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I know you have seen this before, but at the risk of repetition here it is again.

https://charles72f.substack.com/p/basel-faulty-the-financial-crisis

The financial crisis was caused by the egregious leverage and illiquidity of European banks and US shadow banks. The question is "What enabled these institutions to become so leveraged?" The answer is: The Basel Capital Standards. The crisis was caused by misguided regulation. US Commercial Banks were solid as a rock and did not need further punitive regulation (Dodd-Frank, Basel III, stress tests, Basel End-Game, etc.)

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Obviously Ben’s “helicopter money” instincts after the post 9/11, post dot com crash recession also helped fuel leverage and speculation. Moreover, low rates and tight credit spreads created an ROA squeeze at major banks, and regulatory capital requirements made it fairly unprofitable to lend at the tight credit spreads. Hey- but what if banks could buy a security that yielded more than government paper but still had a zero capital risk weighting? Thanks to Basel II, “AAA” securities counted as zero risks. The banks found a solution to their ROA troubles- they just needed someone to provide lots of “AAA” securities.

There was also an international angle. Major mercantilist blocs were artificially preventing their currencies from appreciating, while accumulating ever greater trade surpluses with the US (including China, Japan, Asian Tigers, Latam and GICs). They were accumulating masses of Dollars both in trade and via intervention. These dollars flooded the banking system (and depressed US treasury interest rates) and the banks needed to do something with the cash (see the “AAA” security reference above).

In other words, the GFC wasn’t just about home buyers and condo flippers in America, and not even just about the residential mortgage market, IMO

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I agree with most of what you say. Buying those AAA securities (I don't think the capital requirement was zero but it was close.) would never have made financial sense if Basel didn't allow banks like Deutsche to leverage 100 to 1 and short fund all their long term assets. That is what caused the crisis. See my post comment above.

Actually, the AAA tranches mostly ended up money good even though their prices were driven down 40 - 60% in the heat of the liquidity crunch.

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My completely crazy proposal is that rating agencies, ratings, and regulatory requirements contingent on ratings, all should not exist. The only way anyone should express any opinion on the risk of any asset is to shut up, put their money where their mouth is, and trade instruments involving the asset. Skin in the game or get off the field.

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I will always have a special fondness for the *Critical Review* issue on this topic, in particular, the lead essay by the late Jeffrey Friedman.

***

The rationale of social democracy is to solve what the demos perceives to be important social and economic problems. These solutions necessarily occur on a case-by-case basis—as the mass media bring the problems to public attention—rather than through the implementation of a central plan. After a public outcry has been raised, the legislature redistributes wealth to solve the problem (the “redistributive state”); or it creates the authority for specialist bureaucrats to solve the problem (the “regulatory state”). This case-by-case, problem-solving approach is universal in the West and, arguably, is the key difference between social democracy and communism.

Yet if social democracy is to be truly pragmatic—if it is to solve problems without creating new, worse problems—then the designer of a new problem-solving law or regulation needs (1) to predict the unintended consequences of the new rule, considered in isolation; and (2) to predict

its unintended interactions with other rules. The second requirement would fulfill the regulator’s one conceivable systematic advantage: His motivation to preserve or improve the system as a whole.

The social-democratic principle of case-by-case problem solving, which Karl Popper called the system of “piecemeal social engineering”, is not really a system, and no “engineering” mentality actually stands behind it. In fact, it rarely even rises to the conceptual level, let alone to the level of grandiose aspirations. It is more like a tacit assumption that is inculcated in the citizens of modern countries through primary and secondary education, the mass media, and the unarticulated boundaries of political discussion. It is one of two foundational legitimating principles of modern government (the other principle being democracy itself); but it is also the raw political basis for the success of any politician or party in a jurisdiction where vote buying has become a scandalous exception, and problem-solving promises have become the accepted political practice.

http://arnoldkling.com/econ/book/JFintro.pdf

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Piecemeal reforms were also a feature of communism because, for obvious reasons, central planning (social engineering on a grand scale) created its own set of economic problems. Among other things, soviet-type centrally planned economies were invariably shortage economies. The state-controlled media likewise brought problems to public attention. The solutions typically involved some type of decentralizing, 'market-based' reforms, though often they were timid and short-lived. In the Soviet case, the last of these reform cycles, perestroika, brought the communist system to an end. We can only hope.

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Not to dispute anything said by you or others but banks were told to make more mortgage loans to minorities. It was understood that the only way for that to happen was to loosen the standards.

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I like the explanation of the crisis even more than your underlying theory of the government's reactions.

I recall back around 2012, there were many smart people (at least, smart in their own estimation), who thought the key to preventing future bank crises would be stronger regulatory regimes, with a "Basel III" standard that would ensure banks were stronger. At the time, it seemed to me that a big cause of the bank problems, especially in Europe, was the "Basel II" standards that allowed (or was it required?) banks to treat bonds of Euro-zone governments as risk-free; this encouraged (or was it demanded?) irresponsible loans to Greece (and Italy, Spain, Portugal, and Ireland) which ultimately made all the banks in Europe vulnerable. The problem, I thought, wasn't that the regulators had bad rules, but that they all had the same rules. If any of the rules were bad, the banks were likely to all fail at the same time, in the same way.

