The economic historian Anna Schwartz has described the recent housing bubble as a classic “mania.” She observes that, while the details change in each historical episode, in this case as in others “the basic propagator was too-easy monetary policy and too-low interest rates.”1 In the housing boom, easy money and cheap credit financed an unsustainable increase in investment in residential real estate. Especially in the hottest real estate markets, buying took on a frenzied aspect.
Here, I will first present a brief history of the current economic crisis. Financial services are highly regulated, yet the regulatory system failed. Then, I offer a diagnosis of the crisis, focusing on the issue of the capital position of banks and other financial institutions. Finally, I consider the way forward and the prospects for a return to a sound financial system and a healthy economy.
Origins of the Crisis
During the run-up in home prices, credit was easy, whether measured by its price or by its terms. The nation’s central bank, the Federal Reserve System, pegs the Fed funds rate that banks charge each other for the overnight loans of reserves used to fund loans to the public. From November 2001 to December 2004 the Fed funds rate was at or below 2 percent. From June 2003 to June 2004 the rate remained at 1 percent. For much of this period, real (inflation-adjusted) short-term rates of interest were negative. In other words, amounts of money to be repaid in the future would be worth less than what was borrowed due to inflation. It literally paid to borrow money, especially to finance an appreciating asset like residential housing in overheated markets in California, Nevada, Arizona, and Florida.
Professor John Taylor of Stanford University has argued that the Fed pushed short-term interest rates below levels predicted by an economic model of monetary policy based on historical patterns (the “Taylor Rule”).2 This episode of easy credit can also be put in historical perspective. There was no central bank in the United States until 1913. But the Bank of England was founded in 1694. After the end of the Napoleonic wars and postwar economic recovery, Great Britain enjoyed nearly a century of peace and prosperity under the gold standard, free international trade, and free movements of capital. It was the Pax Britannica. Prices ended the period roughly where they began.
What was Britain’s Bank Rate (the rough equivalent of today’s Fed funds rate)? In June 1822, it was 4 percent, and on July 30, 1914, the eve of the First World War, the Bank Rate was 4 percent. At no point in this remarkable period did the Bank Rate ever fall below 2 percent.3 For the Fed to have set rates so low for so long flew in the face of historical experience and common sense.
There is no rigid relationship between the Fed funds rate and long-term interest rates. But the housing boom was not financed with long-term funds. The days of thirty-year fixed-rate mortgages financed with long-term money were over. There were one-year adjustable-rate mortgages (ARMs) with “teaser rates” for the first two or three years of a mortgage, which were set artificially low and then reset. Many mortgages were packaged into securities sold to the public. Financial intermediaries (banks, thrifts, and mortgage companies) held the underlying mortgages only for a short period. Later, the same institutions sometimes bought some of the securities for their own portfolios.
Meanwhile, financial intermediaries borrowed short-term money in order to lend it longer-term. That practice exposes investors to the risk that they will not be able to refinance their borrowings, or will be able to do so only at higher interest rates. The interest rates on their securities remain fixed, resulting in losses for the financial intermediaries. The short-term borrowing to finance long-term lending was reminiscent of the first phase of the savings and loan (S&L) crisis of the 1980s. The subsequent bad loans on banks’ books remind one of the second phase of the S&L crisis.
In sum, funding was at shorter and shorter maturities with interest rates heavily influenced by the Fed funds rate. Reportedly, some investment banks rolled over 25percent of their funding every night. That funding would have been extremely sensitive to changes in the Fed funds rate. Five year money came to be considered “long term” during the housing boom.
As a result, it became easier and easier for individuals to qualify for a residential mortgage. Down payments became smaller or even effectively disappeared. In turn, rating agencies apparently eased the requirements for what constituted a AAA mortgage-backed security.4 Numerous public policy initiatives contributed to the easing of the terms of mortgages, and these policy initiatives fueled the rising home prices. These included various programs to make mortgages “affordable,” thereby boosting demand. Meanwhile, other programs, such as “smart growth” policies, restricted the supply of housing. Easy credit stimulated the demand for housing, and smart growth policies restricted the supply. Together, these policies boosted housing prices to unsustainable levels.5
The boom phase ended when the Fed began raising interest rates. Housing prices first stopped rising in 2006 and then began declining. Mortgages started going into arrears, and homeowners walked away from their speculatively purchased homes. Many had no equity in their homes, and the fall in prices put them “underwater”: their mortgage balance exceeded the value of their home.
