Here are the causes of the crisis in one table:

Basically, Kling says that the crisis was composed of the things along the top, which were caused by the things on the left. You can see that he places the blame squarely on poor capital requirements regulations, which gave various banks incentives to (a) originate-to-distribute instead of originate-to-hold; (b) securitize every which way they could; (c) use credit default swaps to reduce capital requirements even further; (d) stuff toxic securities into SIVs; etc.

I was surprised at the low weight Kling places on financial innovation, but this turns out to be a function of his conceptual structure: “Apart from practices that were developed for the purpose of regulatory capital arbitrage, financial innovation played a small role in the crisis.” He categorizes CDOs, credit default swaps, and SIVs as forms of innovation that arose for regulatory capital arbitrage purposes, and so the real villain there is lousy regulations in the first place. I could insert a long discussion here of what it means for something to be a cause of something else. Suffice it to say that at you could argue that the end of the day everything is always the government’s fault, since the private sector always does what it does in response to the incentives created by the government; put another way, from a public policy perspective the only actor is the government, since we have no control over the other ones. But I see Kling’s point. (That said, he gives exotic mortgages a pass — I’d be curious to know if he thinks those are also a consequence of bad capital requirements.)

Kling also gives industry structure a relatively low weight, which I think is because he doesn’t think Glass-Steagall would have prevented the crisis. I think he’s probably right there, since Lehman and Bear managed to become too big to fail despite remaining investment banks. (Although I hesitate because if Citi, JPMorgan, and Bank of America were not holding onto trillions of dollars of toxic MBS and CDOs, would the government have had to rescue Bear?) But I think he may overlook the importance of bank size, which made it easier for banks to place bad bets because of the implicit government guarantee. Which brings up the question: Did bank CEOs before, say, 2007 really make decisions because they thought they were too big to fail? It seems unlikely, but David Wessel does have that great story in In Fed We Trust about Goldman Sachs, all the way back in 1991, lobbying to change Section 13(3) of the Federal Reserve Act to allow the Fed to lend to an investment bank in a crisis.

Jumping ahead to the conclusion, Kling doesn’t talk a lot about what specifically should be done, but he does have this good distinction:

“If economic stability inevitably gives way to financial euphoria, then it may not be possible to devise a fool-proof regulatory regime. Instead, it may be more effective to aim for a system that is easy to fix than a system that is hard to break. This means trying to encourage financial structures that involve less debt, so that resolution of failures is less complicated. It also means trying to foster a set of small, diverse financial institutions.”

As you can imagine, when I see “easy to fix” I think that the key institutions should be smaller so they are not too big to fail. Kling instead focuses on scaling back securitization and the various incentives to take on debt, like the mortgage interest tax deduction and the tax preference for corporate debt over equity. But I don’t disagree with most of his recommendations.

My biggest quibble is the emphasis Kling puts on government pressure on Fannie and Freddie to lower their underwriting standards. I think he knows that the truth is somewhere in the middle here. He has a section called “CRA and the Under-Served Housing Market” which, when you read it, barely touches on the CRA (except to make the case that the CRA had nothing to do with the crisis: “Many mortgage loans that met the standards for CRA were of much higher quality than the worst of the mortgage loans that were made from 2004–2007. Thus, one must be careful about assigning too much blame to CRA for the decline in underwriting standards.”). Most of the section talks about the deterioration of mortgage underwriting standards in general, without linking that deterioration to the CRA, and the links to Fannie and Freddie are weak. For example, discussing why Fannie and Freddie were not able to stop private lenders  from offering no-doc loans, he says:

“This time, the GSEs were not able to take a stand against the dangerous trends in mortgage origination. Their market shares had been eroded by private-label mortgage securitization. They were under pressure from their regulators to increase their support of low-income borrowers. Finally, they had been stained by accounting scandals in which they had allegedly manipulated earnings.”

I think that Fannie and Freddie contributed to the craziness in the mortgage market and to the housing bubble, but that they were relatively small factors compared to the originators themselves and the investment banks that were buying their toxic loans for securitization.

By James Kwak

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.

They have little patience for the idea that the financial crisis was the fault of Chinese over-saving:

It is necessary to dispense with the view that all this excess saving from the rest of the world was “forced” upon us. The rest of the world’s capital flowed to us, in part, because we wanted to borrow, and we wanted to borrow because of the Bush administration’s emphasis from 2001 to 2008 on cutting taxes while still spending.

They do endorse as exacerbating factors the low interest rates set by the Federal Reserve earlier this decade, and the growth of a large and unregulated financial sector:

Essentially, the development of an unregulated financial sector has circumvented the entire panoply of banking regulation created in the wake of the Great Depression. This made the financial system vulnerable to traditional “bank panics,” or “runs” on the financial system. The abdication of regulatory oversight (particularly in allowing high leverage) in the presence of too many institutions “too large to fail” meant the buildup of implicit financial liability on the part of the government.

But the overall story is that high borrowing brought in foreign capital; insofar as the borrowing was spent on nontradable goods, such as housing and financial services, necessarily pushing up prices (there is no way for competition from houses in China to keep U.S. housing prices down).

I think it’s hard to argue against the idea that a huge debt-financed bubble was a bad, bad thing. I still think, as you might predict, that the nature of our particular financial system both made the bubble larger than it might otherwise have been, and made its collapse more spectacular than it had to be.

The article is drawn from a book they are working on, which I will be sure to buy.

By James Kwak

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.

This argument has two components:

Moral hazard: Institutions that are too big to fail create systemic risk; thus the government must rescue them if they make bad bets.  This creates asymmetric incentives (one-sided payoffs), which encourage them to make excessively risky bets, thereby encouraging the very systemic risk that regulators are trying to avoid.  Governments cannot credibly threaten to let such banks fail because the results (e.g. Lehman) are catastrophic.

The Oligarchs: This argument is best laid out in the Atlantic piece, in a discussion of previous IMF efforts to restore countries to monetary balance:

Typically, these countries are in a desperate economic situation for one simple reason-the powerful elites within them overreached in good times and took too many risks. Emerging-market governments and their private-sector allies commonly form a tight-knit-and, most of the time, genteel-oligarchy, running the country rather like a profit-seeking company in which they are the controlling shareholders.

