Cupcake Economics

So last night I actually had a speaking engagement. Yes, there were people out there willing to listen to ME talk. 40 female CPA's held their monthly meeting at the Houston branch of the Federal Reserve Bank and asked me to talk about current macroeconomics. I came up with a little story to explain the issues that have arisen with the housing bubble, and since it worked out really well I'm going to force you all to listen to it.

Abby has a problem. She is supposed to give a cupcake to her friend Annie, but Abby got a little impatient and ate the cupcake herself. So Abby comes to Dad(me), and asks if she can borrow my cupcake so that she can pay Annie back. I'm happy to help Abby out, but as a fan of cupcakes myself, I ask Abby what she is going to do for me in return. Abby tells me that tomorrow she is going to get 2 cupcakes - and that tomorrow I can have both of them. So she will exchange her 2 cupcakes tomorrow for one cupcake today. I'm a little skeptical (what is she is lying about getting 2 cupcakes?), but Grandma pipes up and assures me that Abby is owed two cupcakes. (Grandma isn't the one who owes Abby the cupcakes, but she can vouch that someone owes Abby 2 cupcakes)

Great. I give Abby my cupcake, and Abby gives this to Annie. Problem solved. Except that when I come into the kitchen tomorrow to collect my two cupcakes, they are not what I expected. Sitting on a torn paper towel are two crumbly cupcakes with all the frosting licked off, and some kind of sticky kid-goo attached to the them. They are NOT the two high quality cupcakes I contracted for. This leaves me a little miffed, but what can I do?

Well, next week we find ourselves in a similar situation. Abby is supposed to give Annie a cupcake, but she ate it already. So she comes to me for another cupcake loan, and again offers me two cupcakes tomorrow. Again Grandma assures me Abby is owed two cupcakes. But I have done my own research in the meantime, and I discover that the two cupcakes are coming from Madeline. I love her to death, but you can't trust that kid with cupcakes, and I'm quite sure that the two cupcakes will again arrive with all the frosting licked off and some kind of sticky goo all over them. I don't want those cupcakes. So I refuse to make Abby the loan.

What happens? Well, Abby cries. But it is hard to feel bad for Abby because if she hadn't been so impatient she wouldn't need the loan at all. Besides Abby, Annie is crying. She didn't get ANY cupcakes, and she has some right to feel jilted - Abby promised her one and didn't deliver. So Annie is getting hosed in the deal. I kind of could care less - I still have my good cupcake, and that's better than two nasty ones that I have to wait for.

The big problem here is that Annie gets shafted through no fault of her own. Abby caused this problem, but the hang up is that it is my unwillingness to lend her a cupcake that is the proximate cause of Annie crying. And the proximate cause of my unwillingness to lend is the crappy return I'm getting from Madeline.

So who can rectify this situation and how could they do it? The obvious person to turn to in times of crisis is Mom. She has several options

1. Give Annie a cupcake directly (Mom has lots of cupcakes)
2. Give Abby a cupcake directly
   
3. Loan Abby a cupcake for the two nasty ones
4. Give Dad a cupcake
5. Guarantee to Dad that he'll get two good cupcakes tomorrow (taking the nasty ones herself if Maddie messes them up again)
6. Open a bottle of wine and do nothing

So what should she do? If she chooses options 1) or 2), then she is implicitly rewarding Abby for being impatient and eating the cupcake that is supposed to go to Annie in the first place. If she does 3) or 5), then Mom absorbs the "risk" of getting nasty cupcakes herself, and why should Mom be any more willing to eat nasty cupcakes than Dad? If she does 4), there is no guarantee that Dad will use this extra cupcake to make a loan to Abby (and I can assure you I would not - I still don't want nasty cupcakes in return). If she does 6), then Mom absorbs no risk, but she also ensures that Annie gets shafted. Your answer depends crucially on what your ultimate objectives are. If you #1 priority is to make sure Annie stays happy, then you've got to go with 1), 2), 3), or 5).

