Greg Ip

Articles by The Economist’s U.S. Economics Editor

Our Financial 9/11*

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Remarks by Greg Ip, Donald W. Reynolds Distinguished Visiting Professional

Washington & Lee University, Feb. 5, 2009

 

 

            When confronted with new challenges, we all look for analogies in our personal experience. To me this crisis feels in many ways like the financial equivalent of 9/11. Like most of you, I remember 9/11 quite clearly. It was Tuesday morning and our staff meeting in the Wall Street Journal’s Washington bureau was about to begin when the planes struck. After realizing what was happening, we got to work reporting the story. When I was done that evening, I went home on the subway. There were far fewer people than usual. And as I watched others ride the escalator up with me, I wondered, how many of us really know how much our lives are about to change?

            I recently had a very similar feeling. It was last October. The bailout law had finally passed, and the stock market was in freefall anyway. I try to be detached, analytical and objective about the things I cover. But after months of this nonstop crisis, it was getting hard. The stress, the anxiety was getting to all of us. Like on 9/11, it was getting harder to separate the story from worrying about how these cataclysmic events would affect my own life. And that night, as I rode the escalator up from my subway platform, I looked at the people around me and wondered how many of us will have jobs to go to a year from now? Do any of us really appreciate how much our lives are about to change?

            For all its sudden violence, 9/11 was the result of fractures and stresses developing beneath the surface for many years. Before 9/11 we flew in airplanes with unlocked cockpit doors, welcomed millions of visitors without so much as a visa much less a background check, and seldom wondered if the guy next to us on the subway was a suicide bomber. After 9/11, all that changed. We went to two wars because we thought were necessary to end the terrorist threat and endured curbs to our civil liberties, often without knowing it.

            A similar process is going on now with respect to financial risk. Our attitudes about debt, about what banks and businesses should be allowed to do, and about the appropriate level of government intervention in our economy have been changed by the trauma of this financial crisis. The result will be a different economy: one with more saving, less consumption, fewer and smaller homes, and more government oversight.

            To understand the way forward, we have to understand how we got here so I will take you on a whirlwind history of finance in this country. First, let me disabuse you of any notion that this experience is somehow unique. Crises are a recurrent event in human civilization. The first recorded financial crisis may have occurred in 1340 when Edward 3 of England defaulted on debt to Italian lenders after a failed invasion of France that set off the Hundred Years war. This fact comes courtesy of Carmen Reinhart of the University of Maryland and Ken Rogoff of Harvard who have amassed a database of crises going back 800 years.

            The 19th century of the United States was riddled with financial crisis and bubbles, most importantly the panic of 1873 which led to a severe and lengthy depression. Why do banking systems produce crises? Let me inflict some banking 101 on you. Banking is vulnerable to crisis for two important reasons. One is that banks usually borrow short and lend long. That means, they may have deposits that can be withdrawn on a day’s notice but make loans that won’t be repaid for years. If enough people demand their money back at once, the bank can no longer meet its obligations and it fails. A bank whose assets are sound but cannot attract deposits or lenders is illiquid.           

The other reason banks causes crises is that they are levered. That is, for each dollar of stock holder equity, the bank has many more dollars of debt. For example, a bank with $10 of assets – typically loans, but also securities – might finance those assets with a dollar of equity (which we also call capital) and $9 of debt. If the value of its assets rises 10%, to $11, then the value of stockholder equity has doubled. Similarly, if the value of the assets falls 10%, to $9, because, for example, of loan losses, then the equity is wiped out. A bank whose assets are worth less than its liabilities is insolvent.

What is true of banks is also true of what we now call the “shadow banking system:” companies that fulfill the role of banks but are not regulated like banks or have federal deposit guarantees like banks. They include finance companies like GE Capital, Fannie Mae and Freddie Mac, investment banks, hedge funds, and a panopoly of off-balance sheet vehicles whose existence we were only dimly aware of a few years ago.

            These two things – illiquidity and insolvency – are features of almost every financial crisis. That is because a bank facing either illiquidity or insolvency will stop making loans and try to sell the assets it has. This depresses the price of assets, and makes other banks insolvent. The withdrawal of credit leads to weaker economic growth and more impairment of loans.

 The Federal Reseve was created in 1913 as a way of halting the bank panics, most notably that of 1907, which had become a regular feature of our economy. (As an aside, H Parker Willis, who was the first head of this university’s business school, was instrumental in the creation of the Fed as an aide to Virginia Senator Carter Glass.) Suppose a bank had a sudden drain of deposits. The Fed could lend it enough money to survive until the deposits returned or its loans matured. The bank would not have to fail. Where would the Fed get this money? It would, basically, print it. When the bank repaid the loan, the Fed would “unprint” the money. In its early years, the Fed saw this as its main job, that is helping banks deal with temporary illiquidity. It did not see its job as smoothing the business cycle.

The Great Depression changed that. There are many reasons the economy collapsed between 1929 and 1933, but an important one was the Fed’s failure to act more aggressively to prevent a wave of bank failures.

The Great Depression led to a much more activist and interventionist government, particularly in finance. Significant safety nets were thrown up around our banks but in return, their activities were sharply circumscribed. The Fed became much more involved in macroeconomic management. Though we had recessions and periodic crises such as Penn Central’s failure and the near bankruptcy of New York City in the 1970s, there were no serious systemic financial crises from 1940 to 1980. We did have a different problem: the Fed’s excessive efforts to prevent recession led to inflation.