Although theoretically compelling, most of the evidence for this version of TBTF is indirect:

• Higher concentration and profits in the banking industry: (note that the primary source of concentration is clearly M&A activity over 20 years).
• Increasing share of the financial sector in world GDPs and as a percentage of US corporate profits and average wage through 2006.
• The Goldman Sachs mafia (courtesy markets.aurelius).
• Various stories of insiders and whistleblowers who recount specific instances of perverse incentives that encouraged risky behavior.

Along with the explanations underlying Too-Big-To-Fail (TBTF) come certain policy prescriptions that have proven to be very controversial:

a)    Take over large insolvent banks (through temporary nationalization or FDIC receivership), sell off performing assets to smaller banks or investors, and break the bank into smaller pieces.

b)    If needed, employ anti-trust legislation to break apart healthy mega-banks

c)    Build an enduring system that prevents big banks from recreating themselves through M&A (mergers and acquisitions).

Challenges to Too-Big-To-Fail

Timing and Expedience

Is it really imperative to address TBTF first?  Attacking banks in the middle of a crisis has high costs (remember Lehman).  Would it not be better to wait until the credit/equity markets have fully stabilized and confidence has recovered, and then attack the problem in a quiet orderly manner when banks are not wielding a poison pill over the global economy?

This response to TBTF is rooted in the observation that what began as a financial crisis turned into a global panic, and then morphed into the most intense global recession in 70 years, which almost certainly would have become a depression without aggressive govt. response (capital injections, stimulus, base money expansion).  TBTF may have been the trigger, but is not necessarily the most critical step to solving the current global crisis – and solving the financial crisis is critical to addressing multiple other crises (food, water, energy, environment) that were ignored for the past 15 years (and which were recently designated by the National Intelligence Council as threats to national security).

Some TBTF advocates answer that TBTF must be addressed immediately because the window of opportunity may soon shut as the political mood shifts (assuming the economy stabilizes) – see here and here.

In response, the window does not seem that narrow. In a March 26-29 poll, respondents primarily blamed banks and large corporations for the crisis, followed by President Bush (scroll down to see poll). This allocation of blame has been relatively consistent since last October.  Obama’s poll numbers seem to have dipped during the February thru March debacle (after Geithner’s disastrous first speech), then recovered as the stock markets staged a rally.  Recent in-depth polls showed that the public continued to disapprove of Obama’s handling of bank bailouts even as his overall ratings recovered. The public hates bank bailouts, but not as much as economic decline.

I would therefore argue that the primary order of business is stabilizing the economy.  Everyone agrees that attacking TBTF will not be pretty, however – it will take many months to dismantle organizations with trillions of dollars in assets, and the costs of doing this quickly are enormous.  (Consider the massive losses suffered in the accelerated AIG unwinds.)  In the S&L crisis, the FSLIC and Resolution Trust Corp. did not fully dispose of S&L assets until 1995.  The current crisis is worse, and the FDIC and Fed are facing limited organizational capacity.  In the meantime, the big banks will not stand idly by.

Rather than attacking TBTF immediately, we may be better served by building a plan that can be implemented after stabilization is achieved.  For instance, we might pass anti-lobbying legislation now (something that isn’t likely to cause a collapse in the Dow Jones).  Ideally, Team Obama is already building a plan, but if they were, the last thing they would do is announce it.  For those who still hope the administration has resisted co-option and corruption in spite of recent revisions of Obama’s anti-lobbying pledge, the Obama Team’s strategy for GM & Chrysler suggests a road forward. The markets may be seeing this as well – as suggested by the recent divergence between bank stocks and CDS prices for bank debt (as SJ and JK note here).

Some TBTF advocates have raised a second justification for attacking TBTF immediately.  They worry that the oligarchic bank lobby may sabotage or pervert other reforms, unless the oligarchs are first weakened, and they cite intense lobbying efforts by banks. Reforms such as credit card billing rules seem to be passing at the moment, yet we have no assurance that the Obama Administration will remain able to push such reform through Congress in the future.  The rejoinder to these worries is that the Obama Administration’s ability to make future changes will depend on the status of the economy when those changes are sought, which begs the question: how critical is TBTF to securing a recovery?

In its strongest form, the case for attacking TBTF right now states that the economic crisis will not end unless we first deal with TBTF.  In other words, TBTF is a root cause of the crisis (though not necessarily the only cause), and any short-term relief we might gain by temporarily accommodating big banks will only backfire in a few years.  Although the balance of Baseline’s posts suggests there are many causes, the Atlantic piece does identify the overreaching of elites as the “one simple reason” underlying the economic desperation of developing countries in crisis (which are then compared to the US).

The argument for fixing TBTF immediately to resolve the current crisis thus hinges on the importance of TBTF in causing the crisis.  If TBTF is to become one of the dominant narratives behind this crisis, it must contest against other narratives.  There are (at least) three groups of narratives that seem to competing with TBTF.

Competing Narratives

Narrative 1: Systemic Risk

A massively leveraged and unregulated financial system is inherently vulnerable to shocks that rapidly get magnified.  Perceived (or imagined) risks can create self-fulfilling outcomes, and such risks can be manufactured by large unregulated actors (e.g. hedge funds, which have been immensely profitable for investors over the last 15 years even counting the recent hit).

Moreover, tight coupling of global financial systems and economies causes shocks to transmit rapidly throughout the system, with limited fire-breaks. Contagion, once considered a low risk, can spread rapidly throughout sectors and then throughout the world.  IMF report, Figures 1.2 and 1.11 (heat maps)

All of this is worsened by extreme leverage, which has been noted by many scholars (and challenged by some).

Systemic risk was further magnified by the utter elimination of sensible regulation at the behest of free-market ideologues, and indeed the active encouragement of policymakers to engage in risky behavior.  Here is a timeline.

In addition, systemic risk is intensified by pro-cyclical policy responses (easing of money in good times, and pro-cyclical factors like mark-to-market in combination with the capital-asset ratio constraints embodied in the Basel Accords).

