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

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.

A parallel is commonly drawn to the 9/11 Commission, which I believe is widely considered to have been both genuinely bipartisan and worthwhile. However, I think the differences are more important here. On September 12, 2001, most people – certainly including most people in government and policy, and almost certainly including even the most highly-placed people in the country – had only the vaguest idea of how nineteen terrorists had infiltrated the country and managed to hijack four plans, using three of them successfully as bombs. The Commission’s mandate was to understand how that happened, and in particular how our intelligence and security agencies had failed to prevent this attack. That is, there was a shortage of information, and most of the information was classified anyway, so a thorough investigation was called for.

By September 16, 2008, most people in the business already knew the causes of the financial crisis: cheap money, new and predatory mortgage products, lax underwriting practices, the transfer of risk through securitization. dependence on ratings by overwhelmed rating agencies, failure of regulatory agencies to regulate, greediness on the part of banks and bankers who ate up their own AAA-rated dog food, unhealthy dependence on short-term funding, etc. There has been argument about the relative importance of these factors, but the basic story is so well known that it has spawned multiple cartoon caricatures. There is little fact-finding necessary to determine the causes of the crisis; we should already be at the phase of analyzing empirical data, and I can predict with confidence that seventy years from now there will be economic historians arguing both sides of this question; after all, that’s what happened with the Great Depression.

I expect, and hope, that the Financial Crisis Inquiry Commission will uncover some especially sordid details of bankers laughing about screwing their customers, or regulators on the take from the banking industry. And if that happened, then those people should be sued or put in jail. But we already know that bankers were screwing their customers, and we know that regulatory agencies were friendly toward the banking industry (whether because of corruption, simple ideological alignment, or orders by political appointees makes little difference in the broad story).

I am skeptical that months or years of study will bring us any closer to consensus on the major questions, because the crisis is so overdetermined; there is plenty of evidence to construct multiple plausible narratives about how it happened, each one of which points to a different regulatory solution (and whether you could get that solution through Congress is yet another question).

Thinking cynically, spending 1-3 years studying the problem could also be cover to let the issue fade away; the impetus for reform is already far weaker today than it was in, say, February when Citigroup was going through its third near-death experience. I know that’s not Davidson’s intent, but I’m sure there are others who would be only too happy to bet that the economy and the popular mood will return to normal. Remember Sarbanes-Oxley? It was weaker than originally imagined, and by 2007 there was a movement afoot to repeal it, since people had already forgotten Enron and Worldcom. Let’s hope that doesn’t happen again.

By James Kwak

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.)

Um, no.

There were all those nuts saying that Treasury should have taken over the banks. This would have allowed the imposition of haircuts on creditors and limited moral hazard. There was also the less controversial option of making real, lasting constraints on banking practices a condition of the bailouts; the conditions that were imposed were peripheral and timed to evaporate when the TARP money was paid back. As a result, now Geithner has to bargain with Congress and an increasingly confident industry to get his regulatory reform.

It’s also important to differentiate between September 16-October 14, when you could give the government the benefit of the doubt because of the intense panic and uncertainty caused by the collapse of Lehman, and November-February (when the follow-on bailouts of Citigroup and Bank of America took place), when the government was able to choose among a range of options.

Saving the economy was a good thing. Doing it a particular way was a choice.

That said, I’m glad that Geithner says that undoing this situation is “the dominant public policy imperative motivating reform.”

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

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.

1. Financial crises result from fundamental problems that should be fixed.

“It seems difficult to point to any emerging-market economy that experienced a financial crisis but did not have significant fundamental weaknesses that called into question the sustainability of its policies.”

“Bank runs or their international analogues are not driven by sunspots: their likelihood is driven and determined by the extent of fundamental weaknesses. … Preventing crises is heavily an issue of avoiding situations where the bank-run psychology takes hold, and that will depend heavily on strengthening core institutions and other fundamentals.”

In other words, you can’t blame a crisis entirely on investor psychology; there is something rotten. The panic of September-March was not, as some argued, simply a liquidity crisis; the premise of the liquidity crisis theory is that the fundamentals are sound (institutions are solvent), and Summers doesn’t believe that.

2. The strength of domestic financial systems and institutions matters more than aggregates such as the amount of debt.

“When well-capitalized and supervised banks, effective corporate governance and bankruptcy codes, and credible means of contract enforcement, along with other elements of a strong financial system, are present, significant amounts of debt will be sustainable. In their absence, even very small amounts of debt can be problematic.”**

The fact that U.S. consumers and banks had a lot of debt isn’t itself a cause of anything; if our financial system were effectively governed, debt alone would not have brought it down as spectacularly as it did.

3. Short-term funding is dangerous because it can be difficult to roll over in a crisis.

“Policy biases toward short-term capital need to be avoided.”

“A measure of sound management of short-term flows is implicit in any prudential regulation of banks.”

The U.S. failed on this count. A large portion of the shadow banking system – SIVs and SPVs raising short-term funds and investing them in long-term assets – was entirely dependent on short-term capital. It also turned out that most of the large corporate sector was dependent on commercial paper, which is also short-term. When short-term funding vanished in September, everyone was stuck.

