Maxine Udall (girl economist)

Bring Back the Robber Barons? I Don't Think So.

Before we take Daniel Henninger’s advice over at the WSJ and Bring Back the Robber Barons, let’s consider the proposition more fully by reflecting on an alternative view of corporate “entrepreneurship” offered by Barry C. Lynn and Phillip Longman at Washington Monthly.

And while we're at it, let's perform this thought experiment: imagine all the entrepreneurship that is effectively squelched by locking potentially entrepreneurial people into corporate jobs in order to maintain health insurance cover for themselves and their families.

Yeah...that's the ticket...robber barons.

(Thanks to my friend, Obey, for the link to Lynn & Longman’s piece and my friend, Ecrive, for the link to the wsj piece.)

Huffington Post gives us "The People of Bedford Falls Have Bailed Out Mr. Potter instead of George Bailey: The Movie"

From Huffington Post (12/29/09), a more dramatic and possibly more effective version of ideas I presented in a blog posted 12/1/09. I'm glad to see that someone else noticed the parallels. Kudos to Huffington Post!

Rap Video: Keynes v. Hayek

From OpenEconomics:

Should Economists Be Sued for Malpractice?

(This is for my friend, Obey, in partial fulfillment of his request.)

From Paul Krugman yesterday in an article about Fiscal Scare Tactics:

 The trouble, however, is that it’s apparently hard for many people to tell the difference between cynical posturing and serious economic argument. And that is having tragic consequences.

How did it come to pass that many people cannot tell the difference between cynical posturing and serious economic argument? I lay much of the blame at the feet of my own discipline, but how did the discipline of economics manage to accomplish this potentially tragic result?

Many years ago my working hypothesis assigned blame to Paul Samuelson (may he rest in peace) and the Cowles Commission on Research in Economics (1951); Paul because he was among the first to use the calculus of optimization to describe economic theory and formulate testable hypotheses about relationships among economic variables (in Foundations of Economic Analysis, 1947); the Cowles Commission because it seemed to be the most obvious point at which the physicists moved into economics and mathematized it. Hicks’ Value and Capital (1939) preceded Samuelson, but the post-WW II timing of Samuelson and Cowles (when military interests were dominant and operations research methods were the newest and next best thing to sliced bread) represented a powerful confluence of method and madness.

I absolved Samuelson rather quickly. One has only to read him to know that he was about way more than the math. And eventually, I realized it was silly to think that mathematizing what had once been a major component of moral philosophy would be enough to render economics insular and, to many, uninteresting or incomprehensible. Of course, it helped that economics became incomprehensible to anyone scoring less than 700 on the math GREs. It was necessary, but not sufficient. One has also to divorce economics from moral content to arrive at a state where “cynical posturing” is indistinguishable from “serious economic argument.”

So how did that happen?

I think we can lay some of the blame for the excision of economics from the body of moral philosophy at the feet of Lionel Robbins (may he rest in peace), who asserted that “economics is fundamentally distinct from Ethics” in his Essay on the Nature and Significance of Economic Science published in 1935.

Economics is neutral between ends. Economics cannot pronounce on the ultimate validity of judgment between ends....[Economics] is incapable of deciding as between the desirability of different ends.

It was a position taken earlier by John Neville Keynes (Maynard’s father) and by Pigou, but Robbins influence may have been greater because of the timing. The book was republished in 1948 just as mathematical momentum was building. It is probably also significant that Robbins’ pronouncement about the impossibility of interpersonal comparisons of utility gained widespread and rather uncritical acceptance among most economists even today. But that is a technical point better left to another blog.

Of course, all of this was unfolding in a world that had come to view science and the scientific method as the sole road to Truth and Beauty. Mathematization elevated economics above the other social sciences because it rested on magical mathematical foundations. Scientific rigor was ours!

The effect of this was to relegate discussions of economic welfare to narrow corners of discourse grounded in desolate Edgeworth boxes where the emphasis was on relative prices, trades to zero sum optima, and convex preferences with little or no attention paid to why person A started with so few resources relative to person B. The joys of being in the “core of the economy” were celebrated even if being situated at that efficient bliss point left person A holding only a few percentage points of total output while person B held all the rest.