And finally, systemic risk is massively intensified by the complexity of financial instruments (CDOs, CDSs) which allegedly increase liquidity and volatility (evidence for this is mixed; the VIX volatility index declined through 2006 even as CDO usage intensified), exacerbate systemic linkages (IMF report, Figures 2.1 and 2.6), and decouple the financing/servicing aspects of loans that are usually married together in vertically integrated banks (both creating information barriers, and making loan restructuring more difficult).

In the Systemic Risk narrative, fixing TBTF plays an important role in solving the problem, but not the primary role.  The systemic risk narrative suggests that stabilization can be achieved through other mechanisms (reinstating lapsed regulation, lowering overall leverage, reflating the non-debt money supply, better oversight of banks, etc.)  Preserving these reforms against political challenges over time is difficult, however, and that is where TBTF becomes important.

Narrative 2: Destruction of the Middle Class

This narrative ascribes the root cause of the crisis to a long-term decline in middle class spending power; the recent financial crisis was merely the straw that broke the camel’s back.  The various causes are debated widely, but the end result is clear.

Some versions of this narrative focus on regressive shifts in tax policy since the 1930s, or structural economic shifts that reward higher education, or CEO pay, or the decline in union membership.

Perhaps the most popular version, however, focuses on massive trade imbalances due to unfair trade practices and/or trade with repressive foreign regimes.  Unfairly cheap imports have resulted in the hollowing-out of the US economy, loss of real jobs making real things, decrease in labor bargaining power, declines in real median income, increases in US household debt in order to finance stable consumption levels, and a long-term decrease in spending power. The trade deficit data is indisputable: US current account deficit data is here; China specific data is here.

However, the link between international trade and “middle class decline” is heavily disputed (especially by neoliberal economists).  Nonetheless, this narrative has begun to win some backing even among free trade elites.  For example, Hank Paulson made it part of his mission to convince China to allow the Yuan to appreciate (to address the trade balance) when he became Treasury Secretary, but the world still remained dangerously addicted to US consumption which was largely financed by foreign debt.  (45% of world net capital inflows went to the US in 2006)

The “Free-Trade” version of this narrative sometimes focuses on NAFTA, sometimes on China or other countries.  It is generally inseparable from a similar narrative that focuses on Greedy (selfish, lazy) US Consumers who spent instead of saved, with the exception that the Free-Trade version blames foreign trade policy and the Greedy US Consumers version blames US consumers who spend more than they earn.  Yet the remedy to both is similar – decrease foreign imports, either through dollar devaluation (if you believe foreign economies are manipulating exchange rates and/or the dollar’s reserve currency status caused the dollar to be overvalued) or through trade barriers (if you believe repressive foreign regimes or foreign trade barriers caused the imbalance).  Both methods force the US to supply its own consumption.  Critics will point to the disastrous results of such policies in the Great Depression (Smoot-Hawley, etc.), particularly when implemented rapidly, globally, and during an economic downturn – so even if trade caused the problem, now might not be the best time to radically reduce imports.

TBTF plays only a limited role in the Middle Class Decline narrative (although the “oligarch” version of TBTF may argue that financial elites engineered the downfall of the middle class to suit their interests).  Fixing the problems requires deep structural changes, which may require the eventual political expulsion of special interests (like the oligarchs).  But again, this implies that the timing to attack TBTF is a key tactical question.

Narrative 3: Irrational Exuberance (Soft Money, Normal Business Cycle)

The Irrational Exuberance narrative was recently re-popularized by Shiller’s book.

The essence of this narrative suggests that our brains are fundamentally wired to behave irrationally.  Behavioral economists are rapidly assembling data to support this assertion.  (For example.)

When irrational exuberance takes hold, money becomes cheap as investors expect growth to persist.  Consumers and businesses optimistically avail themselves of the cheap credit and increase leverage, until a shock crashes the system and everything reverses.  Investors tighten credit, consumers and businesses turn pessimistic, and leverage causes bankruptcies that magnify the problem (just as soft money magnified the boom).

Bank managers have incentives to ride along with the cycle.  When everyone else is earning more, bank managers who are “underperforming” are often punished. When the crash comes, managers are often forgiven since everyone else made the same mistakes.  Both mass psychology and the competitive environment reinforce this dynamic.

In this narrative, it is hard to argue that bank size matters.  Notably, many past financial crisis involved massive numbers of smaller banks, such as the 1930s Great Depression and the 1980s S&L Crisis. Even in the current crisis, many regional banks are also approaching insolvency.

Indeed, we can even cite circumstances in previous history where collusion by large banks has prevented financial crises from become depressions, such as JP Morgan in 1907.

Importantly, there are two distinctive flavors of the Irrational Exuberance narrative – the Austrian version and the Keynesian version. They dramatically differ in their interpretation of government’s role in causing, and solving, economic downturns.

The Austrian School (e.g. Hayek, Schumpeter, Von Mises) contend that bubbles are exacerbated by government activity (and especially by central banks and soft money policies, but also by government spending). According to advocates of this version of the narrative, deregulation did not cause the crisis, it merely happened at the same time.  Irrational exuberance can’t be stopped.  Bubbles are the problem (made worse, or even caused, by government action), and the “fix” is depression and deflation.

The Keynesians identify the business cycle as a natural outcome of developed economies and capitalist “animal spirits” (alternatively, “spontaneous optimism”), but contend that the system is not self-stabilizing.  Notably, business cycles can create credit collapses that cause deflation, and individually virtuous behavior (excess saving) can perpetuate deflation. The system requires an exogenous demand/credit source (like government) to restore equilibrium.

(At this point, I will abuse my role by noting a few interesting data points:

• Contrary to Austrian predictions, the intensity of economic cycles in the US decreased substantially after WWII, when the govt. actively managed the business cycle.
• As Brad DeLong notes, the end of the gold standard marked the beginning of recovery for every major industrial power during the Great Depression (chart on page 4).
• As Paul Samuelson argues, every major US economic expansion died prematurely at the hands of the Fed …  This was before Alan Greenspan – a noted fan of Hayek – facilitated and defended the greatest bubble in recent history.)

