Category Archives: Causes

The Importance of Capital Requirements

Arnold Kling of EconLog has done the hard work of setting out his theory of the financial crisis and what we should learn from it in a fifty-page but highly readable paper available here. I have some quibbles but think it is  worth a read.

Here are the causes of the crisis in one table:

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Causes: Too Much Debt

Menzie Chinn, one of my favorite bloggers, and Jeffry Frieden have a short and highly readable article up on the causes of the financial crisis. Chinn is not given to ideological ranting and is a great believer in actually looking at data, so I place significant weight in what he says.

Chinn and Frieden place the emphasis on excessive American borrowing, by both the public and private sectors.

This disaster is, in our view, merely the most recent example of a “capital flow cycle,” in which foreign capital floods a country, stimulates an economic boom, encourages financial leveraging and risk taking, and eventually culminates in a crash.

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Guest Post: Too-Big-To-Fail and Three Other Narratives

This guest post is contributed by StatsGuy, one of our regular commenters. I invited him to write the post in response to this comment, but regular readers are sure to have read many of his other contributions. There is a lot here, so I recommend making a cup of tea or coffee before starting to read.

In September, the first Baseline Scenario entered the scene with a frightening portrait of the world economy that focused on systemic risk, self-fulfilling speculative credit runs, and a massive liquidity shock that could rapidly travel globally and cause contagion even in places where economic fundamentals were strong.

Baseline identified the Fed’s response to Lehman as a “dramatic and damaging reversal of policy”, and offered major recommendations that focused on four basic efforts: FDIC insurance, a credible US backstop to major institutions, stimulus (combined with recapitalizing banks), and a housing stabilization plan.

Moral hazard was acknowledged, but not given center stage, with the following conclusion: “In a short-term crisis of this nature, moral hazard is not the preeminent concern.  But we also agree that, in designing the financial system that emerges from the current situation, we should work from the premise that moral hazard will be important in regulated financial institutions.”

Over time, and as the crisis has passed from an acute to a chronic phase, the focus of Baseline has increasingly shifted toward the problem of “Too Big To Fail”.  The arguments behind this narrative are laid out in several places: Big and Small; What Next for Banks; Atlantic Article.

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The Next Big Hearing? (Bill Moyers Tonight)

Bill Moyers asked me to join his conversation this week with Michael Perino – a law professor and expert on securities law – who is working on a detailed history of the 1932-33 “Pecora Hearings,” which uncovered wrongdoing on Wall Street and laid the foundation for major legislation that reformed banking and the stock market.

My role was to talk about potential parallels betweeen the situation in the early 1930s and today, and together we argued out whether the Pecora Hearings could or should be considered a model for today.

Bill has a great sense of timing.  On Wednesday night the Senate passed, by a vote of 92-4, a measure that would create an independent commission to investigate the causes of our current economic crisis; we taped our discussion on Thursday morning.  In the usual format of Bill’s show, a segment of this kind would be 20+ minutes, but I believe that tonight our conversation will occupy the full hour (airs at 9pm in most markets; available on the web from about 10pm). Continue reading

Pointing Fingers

Adam Davidson at Planet Money recently asked, “Who Do We Blame?” Which, I think, is a perfectly legitimate question. While the most important things are getting ourselves out of this crisis and reducing the chances of another one happening, asking who is at fault for this one is a reasonable exercise, for at least two reasons: first, it responds to our basic human curiosity; second, since many of the parties involved care only about their reputations (Bush, Clinton, Greenspan, Paulson, etc. have enough money for several lifetimes), going after people’s reputations is one of the few ways to create some measure of accountability. Politicians who inveigh against “pointing fingers” usually have something to hide.

I started writing a comment on the Planet Money thread, but they have a character limit on comments, and it’s hard for me to write anything in fewer than 1250 characters. So I emailed them my response and, what do you know, they put it up as a post on their blog. To save you any suspense, I think that if you are going to blame any individual (as opposed to, say, a whole category of activity, like “lax loan underwriting”), it should be Alan Greenspan, for reasons described further in that post.

Update: My friend Dave Sohigian blames an entire generation.

