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:
Last week, Planet Money aired an interview by Adam Davidson with Barney Frank, the blunt and colorful chairman of the House Financial Services Committee. Davidson and Frank had a pitched disagreement over the question of whether it made sense to appoint a bipartisan, expert panel to take some time – figures between one and three years were thrown around – to study the causes of the financial crisis and, on that basis, recommend regulatory changes. Davidson thought it was a good idea; Frank thought it was nonsense.
I’m with Frank on this one, and the argument applies to the Financial Crisis Inquiry Commission, also known hopefully as the “New Pecora Commission,” appointed by Congress to study the causes of the crisis.
Probably most of you have already read David Cho’s Washington Post article on how the Big Four banks (a) have gotten bigger through the crisis, (b) have increased market share (“now issue one of every two mortgages and about two of every three credit cards”), (c) are using their market clout to increase fees (while small banks are lowering fees), and (d) enjoy lower funding costs because of the nearly-explicit government guarantee.
I just want to comment on this statement by Tim Geithner: “The dominant public policy imperative motivating reform is to address the moral hazard risk created by what we did, what we had to do in the crisis to save the economy.” (Emphasis added.)
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.
This fall I am taking a course on the “international financial crisis” taught by Jon Macey and Greg Fleming (yes, the former COO of Merrill Lynch). The first assigned reading is a speech that Larry Summers gave at the AEA in 2000 entitled “International Financial Crises: Causes, Prevention, and Cures,”* summarizing the state of the art in preventing and combating financial crises. It’s based on experiences from emerging market crises in the 1990s, and doesn’t even contain a hint that something similar might happen here; however, few people could fault Summers for making that oversight back in 2000, and I certainly won’t.
Many people, including Simon and me, have discussed the similarities between our recent financial crisis and the emerging market crises of the 1990s, so I’ll be brief. The main similarities are excessive optimism that creates an asset price bubble, a sudden collapse of confidence that causes the rapid withdrawal of money and credit, a liquidity crunch, and rapid de-leveraging that threatens solvency. (We have also argued that there are political similarities, but let’s leave that aside for now.) The biggest difference is that instead of being compounded by flight from the affected country’s currency and government debt, in our case the exact opposite happened; investors fled toward the U.S. dollar and Treasuries, making things easier for us than for, say, Thailand. Also, to a partial extent, the parallel requires an analogy between emerging market countries and United States banks; for example, the issue of bailouts and moral hazard arises in the context of the IMF bailing out Indonesia and in the context of the United States government bailing out Citigroup.
Summers’s speech makes a lot of sense, so I’ll just highlight a few points he makes that I think are particularly instructive given our recent experience. I think these are all excellent points. For each one, I’ll quote from Summers, and then comment on its relevance to our situation.
David Wessel seems to be doing the impossible: his book, In Fed We Trust, is getting mentions from all over the Internet, even before its publication, despite competition from what seem like dozens of other crisis books. That’s what a good PR campaign (and a good review from Michiko Kakutani) will do for you.
I obviously haven’t read the book yet, but I was interested in this description in Bloomberg:
None of the senior government policy makers anticipated the credit-market collapse that followed Lehman’s bankruptcy filing in the early hours of Sept. 15, according to Wessel’s book. . . .
On a conference call the previous week, Paulson, Bernanke, Securities and Exchange Commission Chairman Christopher Cox, and senior staff members from those agencies had agreed that companies and investors who did business with Lehman had learned from Bear Stearns and would have acted to protect themselves from a Lehman failure, Wessel wrote.
What were they supposed to learn from Bear Stearns? That they should be very, very afraid of a major bank failure and take steps to protect themselves? Or that the government would step in, so that even if shareholders were largely wiped out, counterparties would be protected? It seems like more of them drew the latter conclusion, even though Paulson, Bernanke, et al. wanted them to draw the former conclusion.
This seems to me an illustration of the fact that you can never be sure what message you are sending. Perversely, even letting Lehman fail ultimately convinced market participants that the government would step in the next time – because the damage done by Lehman’s collapse was so great. One-off intervention are a crude and risky way of communicating policy and creating incentives.
By James Kwak
Timothy Garton Ash is a prominent modern European historian, who became famous writing about the collapse of Communism and the transformation of Eastern Europe in the 1990s. It was something many people thought they would never live to see.
A friend asked me what I thought of Ash’s article a couple of months ago in The Guardian, where he asked what will come of modern capitalism in the wake of the financial and economic crisis.
An extreme “neoliberal” version of the free-market economy, characterised not just by far-reaching deregulation and privatisation but also by a Gordon Gekko greed-is-good ethos – and fully realised in practice only in some areas of Anglo-Saxon and post-communist economies – seems likely to find itself [left in ruins or at least very substantially transformed]. But how about a modernised, reformed version of what postwar German thinkers called the “social market economy”?