The Irrational Exuberance narrative is perhaps the least friendly to TBTF.  Even the Austrian version identifies TBTF as a problem only because governments have powers they should not have.  Remove those powers, and the world-wide depression will hastily fix TBTF.  (Notably, this did not happen in the Long Depression of 1873-1879, which was followed by an anemic recovery and the massive inequalities of the Gilded Age).  In the Keynesian version of Irrational Exuberance, TBTF is only a problem if the Lords of Finance oppose the aggressive government action that is needed to restore growth.

So Where Does That Leave Us Now?

Your own favored response to the current economic downturn probably depends on which of the narratives above you find most convincing – Systemic Risk, Middle Class Decline, Irrational Exuberance, or Too-Big-To-Fail.

But of course, more than one narrative may be true, and some of these narratives reinforce each other.  Combining Systemic Risk and Irrational Exuberance is particularly nasty, for example.

Interestingly, Too-Big-To-Fail synergizes well with the Systemic Risk narrative, and the Oligarchy version of TBTF plays well in the Middle Class Decline narrative.  TBTF has a more diminished role in the various Irrational Exumberance narratives.

In the broader context, the Too-Big-To-Fail narrative seems like an upstart next to the other narratives, but it has a few things working in its favor.  For one thing, it points the blame at a specific group of people, and Americans really want someone to blame for this crisis.  TBTF also taps a populist/anti-elitist sentiment that harkens back to Teddy Roosevelt’s battles against the Robber Barons.

My own objections to TBTF are primarily that TBTF is probably not the dominant cause of the crisis, that attacking TBTF right now could exacerbate the downturn, and that dismantling big banks will require additional measures to address unforeseen complexities (e.g. competing international big banks with lower cost of capital, reduced tools to implement US foreign policy).  TBTF is undoubtedly a problem, but is it our most serious and immediate problem?

We are fortunate to have champions like Johnson, Hoenig, and others carrying the banner of Too-Big-To-Fail.  Yet while I agree with Baseline Scenario that many other problems in this global crisis require quick action and overwhelming firepower, addressing TBTF requires deliberate and patient action.

I am confident this action can succeed over the long term (should the Obama Administration pursue it) for one primary reason – recent events have widely discredited the dominant paradigm of neoclassical economics.  This paradigm, which arguably began with Milton Friedman and was propagated in the public sphere by well-funded think tanks, served as the intellectual artillery that allowed the Oligarchs to shred the laws and regulations that prevented excessive concentration and abuse of financial power.  The willingness of respected economic scholars to step forth with new and pragmatic economic ideas is more encouraging than any single change in policy that I could imagine.

By StatsGuy

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).

Speaker Pelosi has also come out in favor of some sort of commission, so there is momentum (and detailed negotiations).  But many big questions are still on the table, including: what should be the scope of an enquiry, will it have subpeona powers, and who will run it?  And how exactly should we consider benchmarking this against the Pecora Hearings?

Popular anger during a major crisis is completely standard – I can’t think of a country that has avoided this.  Not many countries can control that emotion and channel it into a productive conversation.  Even fewer can figure out how to turn that into meaningful legislation – let alone enforcement of new rules that make sense. 

The US has the kind of democracy that could do this. But, as Michael Perino emphasized effectively, given the power of the big finance lobby (now and in the early 1930s), even we need to get lucky.

Perhaps we can tilt the odds slightly in our favor using one edge that was not available in 1932. Write up your suggestions for how to organize the hearings, questions to ask, witnesses to call, and more.  Even better, provide the details – substantiated – of what went wrong, and make specific suggestions about the lines of enquiry to pursue.  Put these in a comment here or, if you prefer, The Hearing on WashingtonPost.com – this is already starting to get the right kind of attention on Capitol Hill.

This is not a call to populism.  This is a call for ideas that can constructively rebuild financial services in this country and, much more broadly, restructure our economy in sensible and sustainable ways.  Ultimately, the Pecora Hearings had impact because they affected the country’s debate – and because top leaders paid attention.  Surely, we should aim for the same.

By Simon Johnson

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.

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.

1. The seeds of the crisis were sown in the Great Moderation (the low inflation, relatively stable last 20 years or so).  Everyone who patted themselves or others on the back during that time was really missing the point (p.3).  The same interconnections that reduced the effects of small shocks created vulnerability to massive system-wide domino effects.  No one saw this clearly.

2. The predominant view was that the US and other relatively rich countries had pretty good institutions (i.e., rules, laws and practices underpinning economic transactions) and that these institutions would prevent powerful people from the kind of abuse that endanger social systems in many parts of the world (pp.4-5).  That view was incorrect.  (Speaking personally, I had no illusions about the power of the strongest on Wall Street – particularly after my experience on the SEC’s Advisory Committee on Market Information in 2000-2001.  But I didn’t have the right mental model of how this power aggregated up, i.e., the way in which these people, and the firms they controlled, had created or recreated a deeply unstable system.)

3. The way we think about reputation, including how it is acquired and maintained, is way off base (pp.6-7).  This is fundamental for both formal economics and how you go shopping.  You walk into a grocery store with a mental model that is based on the premise that the individuals all through the production chain operate in a control structure designed to build brands and make you think their products are healthy and tasty.  Such reputations are costly to build and not readily squandered.  But, Daron points out, this is too simple.  In particular, we should no longer make the mistake of saying “the company” wants this or that.  There are no companies in any kind of behavioral sense.  There are people, struggling to get ahead, and it is their interactions that can lead – particularly in finance – to products that are really terrible for you and your neighbors (and even quite bad for themselves).

Daron also urges that we not lose track of longer term economic growth issues in the current policy debate.  If the bailout process – including the evergreening of credit by the Federal Reserve – slows down or even freezes the reallocation of resources out of the financial sector, we have a problem.  We need to move, at least somewhat, out of a bloated financial sector and back into the kind of nonfinancial technology-developing sectors that have primarily driven growth in the US since the 1840s.

