And now we are sitting here in the middle of the greatest macroeconomic catastrophe since the Great Depression itself, and we economists are all scratching our heads and saying: "what happened?"Go read the whole article. It has much more material that is important to read.
The outline of the story is familiar. We had a global savings glut. We had the rich of the emerging global periphery looking for insurance--in the form of places to park their money where, if something went badly wrong at home, and they had to flee in the Lear Jet or the rubber boat, they could find a bolthole. So they were anxious to park their money in the United States. To an even greater degree, the governments of the periphery were anxious to keep the values of their currencies low so they could keep their exports high to provide employment for the masses moving to Shanghai. They bought up dollar-denominated assets at a furious pace, and then they had to park those dollars somewhere.
The result was a large increase in the demand for safe dollar-denominated assets.
Investment bankers saw this. Investment bankers calculated that if they could produce safe dollar-denominated assets--or even dollar-denominated assets that they could claim were safe without the rating agencies blowing them up--they could make fortunes. And so they turned their financial alchemists at work on the problem of turning risky-mortgage lead into derivative gold. And the financial alchemists took a look at the problem and got out the can of gold spray paint and let loose.
Then the salesmen got to work, saying that this time it was different--that this time the risk was really contained and diversified, and never mind the riskiness of the underlyings, the securities that we are selling you are as good as U.S. Treasury bonds.
And then came the collapse of lending standards. For, after all, if the riskiness of the derivative is not dependent on the riskiness of the underlying because of the financial alchemy, who cares about the riskiness of the underlying? The key is to make the loans and then to spray paint the lead bars with gold--not to make only those loans that pass some quality test.
We economists watched this process. And we economists had worries about Wall Street. But our worries were not about systemic risk arising from subprime.
Some of our worries were about Glass-Steagall repeal. Others were about Fannie Mae. The old Glass-Steagall Act of the Great Depression built this wall between commercial and investments banks. The government was going to guarantee commercial bank deposits and did not want investment bankers then using those deposits toplay the investment banking game of heads we win and tails the government pays. We feared that. But that wasn't the disaster that hit us. It simply was not the case in the 2000s that those post-Glass-Steagall investment banks with large commercial banking deposits were in any sense engaged in riskier behavior than those that had only hot money liabilities. The JP Morgan Chases which had large inertial commercial bank deposits came through in much stronger shape precisely because their funding sources were government guaranteed and so were not hot. The connections of commercial and investment banking were, this time--and I want to stress the "this time" because the theoretical basis for our worries is strong--not the problem.
And Fannie Mae was not the big problem. The worry was that Fannie May would be trading on its implicit government guarantee. It would take on lots and lots of risk because it could do so and yet still attract funds because it had a government guarantee, and then something would go wrong. If we had actually had a Fannie Mae-centered crisis we would be a lot happier right now. It would have worked out like the savings and loan crisis of the 1980s: costly, embarrassing, painful, lots of bills to be paid by taxpayers, but not a macroeconomic disaster because the failure of Fannie Mae would not have induced any other bank failures or any general panicked flight to safety. The unemployment rate in the U.S. rose by only 1.5% as a result of the S&L crisis--not by the more than three times as much it has risen this time.
As the foundations of this crisis were laid, there were always arguments against massive regulatory intervention to deal with it. Those arguments always sounded convincing. The stayed convincing even as the situation transformed itself from a justified boom in long duration assets driven by advances in diversification and by capital inflows pushing down interest rates, to froth, to irrational exuberance, to a full-fledged bubble.
The first argument was: "well it is their money." Countrywide probably knows what it is doing. There are major benefits from diversification and better access to credit. Even if it does not know what it is doing, it isn't the government's job to rescue the investors in Countrywide from the fact their risk controls are not what they ought to be.
Second, Alan Greenspan really is a Randite, really is a follower of Ayn Rand. He really does believe that it is a bad thing to infringe your freedom and protect you from yourself. He really is the kind of person who thinks that it is bad for you if the government keeps you from making stupid investments that cost you all your money. You can ask him--"do you think there should guardrails on the ledge of the Grand Canyon?"--and he might well say no--that there should be warnings, but if grown-ups wish to venture too close to the crumbling edge... they are grown ups, and should not be treated like children.