More than tougher regulation, we need regulation that allows different approaches to risk management. Even if some rules are generally better than others, we can't afford to have all the banks failing together.

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Neither the origin of the financial crisis and the origin of COVID had much to do with the poor response to the "event."

The Fed simply failed to keep inflation and inflation expectations up to target. Their bad. Shame!

CDC failed to give individuals and policy makers the information with whihc to make cost effective decisions about trading off harm of the disease and the costs of avoiding those harms. Their bad. Shame!

FDA impeded development of cheap screening tests and could have speeded up the approval process of vaccines. Their bad. Shame

https://thomaslhutcheson.substack.com/p/covid-policy-errors

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Bernanke's praise of risk management was role-appropriate for the time. His invocation of the Great Depression was role-appropriate at a later time. In between was the fog of war.

I don't know that socially relevant policy can ever be made "engineering-like". If the players last long enough, they might have time to integrate all the pertinent details This seems to have happened now and again; the 1970s Earl Butz innovation in ag subsidy seems an example. I'm no specialist but I recognize some features of that as suspiciously like signals processing controls. Vaguely.

As noted, there was no such feedback on the financial instruments themselves. We, roughly, were not smart enough.

"Wir zu früh alt, zu spät klug erhalten!" - we grow too soon old and too late smart.

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We still do not know how much of the Fed's failure to keep inflation and inflation expectation up to target were the fault of Bernanke or the rest of the Board.

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Indeed. See also Scott Sumner.

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I have seen Summer's view, but I would like a much more detailed account. And the Board? What was their view? Pure "conservatism?"

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> much more detailed account.

https://www.themoneyillusion.com/faqs-2/

> Pure "conservatism?"

Fed gonna fed. They have strange governance constraints. Nobody anywhere understands inflation that well.

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You have restated my question. Why did the Fed Board not want (?) to keep inflation up to target? Saw 2% as a ceiling not a forward looking average to be achieved?

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I wonder whether you have read the Steve Sailer critique of the housing policies pre-2008, in his view a key cause of the crisis above financial shenanigans, and whether you'd agree with that view

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Arnold wrote: "The main point of my paper is not just that policy makers created incentives that exacerbated the crisis, but that they did not realize they were doing so." Possibly so, or maybe they were naïve realists, and never asked themselves what could go wrong. The enthusiasm across the political spectrum was intense. It was thought that home ownership could solve major social problems by turning renters into homeowners, but OK renters turned out to be not up to the responsibilities of home ownership.

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Sumner and Erdmann are definitely on the side of "no such thing as a (housing) bubble" argument. At least for Sumner this is driven by his support for the efficient market hypothesis. The EMH can be a useful simplifying assumption, but it has to connect with reality at a certain point. In the real world, there are occasionally periods of time where markets have got it wrong, even just focusing on the information that is available at the time, not even looking back ex post.

With respect to nominal GDP targeting, I think Sumner might acknowledge the difficulty in hitting a nominal GDP target in any given quarter. Sumner puts a strong emphasis on the importance of level targeting. So for instance, suppose the central bank is using nominal GDP level targeting, but for whatever reason we still have a banking crisis that sends nominal GDP down significantly, then with the level target the Fed would be much more aggressive than the Fed was post-GFC in order to bring nominal GDP back to trend. That would help ameliorate the banking crisis. Many would stop at that point and wonder whether the Fed would have the ability to manage that on its own. That's still a bit of an open question, but I think the post-pandemic response makes it clear that it no doubt could when paired with fiscal stimulus.

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I think the rise in housing prices since 2008 and the estimates for underbuilding the last ~50 years pretty conclusively demonstrate we did not have an actual housing bubble.

Somewhere like China may have an actual real estate bubble, but we did not and do not have newly built empty cities in the US.

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Newly built empty cities may be evidence in favor of a housing boom in China, but that isn't the main factor one can use in identifying a bubble.

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My understanding is that Chinese policy incentivized overbuilding beyond what market forces would call for.

Leading to this: https://en.m.wikipedia.org/wiki/Chinese_property_sector_crisis_(2020%E2%80%93present)

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See also Liebowitz's "Anatomy of a Train Wreck" https://www.independent.org/publications/article.asp?id=9270

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May 15·edited May 15

Somewhat off topic, but your link reminded me of Liebowitz's *Winners, Losers & Microsoft*.

In hindsight, I think the authors got it correct that “path dependence” was overrated as a form of monopoly power for Microsoft. Reading the negative reviews 20+ years later on Amazon is interesting. Now, I guess we can debate “walled gardens” instead?

https://www.amazon.com/Winners-Losers-Microsoft-Competition-Technology/dp/0945999844

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Where I work, Microsoft is treated as if it has so much permanent monopoly power that it's hard to tell who answers to whom.

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