This is not an argument against a comprehensive stimulus package.  But it recognizes the legitimacy of any backlash both against the models that brought us here and many of the sweet deals for leading financial figures (received so far and no doubt currently pencilled in).  Beginning with designing, arguing about, and implementing the stimulus, we need to think more clearly about the economics and politics of how we rebuild the financial system.  If we recreate something fundamentally unfair and unstable, that will also undermine growth.

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.

Paulson argues that he lacked the legal powers and resources necessary to intervene decisively and early on in the crisis, and this may account for some of his actions through mid-September.  Still, the Fed has plenty of powers and essentially unlimited resources in a crisis, and it’s not clear why Paulson and Bernanke, acting together, couldn’t have done more – for example, after Bear Stearns revealed (to most observers, private and official, and presumably to them) the depth of the systemic problems.  It’s odd that Paulson feels the severity of the crisis was only apparent after the intervention in Fannie Mae and Freddie Mac.

The greatest puzzle, of course, is why Lehman was not saved.  Paulson essentially says that letting Lehman fail was not his idea, and the well-informed FT article implies it was definitely not due to Geithner.  Yet it’s not plausible that Bernanke would have taken such a stand.  So who did it?

(The excellent recent WSJ article on that critical weekend – link here, but subscription required – also jumps that key moment; it’s as if there is a cone of silence on this point.  Perhaps Geithner’s upcoming confirmation hearing will reveal more.)

But there is also a more analytical puzzle.  In his interview, Paulson stresses the role of capital flows and the so-called “global savings glut” in driving down risk premia and encouraging a system full of bad decisions (and the FT rightly regarded this as an important statement, and put it on the front page).  Paulson also implies that more urgent multilateral action on this dimension would have helped.

Yet Paulson himself was instrumental in blocking, or not taking forward (and that’s close to the same thing), the deal brokered in the Multilateral Consultation between the world’s major trading areas.  This was a major opportunity to advance policies both in the US and elsewhere that would have exactly addressed what Paulson now says was an evident first-order system problem.

Of course, the idea of de-emphasizing any kind of multilateral approach might have come from the Bush White House, but this level of detail is almost always delegated to the Treasury.  And there is every indication that Mr. Bush trusted completely and listened carefully to Paulson at every stage, including throughout this fall’s downward spiral.

Corroborating evidence for the idea that Paulson did not want to work in a multilateral fashion comes from the fact that in fall 2007 he called for sharp spending cuts at the IMF (see his IMFC statement, near the top of the last page).  The US Treasury continued to push for these cuts in the ensuing months, despite the obvious onset of a serious worldwide financial crisis – about which they, of all people, surely had the most inside knowledge.  In fact, despite the current series of urgent crises, the IMF still finds itself constrained by the roughly 20% budget cut that the US insisted upon.  Quite why these limits on spending were not immediately relaxed after September – which would have been easy to do under G7 or G20 leadership – is yet another mystery that can presumably be traced back to the attitude of the US authorities, although the crisis-deniers in Europe probably also played a supportive role.

In any case, Paulson was entitled to choose a strategy to address global imbalances other than that of the Multilateral Consultation.  But what was his global strategy.? No one has yet been able to explain that to me, but please do make suggestions in comments on this post.

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.

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.

I think it’s generally accepted that the crisis we know today first appeared in the subprime lending market, where an increase in delinquency rates triggered a fall in asset values. Those problems were clearly visible early in 2007 (it’s impossible to say exactly when they were first visible, because some people had been warning of the problem for years, to little effect), and over the next year the main entertainment in the financial sector was watching banks and hedge funds suddenly realize they had large subprime exposures and either take writedowns or fold. But I think there are three ways to understand the relationship of subprime and the current crisis:

1. Subprime was the first place where various structural problems appeared, but those problems existed elsewhere, where they only appeared later. If the subprime lending boom had never happened, we would still be roughly where we are today. Call this the “canary in the coal mine” theory.
2. Subprime was the first place where various structural problems appeared, and the subprime crisis generated additional pressure that exposed those problems in other areas. For example, subprime concerns caused a pullback in lending, which caused a leveling off in home prices, which caused a reduction in housing construction, which slowed economic growth, etc. Call this the “domino” theory.
3. Subprime was a necessary cause of the crisis. Without subprime, the levels of housing prices, indebtedness, and risk in the system would have been sustainable indefinitely. Call this the “prime mover” theory.

Only under the prime mover theory can subprime truly be said to have caused the crisis. Under the domino theory it played the role of a precipitating but unnecessary cause. Under the canary theory it is just a leading indicator.

In my opinion, subprime was probably the canary, and possibly the first domino. There are various arguments against the prime mover theory:

• The U.S. subprime sector is simply not big enough. Although the numbers have been shifting in the last couple of years, roughly 80% of outstanding residential mortgages in the U.S. are prime; the other 20% is split between subprime and Alt-A. About 50 million homeowners have a mortgage, of which about 7 million have subprime mortgages. The idea that an increase in the delinquency percentage among 7 million U.S. homeowners (total mortgage value about $1-2 trillion, so losses on foreclosure – assuming a 100% foreclosure rate – about $0.5-1 trillion) could have by itself caused the largest economic downturn in the world since the 1930s is  hard to credit.
• In absolute terms, losses in the subprime sector will be dwarfed by losses in the prime sector. Credit Suisse is now forecasting 8.1 million foreclosures by 2012, over 5 million of those outside of subprime. Current-month foreclosures among prime mortgages have already caught up to and passed (see chart on p. 4) foreclosures among subprime mortgages.
• The U.S. and global economies bumped along passably for over a year from the beginning of the subprime crisis. The U.S. recession did begin in December 2007 (Econbrowser for a good post on recession dating), but most of the numbers don’t start falling off cliffs until the second half of 2008. By the time Lehman went bankrupt in September, it’s probably true that all of the bad news about subprime was already priced into the various markets. What’s happened since then is new bad news about every other market.

