I have been taking an informal poll on what or who caused the current unpleasantness. Here is the preliminary list of potential scoundrels, in rough descending order of how many people believe they are the ones responsible:
So, you ask, what do I think went wrong and caused a credit crunch and an abrupt drop in GDP and rise in unemployment? Well, as you might expect me to say, basically none of the above except perhaps the last one. The immediate cause was a housing bubble which began to pop in late 2007. But the housing bubble may have been the culmination of a bubble-headedness that began in the 1990ies with the emergence of the microcomputer and its miraculous insertion into every crevice of our lives. Firms such as Intel and IBM had the knowledge and infrastructure in place to exploit these new technologies. Newly established companies such as Yahoo and Google had the vision to carve out new business opportunities. No-one really knew how much value these players could create, but there was a general conviction that there was something magical going on (which I still think is true) and that it could create immense amounts of wealth (which I still think is true, although it is still not clear who are going to be the lucky recipients of this wealth). It was not surprising, perhaps, that investors let their imaginations run wild, to the extent that market capitalizations of companies having anything to do with computers were valued entirely by investors’ dreams.
The dreams fueling the internet bubble were punctured in 2000 when tech stocks plummeted breathtakingly and stock valuation methodologies for emerging technologies returned to more traditional calculations. But I believe that the optimism that had fueled the internet bubble did not die, even after the events of September 11, 2001 and subsequent recession. Instead, real estate became the new internet. And why not? Home prices never seemed to go down, even in a recession. Mortgage lending was remarkably safe; if you owned a house and then defaulted on your mortgage, you risked getting booted out of your home, so very few home owners were tempted to default, even when things got tough – better struggle to make payments by selling off Grandma’s china than sleep in the streets. In addition, if you had owned your home for even a couple of years, the chances were you could sell it for a profit, so if all else failed, you’d still be better off selling the house rather than surrendering it to the bank. It seemed like home owners and lenders alike could not lose money, so long as rising prices kept bailing them out.
And prices did keep rising, for a while at least. Mortgage defaults were incredibly low during much of the decade and lenders saw new opportunities to lend money to people who had up to now been considered excessively bad risks – who had little or no money to put down and who would be struggling to make their monthly payments. Some of these new borrowers would in fact be able to make the payments, stay current and enjoy the fruits of home ownership. Others would not, but by the time they gave up the struggle, the price of their house had gone up enough so that they could at least get out without defaulting. Thus the sub-prime mortgage market was born.
How did people react to the continuing rise in house prices?
As with all bubbles, the house price bubble had to burst. The builders were going great guns pumping out new houses, but eventually the supply of unsold houses had to start rising. Pretty soon, builders found themselves having to discount their houses to sell them and prices everywhere started to collapse. They collapsed slowly, unlike the stock market, which has a tendency to crash and burn overnight. But the overall effect was devastating. In some parts of the country, average house prices fell by more than 50% during 2008. The overall reduction in peoples’ wealth was in the tens of trillions of dollars, not counting the further reduction from the fall in the stock market. It is not surprising, then, that people stopped buying stuff – they had to rethink the whole question of how much they could now afford to spend, given that their dreams of retiring with a huge wad of cash from the sale of the house had gone up in smoke.
The fallout from the housing price collapse has been widespread. First, as noted above, people stopped buying stuff. Some part of this new frugality may have been more the results of panic than rational thought, and this may now be returning to normal, but the level of consumer spending will not return to the level of a few years ago for quite a while. Why should it? As a nation, we have found out we are poorer than we had imagined by many trillions of dollars – would it really be appropriate for us to resume spending as before? So we should be resigned to a persistently lower level of consumer spending, which in turn means that businesses selling consumer goods, which have been hammered by consumers’ reluctance to spend, will have to adjust to a lower level of domestic demand. And as an obvious corollary of that, employment in those businesses will not soon return to the levels of the past, nor will the market values of these businesses as reflected in the stock market soon return to former levels.