Ash goes even farther than what you might call the Continental European social-democratic model, and envisions a world with a better balance between production and consumption, between national and international governance, and between exploitation and protection of the environment.
Back in November, Michael Lewis wrote a great story in Portfolio on the financial crisis, focusing on the traders who saw that the housing bubble was going to crash, bringing mortgage-backed securities down with it – and made lots of money betting on it. Now Lewis is back with his article in Vanity Fair on AIG Financial Products (FP) and its last head, Joseph Cassano. This time, though, it feels like it’s missing the usual Lewis magic.
Lewis sets out to tell the untold story of FP, based on extensive interviews with people who actually worked there. He starts by laying out the conventional wisdom about FP, which presumably he is going to debunk. The conventional wisdom, according to Lewis, is that the problem lay in credit default swaps: “The public explanation of A.I.G.’s failure focused on the credit-default swaps sold by traders at A.I.G. F.P., when A.I.G.’s problems were clearly much broader.” Indeed, Lewis implies that the government essentially framed FP: “Why were officials, both public and private, so intent on leading others to believe all the losses at A.I.G. had been caused by a few dozen traders in this fringe unit in London and Connecticut?
Sorry about the recent silence; I’ve been trying to kill off a rewrite of a paper, and sometimes I find that to get things done you just have to be singleminded about your priorities.
In case you haven’t seen them yet, I wanted to point out a couple of things that have been making the rounds of the Internet:
- Most of the people writing about health care reform on economics blogs – present company included – are not health care economics specialists. Uwe Reinhardt is. So when he writes about “rationing health care,” I recommend reading (hat tip Mark Thoma).
- Brad Setser is branching out from foreign reserves, holdings of U.S. government and agency bonds, and China – on which he is probably the leading figure on the Internet – to, well, everything. Visit the Council on Foreign Relations’ “Crisis Guide: The Global Economy” and click on Motion Charts. There are four charts in the sidebar to the right. For each one, you can watch Setser on video, or you can click the “Interact with Motion Chart” link and play with it yourself.
By James Kwak
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.
One of the central themes of our Atlantic article was that the current crisis in the U.S. is very similar to the crises typically seen in emerging markets, and that resolving the crisis will require (some of) the measures often prescribed for emerging markets. This, Simon said, would be the assessment of IMF veterans who had worked on emerging markets crises.
At the exact same time that we were writing that article, Desmond Lachman – who worked at the IMF for 24 years, and then worked on emerging markets for Salomon Smith Barney for another seven years – was writing an article for the Washington Post saying many of the same things.* Here are the first three paragraphs:
Back in the spring of 1998, when Boris Yeltsin was still at Russia’s helm, I led a group of global investors to Moscow to find out firsthand where the Russian economy was headed. My long career with the International Monetary Fund and on Wall Street had taken me to “emerging markets” throughout Asia, Eastern Europe and Latin America, and I thought I’d seen it all. Yet I still recall the shock I felt at a meeting in Russia’s dingy Ministry of Finance, where I finally realized how a handful of young oligarchs were bringing Russia’s economy to ruin in the pursuit of their own selfish interests, despite the supposed brilliance of Anatoly Chubais, Russia’s economic czar at the time.
One of our goals is to help increase understanding of the financial crisis, so that people can understand the policy choices facing our countries today. Doug Diamond and Anil Kashyap have done two guest posts on the crisis for the Freakonomics blog: one on September 18, just after the announcement of the Paulson plan, and one just yesterday. These aren’t quite explanations for beginners – they presume some understanding of debt, equity, credit default swaps, and so on – but they summarize and explain some of the key developments relatively clearly, and also lay out their opinion of the current U.S. recapitalization plan.
Simon discusses the financial crisis and some possible solutions on an MIT podcast (11 min.).
The Center for Economic and Policy Research has rushed out, and I mean that in the best sense of the term, a survey of economists’ recommendations for the world’s economic policymakers and, specifically, for the meeting of G7 finance ministers this week. The economists who contributed to the 40-page report (once there, click on the title to download the PDF), while presenting a range of views, generally agree on the need to recapitalize the banking sector and, with some dissent, to guarantee short-term bank liabilities in order to calm fears in the financial markets. They also agree on the urgent need for coordinated action across countries. These are positions we have been advocating on this site, and we are glad to see many other people on the same page.
Events of the past several days have convinced us that the state of the global economy is getting worse and we have revised our analysis and proposals accordingly. In short, coordinated, large-scale actions by the U.S. and Europe, including bank recapitalization plans and guarantees of banks’ obligations, are necessary to limit the spread of a crisis that threatens to trigger national defaults in vulnerable countries around the globe.
Editor’s Note: The content below was originally a separate page, linked to from the short blog post above. I have consolidated it into this single post, after the jump.