Deciding between the canary and domino theories is tougher. The canary theory is that there were lots of boulders perched precariously on a cliff and subprime was just the first one to fall. The domino theory is that the subprime boulder knocked into a lot of much bigger boulders and knocked them off, but something else could have knocked them off just as easily. The domino theory could go something like this: Subprime caused writedowns and instability in the financial sector and nervousness in the housing market; nervousness in the housing market caused housing prices to start to fall, making it harder to refinance and increasing delinquencies on all kinds of mortgages; expanding writedowns caused a liquidity run on banks such as Bear Stearns and eventually Lehman; falling house prices and the consequent wealth effect reduced U.S. personal consumption, slowing economic growth; reduced consumption had the usual multiplier effect, reducing incomes and creating a recessionary cycle; the the recession hurt the value of every other type of debt (commercial mortgages, credit cards, etc.), triggering a full-scale banking crisis; and the fear created by the banking crisis led to the sharp downturn in credit and in consumption that put us where we are today.

I think there are at least three arguments for the canary theory and against the domino theory.

First, there is the issue of timing. The subprime crisis took an awfully long time to blossom into a full-fledged global recession and, as I said above, by the time the latter occurred the full scale of the subprime problem was more or less known to everyone. On that principle, the other boulders withstood the bump they got from the subprime boulder.

Second, once we had a housing bubble, it was inevitable that it was going to pop one way or another. So one question to ask is whether subprime lending was the reason for the housing bubble. Even at the peak of housing prices in 2006, subprime loans only made up about 20% of total mortgage origination volume. (Everyone cites Inside Mortgage Finance, but you have to pay for their data; here’s an NPR primer on subprime with a chart.) Could that 20% have have been solely responsible for the bubble? I suppose it’s possible, depending on the shape of the supply curve, but count me as skeptical.

Third, there is another good explanation for what pushed all those boulders down. James Hamilton thinks that the economy was structurally fragile, and the shock that knocked the boulders down was the oil price spike.

My view is that we were teetering on the edge of a cliff last summer, and the oil price shock may have been just enough to tip us over the edge. As we did so, the financial disaster that had always been a potential became a reality.

The trouble is, now that the economy is in free fall, it’s going to take more than $2 gasoline to pull us back up.

Ultimately, I think this question (canary or domino) is not definitively answerable, like many historical counterfactual questions, but I’m on the side of the canary.

One final note: Blaming subprime can have a disturbing overtone of blaming poor people for reaching beyond their means. First of all, it’s not true that subprime has more than a vague correlation with income. In the words of the late Tanta:

The capacity C of traditional underwriting was, of course, always relative to the proposed transaction. A lower-income person buying a lower-priced property was, you see, not a case of subprime lending; assuming a reasonable credit history, it was a prime loan. People with quite good incomes and stellar credit histories who tried to buy way too much house got turned down by the prime lenders.

More often, however, people in gentle society realize it’s not proper to blame poor people, so they take aim instead at the Community Reinvestment Act and liberal politicians generally for attempting to extend homeownership to people who couldn’t afford it. This line of attack was most recently exhibited on the New York Times op-ed page. I will leave the rebuttals to the experts:

• Mark Thoma (2 separate posts, with additional links)
• Barry Ritholtz (2 separate posts)
• Randall Kroszner (cited by Ritholtz)

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.)

I have a lot of sympathy for the argument that deregulation was a significant cause of the crisis. Calling it “deregulation” is not entirely accurate, because there are not that many major regulations you can point to that were actually repealed. Glass-Steagall is one, but I’m not sure that was centrally important. Even if commercial banks and investment banks had not been allowed to combine, I still think commercial banks would have made foolish loans, and investment banks would have still bought them to package them into securities. Actually, a lot of the subprime lending was done by specialized mortgage lenders – not by the hybrid institutions created by Glass-Steagall – until they got bought up at the peak of the boom.

In addition to traditional deregulation, I think there was a failure to enforce existing regulations, and a failure to create new regulations to keep pace with innovation in the financial sector. On paper, federal bank regulators have a great deal of power already. For example, the Office of the Comptroller of the Currency, which regulates national banks, has the following powers (from their website):

• Examine the banks.
• Approve or deny applications for new charters, branches, capital, or other changes in corporate or banking structure.
• Take supervisory actions against banks that do not comply with laws and regulations or that otherwise engage in unsound banking practices. The agency can remove officers and directors, negotiate agreements to change banking practices, and issue cease and desist orders as well as civil money penalties.
• Issue rules and regulations governing bank investments, lending, and other practices.

The FDIC similarly has the power to examine banks, assessing issues such as capital adequacy, asset quality, and liquidity (those three concepts should be familiar to anyone following the crisis over the last three months). Now, it is true that most people failed to see the huge insolvency risks in the banking sector before they became frighteningly visible this fall. But most people aren’t bank regulators, either.

Perhaps more importantly, there was a failure to keep regulation up to date with changes in the financial sector. The event that has gotten the most attention is the passage of the Commodity Futures Modernization Act in December 2000, which, among other things, preempted any regulation of credit default swaps. Another example is the hands-off attitude that was taken toward hedge funds, even as they became a larger and larger part of the financial system, and even after the crisis caused by the near-collapse of Long-Term Capital Management in 1998. Another is the failure of regulators to adapt to the proliferation of new types of subprime lending, recounted in the New York Times article with the great title, “Fed Shrugged as Subprime Crisis Spread.”

What could better regulation have accomplished? It could have reduced the growth of exploding subprime loans that borrowers had no chance of paying off. It could forced credit default swaps onto exchanges. It could have required greater disclosure by financial institutions of off-balance sheet positions. It could have brought more of the “shadow banking system” into the light. It could have forced banks to increase their capital. It could have prevented AIG from taking huge unbalanced credit default swap positions. In summary, it could have slowed the growth of the bubble and made the systemic risk in the financial sector more visible.

Well, maybe. I don’t want to convey the impression that it’s possible to have a perfect level of regulation, and there certainly is such a thing as too much regulation. And any administration that tried to regulate the financial sector more closely would have faced bitter, vicious, well-financed opposition from the industry itself. The truth is we don’t know what the consequences of different regulations would have been. Also, even with better regulation, there still would have been trillions of dollars sloshing around, and lots of greedy people trying to divert it their way, and lots of bubble-prone investors. But in general I think Stiglitz is right that we have definitely erred on the side of too little regulation for quite a while now.