Many types of business have been hit hard, notably homebuilding, the auto industry and the financial sector. For a while, it seemed to me, the financial sector was being singled out as a possible villain responsible for the whole disaster. Sub-prime lending, which might have been characterized in earlier times as bringing the American dream to people who previously did not have access to it, became described as "predatory lending". (What a scary thought! “You must borrow this money from me or you will never see your son again!”) Then there were the mortgage derivatives (“toxic assets”) lurking at the bottom of the balance sheet of large commercial banks and Wall Street investment banks. The most evil of these derivatives were known as “residuals” and were described as the result of reckless financial engineering, designed by mathematicians who understood nothing of the real world aided and abetted by traders who would like nothing better than to risk it all on one toss of the dice. (Actually, I like the idea of demonizing mathematicians, or "quants" as we call them on the "Street". And we thought they were just nerdy guys who worked a lot because they weren't comfortable with girls! As a quasi-quant myself, I much prefer the notion that I was acting out of sinister motives.) These securities were deemed to be so complex that no-one had any idea what they might be worth. This made much better copy than the fact that these residuals were designed to absorb the bulk of any defaults on a mortgage portfolio, rather like mortgage insurance. Like an insurance policy, these assets could vary dramatically in value, depending on what happened to the performance of the underlying mortgages. As house prices continued to decline, more and more borrowers who were having trouble making payments saw that they’d be better off surrendering the house to the bank rather than struggle to make payments by selling off Grandma’s china. Foreclosures rose, house prices continued to fall. As a consequence, mortgage residuals had little or no value. Somewhat more surprisingly, other mortgage securities that had been protected by the existence of the residuals also suffered losses; this had been contemplated in the structuring of the deals, but in recent history these assets had not had to bear any of the losses and investors were hoping that would continue. Sorry Charlie!
The sudden collapse of Freddie Mac and Fannie Mae took me by surprise. These are two mega-corporations, created by the Federal Government but privately owned, that effectively provide insurance to a large fraction of the residential mortgage market. When I worked at Freddie Mac, one of our main concerns was making sure that we had enough capital to keep the company going even under the most adverse circumstances. We interpreted that to mean that we would have to be able to survive a fall in house prices similar to what happened in the Great Depression. After looking at statistics over the decade of the 1930ies, we concluded that this meant four successive years of 25% declines in house prices followed by price stagnation and then an anemic recovery. Our recommendations for Freddie Mac’s capital, then, was enough to withstand the losses generated by that scenario. Looking at the past year, though, we see that in many areas house price declines were significantly worse than those seen at the beginning of the Great Depression, so perhaps I shouldn’t be surprised that Freddie Mac fell apart. Am I one of those reckless employees who drove the company into bankruptcy? Maybe so, but it certainly didn’t feel so reckless at the time to set a capital standard of being able to survive the Great Depression.
Should the government have prevented the housing bubble? I think it is madness to expect the government to play this role in society. Politicians don’t know much about how markets work; besides which, they don’t really care. Who wanted to hear about “irrational exuberance” in the stock market? Who would want to hear about it in the housing market? The same politicians now wagging their fingers about predatory lending are the ones that are also trying to make it easier for people to buy a house in the hope that the housing market picks up a bit. Politicians like it when their constituents feel wealthy and happy and able to take fancy foreign vacations because happy voters tend to reelect incumbents.
Bubbles do happen occasionally – e.g. the South Sea bubble, the tulip bubble, the Florida land bubble – but people who buy and sell in such markets have a strong financial interest in trying to sniff out the bubble to avoid getting clobbered by it. They may occasionally be mistaken, but it’s rare that things go on long enough to cause such damage. When they do, the bubble makes it to the record book, as this one will.
How should we grade the politicians on their response to the crisis? Well, I am certainly willing to pass out some praise, but not much. Bernanke at The Federal Reserve, supported by first by Paulson and then Geithner at the Treasury, reacted quickly and appropriately by flooding the banking system with reserves. This drove interest rates down to almost unprecedented levels, which took a lot of pressure off both corporate and individual borrowers whose interest payments were greatly reduced. It also put pressure on the banks to find more profitable places to invest their assets than Treasury securities, which ultimately got the lending process started up again. Well done!