Within the ever-popular Paretian framework, there was no possibility that person B might care about person A’s relative lack of resources, that B might be willing to give up something, transfer it to A to make A materially better off, while allowing B to become (at least in moral utility space) much better off. Or that B might be willing to tolerate some inefficiency in order to make A better off. Kaldor-Hicks introduced even more profound and possibly unjust principles, but that is another blog, too.

Back to my somewhat simplified story: economics was mathematized and divorced from moral philosophy, but it was the timing that mattered. The Great Depression had concentrated both policy and political interest on distributional aspects of allegedly efficient allocations. The events leading up to the Depression demonstrated the lie of market efficiency, at least in financial markets. And it showed that what happened at the top of the economic and social pyramid had dire consequences for the bottom of the pyramid and for the wealth of the nation as a whole (something that apparently would not have surprised Adam Smith). The Great Depression caused many to doubt the value of capitalism, except, of course, investment bankers who knew that speculation (as opposed to long-term investment) was quite lucrative as long as they got out before the crash or, as they have recently learned, as long as they can induce the taxpayers of the US to provide single-payer credit default insurance.

Because of the Depression, John Maynard Keynes’ (at the time) rather radical thoughts on employment, money, and interest increasingly gained acceptance. World War II provided the massive Keynesian stimulus needed to haul us out of depression and to cement Keynes ideas about the roles that government could and should play both during economic downturns and to prevent them. Of course, the increased regulation and taxation that accompanies such policies represented a major threat to business as usual particularly in financial markets where the lure of speculative gains is always irresistible.

Keynes, who advocated that government play a role in moderating the effects of peaks and  troughs in the business cycle through regulation of investment banking and automatic demand stabilizers (for example, unemployment compensation and jobs creation through public works) became conflated (perhaps intentionally) with “socialism” and “communism.” When Lauri Tarshis tried to write about Keynesian economics in his 1947 textbook, he was effectively silenced in much the same way and by many of the same people who were so effective at silencing Samuelson on military spending. Samuelson’s text “contained no more than a few words on American defense spending, and none on its size in relation to the federal budget or its effect on the economy.” The Right would paint them as “red” and the Board of Regents of their universities would bring pressure to bear for writing subversive textbooks. 

Economics, mathematized and divorced from moral philosophy, was effectively neutered after WW II, at the point when its relevance to “serious economic argument” might have been established and developed. The outcome was perfectly aligned with market forces that would continue to shift the national narrative in ways that would finally succeed in convincing people that “government is the problem”. It culminated in repeal of Great Depression era regulation, thereby freeing investment bankers for unfettered speculative gains supported by a seemingly unfettered single-payer credit default safety net.

Now add to this the promotion and tenure policies at even second rate economics departments that require and only reward publication in journals that favor morally vacant, mathematically rigorous, theoretically obtuse existence proofs that more often than not bear no relation to reality as we know it. One is then left with an economics literature that few people, including some who have majored in economics as undergrads, can truly understand, either in its content or in its relevance to the important moral and economic issues that confront us today.

It is no wonder that many people cannot “tell the difference between cynical posturing and serious economic argument.” This is a resounding indictment of economists and the economics profession. The market supported and promoted it. We as a profession benefited from it with higher salaries and consulting fees. Meanwhile, the “tragic consequences” of our failure include  a country that inefficiently spends twice as much as any other developed country on health while leaving roughly 20% of the population with no cover, a 10% unemployment rate, and a growing home mortgage foreclosure rate, all while providing single-payer credit default insurance, financed by low and middle income taxpayers, to the richest portion of the population, the guys who ran us into the ditch; the guys who cannot be taxed for fear they will cease to provide us with the dubious benefits of their financial expertise and acumen.

We appear to be at a political impasse because the idea that “government is the problem” has become entrenched. A moral philosophy pretending to be a science devoid of normative judgment has aided and abetted that idea by elevating efficiency above any other possible moral or even economic consideration. The result is that many in the US and in the world who lack the math acumen to appreciate the subtleties of economic theory stand enthralled by sound bites derived from a handful of dead economists and one dead president.