Alright, this is all kind of contrived, but what relevance does it have to the current situation? Let's take each person and thing in turn and describe who they represent

• The cupcake: Cash or liquidity. The cupcake represents something you can either consume directly, or you can use it to buy things to consume directly.
  
• Annie: The "real" economy where people exchange cash for goods and services. Annie needs the cupcake in order to function. Annie needs cupcakes from Abby in order to finance her activity. Think of a company that needs to make payroll or pay suppliers, but is short on cash. They need a line of credit or a loan - a cupcake. Without it they'll have to lay people off or cancel orders.
• Abby: Investment banks and financial firms. They are in the business of providing liquidity to the real economy, but in their haste to profit from their activities they sometimes just eat the cupcakes themselves.
• Dad: Regular banks. They often work with investment banks and other financial firms to fund their activity (e.g. lend them cupcakes). They are concerned with the quality of assets that they get in return for lending out cash to the other financial firms.
• Grandma: Rating agencies. They are supposed to tell banks whether the assets they are receiving are high quality or not. But they can get fooled by a cute smile and pretty face.
• Madeline: Sub-prime mortgagee's. They probably shouldn't be trusted to deliver quality cupcakes (or regular monthly payments) to their creditors. But their cute smile and pretty face can fool Grandma sometimes.
• Mom: The Fed. Trying to induce something in this system to happen so that the real economy gets the liquidity it needs to function.

So last fall, sub-prime mortgages started to default and miss payments (they delivered gunky cupcakes) at higher rates than rating agencies would have led you to believe (Grandma got duped). This means that the banks which were collecting these payments (Dad) got skittish and started to examine the source of these funds more carefully. The banks decided that the payments were untrustworthy and no longer sufficient collateral for loans to other financial firms (Abby). The financial firms (like Bear Stearns) needed loans, though, to make their payments to other creditors in the real economy (like Annie). When the banks decided to stop lending to the financial firms, the financial firms were not able to keep funding real economic activities (and in fact the banks became wary of lending to "real" economic agents as well). This meant that lines of credit were hard to come by and therefore firms stopped hiring, or laid people off, or canceled orders, or delayed payment on existing orders. This slows down economic activity.

So what has the Fed tried to do? First, they pumped cash into the market by lowering interest rates. Essentially, Mom dumped a dozen cupcakes in Dad's lap. But the problem isn't that Dad didn't have cupcakes to lend, it's that he didn't trust the payments from Madeline (the sub-prime people). So he didn't lend Abby any cupcakes, and Annie was still crying (banks didn't use this cash to lend to financial firms or to real economic agents).

To ensure that the "real" economy continued to get the credit it needed, the Fed had to look to different possibilities. It made a big change in its policy, and started to do several things

• The Fed guaranteed the assets of Bear Stearns so that JP Morgan would bail them out (Mom guaranteed that Dad would receive two good cupcakes, and took on the risk of getting bad cupcakes herself)
• The Fed started to deal directly with financial firms, taking on their lower quality assets in exchange for cash (Mom loaned to Abby directly, in return for the two potentially nasty cupcakes tomorrow)

In doing this, the Fed has absorbed risk. The bad cupcakes are now essentially on the Fed's book, not the financial firms. They did this to make sure that Annie got her cupcake, and the real economy was able to continue to access credit. Now, if it turns out that the sub-prime mortgages are not totally worthless, the Fed could make a profit (if Maddie learns some self-control then Mom will get back two edible cupcakes, or at least cupcakes with most of the frosting still on them). However, the Fed might get saddled with worthless assets (nasty cupcakes).

Should the Fed have done this? That depends on whether you are concerned more with punishing Abby or more with making sure Annie doesn't get shafted. Yes, Abby is probably at the root of this problem, but is it fair that Annie suffers as well to punish Abby? Is it fair that we allow the economy to go into a longer recession, just to make sure the owners of Bear Stearns lose their lunch? This is the dilemma the Fed faces, and they've generally sided with the idea that it is more important to keep credit flowing to the economy than it is to punish the bankers who caused this in the first place. The alternative was higher unemployment and slower growth.

I'm hungry.