Stiglitz also raises the issue of incentive structures, which I think is a special case of the issue of regulation. One of the cardinal principles of undergraduate economics is that firms are rational profit-maximizing actors. This is widely understood to mean that firms act in the best interests of the shareholders who own them. However, in the real world, firms are controlled by their senior executives, who are loosely controlled by the board of directors, who are partially controlled by the CEO and very tenuously controlled by large institutional investors. During bailout season, we’ve all heard the phrase “capitalizing the upside and socializing the downside” or something to that effect – shareholders get the profits and taxpayers get the losses. But there’s another version of this that applies even without a taxpayer bailout.

Stiglitz is right that stock option-based compensation provides disproportionate rewards to executives (relative to shareholders) when stock prices rise and underproportionate risks to executives when stock prices fall. Even though, in general, it’s better for everyone for the stock price to go up and worse for everyone for it to go down, the benefits (as a function of stock price) differ for the two groups. This induces executives to take excessive risks and to take steps to boost short-term profits at the risk of long-term losses. But I don’t think the solution is government regulation to ban certain forms of compensation, because I just think it won’t work; boards of directors can be very creative about finding ways to pay CEOs obscene amounts of money. This is basically a corporate governance problem, and the solution is some form of increased disclosure by companies and increased shareholder rights, so shareholders can more easily replace directors who are complicit in paying CEOs obscene amounts. Both of these things (disclosure and shareholder rights) probably require new regulations or legislation.

It’s also important to remember that the U.S. was not the only country that had a housing bubble, and there was plenty of other bubble-like activity around the world, such as huge amounts of lending by Western and Central European banks into Eastern Europe and Latin America. Right now those banks are being burned as much by their emerging market investments as they are by their purchases of U.S. mortgage-backed securities. So when we talk about regulation, we have to remember that we live in a global financial system, and even if there were a virtuous country out there – call it Perfectistan – it would still be hurting today as a result of the downturn of the global economy. But the U.S. is still at the center of it all, for better or for worse.

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).

The implication is that if you put people in front of a market that is behaving a certain way, you are going to get a bubble. It’s not simply a question of not understanding the fundamentals, or getting suckered by real estate brokers, or trying to keep up with the Jones’s new McMansion (although all of these can help amplify the bubble); people are just wired to create asset price bubbles. The fact that we have so few of them is probably a reflection of the size of asset markets (it takes longer to get millions of investors bought into a bubble than a few dozen) more than anything else.

Certainly there are things that we (or policymakers, rather) can do about bubbles. If they see a bubble building, they can try to talk it down, or try to make money more expensive, or start selling lots of the thing that is appreciating quickly. But this hinges on two things: the ability to spot the bubble, and the will to do something about it. It’s not helpful to have a belief on principle that asset prices are always rational, because then you will never do anything about them. (As an aside, perhaps one solution would be to have some form of market intervention that is automatically triggered when some class of assets accelerates beyond a predetermined threshold – precisely to eliminate the ability of policymakers to convince themselves that “things are different this time.”)

But the broader point, I think, is that it’s not that useful to say the bubble happened because people were stupid, or greedy, or irresponsible. Yes, people can be stupid, greedy, and irresponsible, but you have to take people the way they are; mass psychological reeducation is not an option. And even if you could reeducate them to the point where they all fully understood the assets they were trading, there would still be bubbles.  The issue to focus on is what regulatory policies or systemic changes can limit the incidence and cost of bubbles. (There’s an argument to be made that individuals should not be managing their own investments, since on average they just destroy value. But in an individualist, free-market society like ours, that argument will never fly.)

Besides the greed of the common man, though, much more has been made of the greed of the Wall Street banker. One argument, heard often around the time of the voting on the initial bailout bill, was that the financial crisis was caused by greedy bankers (and mortgage brokers, and hedge fund managers, and anyone else involved in the securitization chain) who created exotic new financial instruments and took on excessive risks in order to make lots of money for themselves. This has never satisfied me as an explanation. As I read somewhere, greed is like gravity. (I tried to look that phrase up to see whom to attribute it to, but apparently it’s a commonplace with no known source.) Blaming a financial crisis on greed is like blaming an airplane crash on gravity. Sure, there may be some correlation between greediness and working in certain parts of the financial services industry. But take people randomly off of Main Street and put them in that position – where most of your compensation is in a year-end bonus, and your bonus depends on the volume of business you do that year, not on the long-term profitability of that business, or on the success and satisfaction of your customers, and no one can take that bonus away from you in the future – and I wouldn’t bet that they would behave any differently.

Henry Blodget – yes, that Henry Blodget – has a variant of this argument in an article also in The Atlantic (yes, I’m a subscriber, and I finally found a few minutes to look at the latest issue). After the usual explanation of bubbles, he looks at things from the Wall Street perspective.

Professional fund managers are paid to manage money for their clients. Most managers succeed or fail based not on how much money they make or lose but on how much they make or lose relative to the market and other fund managers. . . .

In the money-management business, therefore, investment risk is the risk that your bets will cost your clients money. Career or business risk, meanwhile, is the risk that your bets will cost you or your firm money or clients.

The tension between investment risk and business risk often leads fund managers to make decisions that, to outsiders, seem bizarre. From the fund managers’ perspective, however, they’re perfectly rational.

This is similar to my earlier theory about why banks won’t lend. It’s also similar to Andrew Lo’s explanation of why chief risk officers didn’t clamp down during the bubble. Basically, the incentives are such that it is more valuable to you or your company to be doing roughly what everyone else is doing than to do what you think is right (not in the moral sense, but in the profit-maximizing sense). We thnk the capitalist system is wonderful because all firms act to maximize their profits (and I do think that capitalism is the best economic system around, if that phrase even means anything), but the fact is that firms are made up of people, and the connection between the interests of those people and the interests of their firms is indirect at best. OK, I’ll cut off the tangent there; the rest of that thought will have to wait for another post.