Economics provided the theory and language that supported the drive to the ditch we find ourselves in. We did it by allowing economics to become divorced from moral philosophy. Now the economy is on life support and most people in this democracy can’t tell the “difference between cynical posturing and serious economic argument,” but they can and will vote.

If economists were physicians, we would be sued for malpractice.

The Price of Principle Is Too Cheap

Maxine has been reflecting on the men and women who laid the foundation of our Republic and the prices that some of them paid for it. (Yes, women laid the foundation and paid a price, too. Someone had to mind the farm, raise the kids, run the household while the men were off fomenting rebellion and at least one woman did jail time for her husband’s role in that rebellion.)

While visiting Monticello a few years back, Maxine picked up a small book, “The Declaration of Independence with Short Biographies of Its Signers” published  by Applewood Books in Bedford, MA. Here is a tally of the sacrifice of personal blood, sweat, and treasure by some of the signers and their families according to the book:

William Whipple (1730-1875, New Hampshire) who resigned the Continental Congress in 1777 to become Brigadier General of the New Hampshire militia. “He recruited, equipped, and led troops against Burgoyne,” i.e., he spent his own money.

William Ellery (1727-1820, Rhode Island) “A successful lawyer [who] so infuriated the British with his patriotic activities that they burned his home and destroyed most of his property when they took Newport.”

William Floyd (1734-1821, New York) “British Troops occupied his mansion and estate for seven years while he served in federal Congress and the state senate.”

Francis Lewis (1713-1803, New York) “A wealthy businessman...when the British captured Long Island, his property was destroyed and his wife taken prisoner and confined for several months.”

Richard Stockton (1730-1781, New Jersey) “Captured by the British, he was treated harshly for having signed the Declaration of Independence and lost his health as well as his wealth.”

John Hart (1714-1780, New Jersey) “A delegate to the General Congress in 1776, he lost everything when the British overran New Jersey.”

Abraham Clark (1726-1794, New Jersey) “His two sons were incarcerated by the British on the prison ship Jersey.”

Robert Morris (1733-1806, Pennsylvania) ‘When the United States could not obtain credit, he personally secured the financing necessary to continue and complete the Revolutionary War,” i.e., he used his own money to pay Washington’s troops.

Thomas Nelson, Jr. (1738-1789, Virginia) “The first to propose a state militia to defend the rights of the people...he used his own resources to recruit troops.”

Edward Rutledge (1749-1800, South Carolina) “...returned to SC to help defend the state and was taken prisoner in 1780 during the siege of Charleston and shipped to St. Augustine (where) he was exchanged after a year.”

Thomas Heyward, Jr. (1746-1809, South Carolina) “Commissioned during the Revolutionary War, he as wounded, then later captured and sent to St. Augustine for a year.”

Arthur Middleton (1743-1788, South Carolina) “He joined in the defense of South Carolina, had his estate ravaged by the British in 1779, was taken prisoner in 1780, and sent to St. Augustine for a year.”

Lyman Hall (1721-1784, Georgia) “The British confiscated his property...”

George Walton (1740-1804, Georgia) “Walton remained in Congress until 1778 when he returned home to help defend the state as colonel of a regiment.  [He was] wounded and captured in the war.”

The point being that the individual’s price of doing the right thing for a nation can be quite high even if the individual expects to benefit, too. Moreover, the above list does not include the time and money costs for all members of Congress of the many tortuous hours spent on horseback and in carriages on bad roads traveling to and from Philadelphia at their own expense or the many months or years spent away from home, hearth and kin.

Maxine draws two conclusions from the above: 1) Don’t live near the coast if you’re going to become openly and publicly involved in a rebellion with a major naval power and 2) the current price of principle is too low. (Thanks and credit to Scriptamus for making the latter so clear.)

Is it too much to ask that modern day politicians pay some price for obstructing or advancing major legislation? Imagine watching Frank Capra’s film, Mr. Smith Goes to Washington, only to find that when push comes to shove Mr. Smith can’t be bothered to incur the inconvenience and unpleasantness of a filibuster.