I’m a lot less enthusiastic about the government’s plan to substitute government spending for the missing consumer and business spending. Let me once again summarize what has happened to us so far. First, we have been hammered by the collapse of the real estate market. Then, we have been hammered by the stock market, although some of that hammering has been undone in 2009. Then a bunch of us (including Louise) have been hammered by the job market. We are indeed measurably poorer than we had earlier thought we were by numerous trillions of dollars.
Being poorer, we want to cut back on our spending. This is our right and our duty as rational consumers. However, this lack of spending is what is keeping people out of work. So we need some way of cranking up spending again so that we can get back to full employment. Is the stimulus package the right way to do this?
Read my lips – NOOOOOOOOOOOO! If the government spends additional money, we surely know that it is also coming out of our pocket. So why on earth would I, newly impoverished, consider myself better off if the government passes a lot of new spending initiatives that I have to pay for? Now I’m going to be hammered by increased taxes, after all the other hammerings enumerated above. And for what? After all, these are spending programs that we were unwilling to finance a few years ago when we thought we were really rich! And now we need them like a hammer in the head! Even if the government pays for these programs by borrowing money rather than taxing us immediately, the taxes have to come sooner or later. I’ll be dead (heh, heh!), but you other poor sods will end up paying my share. (So sorry, Maddi and Toni!)
A further trouble is that when a politician hears the words “Stimulus Package”, it is like the words “Free Heroin” to a junkie. Spending other people’s money to the benefit of their key constituencies is how politicians succeed – the usual problem is that taxpayers resist paying for it. But with millions unemployed, the clamor for spending is overwhelming everything else, including good sense.
Let’s think carefully for a moment about the proper way of fixing the economy. What do I want, as an individual? Following the popping of my bubble, I can no longer rely on the pot of gold I used to count on from the sale of my house when I retire and move to the beach house. So long as I am still employed, I still have my income, but now I must save more of that income in order to be comfortable in retirement. When I save more money, I need to invest that money productively in financial assets such as stocks and bonds. So now I need someone to create new businesses; these will take my new savings and use them to build factories, research labs, hire managers, planners, machine operators, accountants, night watchmen and so on. Why should these businesses spring up? Because it is dirt cheap to borrow money right now and because the unemployed are supposedly standing in line drooling at the chance to get a job again. Employment rises, we also prepare more prudently for our retirement, and - presto! - all is well again.
Well, all right, I concede that makes it look a little too easy. The problem with this scenario is that we already have an economic infrastructure that is designed to feed an overly high rate of consumption. Now we need to exchange that for an economic infrastructure that produces fewer consumption goods today, but provides for a steady increase in its capacity to do so in the future. What government policies might help us get from here to there?
Well, there are two key policies that can make this adjustment as close to painless as possible. First, a loose monetary policy that reduces the cost of borrowing money, and, second, the provision of a stable and predictable business environment. And while we have had the former, the business environment has never been more unpredictable. Financial institutions, widely viewed as "the bad guys", still do not know the extent of new laws and regulations they will be subjected to. Under this uncertainly, why would we expect financial institutions to be dreaming up bold new ways of doing business? Hunkering down and protecting their assets seems a more prudent course of action. Democrats are calling for the rich to pay more taxes - will that encourage innovation and investment? Clashes between the Democrats and Republicans in the House produce a lot of smoke but no action, despite the alarming run-up in the national debt. Will teetering on the brink of the various cliffs create the investment we need? Will temporary programs to spend more money on public programs we don't want do it? I don't think so!
The most depressing thing about all the government spending is that we all know (don't we?) that these programs are not just to kick-start the economy and then gracefully go away when private spending rises to take its place. You know the thing with heroin – easy to start, hard to stop. So don’t expect the trillions to stop being spent just because the crisis is over.
Copyright © 2009 by Peter Lloyd-Davies. All rights reserved. Privacy Statement.