On the Contrary

A while back as the housing bubble was deflating, I was listening to a discussion between two rather frugal and conservative friends of mine discussing how if people would have just not taken loans they couldn’t afford, this collapse would have never happened. It was the blame game that we all participate in and sadly it only touched on the final straw that broke the camel’s back, not the whole underlying failure of our system.  There are multiple causes that snowballed in the last ten years but started over 30 years ago.  By the way, there were two recent television shows that touched on all these problems, CNBC’s House of Cards, and Frontline’s Inside the Meltdown for those of you who like your information delivered by video.  The following are all of the contributing factors that built into the perfect storm:

• “Government is the Problem” – Set the stage for an economic climate that believed that either the stockholders or the board of directors would put the brakes on risky investment and thought government regulation just hindered these natural processes
• Arrogance of the Fed – The belief that the Fed can control all booms or busts with monetary policy (print money or raise or lower interest rates).  Said another way, a belief that Depressions are a thing of the past which led to an environment of unbridled risk taking with a belief the Fed will bail them out (Moral Hazard)
• The Unbridled Growth of Private Debt – Between the 1980s and 2006 private debt (the debt you and I hold, not public debt by federal state and local governments) rocketed from less than 150% of GDP to over 335%.  “…credit markets increasingly are being used less to facilitate economic activity and more to leverage bets on changes in asset prices” (Bad Money, Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, Kevin Phillips)
• Financial Sector Expansion – “Goods production lost the 2:1 edge in GDP it had enjoyed in the seventies – In 2005, on the cusp of Greenspan’s retirement, financial services – the new uber-category spanning finance, insurance, and real estate – far exceeded other sectors, totaling over one fifth of GDP against manufacturing’s gaunt shrunken 12 percent” (Bad Money).  Basically we no longer invest in goods and services, but in financial markets.  In essence what we were now importing to the world was securitized debt investments.  This one is really important if you want understand that the real money to be made in the stock market is in debit instruments not in investing in business that make anything
• Fed Policy – Fed policy was instituted such that whenever the market’s rate of growth decreased, monetary policy was used to keep the growth strong, encouraging ever growing bubbles.  Some think that growth needs to be managed around a reasonable amount, with policy focused at deflating bubbles and not allowing them to grow out of control.  This means sometimes we have to force small recessions
• Our Psychology of Wealth Creation – A psychological state in which those who create wealth are “the Masters of the Universe” and the wealth is good by definition because it benefits us all.  Although the reality is that only a few rich have benefited from the growing credit bubble, there is a pervasive attitude that no one should question or interfere with their wealth creation since all wealth creation is good by definition
• Exponential increase of unregulated securitized debt instruments – Creation of debt instruments to package debt and the profits from selling these debt instruments.  This by itself is not bad since it provides money for investment, but the investment was primarily in other debt instruments grossly expanding the credit bubble without sufficient equity (in this case a realistic assessment of the equity backing these loans)
• Lack of Regulation – No regulation of the markets selling these instruments and the multiplier effect of leveraging (using debt to invest) which allowed investments that were leverage 30:1 or greater (thirty dollars of borrowing or every one dollar of your own equity).  The effect of this multiplies the gains when your bet wins, but multiplies your losses when you lose
• Failure to Correctly Evaluate Risk – Risky debt repackaged in CDO’s using faulty risk models that assumed normal distribution on price variations (The Origins of Economic Crises:  Central Banks, Credit Bubbles, and the Efficient Market Fallacy, George Cooper) and did not take into account black swan events. The result was a gaming of the rating system to allow these assets to be improperly rated as AAA.  Basic to this risk model was the assumption that the underlying equity backing up these risky loans, home values, would keep rising forever
• Failure of the Rating Agencies – Rating agencies that were dependent on those they rated for their income and no regulation by the SEC which was a revolving door for the industry
• Credit Default Swaps – Creation of “insurance” called credit default swaps which required no equity backing the insurance and no regulation of their markets.  If the market collapsed, there was no ability to pay these obligations.  You could make these bets even if you didn’t own the stock you were betting on.  Maybe even turning Wall Street into a casino
• Interdependence of all the Banks – With these massive debt and insurance instruments held by almost everyone, based upon housing prices, there was incredible interconnectiveness of the financial institutions so that any default would ripple throughout the industry.  In other words if one institution failed, others would be dragged in
• Greed – Then we get to greed and the idea that greed is good, part of the flow down litany and Masters of the Universe mentality.  In order to continue the amazing profits that were being made by these financial institutions, there was tremendous pressure to keep creating debt so they could repackage it and sell it.  That is when exotic loans for housing really took off
• Risk Transfer – The transfer of risk to the investors relieved the lending agency from holding the loans or being responsible if the loans defaulted. The more loans they issued the more money they made with no risk to them
• Housing Bubble – The belief that housing prices would always rise, allowed almost everyone, even if they couldn’t afford the loan, to take the money thinking they could bail themselves out later if they had to sell.  This is how many of these loans were fostered off on people who had no way to repay
• International Effect – The international impact of this crisis came about because the banks were selling these toxic assets as AAA rated investments and stockholders/voters were demanding more and more return on their investments because everyone else was getting that level of return which leads to the final real straw that broke the camel’s back (bank)
• Group-Think – Finally we have group-think throughout the whole system.  Everyone was making a bundle and everybody wanted a piece of the action.  It is easy to justify what you might consider risky or foolish if everyone around you is making a bundle and you look like a fool for not taking advantage of the easy money.  Anyone who say there is a problem and wanted to put the brakes on, put their institution at risk, not getting the return others were making and were therefore sidelined by their management.  The prevailing mentality was to take the money and run

