… I happily obliged; there’s no diminishing returns to lighting light bulbs)).

And then, when the density of lit light bulbs is sufficiently high (I shoot, aggressively, for 25% coverage), I hit them with: “We think the U.S. is near the steady-state level of capital because capital been at about 2.5 times GDP for over a hundred years. Yet, the U.S. GDP has been growing at about 2% a year for just as long. How can this be? How can we have income growth if the number of machines in the economy isn’t changing?”

“Technological improvements!” shouts Smart Kid ™, “They make capital more productive.”

Ah, light bulbs!

Now, did Smart Kid, and hopefully at least some others, learn anything about growth? YouNotSneaky! thinks so. In any case, I certainly hope so because it feels a hell of a lot like I’m teaching!

The many meanings of great

When lecturing, I often let enthusiasm get the best of me. Interesting theoretical results and strange/noticeable empirical results are declared “great!” whether or not those results are normatively great things.

For example, one time I was showing my students a chart comparing child mortality to per capita income level. The data cluster very tightly around a negatively sloped line. I exclaimed, “this relationship is really great!” to which I heard gasps from my students. Red faced, I explained to students that I meant there seems to be a high correlation between income levels and child mortality and this is important because even if you don’t give a hoot about levels of GDP, you might care about the health of children and their mothers.


Anyway, these charts showing what’s going on in the mortgage market are great(!) in much the same way.

Learn some economics, be entertained… (part III)

YouNotSneaky’s at it again. Why might prices be more stable under monopolies (and why might we care)?

Here’s my favorite line:

Probably less explicitly but more importantly, when prices keep changing on you it means you’ve gotta recalculate your optimal allocations of expenditure again. You gotta set up a new Lagrangian, take the damn first order conditions and figure out if making out the adjustments in your optimal consumption basket – given your income – are worth it. What? You don’t think that way? You don’t set up constrained Lagrangians every time there’s a change in prices and compute your Kuhn-Tucker conditions?