As mortgage payments slowed, the value of mortgage-backed securities declined precipitously. That created the shock to the balance sheets of individuals and financial institutions. A balance sheet measures the assets and liabilities of individuals and firms. The difference (if positive) is their net worth or wealth position. The balance sheet shocks came first to heavily indebted homeowners caught up in the housing bubble; then to the institutions that financed the housing bubble directly or through their purchase of securities whose values were tied to mortgages; and finally to the general public whose savings were destroyed in the ensuing financial meltdown. Declining spending was a consequence of the balance sheet shock. The economy slid into recession (negative economic growth) at the end of 2008.
For banks, the balance sheet shocks led to capital impairment and diminished capacity to make fresh loans. On a bank’s balance sheet, capital absorbs losses on loans and investments. When capital falls below safe levels, banks cannot afford to make new loans or buy fresh securities because they no longer have a cushion against future losses. Indeed, desired capital ratios are counter-cyclical, rising in economic downturns.
Capital is vital for banks and other financial institutions. Capital is the difference in the value of the assets and liabilities of a bank. It is a cushion against losses on loans and investments, ensuring that banks can sustain some losses and yet remain viable. For regulated financial institutions like banks, capital ratios are set by law and regulation. In the crisis period, required capital ratios became doubly redundant. For impaired institutions, they simply could not be enforced. For those institutions that could raise capital, the desired capital ratio would exceed regulatory minimums. Markets compel the prudence in lending in down cycles that regulators dare not impose in booms.
Bad loans are made in good times, however, and it is in booms that prudent supervision over capital and lending standards is most needed. We know from history, however, that regulatory stringency is also counter-cyclical, declining in good times and rising in bad times. Financial services regulation has become dysfunctional, regardless of one’s attitude towards government regulation in theory.
Even under a limited regulatory regime, the state is expected to provide protection against fraud. Yet every day there are fresh reports of fraud having occurred in the housing and mortgage markets. Thomas Ferguson and Robert Johnson examined the failure of regulators—especially the Fed—to deal with evident fraud in mortgage lending during the housing boom.6 Even senior Federal Reserve officials acknowledge regulatory shortcomings. As Dallas Fed president Richard Fisher has said, “The regulators didn’t do their job, including the Federal Reserve.”7
The primary mission of bank regulatory agencies is to protect the safety and soundness of the banking system. These agencies include the Fed, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and state banking agencies.
The Securities and Exchange Commission oversees public companies generally and investment banks in particular. On the homepage of the Securities and Exchange Commission, a visitor can click on “What We Do” and be told the following: “The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” 8 Along with the other financial services regulatory agencies, the SEC utterly failed in its stated mission. The Lehman failure, the forced mergers of Bear Stearns and Merrill Lynch, the failures and mergers of Wachovia and Washington Mutual, the AIG debacle, and the Madoff scandal are only the tip of the iceberg of regulatory failure.
This sorry record is one predicted by public choice theory: regulatory agencies are captured by the industries they regulate. Willem Buiter observes that “capture occurs when bureaucrats, regulators, judges or politicians, instead of serving the public interest as they are mandated to do, end up acting systematically to favor specific vested interests—often the very interests they were supposed to control or restrain in the public interest.”9
To suppose the contrary would be to adopt what James Buchanan described as “a romantic and illusory theory” of politics, in which government officials selflessly act for the public good rather than for their own private interests.10 Those advocating enhanced regulation in response to the current crisis must therefore explain why we should expect a reformed system to work any better in the future. Specifically, a regulatory system in the public interest must be designed to be incentive-compatible. The actual flesh-and-blood human beings doing the regulation must have an incentive to act in the public interest, rather than to capitulate to the demands of the regulated firms. That has not been true for financial services for a long time.
The bailouts of financial firms using taxpayer money speak loudly to the question of cui bono. The Treasury has announced that the nineteen largest financial firms will not be permitted to fail. It appears that taxpayer support of those firms has no limits. This is the very essence of crony capitalism: the use of public monies by government officials to the advantage of favored private interests. In such a system, profits are privatized, and losses are socialized. It is far from a free market. Capitalism without failure is like religion without sin. It doesn’t work.
A great deal has been written about the failure of markets and capitalism in the current crisis. But the failure is at least as much one of government and government regulation. The financial system is one of the most highly regulated parts of the economy (as the extensive listing of regulatory agencies suggests). Yet the regulatory system failed in its mission of preserving the integrity of financial services firms and protecting the consumer.