Causes: Economics

We are not short of causes for our current economic crisis.  The basic machinery of capitalism, including the process of making loans, did not work as it was supposed to.  Capital flows around the world proved much more destabilizing than even before (and we’ve seen some damaging capital flows over the past 200 years.)  And there are plenty of distinguished individuals with something to answer for, including anyone who thought they understood risk and how to manage it.

But perhaps the real problem lies even deeper, for example, either with a natural human tendency towards bubbles  or with how we think about the world.  All of our thinking about the economy – a vast abstract concept – has to be in some form of model, with or without mathematics.  And we should listen when a leading expert on a large set of influential models says (1) they are broken, and (2) this helped cause the crisis and – unless fixed – will lead to further instability down the road.

This is an important part of what my colleague, Daron Acemoglu, is saying in a new essay, “The Crisis of 2008: Structural Lessons for and from Economics.”  (If you like to check intellectual credentials, start here and if you don’t understand what I mean about models, look at his new book.)  To me there are three major points in his essay. Continue reading

Causes: Hank Paulson

Other posts in this occasional series.

I generally prefer systemic explanations for events, but it is obviously worthwhile to complement this with a careful study of key individuals. And in the current crisis, no individual is as interesting or as puzzling as Hank Paulson.

The big question must be: How could a person with so much market experience be repeatedly at the center of such major misunderstandings regarding the markets, and how could his team – stuffed full of people like him – struggle so much to communicate what they were doing and why?

Hank Paulson’s exit interview with the Financial Times contains some potential answers but also generates some new puzzles.

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Causes: Econbrowser Speaks

Other posts in this occasional series.

As you might imagine, I read (or skim) a lot of economics blogs. One of my favorites is Econbrowser, written by James Hamilton and Menzie Chinn. Whereas many blogs tell me good ideas that I didn’t think of but that theoretically I might have come up with (given infinite time and mental alertness), Econbrowser almost invariably teaches me something I absolutely couldn’t have known beforehand.

In the last week, both Hamilton and Chinn have written about the causes of the current economic crisis.

Menzie Chinn

For Chinn, the current situation was created by a “toxic mixture” of:

  • Monetary policy
  • Deregulation
  • Criminal activity and regulatory disarmament
  • Tax cuts and fiscal profligacy
  • Tax policy

He thinks that lax monetary policy was not particularly significant (or, more specifically, the policy was not lax given the information available at the time). He says that some examples of deregulation were more significant than others (repealing Glass-Steagall OK, the Commodity Futures Modernization Act not so much, which is the distinction I also made in an earlier post). Deregulation bleeds into the third point – the abandonment of regulatory agencies of their policing functions, along with examples where regulators committed actual fraud to aid the companies they were supposedly regulating (IndyMac being the prime example).

But the last two points are the ones you don’t hear a lot about. The Bush tax cuts fueled the asset price bubble, especially the second one (in 2003), which came long after the recession had ended and when housing prices were on the steep part of their climb. Under tax policy, Chinn takes aim at the tax deductibility of second homes; combined with tax cuts that largely favored the rich, this increased demand for second homes, and therefore the prices of homes. Right now many people are calling for tax cuts as a way to stimulate the economy, and while you can debate whether tax cuts are more effective than increased spending, that is a reasonable debate to have. In retrospect, the error Chinn is pointing to is cutting taxes – providing a fiscal stimulus, in other words – when it wasn’t needed, at the same time that interest rates were low. Since the Reagan administration, the argument for tax cuts has been to shrink the size of government, increase the incentive to work, and return money to people who know how to spend it better than the government. Only this time, we’ve reached a point where (almost) everyone agrees we need a fiscal stimulus, and the need is so pressing we’re going to ignore the fiscal handcuffs created by the Bush tax cuts, which makes no one happy.

James Hamilton

In a November 2008 lecture, current IMF chief economist Olivier Blanchard discusses the boom in oil prices in a footnote:

How could the very large increase in oil prices from the early 2000s to mid-2008 have such a small apparent impact on economic activity? After all, similar increases are typically blamed for the very deep recessions of
the 1970s and early 1980s.