Maxine is no political scientist, but as far as she can tell, filibusters no longer require the kind of conviction and dedication to principle that would make standing and holding the floor and one’s bladder for 24 hours a small price to pay. When Maxine thinks of lawmakers she admires, Senator Strom Thurmond never comes to mind, but she has some respect for his willingness to be inconvenienced for the sake of his misguided principles.

In their truest form, filibusters impose costs on the filibusterer and on the majority party which must maintain a quorum in order to wear down the filibusterer. The costs should in some measure reflect the strength of conviction of both majority and minority. To have a real filibuster, senators have to sleep at the Capitol building; they have to give up campaign fund raising; they have to give up trips home to see their families. In short, they have to inconvenience themselves in direct proportion to their conviction and commitment to principle in order to produce laws over strong minority opposition.

Ten percent of the population is experiencing the “inconvenience” of unemployment; 52 million Americans are expected to experience the “inconvenience” of not having health insurance in 2010; 2.8 million US homeowners experienced the “inconvenience” of foreclosure in 2009 with a higher number possible in 2010. These are the real prices of unprincipled stalemate and obstruction.

The Democrats have the opportunity and the votes to deliver the rudiments of health reform, something that once in place can be modified more easily than the initial hurdle of getting it in place. If the Republicans want to block it, then MAKE THEM FILIBUSTER. Please make them pay the same high price for obstruction that many of us are paying for the resulting inaction.

There would be no United States of America if the signers of the Declaration of Independence and the framers of the Constitution had shared our current legislators’ preferences for convenience at any price. It’s hard to imagine our lawmakers paying out of their own pockets for a bumpy 10 day carriage ride to DC or writing checks on their own accounts to keep the Republic intact or risking incarceration and the loss of property to birth a nation. Is it asking too much that they occasionally inconvenience themselves, that they gladly pay a higher price in time, inconvenience and foregone campaign contributions, when they hold a majority, have a bill, and know that the right thing to do is to make it law?

Please, sir, may we have some justice?

We have just witnessed highly compensated investment bankers asserting that they are the clueless victims of an unforeseeable, unpreventable hundred year financial crisis (except when it happens every five to seven years).

Until last year, Maxine had always assumed that at least one reason for investment bankers' high compensation was that the market had chosen to reward them for competence and knowledge about high finance, things we lesser mortals couldn’t possibly grasp with our mundane, tiny little minds. Now we find out that they apparently hadn’t even grasped the basics that Maxine’s rather less well-paid businessman father drilled into her from a very early age. “Maxine,” he used to say. “The higher the returns, the higher the risk, and if the returns are high and sustained, you’re in a Ponzi scheme or a bubble. Never forget that.” And Maxine never has.

It seems so basic and no amount of clever math and models can really change it. Say it now, all together, children: Higher returns means higher risk and if the returns are high and sustained, you’re in a Ponzi scheme or a bubble.

We and our elected representatives have a choice to make. We can continue to compensate clueless victims way beyond the value of their marginal product in any domain of productivity you care to name and we can continue to allow them to cluelessly manage financial institutions for their own short-term short-sighted gains until they plunge the rest of us into serfdom or we can change how they are compensated and maybe even who is compensated (as in throw the bums out) and we can change the rules by which they are allowed to "play" with our money.

The latter shouldn’t be rocket science were it not for the wealth and power bankers are able to exert in their own interest. If the political will is not there now to do this, for heaven’s sake, when will it be????

Oh, right...after a full-blown depression, like last time.

But even then, reform and regulation will not be enough. We need a new language about business and markets that is sensible and grounded in reality. In the last thirty years, both have been elevated to near religion, with financiers and CEOs as high priests.