In any case, the question isn’t how to make bankers less greedy, but how to create incentives that better align their personal greed with the interests of their firms and their clients. And how to do it without doing things that are possibly unconstitutional – like simply banning certain forms of compensation – or that have all sorts of unanticipated consequences. Maybe strict limits on executive compensation would do the trick. I know the argument that this will deter talented people from entering the industry, but – and the business world is one place where I do have a lot of experience – the difference in “talent” between CEOs and people one or two levels down is minimal if not negative. (Rakesh Khurana has a book on the distorted market for CEOs, and either he or Jim Collins – can’t remember which – has evidence that companies would be better off promoting people (who have never been CEOs) from within than shopping on the CEO market.) Put another way, I think there are plenty of hardworking, bright, experienced people in banks today who would be happy to be senior executives for a mere $1 million per year.

In the end, this is all probably pretty obvious: don’t blame people for being the way they are, and instead try to create structures and incentives that will protect them (in general) from themselves (in particular). More on that another time.

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.”

There has been a lot of tut-tutting, here and especially abroad, about over-consumption and over-indebtedness in the U.S. According to this story, the problem is that U.S. consumers grew addicted to spending, and financed their spending through ever-increasing amounts of debt. Over-consumption fed itself, because it drove up asset prices, which enabled consumers to take on even more debt, which enabled them to spend more, and so on. But, according to this story, the assets were not actually getting more valuable – a house in the suburbs of Las Vegas is the same house it was ten years ago – and the asset price bubble and the debt mountain both had to collapse. (Note that, if you blame the U.S. consumer, then mortgage brokers, investment banks, and bond rating agencies all become mere enablers; if they hadn’t existed, the consumer would have figured out another way to rack up the debt.) The counterfactual “solution” (the historical path that would have avoided this outcome) was for the U.S. consumer to live a more sober life, consume less, and take on less debt.

I am unsatisfied with this story for two reasons. First, I don’t think it’s much of an explanation to say that people were insufficiently virtuous. People are the way they are, and you can only change them slowly, if at all. (The radical stage of the French Revolution, and the Chinese Cultural Revolution, both tried this, and failed miserably.) So maybe Americans are more like grasshoppers than ants. Maybe it’s our popular culture, or our mediocre public education system, or our irrational optimism, or something else. And maybe, at the margins, our leaders could have take a few steps to talk people down from their belief that assets only appreciate in value. But it wouldn’t have changed much.

Second – and this was supposed to be the topic of this post – it takes two to tango. If the U.S., seen as a single unit, borrowed a big pile of money, that’s because someone else lent it to us – and lent it to us cheaply. And while China isn’t the only country that lent us money, it was the major new lender of the last decade.

The U.S., as we all know, has been running a large trade deficit. The flip side of a trade deficit, leaving aside a few details, is foreign capital inflows. Again, looking at the U.S. as one big household, if we consume more than we produce, we have to pay for it somehow; we pay for it by selling assets (foreign direct investment in the U.S., foreign purchases of U.S. stocks, etc.) or borrowing money from overseas (foreign purchases of U.S. bonds).  If we are not saving enough to invest in our economy, then the investment is coming from some other country that is saving more than it needs for its economy.

So far, this may sound like ants and grasshoppers, one being more virtuous than the other. (Although, in the current situation, both are equally responsible for the degree of economic imbalance in the world.) But it’s a little more complicated. Because while Americans were over-consuming, the Chinese government was consciously and explicitly suppressing domestic consumption. It did this by intervening on foreign currency markets to keep its currency, the renminbi, artificially low. Having a cheap currency made Chinese goods cheaper in the U.S., increasing our imports. It also reduced the purchasing power of people in China, making it harder for them to buy imported goods and reducing their standard of living. So to the extent that the U.S. over-consumed, it was aided and abetted by other countries under-consuming, China most prominently.

I don’t know the specific mechanism used to control the exchange rate, but in general the most direct means would be some combination of printing more renminbi and using it to buy U.S. dollars. In order to be able to control its currency, and as a result of keeping it low against the dollar, the Chinese government has amassed roughly $2 trillion in foreign currency reserves, which are believed to be largely in U.S. dollar-denominated assets, such as Treasury bonds and the bonds of government agencies such as Fannie Mae and Freddie Mac.

Now, China wasn’t the only country building up foreign exchange reserves, largely in dollars. Since the emerging markets crisis of 1997-98, the conventional wisdom has been that large currency reserves are necessary to protect yourself against an attack on your own currency, and as a result countries like Russia, South Korea, and Brazil (all victims in 1997-98) amassed hundreds of billions of dollars’ worth of reserves on their own.

All of the U.S. dollar reserves held by all of these countries were effectively loans to the U.S. Treasury bonds were loans to our government; agency bonds were loans to our housing sector. This large appetite for U.S. bonds pushed up prices and pushed down yields, lowering interest rates and thereby fueling the U.S. bubble. Even though the money didn’t go directly into subprime lending, it lowered the costs for all the investors who were investing in subprime. so at the same time that irrational beliefs about asset prices were driving those prices up, the increased availability of money looking for things to buy also drove prices up. Looking at it counterfactually, if there had not been so much global demand for U.S. assets, it’s unlikely that even the once-divine Alan Greenspan could have kept 30-year mortgage rates as low as they were, since the only lever he had control over, the Fed funds target rate, is an overnight rate. And if mortgage rates hadn’t been so low, the bubble couldn’t have been as big.

Which brings us back to the present. Does China really want us to mend our ways, “raise [our] savings ratio appropriately and reduce [our] trade and fiscal deficits,” or do they just enjoy hearing themselves say it? If the U.S. does start saving and reduces its trade deficit, the impact on China’s export-led economy could be devastating. On paper, China could switch toward promoting domestic consumption, thereby reducing its reliance on exports, but at a minimum this is likely to cause significant internal dislocation for a period of years. In any case, they are likely to get what the wish for: the U.S. savings rate is likely to increase significantly simply due to the rush of panic that many Americans have felt for the last two months, and the trade deficit is likely to improve both due to a reduction in consumption and due to the fall in commodity prices.  Countries that want someone else to do their consumption for them may have to start looking elsewhere.