Diagnosing the Crisis
The housing boom was a classic credit induced bubble: an unsustainable rise in asset prices. It exemplified the bubbles already familiar to economists by the nineteenth century. Economists developed an analysis of these booms and busts that came to be known as business cycle theory. Joseph Schumpeter noted the “pivotal importance” of the fact that “constructional” (construction-related) industries exhibit relatively greater volatility over business cycles than producers of consumer goods. Public figures have repeatedly spoken of the “unprecedented” nature of the current crisis, but the volatility of capital goods, and especially “constructional” industries, was already a commonplace among economists by the end of the nineteenth century.11
The prices of long-lived capital are especially sensitive to changes in the real (inflation-adjusted) rate of interest. The value of future events—income, benefits, or costs—is smaller than that of present events. The future is discounted by interest rates to a present value. The future flows of income or other valuable services (such as housing services) become more valuable as interest rates fall. The lower the rate, the lower the discount for future events.
The prices of long-lived capital, including housing, thus tend to rise in eras of low real interest rates. (The reverse is also true.) As we have seen, there was a sustained period of historically low interest rates for a crucial three-year period that fueled the housing boom and a corresponding stock market bubble.
Fearing the onset of price inflation, the Fed began raising the Fed funds rate in June 2004. At their December 2004 meeting, the Federal Open Market Committee (FOMC) raised the target for the Fed funds rate to 2.25 percent. That was the first time the rate had topped 2 percent since the October 2001 meeting. In a series of steps, the FOMC continued raising the target until it peaked at 5.25 percent at the June 2006 meeting. Thus, in the course of two years, the FOMC had raised the Fed funds rate from 1 percent to 5.25 percent. Not surprisingly, the housing bubble then burst, and a financial crisis ensued.
The current crisis is both a classic financial crisis and a deep recession. There has been a panic quality to the crisis. There have been runs on bank deposits and runs on the commercial paper of some issuers. I have emphasized the balance sheet aspects of the crisis because policymakers have systematically misidentified the problem as one of liquidity.
Liquidity and Capital Impairment
Liquidity is a term of art signifying ready funds that can be quickly spent. Cash and cash equivalents, such as short-term securities of high quality, are the most liquid assets. Individuals and corporations in some cases found themselves illiquid. The ability to borrow at reasonable interest rates can be a substitute for liquid assets. That ability depends, of course, on others’ having liquid assets to lend.
In the current crisis there have been liquidity “events,” as in the drying up of finance through commercial paper for Lehman that led to that bank’s quick collapse. Other commercial paper issuers have had less life-threatening periods of difficulty raising short-term funds. Since deposit insurance limits were raised to $250,000 per insured account, banks have had no reported difficulties funding themselves through deposits. It is now the creditworthiness of the federal government, not that of the individual bank, that matters. Thus far the government’s creditworthiness has held up.
If markets doubt the value of assets on an institution’s books, they will either not supply funds or do so for shorter and shorter durations and at higher and higher interest rates. Capital impairment is the real culprit in the crisis, but policymakers have perceived it to be a liquidity problem. Only additional capital, not more liquidity, can resolve the problem. That is why the TARP, as originally conceived, was misguided. It was aimed at providing liquidity, not capital. And this is also why all the Fed’s credit programs to date have had limited success, at best.
Government provision of capital to banks, as occurred in the Depression era Reconstruction Finance Corporation, could, in principle, have helped. The actual provision of capital to banks by the Bush and Obama administrations did not follow the RFC model and was bungled. Institutions should have been “stress-tested” before receiving capital injections, not after. Failing that, there was no way to determine how much capital the banks actually needed. There was no determination of which banks were hopelessly under-capitalized and needed to be closed.
The multiple injections of government money into the same institutions (as with Citigroup and Bank of America) are evidence that insufficient funds were provided initially. Whether the new requirements for some banks to raise fresh capital will suffice depends on whether the Treasury’s stress-testing of banks was severe enough. On that, there is conflicting evidence.12
Fed chairman Ben Bernanke reminds us that he studied the Great Depression of the 1930s, but he evidently learned the wrong lessons. Providing liquidity is a tonic for a squeeze in short-term credit markets. The Depression began with that problem, and its severity would have been mitigated by providing liquidity (i.e., by monetary expansion rather than contraction). That was the correct lesson.