I probably missed some stuff, but those are the major elements.  So just blaming it on the end of the chain and people who knowingly took risky loans is a grossly oversimplified view of what happened.  Yes, people lacked discipline and good judgment, but that went throughout the system.  If the system was not so tightly interconnected and we now have a world economy, maybe the damage would have been limited.

Alan Greenspan in the Frontline segment, Meltdown, said he thought that this could not happen because the board of directors would recognize the high level of risk and take the appropriate action to limit these risky bets.  They did not and he was troubled by this.  One might ask why he didn’t take the appropriate action.  The answer that he gave when asked was that he could not imagine that this could happen.  It would appear that a lack of imagination not only is fatal in our Iraq policy, but in our economic policy.

But then he said something very interesting.  To paraphrase him, even if this results in a depression, it is still the best system we have devised to create wealth for the majority of players and we will have to learn to live with it even though these contraction will occur again in the future.  I would agree with him although there are important lessons to be learned here.

First on the wealth issue he is correct and also not so much correct.  In China, millions were being pulled up to a middle class standard of living while in our country, the middle class and poor were losing ground.  One possible conclusion is that the capitalist function of manufacturing and exporting of goods works well to expand wealth in society, while the creation of financial instruments and betting on them with leveraged investments only focuses wealth on the wealthy.

Second it is clear that when we enter a bubble, greed clouds our judgment until the “house of cards” collapses (pun intended).  This says that regulation is the only way to stabilize this system.  Somehow sanity must be restored even though everyone is making money.  We thought we learned this lesson after the Great Depression, but most of these rules were cast aside as impeding profit and being out-dated.

One last thought:  In my essay on Marcoeconomics, I raised the point made by George Cooper in his book The Origins of Economic Crises:  Central Banks, Credit Bubbles, and the Efficient Market Fallacy, which is that markets are inherently unstable and maybe the real job of the Central Banks is not only to stop down turns, but to also moderate growth so that bubbles are small and will not have a destructive effect when they are deflated.

It will be interesting in the days to come to see how Republican laissez-fare dogma will argue against the needed change in rules and how the Fed and our banking system should function in the future.  Since they were the ones who mostly benefited from the old failed system, they will try to reinstitute it while reinventing history.  The question is have we learned our lesson and will we let them.

Note:  No I am not an economist and I could have this wrong but I don’t think so.  I think it is critically important that all of us understand what happened because the future of our system rests on us getting it right.  It is not and has never been about who is to blame.  There is plenty to go around.  It is about understanding what happend to prevent it in the future.  As long as we let experts talk and understand for us, we will be forever be at their mercy, thus my attempt to put into words what I understand, probably only for my own benefit.  There is a excellent web site that explains many of these basic concepts called The Baseline Scenario written by real economists.