Hamilton takes almost the opposite approach: maybe it was high oil prices that tipped the global economy into recession. While this may sound preposterous (everyone knows it was housing, right?), remember that the U.S. housing bubble has been front-page news since at least early 2007, yet the peak of financial panic didn’t occur until September-October 2008. Was there really a lot of new information about the subprime mortgage market that appeared during that time? Christopher Dodd was already holding hearings on the subprime meltdown in March 2007 (thanks to Michael Lewis’s book Panic! for reminding me of that.) Or was it something else?

Hamilton takes a 2007 model created by Lutz Kilian and Paul Edelstein of how changes in energy prices affect personal consumption. (Summary: an increase in energy prices that would require a 1% reduction in other purchases to buy the same amount of energy actually leads to a 2.2% decrease in consumption over 15 months.) He then applies the model to actual energy prices since the middle of 2007 and (according to my eyeballing the chart) shows that about half of the falloff in consumption over the period is due to increased energy prices.

The (possible) implication is that if oil had remained at its early 2007 prices, the decline in housing prices that was already clearly visible would not have been enough to cripple the financial system and bring the global economy to its knees. In the process, of course, we ended up with oil in the $30s, but the damage has clearly been done. Hamilton promises to continue this topic in a future post, and I’ll be watching out for it.

Causes: Subprime Lending

Other posts in this occasional series.

Six months ago, this post would have been unnecessary. Back then, for most people, the crisis was the “subprime crisis:” subprime lending had become too aggressive, many subprime mortgages were going to go into default, and as a result securities backed by subprime mortgages were falling in value. Hedge funds, investment banks, and commercial banks were in danger insofar as they had unhedged exposure to subprime mortgages or subprime mortgage-backed securities (MBS). Still, if you were to stop the average reader of the New York Times or the Wall Street Journal on the street and ask what caused the current financial and economic crisis, there is a good chance he or she would start with subprime lending.

Asking whether subprime lending caused the crisis raises all the questions about agency and causality that I’ve raised before. On the agency question, insofar as there was a problem in the subprime lending sector – and few would deny that there was – does the fault lie with borrowers who took on loans they had no chance of repaying, perhaps sometimes without understanding the terms; with the mortgage lenders who lent them the money without doing any due diligence to determine if they could pay them back; with the investment bankers who told the mortgage lenders what kinds of loans they needed to package into securities; with the bond rating agencies who blessed those securities while taking fees from the investment banks; with the investors who bought those securities without analyzing the risk involved; or with the regulators who sat on their hands through the entire process? Note in passing that it may have been perfectly rational, as well as legal, for an investor to by an MBS even knowing that the loans backing it were going to default, but making a bet that he could resell the MBS before the price fell, under the “greater fool” theory of investing. (It may have been rational for an investment bank to do the same, but not necessarily legal, given the disclosure requirements relating to securities. Goldman Sachs is being sued over precisely this question.) Readers of this blog know that my opinion is that, although there is blame to be shared along the chain, the greatest fault lies with the regulators, for a few reasons. First, although the desire to make money may cause problems, it can be no more be said to be a cause of anything than gravity can be said to be the cause of  a landslide; second, bubbles are inevitable, at least in an unregulated market;  and third, there is a difference in kind between the mistake made by an investor, who is foolish and loses some money, and the mistake made by a regulator (or a legislator who votes to reduce funding for regulators), whose job is to serve the public interest.

But that was all the preamble, because today I want to talk about the question of causality.

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Causes: Free Market Ideology

Other posts in this occasional series.

Joseph Stiglitz, the 2001 Nobel Prize winner and the most cited economist in the world (according to Wikipedia) has an article aggressively titled “Capitalist Fools” in Vanity Fair that purports to identify five key decisions that produced the current economic crisis, but really lays out one more or less unified argument for what went wrong: free market ideology or, in his words, “a belief that markets are self-adjusting and that the role of government should be minimal.”