But in the case of the Great Depression there was monetary contraction and an economic downturn that turned into a depression. Then there was a series of banking panics. The banking system was stabilized not by Fed action, but by the eventual recapitalization of the remaining institutions. That is where the RFC played a role by providing capital to banks and other fi rms. Capital-starved institutions need capital, not loans. In fact, the RFC started as a lending program and was unsuccessful until it was converted into a capital provider.13
I am not suggesting by any means that public provision of capital is to be preferred over private provision. I am arguing, however, that the public-policy response to the current crisis has generally been ill-conceived and has failed to learn from historical experience in our own country. Again, the public policy of both the Bush and Obama administrations appears to have been more focused on protecting particular private interests rather than the public interest.
For the most part, the Fed has been doing two things. First, through its many special credit facilities, it has been conducting fiscal policy through credit allocation. Second, it has provided massive injections of liquidity to financial markets (“open-market” operations). These liquidity injections have done little to relieve the holes in the banks’ balance sheets, but they have created the potential for inflation down the road.
Easy credit and regulatory forbearance fueled the housing boom. Easy credit and regulatory forbearance is not the solution to the bust. The recession and financial crisis in which we still find ourselves is the result of a credit-induced housing boom, which, in turn, fueled a consumption bubble. Households and firms were left over indebted. The solution to that is a restoration of balance sheets across the economy through higher savings rates.
By consuming a lower proportion of income for a time, individuals and families accumulate funds to replenish their lost wealth. Additionally, the crisis has provided a valuable lesson: households need savings to weather financial storms. Houses are not liquid assets, and a home is not an ATM machine. Having equity in a house is not a substitute for having money in the bank.
It would not be surprising to see the personal savings rate rebound from near zero to a more traditional level of 6 to 8 percent of personal income. As this is being written, it appears that consumers are in the process of making that adjustment. 14 The recent very low savings rate was a byproduct of the housing bubble and should vanish with it.15
Consumers and businesses are attempting to save more but are being frustrated by public policy. Almost everything the Treasury and Fed have done is designed to stimulate spending through debt creation, while more savings and further debt reduction are the needed remedies. This is what is known as de-leveraging. Additionally, the U.S. deficits and accumulating debt threaten America’s future.16
If the government wanted to do something constructive, it should have permanently reduced taxes by cutting marginal tax rates. Only permanent tax cuts provide substantial and enduring benefits. Temporary tax cuts have only a fleeting and comparatively small effect on the economy. John Taylor examined the specific case of the Economic Stimulus Act of 2008 (passed in February of that year), which sent rebate checks totaling $100 billion to individuals and families. He concluded that “the rebates caused no statistically signify cant increase in consumption.”17
Lawrence Lindsey proposed instead a permanent halving of the payroll tax. He estimated the direct revenue effects at $400 billion. The cut would have an immediate impact on households—with the very first paycheck—and help households restore their balance sheets. By lowering labor costs, the policy would encourage hiring. There are plenty of bold tax cuts with immediate, positive effects that could have been implemented.18
Government programs to prop up home prices have been half-hearted and ineffective overall, and mercifully so. Falling home prices are not the problem, but the solution, to the housing bust. In the bursting of an asset bubble, prices can go into what can appear to be a free fall.
What eventually stops the fall is that, at some point, asset prices decline so much that speculators are tempted by the prospect of abnormally high future rates of return from holding the asset. In the case of housing, that includes, importantly, first-time home buyers. The decline in home prices can clear the market in less time than normal home-buying would take to work off excess inventories of homes. If markets are left to operate freely, then the speculative forces that contributed to the boom can help halt the bust. A recent report chronicled the market forces at work in the Phoenix real estate market. A 50 percent drop in home prices there has attracted speculative buyers from as far away as Canada.19 Anecdotal evidence and some sales data suggest that the process is also at work in various local real estate markets, including the Bay Area and Reno, Nevada.
Some analysts have argued that allowing asset markets to clear will result in the “undershooting” of prices. Prices will fall more than necessary, causing needless losses. That argument misconstrues the purposes of markets and the capabilities of pricing models. We lack the information to know when prices are “undershooting.” It is only by actual transactions that price movements produce the information that investors use to make calculations of expected profits. Only when the successful entrepreneurs book extraordinary profits do we know—after the fact—that most investors were overlooking profitable opportunities. Those analysts who are sure markets have mispriced homes should put some skin in the game and start buying.
To end an asset bust, there is no alternative to allowing prices for the asset to decline to the point that new buyers are attracted into the market for those assets. That is true whether we are talking about housing markets, which are localized, or global securities markets.
The Way Forward
In the current crisis we have had repeated misdiagnoses of the nature of the problem and poorly prescribed remedies. The actual economic problems have gone un- treated and correct treatments thwarted. The policy responses of the Bush/Obama regimes are as far off the mark as many of those implemented in the Hoover/Roosevelt Great Depression.