4. Transparency matters.

“If one were writing a history of the American capital market, I think one would conclude that the single most important innovation shaping that market was the idea of generally accepted accounting principles. The transparency implicit in the generally accepted accounting principles (GAAP) promotes efficient market responses to change, and it supports stability. Furthermore, if as Ken Galbraith has observed, conscience is the fear that someone may be watching, it may be the single most effective means of promoting self-regulation.”

I think Summers is right on a historical scale – standard accounting conventions promote transparency. But looking only at the last two decades, I thnk that GAAP did not keep up with the realities of financial innovation, for example in accounting for SIVs. For the beneficial effect cited by Summers to hold – accounting standardization promotes effective self-regulation – the accounting has to accurately reflect the true risk being taken by institutions. If not, the causal chain breaks down.

5. Expectations of bailouts are bad.

“While conditioned, precautionary financial support is constructive in some cases, the risk inherent in systematic availability of unconditional credit to countries can be summarized in two words: moral hazard.”

“It is certain that a healthy financial system cannot be built on the expectation of bailouts.”

Enough said.

6. Rapid intervention in unhealthy institutions is critical.

“Prompt action needs to be taken to maintain financial stability, by moving quickly to support healthy institutions and by intervening in unhealthy institutions. The loss of confidence in the financial system and episodes of bank panics were not caused by early and necessary interventions in insolvent institutions. Rather, these problems were exacerbated by (a) a delay in intervening to address the problem of mounting nonperforming loans; (b) implicit bailout guarantees that led to an attempt to “gamble for redemption”; (c) a system of implicit, rather than explicit and incentive-compatible, deposit guarantees at a time when there was not a credible amount of fiscal resources available to back such guarantees; and (d) political distortions and interferences in the way interventions were carried out.”

Again leaving aside (d), I think our government was guilty of (a), (b), and maybe (c) in the recent crisis. It’s not clear that (a) has yet been satisfactorily addressed (even PPIP seems to be evaporating), especially when it comes to commercial real estate, and we clearly have (b). As for (c), we did move to explicit deposit guarantees, but we still have implicit guarantees on other bank funding (bonds); and though the government probably has a credible amount of fiscal resources, there is still the question of whether Congress or the Fed will come up with the money in a pinch.

So again, I think the Summers of 2000 was basically spot-on. However, I think the Obama Administration – of which Summers, of course, is a central figure – is doing a spotty job of implementing his lessons. Most notably, we have increased the expectation of bailouts by supporting unhealthy institutions, increasing moral hazard; and we have left the problem of toxic assets largely untouched, hoping that economic recovery will make it go away. I think this has been due largely to political realities, not to any failing of Larry Summers to understand his own thinking; the United States government has a lot more power negotiating with itself than an emerging market country has negotiating with the IMF.

The big current question is whether financial regulatory reform will fix the underlying problems that, according to the Summers, are the root of financial crises. For example, according to Summers (2000), we want a regime that discourages dependence on short-term funding, we want more transparency, and we want something that reduces rather than increases expectations of bailouts. Whether we get that – or whether the administration prefers to let regulatory reform fade away in the wake of the health care war – is the remaining test.

* The offiical online home of that paper doesn’t allow free downloads, so I don’t think I should post my copy, although other people may have.

** Citing a paper by Simon, Peter, Alastar Breach, and Eric Friedman!!

By James Kwak

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

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.

Ash’s essay reflects the feeling that the financial crisis was so cataclysmic, and the behavior that precipitated it so indefensible, that it could not help but trigger a major change in economic organization and perhaps even in societal values. Today, it’s pretty easy to label it as hopelessly optimistic. Many emerging markets, with China in the lead, are determined to return to an economic boom as quickly as possible. In the United States, the official administration strategy is to reflate the banking system as a means of stimulating the economy. After a couple of months of uncertainty, the media has consolidated around reporting this as an ordinary recession, though more severe than most.

More fundamentally, people change only a little bit, and only very slowly. People may be a little less willing to buy flat-screen TVs on credit, but they will still aspire to own flat-screen TVs. Domestic political systems will still undercut attempts at international governance; “internationalism” is perhaps more a dirty word than ever in the United States, as evidenced by the shameful attempts to portray Harold Koh (until recently dean of the Yale Law School) as un-American during his confirmation hearings. As for the environment, I have yet to see compelling evidence that the human race will pull it together in time to meaningfully slow down global warming, and if anything the recession is being used as an argument against investing in alternative energy.

In the longer term, I think we can hope for a few silver linings from this crisis and recession. People may be less willing to take on debt, which will mean greater domestic savings and therefore greater domestic investment with less foreign debt. People may feel less secure economically, or maybe will at least remember feeling less secure during the dark days of 2008-2009, which may make them a little more concerned about the poor and a little more willing to pay for a better social safety net. Graduates of our top universities may want to do something other than become bankers and hedge fund managers, and may invent new technologies and teaching methods instead of new derivatives. Maybe the glorification of extreme wealth will be tempered a bit for a few decades, so the ultra-wealthy will flaunt it a little less and the rest of us will admire it a little less.