Something has been lost in that transformation. When Adam Smith wrote about the value and advantages of commercial society, he saw all of society (and, of course, was comparing it to the vestigial remains of feudalism which set a very low, preliminary standard). He wrote about how even those at the bottom were made better off. He appeared to care about them. He worried that because of the drudgery of the work at the lower end of society, people in those roles would require additional inputs, like education, paid for by the larger society. He viewed the entire wealth of the nation including the distribution not only of wealth but of opportunity (admittedly within the confines of a rather rigid class structure). And he was quite critical of the ne’er-do-well rich and of businessmen who colluded to extract welfare from consumers in the form of higher prices.

Perhaps most importantly, Adam Smith appears to have understood the value of the moral side effects of commercial transactions: trust, sympathy for our fellow tradesmen and women, for our customers, for our neighbors, a sense of community and of the common good, all traded in the marketplace along with the money, goods, and services that change hands. He recognized the interdependencies that markets create and reinforce, interdependencies that bind us to common objectives and that lower the transaction costs of achieving them.

So you see it isn’t just about the money. If it were, then the investment bankers who appeared before the Financial Crisis Inquiry Commission would still have much to answer for. But it’s about more than money. It’s about the moral side effects of market transactions and exchange. Morally clueless investment bankers have trashed the fabric that binds us together as a nation. They have sent a message loud and clear that short-sighted, immoral cluelessness that serves only one’s own short-run self-interest is what is rewarded. That unearned wealth, power and prestige have more political and economic currency than the hard-earned trust, confidence, and lower profit margins of honest businessmen embedded in, committed to, and serving their customers and their communities.

Remember Potterville in the Frank Capra film, It's A Wonderful Life? The movie is a capitalist morality play that explains how banking and commerce are supposed to serve the greater good and the public interest, even as they provide returns to investment and commercial endeavor. (You thought it was just a Christmas movie, didn't you?) In the movie, the problem with Potterville isn't just that it was economically unequal. It was morally bankrupt. People were ill-natured and distrustful, not inclined to help each other or to help a stranger.

The community's moral bankruptcy was a cause and an effect of the income inequality. The income inequality was a cause and an effect of the community's moral bankruptcy (combined with Mr. Potter's unfettered market and political power and his "clueless" immorality). This is how empire's fall.

Moral, socially responsible, honest (usually small) businessmen and women like George Bailey (and Maxine’s father) provide some of the moral glue that holds us together. Market forces in small, truly competitive, transparent markets (which financial markets most definitely are not) often reinforce the moral glue and sometimes even provide it by reining in the Mr. Potters and the Gyges of the world.

Mr. Potter testified last week, pockets bulging with cash earned on the backs of the people of Bedford Falls, that he is clueless and incompetent and that stuff happens. He harmed Main Street, both the people who shop there and the people who own businesses there. He harmed the backbone of our democratic society. We bailed him out. Isn’t it time we held him to account?

We can reduce the moral hazard we’ve created with a no-strings bailout, we can reduce the moral side-effects of the moral hazard, and we can help Main Street. Let’s start by using all the bonus money to extend the safety net for unemployed workers, please. Then let’s tax the finance sector’s inordinate Ponzi scheme profits and use the proceeds to build new infrastructure and to retool the US workforce for the 21^st century. And for God’s sake, let's regulate Mr. Potter.  Let’s take a longer-term view of economic and societal well-being. Let’s make something good from this that will benefit our grandchildren.

Please, sir, may we have some justice?

The Price of Casino-Like Finance Is Higher Than We Think

With the New Year, Maxine has been thinking about old problems: banks, risk management, prices and wages as signals in well-functioning markets, and the efficient allocation of capital. She has been marveling at the disconnect between what her economics textbooks assert and the realities she has observed lately.

Things that have been especially salient are the misallocations that have resulted from very distorted signals in financial markets. Remember that one of the foremost advantages of capitalism and well-functioning competitive markets is the wonderfully efficient way in which prices and wages (at least in theory) signal profits to be made and value to be added to the economy and to us all.  When they work, the signals coordinate a large complex economy far better than any central planner (aka government) could do and they assure that resources are diverted to sectors and productive enterprise that most closely match people’s preferences. To the extent that individual preferences correspond to individual and societal well-being, both individual and societal well-being is also improved. (For an example of a case in which individual preferences do not necessarily correspond to individual or societal well-being, think "drug addict" or "alcoholic." For an example of a case where individual preferences correspond to individual well-being, but not in all cases to societal well-being, think "investment banker who required a bailout.")