The third argument was: "who is going to get hurt?" Investors in Countrywide, but they are rich and risk-loving and if they want to build the rest of us houses we should probably say "thank you." And somebody buying a house east of Riverside California with a zero-down, a teaser rate, a pick-what-you-pay mortgage--what they are really doing from an asset-price perspective is renting a house at a below-market rent for three years and being given a free call option on the house. They will be sad if the house price doesn't go up and the call option is not worth exercising. But that is regret. That is not harm: they did still get to live in the house at a low rent for three years. So why should the government step in and keep people from getting these deals if Countrywide wants to provide them?
Fourth, and most important, it is a big political looser for regulators to go before Congress. The Democratic members would whack them: why aren’t you letting my constituents buy the houses they want to buy? The Republican members would whack them: why aren’t you letting my contributors make the loans they want to make?" That’s a very unpleasant position for a regulator to be in--when both Republicans and Democrats agree that you are an ass.
Fifth, there was the fact that the old framework for lending locked lots of people out of the real estate asset class, and a belief that we should be experimenting with new ways to get money to people who want it to make investments--that we should be trying to broaden the access of the poorer half of Americans to high-return investment vehicles.
Most important, however, was the overall belief on the part of the regulators that they could handle it. Subprime was a small asset class in the global economy. The Federal Reserve was powerful. Whatever stupid things financial markets did, the Federal Reserve could clean up the mess afterwards and build firewalls between finance and the real economy so that we would not suffer from high unemployment and a deep recession. The Federal Reserve had handled it in 1987 with the stock market's Black Monday, had handled it in 1991 with the Savings and Loan crisis, had handled it 1995 with the Mexican crisis, in 1997 with Malaysian crisis, in 1998 with the triple crisis--the Korean crisis, the state bankruptcy of Russia as it became clear that just because you were a nuclear armed ex superpower that did not mean the IMF thought you were too big to fail. the bankruptcy of the largest hedge fund in the world, LTCM. We had the 2001 collapse of the dot-com bubble. And in every single case we managed to handle it: contain systemic risk, stabilize the financial system, and avoid a deep recession.
We did worry back in the mid-2000s. But what we worried about was the dollar crisis. What happens when the Chinese government suddenly decides it wants to sell some of its dollar-denominated asset holdings and the dollar falls by 40% in a month--or when European investors decide that the Chinese government is about to sell some of its dollar-denominated asset holdings and the dollar falls by 40% in a month? I remember back in 2005 a bunch of us quizzing then-New York Fed President Tim Geithner in the wilds of Grand Teton National Park about how he was guarding against the next financial crisis. We asked a lot of questions about the dollar and global imbalances. We asked no questions about subprime--it was, we thought, too small to pose any systemic risk.
Even in the spring of 2008, when I was a worrywort, the general line was that all the losses in subprime mortgages had a maximum value of $500 billion in a global economy with an $80 trillion asset base. A loss of $500 billion out of a total of $80 trillion is not, should not be the kind of thing that could set the whole financial system on fire. It is one eighth the size of the dot-com crash. It is one fifth of the size of Black Monday in 1987 on the stock market. And there were all these fancy derivative securities associated with subprime mortgages to spread the risks associated with holding them all over the world and to keep them from being concentrated in the large and highly leveraged money center banks.
But they were concentrated: the derivative securities didn’t spread risk, they concentrated it.
There was regulatory arbitrage: banks decided that now that we’ve gotten Moody’s to rate this security as AAA we might as well hold them as if they were AAA. And it turned out that the banks themselves did not have any idea what their risks were. CEOs would ask if they were hedged against subprime right. Subordinates would say: "Right, chief, we are." And the subordinates would lie.
So we had the crisis, and the collapse. We had the subprime losses. We had the general panic as everybody feared that the large highly-leveraged money-center banks' debt was no good because they held a lot of subprime and their subprime losses had eaten through their capital. And we had a bigger panic as people feared other things that might go wrong--the same financial establishment that had no clue what risks they were running in subprime probably had other points of vulnerability as well. All confidence that the highly-trained and highly-compensated risk management professionals on Wall Street knew what they were doing evaporated.
It was the standard story.
It was the story that we have seen over and over again since 1825.
As my old teacher Charlie Kindleberger liked to describe it: panic, revulsion, and discredit. Nobody trusts anybody else’s paper. Everybody stops spending on currently-produced goods and services to build up their holdings of safe assets. But because one person's spending is another person's income, stopping spending stops income too--so there is no buildup of safe assets but rather a fall in demand, production, employment, and incomes that further increases risk and further increases people's desire to cut back on spending in order to build up their safe asset stocks. The result is the deepest downturn in the post World War II era, and a painfully slow recovery since.
