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A plainmoney guide to the meltdown

Wall Street is going crazy, but how can you make sense of it all? Here is‘s simplified guide in ten easy steps:

1. It starts with the old-fashioned savings and loan association, like the Bailey Building & Loan in the classic movie It’s a Wonderful Life. That savings and loan association would accept deposits from people, loan them out on mortgages, and all was well. (Stay with me; this is going to be easier than you think.)

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“Conservative economic theory” sillies

The Wall Street Journal columnist Thomas Frank has come up with something he calls “conservative economic theory,” apparently placing the term in the mouth of a source on the subprime mortgage fiasco.

Like many people outside the field he assumes there’s a conservative economic theory and a liberal economic theory — overlooking the large analytical core shared by all economists. What does that core say about the role of mortgage originators in the subprime affair?

Simply this: that self-interested private firms disregard the costs they place on others. (See “externalities.”)

Therefore, if you want firms to be careful about costs, you make sure they pay the relevant costs. In the subprime mortgage affair, mortgage originators faced simple incentives to write as many mortgages as possible, short of outright fraud. They received origination fees for doing that while being relieved of liability if the owners later defaulted. Naturally, the law is complicated, but mortgage originators who simply reflected the overall market’s bad judgment — as opposed to committing fraud or misrepresentation — aren’t in much trouble.

Put yourself in the position of a mortgage officer. The housing market is hot and a ready market exists to buy up the loans you write. Are you going to inquire deeply into whether the borrower will pay it back? I didn’t think so.

It’s not a failure of economic theory, “conservative” or “liberal” or otherwise, when people respond rationally to perverse incentives. The task for reform is simple in concept: correct the incentives (as opposed to lamenting greed or making broad pronouncements about non-existent schools of thought).

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How will it affect me?

How do Wall Street’s troubles affect ordinary people? Here are some possible outcomes:

1. A rescue plan is passed and is effective. Then we get a minor increase in overall unemployment, two quarters of economic recession, and we’re done. Maximum unemployment is about 7 percent or so.

2. A rescue plan is passed and doesn’t work. Then we get an extended recession, possibly taking years to recover, with unemployment maxing out at about 10 percent.

3. No plan is passed. Here we get into uncertain territory. It all depends on how adaptable our economy is in getting savings converted through to make funds available for economic activity — something our system has been very good at, but that now seems shut down by the events of September 2008.

How bad is a recession in general? It’s terrible for those who lose their jobs, but in the U.S. it doesn’t mean people starve in the streets. Remember, even if unemployment hits 10 percent, 90 percent of the labor force is still working. As for making drastic changes in plans because a “recession is coming,” that’s a losing game. Example: Should someone drop out of college to save money because “a recession is coming”? Answer: No. The average recession lasts about 11 months. It’ll be over by the time you graduate.

Examples could go on and on, but you get the idea. Anything that’s a smart idea now — such as working hard and saving — will be an especially good idea is there’s a recession. Dumb ideas — such as buying a fast car you can’t afford — become even dumber if there’s a recession.

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What will happen with the bailout?

I have gotten this question a lot. Here’s an answer, step by step:

  1. Nobody knows what will happen, including me. So be skeptical about anyone making predictions, including me.
  2. If there really is going to be a collapse of financial institutions in the absence of government intervention, then we will have a long period of economic distress. It would have all the usual hallmarks of tough economic times: stagnant income growth and high unemployment. People would not starve in the streets, however, and it would not be another Great Depression.
  3. But there’s reason for skepticism about collapse. One alleged example of collapse was that McDonald’s was having trouble getting working capital. That proved to be overblown, and beyond that: Do you really think that a business model as sound as McDonald’s couldn’t somehow get funded in its day-to-day operations, even with ready investors holding trillions of dollars of cash and looking for a return? My own opinion is that awkward makeshift institutions would begin to fill in the gaps and McDonald’s would find a way to run. It wouldn’t be as good as our current system but I think we would muddle through.
  4. Politically, both sides have been guilty of brinksmanship in the proposed bailout. The Democrats have been trying to get goodies for political allies in the bailout, while the House Republicans have been trying to put in some long-hoped-for tax changes. This is not the time for any of that.
  5. So, my favored solution: Do a clean, technical bailout that allows the government to buy up distressed mortgage-backed assets and establish an orderly market for their disposal. If there are eventually profits from this, apply them to reducing the national debt.
  6. And when all this is done, get the government out of the business of holding mortgage debt.
  7. And for the future, try to draw a sharp line between assets the government will guarantee (such as bank deposits) and those it won’t (such as hedge fund holdings). Then try to structure things so that anyone who places a bet on non-guaranteed assets is on their own. Too often we have allowed people to take giant risks, reap the giant returns, and then put the losses on the taxpayers if the gamble goes bad.