Over the last several hundred years, as capitalism and commercial enterprise have come to dominate, there have been a series of cyclical downturns usually brought on by “irrational exuberance” or “animal spirits” in some market. Casino-like behavior aimed at capturing high short-term gains replaced sober, sound, long-term business investment supporting long-term corporate growth and survival. Notice that including “survival” rules out Enron-like "growth."

Economic theory is pretty specific about the characteristics of investors, producers, and consumers that will prevent animal spirit-induced bubbles: reason, self-interest, and full-information. It is not often explicitly stated, but reason and self-interest are taken to mean that the individual is rational and self-interested enough to take a long-term view of their own well-being, their reputation in the market, and their own or their firm’s survival. Full-information means that there is no uncertainty or risk, such as one might find in oh, say, futures markets, mortgage and health insurance markets, stock markets, bond markets. One could go on and on, but Maxine thinks you must get the point.

Unfortunately, an entire cottage industry called the economics profession sprang up, firmly anchored on the shores of Lake Michigan, aimed at creating cultural narratives and myths about how “markets” (meaning some abstract aggregation of semi-rational, often ill-informed, but definitely self-interested points of light) would magically “know” and act rationally and with perfect foresight. In many ways, the birth of the cottage industry known as freshwater economics is a testimony to the power of markets. There was and is a lot of money to be made in that cottage industry, especially if one was willing to drink the “business as usual,” “just ignore the man behind the curtain,” “the business of business is business” kool-aid that until recently has characterized Maxine’s profession.

One under-recognized effect of distorted price signals in a frothy economy is the distortion of intellectual curiosity and endeavor. While a course correction, championed by Keynes, Robinson, JK Galbraith and others in the past and now led by such notables as Paul Krugman, Brad Delong, Joe Stiglitz, Mark Thoma and many others is underway, Maxine believes that considerable damage has been done. Not least because most non-economist Americans are unwittingly under the sway of several "defunct economists." The defunct economists have provided a convenient narrative in which government of, by and for the people can never act as a countervailing force against large corporations, but instead is viewed as promoting individual freedom only when allied with and strenuously promoting the financial well-being and increased power of those very same large corporations. Thank you, Milton and Friedrich and all the others who have piled on that beneficial for a few bandwagon.

Another effect of distorted price signals that is obvious to us all is the way in which trillions of dollars were siphoned away from alternative productive, life enhancing activities and diverted into housing; housing that now stands abandoned on overgrown lots throughout the US or that is siphoning off yet more consumer income to the banking and finance sector in the form of mortgage payments on principal that is now higher than the current market value of the property. Money that would otherwise be available to spend and stimulate other sectors of the economy.

However, Maxine suspects that the longest term and most severe damage from the finance casino will not be from government deficits required to shore up too-big-to-fail banks and insurers. It will be from two powerful, long-standing price distortions that have distorted the composition of our labor force and the mix of human capital within it. The first distortion is the past diversion of some our best technical and mathematical minds away from physics, engineering, biology, chemistry, and, yes, even economics, to financial modeling, risk analysis, and all the other marvelous tools of speculation and gaming. Over the last 20 years or so, the financial sector has been diverting our future scientists and mathematicians into creating new derivatives aimed at managing risk (ha!) and into developing creative investment instruments aimed at obscuring risk.

The second long-term distortion is similar to the first. Maxine is thinking of all those bright, young, energetic people who came out of some of our best universities and opted to go to work for investment banks, not in technical jobs, but as traders, ratings specialists, analysts, again to support the conversion of trillions of dollars into chaff.  Many of them might have gone on to graduate degrees in chemistry, biochemistry, physics, engineering, biology or medicine. Graduate work in psychology, sociology, English, history, political science, public health would have added more value than destroying wealth across the globe. Instead of a workforce that gained diverse skills that might one day transform the world in positive and substantive ways, we have a surfeit of MBAs with concentrations in finance and empty houses on overgrown lots.