The way forward must include reliance on the innovative spirit of Americans and the resilience of their economy. Government can implement good policies but, in the absence of that, “do no harm” must be the guiding principle. A great deal of harm has already been done by the response of the Bush and Obama administrations.
President Obama’s advisers claim to be following the policy prescriptions of Keynesian economics: spend and run deficits. That response is particularly ill suited to the current crisis. The current crisis is at root not one of an aggregate demand failure, but a balance-sheet shock brought on by a credit-induced housing boom and subsequent bust.20 The housing boom was fi nanced by a complex array of securities and other fi nancial products. In many cases, the fi nancial products were poorly designed.21 In any case, their value was severely compromised when the housing boom ended, i.e., once housing prices stopped rising.
Financial stability and economic growth will come again after the bursting of the asset bubble has run its course, savings have increased, and balance sheets have been restored. Easy credit and stimulus to consumption (for which most government spending is designed) are counter-productive for the adjustment process. Moreover, easy credit risks infl ating another bubble.
- Brian M. Carney, “Bernanke Is Fighting the Last War,” interview with Anna Schwartz, Wall Street Journal, October 18–19, 2008.
- John B. Taylor, Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis(Palo Alto, CA: Hoover Institution Press, 2009), 1–11.
- For the historical series, go to: http://www.bankofengland.co.uk/statistics/rates/baserate.pdf.
- Gary Gorton, “The Panic of 2007,” National Bureau of Economic Research Working Paper, no. 14358. Available at: http://www.nber.org/papers/w14358.
- Thomas Sowell, The Housing Boom and Bust(New York: Basic Books, 2009).
- Thomas Ferguson and Robert Johnson, “Too Big to Fail: The ‘Paulson Put,’ Presidential Politics, and the Global Financial Meltdown, Part 1: From Shadow Financial System to Shadow Bailout,” International Journal of Political Economy38 (Spring 2009): 3–34.
- Mary Anastasia O’Grady, “Don’t Monetize the Debt,” interview with Richard Fisher, Wall Street Journal, May 23–24, 2009.
- Willem H. Buiter, “Central Banks and Financial Crises,” paper presented at the Federal Reserve Bank of Kansas City symposium on “Maintaining Stability in a Changing Financial System” in Jackson Hole, WY, August 21–23, 2008.
- James M. Buchanan, “Politics without Romance: A Sketch of Public Choice Theory and Its Normative Implications,” in The Collected Works of James M. Buchanan, Vol. I: The Logical Foundations of Constitutional Liberty(Indianapolis: Liberty Fund, 2003), 46.
- Joseph A. Schumpeter, History of Economic Analysis(Oxford: Oxford University Press, 1954), 1126 and 1126n8.
- Ken Beauchemin and Brent Meyer, “How Realistic Were the Economic Forecasts Used in the Stress Tests?” Economic Trends, Federal Reserve Bank of Cleveland (May 2009): 28–30. Available at: http://www.clevelandfed.org/research/trends/2009/0509/ET_may09.pdf.
- Walker Todd, “History and Rationales for the Reconstruction Finance Corporation,” Quarterly Review of the Cleveland Federal Reserve Bank28, no. 1 (Quarter 1, 1992): 22–35. Available at: http://www.clevelandfed.org/research/review/1992/92-q4-todd.pdf.
- Kelly Evans, “Americans Save More, Amid Rising Confi dence,” Wall Street Journal, June 27–28, 2009.
- The personal savings rate from 1959 to early 2009 can be found at http://research.stlouisfed.org/fred2/data/PSAVERT.txt.
- John Taylor, “Exploding debt threatens America,” Financial Times, May 26, 2009.
- Taylor, Getting Off Track, 21.
- Lawrence Lindsey, “Not All Stimuli Are Created Equal,” Weekly Standard, January 5, 2009.
- David Streitfeld, “Amid Housing Bust, Phoenix Begins a New Frenzy,” New York Times, May 24, 2009. Available at: http://www.nytimes.com/2009/05/24/business/24phoenix. html?_r=28th&emc=th.
- Axel Leijonhufvud, “Wicksell, Hayek, Keynes, Friedman: Whom Should We Follow?” paper presented at the Special Meeting of the Mont Pelérin Society, “The End of Globalizing Capitalism? Classical Liberal Responses to the Global Financial Crisis,” New York City, March 5–7, 2009.
- Gorton, “The Panic of 2007.”