The five “decisions,” with Stiglitz’s commentary, are:

  1. Replacing Paul Volcker with Alan Greenspan, a free-market devotee of Ayn Rand, as Fed Chairman. (Incidentally, when I was in high school, I won $5,000 from an organization of Ayn Rand followers by writing an essay on The Fountainhead for a contest.) Stiglitz criticizes Greenspan for not using his powers to pop the high-tech and housing bubbles of the last ten years, and for helping to block regulation of new financial products.
  2. Deregulation, including the repeal of Glass-Steagall, the increase in leverage allowed to investment banks, and the failure to regulate derivatives (which Stiglitz accurately ascribes not only to Greenspan, but to Rubin and Summers as well).
  3. The Bush tax cuts. Stiglitz argues that the tax cuts, combined with the cost of the Iraq War and the increased cost of oil, forced the Fed to flood the market with cheap money in order to keep the economy growing.
  4. “Faking the numbers.” Here Stiglitz throws together the growth in the use of stock options – and the failure of regulators to do anything about it – and the distorted incentives of bond rating agencies – and the failure of regulators to do anything about it.
  5. The bailout itself. Stiglitz criticizes the government for a haphazard response to the crisis, a failure to stop the bleeding in the housing market, and failing to address “the underlying problems—the flawed incentive structures and the inadequate regulatory system.” (There’s regulation again.)

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Causes: Maybe People Are Just Like That

This is the second in my new occasional series of reflections on some of the root causes of the global economic crisis. As is probably evident from the first one, I’m not going to try to identify the cause of the crisis, or even render particularly analytical judgments about the relative importance of various contributing factors. Instead, I’m more just presenting and thinking about some of the forces that were at work.

One of the singular features of the last decade was the U.S. housing bubble (replicated elsewhere, such as the U.K. and Spain, but nowhere on such a grand scale), which was accompanied by a broader though not quite as frothy bubble in asset prices overall, including the stock market. One of the standard explanations is that bubbles are created when greed takes over from fear: people see prices rising, and at first their fear of getting burned keeps them on the sidelines, but as the bubble continues and other people get rich their own greed increases until it wins out over fear, and they buy into the bubble as well. As a result, some say, we are bound to have bubbles periodically, especially when new investors (young people), who have never experienced a crash, come into the market.

There is psychological research that not only backs all of this up, but goes even further and says that bubbles are a virtual certainty. Virginia Postrel has an article in The Atlantic that centers on experimental economics research by people such as Vernon Smith and Charles Noussair. In one experiment, investors trade a security that pays a dividend in each of 15 periods and then vanishes; the dividend in each period will be 0, 8, 28, or 60 cents with equal probability, so the expected dividend is 24 cents, and there is no time value of money (the whole experiment takes an hour). Despite the fact that the fundamental value of the security is absolutely, completely, easily knowable, bubbles develop in these markets . . . 90% of the time. When the same people repeat the same experiment, the bubbles get gradually smaller; but simply change the spread of dividends and the scarcity of the asset, and the bubbles come back with full force (so much for experienced investors).

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Causes: Where Did All That Money Come From?

We’ve gotten some comments to the effect that, for all the discussion of the financial crisis and the various bailouts, we haven’t looked hard at the underlying causes of the financial crisis and accompanying recession. The problem, as I think I’ve hinted at various times, is that any macroeconomic event of this magnitude is overdetermined, on two dimensions. First, there are just too many factors at play to identify which are the most important: in this case, we have lax underwriting, lax bond rating, skewed incentives in the financial sector, under-saving in the U.S., over-saving in other parts of the world, insufficient regulation, and so on. How many of these did it take to create the crisis? There is no good way of knowing, because the sample size (one, maybe two if you add the Great Depression) is just not big enough. Second, there is still the conceptual problem of identfying the proximate cause(s). To simplify for a moment, we had high leverage which made a liquidity crisis possible, and then we had the downturn in subprime that made it plausible, and then we had the Lehman bankruptcy that made it a reality. Which of these is the cause? Leverage, subprime, or Lehman?

In any case, we’re not going to resolve these issues. But I want to start an occasional series of posts looking at one of the root causes at a time.

Today’s topic was inspired by this week’s meetings between U.S.-China meeting in Beijing, where, according to the FT, “the US was lectured about its economic fragilities.”

Zhou Xiaochuan, governor of the Chinese central bank, urged the US to rebalance its economy. “Over-consumption and a high reliance on credit is the cause of the US financial crisis,” he said. “As the largest and most important economy in the world, the US should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits.”

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