In the long run, the present and future productivity losses from labor force and human capital distortions may well dwarf the more obvious losses from distortions in real and financial capital markets, both in magnitude and scope. At the very least, they add to them in ways that are important to counter if we are to have a solid economic recovery.

Market forces did this. In fact, free market forces did this. Prices and wages signaled money to be made. Rational, self-interested people did the rational, self-interested thing: they went to work where the pay was highest and the jobs were plentiful. Even had they been fully informed about the ultimate downturn (and even if they had believed that the ultimate downturn would not be cushioned by the (bad, intrusive) government) what rational, self-interested person would have behaved any differently with all that easy money to be made?

Don’t get Maxine wrong. She is not making a case for central planning. Maxine remains committed to capitalism: free markets when they function well, regulated markets when they don’t.  The above are simply additional arguments for reining in and regulating casino-like behavior and casino-like rewards in any market, not just capital markets. In the long run, we will all be dead, but as long as someone will be alive, they deserve a better world and a better life than one gets in a casino where the odds are disproportionately in favor of the house and the house is an unholy combination of corporate power and wealth backed by government laissez faire and largesse. 

Cross-posted at Maxine's TPM Cafe blog

Financial Win-Win or Financial Debacle-in-the-Making: What Is Wall Street Up to Now?

A recent article in the New York Times describes how investment funds are buying “billions of dollars worth of home loans, discounted from the loans’ original value.” The investment funds are helping home owners refinance the loans working with lenders that work with the Federal Housing Administration (FHA) and other Federal agencies. The advantage for homeowners is that because the loans were purchased at a discount, the funds can afford to refinance by reducing the loan amount below the amount of the homeowner's original loan.

The funds make money by selling the refinanced and now taxpayer-insured loans to another Federal agency, the Government National Mortgage Association (GNMA) or Ginnie Mae which in turn bundles them into mortgage-backed securities (MBS) that are sold to other investors.  As long as the refinanced amounts in aggregate exceed the value originally paid by the investment fund for the discounted block of loans, the funds make money.

Homeowners benefit because as of last June roughly 30% of outstanding mortgages were under water. By reducing the value of the loan, homeowners enjoy lower monthly payments, a loan amount that is closer to the home’s true market value, and increased incentives to continue to make payments on the loan. All of this contrives to elevate the probability that they will continue to make mortgage payments (barring job loss) and taxpayers won’t be called upon to pay off the loans when homeowners default.

Is this the beginning of another sub-prime mortgage mess with US taxpayers underwriting investment fund profits or is this an example of the beauty and power of financial markets to “fix” some of the problems created by many of the same players in those markets using  similar securitized instruments?

Maxine doesn’t know. She knows that homeowners are more likely to keep making payments on a mortgage that reflects the true value of the house it secures and they’re more likely to keep making payments when the payments are a smaller share of their income. She knows that investors holding MBS that have fallen in value can either hold or sell at a loss. Maxine thinks some of them deserve to take a loss and if that loss can be turned into a win for homeowners, it’s not a bad thing.

Because she’s an economist, Maxine probably isn’t as exercised as some might be by the same wonderful players who nearly bankrupted us now making a profit by refinancing loans. She’s enough of a realist to know that fairness is elusive and markets often don’t even approximate it.

But Maxine also wonders about the loan insurance that taxpayers are being asked to underwrite along with all the other risk and potential liabilities we’ve assumed over the last year or so.  If the economic recovery doesn’t include a rebound in consumption and increasing employment, the refinanced loans may be underwater again or in default with US taxpayers obligated to pay investors holding Ginnie Mae MBS.

This is either the best example of the market producing a financial win-win that Maxine has ever witnessed or it is the beginning of a national disaster. She can’t tell which. The best solution would be transparency in these markets. It would greatly reduce the likelihood that Gyges is lurking, obscured behind complex financial instruments, syphoning off capital while US taxpayers are left holding the risk and the obligation to compensate investors holding Ginnie Maes.

Let the sunshine in.