All of these things would be good, and they may still happen. But it will be within a capitalist system that remains pretty much the same as before – perhaps with a tiny bit more regulation.

By James Kwak

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?

The problem is that, having actually paid for the magazine and read the article, it seems to me that Lewis only reinforces the case against FP and credit default swaps. He says that all of the FP people he talked to “were fairly certain that if it hadn’t been for A.I.G. F.P. the subprime-mortgage machine might never have been built, and the financial crisis might never have happened.” That sounds to me like a more damning case than I would have made.

In Lewis’s story, it was credit default swaps sold by FP that enabled banks to issue securities backed by subprime mortgages earlier this decade. He has evidence that the people at FP who were insuring these securities had no idea how much subprime debt was inside them. When Gene Park figured it out around the end of 2005, Joe Cassano actually agreed to stop insuring subprime-backed securities. Yet Lewis even holds FP responsible for what came later:

“A.I.G. F.P.’s willingness to assume the vast majority of the risk of all the subprime-mortgage bonds created in 2004 and 2005 had created a machine that depended for its fuel on subprime-mortgage loans. . . .

“The big Wall Street firms solved the problem by taking the risk themselves. . . . Unwilling to take the risk of subprime-mortgage bonds in 2004 and 2005, the Wall Street firms swallowed the risk in 2006 and 2007.”

This is somewhat plausible, but it’s a funny argument. Essentially it says that: (a) FP was responsible for subprime lending because, without insurance, investment banks wouldn’t have been willing to take on the risk of the securities in the first place (and demand from investment banks is what caused frontline lenders to originate these loans); but (b) when FP stopped insuring the securities, investment banks suddenly decided they were willing to take on the risk. I say it’s plausible because it could be that FP enabled a profit machine in 2004-05 and the banks were unble to shut it down in 2006-07 without torpedoing their earnings. But if that were the case, they would all have behaved like Goldman – shorting the mortgage-backed securities markets with one hand at the same time that they originated the stuff with the other. In 2006-07, most banks simply underestimated the risk of the stuff they were holding; that is FP’s fault only if you claim that FP made banks like Bear and Lehman stupid.

So when Lewis says, “A.I.G. F.P. wasn’t an aberration; what happened at A.I.G. F.P could have happened anywhere on Wall Street . . . and did” (ellipsis in original), I’m not sure which side he is arguing. Is he saying that FP is to blame for the crash? Or is he saying that FP caused the crash, but doesn’t deserve to be singled out because it “could have happened anywhere?”

The latter argument, to me, doesn’t make sense. The problem is better illustrated when Lewis describes the rise of credit default swaps in the 1990s:

“The traits required of this corporation were that it not be a bank – and thus subject to bank regulation and the need to reserve capital against the risky assets – and that it be willing and able to bury exotic risks on its balance sheet. There was no real reason that company had to be A.I.G.; it could have been any AAA-rated entity with a huge balance sheet. Berkshire Hathaway, for instance, or General Electric. A.I.G. just got there first.”

I don’t think anyone has ever argued that for some structural reason AIG was the only company that could have created the mess it did. AIG created the mess because it made stupid business decisions that other companies did not make. Other companies made other stupid decisions, but not the one to take a huge, one-sided bet, with no reserves, on the solidity of the housing sector and the entire economy.

Ultimately, I think Lewis is actually too harsh on FP. They made bad decisions, they essentially blew up all of AIG, and they required an enormous taxpayer-funded bailout to limit the collateral damage. But holding them responsible for the bad decisions at all the Wall Street investment banks seems a bit much.

By James Kwak

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.

Happy reading.

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

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.

At the time, I could not imagine that anything remotely similar could happen in the United States. Indeed, I shared the American conceit that most emerging-market nations had poorly developed institutions and would do well to emulate Washington and Wall Street. These days, though, I’m hardly so confident. Many economists and analysts are worrying that the United States might go the way of Japan, which suffered a “lost decade” after its own real estate market fell apart in the early 1990s. But I’m more concerned that the United States is coming to resemble Argentina, Russia and other so-called emerging markets, both in what led us to the crisis, and in how we’re trying to fix it.

Over the past year, I’ve been getting Russia flashbacks as I witness the AIG debacle as well as the collapse of Bear Sterns and a host of other financial institutions. Much like the oligarchs did in Russia, a small group of traders and executives at onetime venerable institutions have brought the U.S. and global financial systems to their knees with their reckless risk-taking — with other people’s money — for their personal gain.

And here’s the conclusion:

In the twilight of my career, when I am hopefully wiser than before, I have come to regret how the IMF and the U.S. Treasury all too often lectured leaders in emerging markets on how to “get their house in order” — without the slightest thought that the United States might fare no better when facing a major economic crisis. Now, I fear time is running out for our own policymakers to mend their ways and offer real leadership to extricate the United States from its worst economic calamity since the 1930s. If we insist on improvising and not facing our real problems, we might soon lose our status as a country to be emulated and join the ranks of those nations we have patronized for so long.

Enjoy.

* For the record, the Atlantic article was finalized on March 17 and went up on the web on March 26; judging from the URL, it looks like Lachman’s article went up on March 25.

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.