Now, this downturn is not nearly as bad as it could have been. Kevin O'Rourke and Barry Eichengreen point out that the 2008 shock to the world economy was bigger than the 1929 shock. In 1933 our unemployment rate kissed 23%, and our nonfarm unemployment rate kissed 28%. This time the unemployment rate only kissed 10%. The nonfarm unemployment rate didn’t get anywhere near the 28% of the great depression, it didn’t get anywhere near the 16 or 17% that Allan Blinder and Mark Zandi calculate would have been the peak unemployment rate had the government followed ineffective and counterproductive Herbert Hoover policies.
I think that if you could go to Tim Geithner get him to tell you what he thinks, he would say that a 10% unemployment peak is not a good thing but it is not 17%, and it is definitely not 28%. He would say that he and his peers have done a lot better job at handling this than their predecessors 80 years ago did handling their problem.
And he would be right.
But now we have a stubbornly persistent slump in the economy. Now we have economic growth at about our normal long-run pace, with very little signs of closing the gap between the productive capacity of the American economy and its current level of production. We have a Washington DC that is dysfunctional--out of ammunition to take any effective additional steps to boost the economy. There is now substantial fear of inflation--even though there are no signs of inflation gathering anywhere rather than energy and food prices, and we understand that those reflect China’s growing demand and not any domestic price spiral. There is now substantial fear of crowding out--that boosting US government spending or cutting taxes to get more money into the hands of the consumers would discourage private investment even though there are no signs of crowding out even at our rapidly-growing level of the national debt. It is a fact that a bunch of us--including me--think that there really should be signs of crowding out right now--that financial markets should be scared of the fiscal future of America--but they are not. And there is the problem that Washington DC has degenerated into pure Dingbat Kabuki theater on lots of levels.
It is a fact that if congress simply goes home--doesn’t do anything for the next 10 years except keep the federal government on autopilot, or if it does do things if it pays for whatever increases in spending it enacts by raising taxes and pays for whatever tax cuts it enacts by cutting spending--that we do not have a long run deficit problem. If congress goes home for ten years our program spending is matched to our tax revenues, which means a declining debt burden because the growth rate of the economy is larger than the interest rate on our debt.
Our belief that we have a long-run deficit problem is based upon the belief that congress will pass laws that increase spending and that cut taxes--that it will repeal the Independent Payment Authorization Board's authority to try to make Medicare more efficient, that it will repeal the Affordable Care Act's tax on high-cost health plans. Given that the fear is based on a belief that some future congress will bust the budget, it is hard to see how we can address this fear through any possible piece of legislation today--for no congress can bind its successors.
Sadly the Washington politicians are off chasing "inflation" and "debt/deficit" worries when they should be focusing on the primary and very serious problem with the US economy: unemployment! They should be working hard to get growth up to a level that can close the output gap between where the economy would be following historical growth rates and the rut it fell into because of the 2008 banking panic.
Here is what the Washington politicians should be focusing upon with a laser-like beam:
And so we are in trouble: right now there are no signs that the economy is crawling up back to anything like full employment on its own.But they aren't. They clearly don't understand economics and they are not relying on impartial economists for advice. They are relying on money under the table from Wall Street lobbying and from "advice" from ideologues busy selling lies as "scientific truth".
Back when I started in this business, back in the Spring of 1980, I had as teachers two of the smartest men I have ever known: Marty Feldstein and Olivier Blanchard. They taught that John Maynard Keynes had feared that if the economy got itself wedged into a situation of high unemployment that it would never recover by itself--that it would settle into an "underemployment equilibrium." It would need some large positive shock--either a wave of business exuberance, either rational or irrational, or activist stimulative monetary, banking, and/or fiscal policy on the part of government in order to knock unemployment down and employment back up to where it ought to be. Back in 1980 they said that we economists had learned that the market system worked better than that, and that there were substantial equilibrium-restoring forces in the world economy.
But look at the U.S. labor market over the past two years. Those forces are not there. There are no signs that the share of American adults with jobs has been growing, or is about to start growing. Ben Bernanke and Barack Obama both like to talk about how the unemployment rate is falling. But all of the decline in the unemployment rate has come from the fact that people have been dropping out of the labor force. None of it has come from any increase in the share of the adult population with jobs.
That suggests, to me, that we fact a very long slog. The economy will grow, but we won’t close the gap between actual and potential output. We will not for a long time to come get back to the 62 to 64% of the adult population having jobs that we thought was normal back in the decades of the 2000.
And that is the depressing overall macroeconomic picture.