Fed Chairman Paul Volcker stamped out inflation in 1981-82. I was in the audience at the New York Economics Club when I saw Volcker criticize the Fed’s bailout of Bear Stearns. I thought to myself, Paul Volcker is the father of bailouts. As he was slaying inflation, he presided over a cycle of crise and intervention that led us to where we are today. The first was the Latin America debt crisis which would have wiped out many of our banks if Volcker had not intervened and enabled those banks to in effect deny that their loans were impaired when in fact they were. In 1984, Continental Illinois, then our seventh largest bank, nearly collapsed from excessive real estate and oil lending. Volcker intervened to prevent its collapse. 

            The list of crises grew: the stock market crash of 1987, the savings and loan crises and commercial bank crises of 1989 to 1992. In 1994, the tequila crisis: Mexico’s peso plunged and the country almost defaulted. In 1997-98 we had the serial crises of East Asia, Russia, and Long Term Capital Management. In each of them, the federal government (usually the Federal Reserve) intervened to prevent normal market forces from taking their natural, destructive course. In 2001-2002 we had the dot-com/telecommuncations collapse and the bankruptcies of Enron, Worldcom and Argentina. Although no explicit intervention was necessary, the Fed did respond with two years of prolonged low interest rates.

            One of the remarkable things about this age of crisis is how well the underlying economy performed. From 1982 to 2006 inflation fell to low, stable levels, as did unemployment. We had just two recessions, both among the mildest on record. Economists began to call this period the “Great Moderation.” They attributed this to luck and to enlightened central banking. But on Wall Street they had another explanation: the Greenspan put, or the Fed’s remarkably successful record of crisis intervention. This is usually meant pejoratively, but it should not: what is intrinsically bad about a policy that saves jobs without fueling inflation? More important, in the heat of each crisis, when it is impossible to know what lies ahead, it is hard to imagine any policy maker – certainly not Volcker – behaving differently. If you have just been told that Bear Stearns plans to file for bankruptcy protection in a matter of hours and as a result, at 7 a.m., the $4 trillion repo market will come unglued and chaos will ensue, wouldn’t you do all you could to prevent that outcome?

The crowning achievement of Fed policy was the recovery from the collapse of the internet stock bubble in 2001-2002. In 2004, Alan Greenspan claimed that his strategy of not pricking a bubble in advance but of cleaning up the mess afterwards had been vindicated. And he certainly looked right at the time. In fact, it appeared that it was not just his monetary policy but also his regulatory policy that was vindicated: by this I mean letting financial innovation grow with as little regulatory intervention as possible. The price of a dynamic, innovative financial system that better channeled our savings to productive uses was the occasional crisis, but such crises had proven manageable.

            How did we respond to this period? Our perceptions of risk declined. We became more willing to buy things like stocks and houses because a stable economy with low interest rates meant their value was less likely to collapse. We allowed our saving rate to decline from over 10% of disposable income in the first half of the 1980s to zero in 2005 because we now had our homes to fall back on as a source of wealth and emergency cash.

Meanwhile, in our financial system, leverage grew. Instead of levering a dollar of equity into $10 of loans, the shadow banking system levered it into $30 of loans. Regulators constrained banks from increasing their leverage as much, so the banks found other ways: they bought their own pieces of the shadow banking system such as subprime finance companies and investment banks. They set up off balance sheet vehicles, financed with short-term debt and invested in illiquid asset-backed securities with little or no capital.

            It is important to realize that all of this was a logical response to the Great Moderation. If recessions were less frequent, than it was less likely that a loan would default and thus you could maintain higher leverage without endangering your capital. If you were a banker who did not take on more leverage, you were denying your shareholders potential profit. And there were social benefits: if banks could make more loans for each dollar of equity, more people could own homes and more businesses could get credit.

            Yet into this mixture, two important forces intervened to bring us to today’s crisis: one global, one domestic. Recall that in the 1990s, numerous countries either went bankrupt or nearly did and had to borrow from the IMF or the U.S. Treasury who in return imposed draconian conditions. Many countries suffered economic depressions and social upheaval. In Indonesia, the government fell, and there were ethnic riots. The lesson many countries drew from the Asia crisis was to never be so vulnerable again. They thus pursued policies of holding down imports and boosting exports in order to run large trade surpluses. The foreign currency they earned on those surpluses went into a growing stash of reserves that would ensure they never had to beg the IMF for help again. China did not suffer a crisis in this period but responded in much the same way, as did oil exporting countries when oil prices rose.

Those reserves had to be invested somewhere: they mostly went into government bonds in the U.S., Britain and other trade-deficit countries. Ben Bernanke called this flood of foreign capital the “global saving glut.” It helped hold long-term interest rates artificially low in western countries, sparking housing booms in the U.S., Britain, Spain, Ireland and Australia, and many other countries.

How did a housing boom become a bubble? For that we have to turn to a second set of purely domestic factors, the most important of which was the widespread belief that home prices would never decline nationally. After the collapse of the stock market bubble in 2001-2002, the Fed deliberately sought to boost home construction and housing wealth as an offset. Many people burned by the stock bust still yearned for capital gains and they turned to houses. Since they were repeatedly told, by Alan Greenspan and others, that home prices had never fallen nationally (a true statement, by the way, at least since the Depression), this seemed like a reasonable conclusion. And because long-term interest rates were low, home prices could rise quite a bit without making homes that unaffordable. The subprime market had been around for years, but got its real boost this decade from the growth in the number of people who wanted to buy a home but could not afford one based on normal criteria. We now routinely call bankers and other lenders irresponsible lunatics for making zero-money down mortgages to homeowners who could not or would not document their income or for investing billions of their own capital in complex mortgage backed securities without carefully checking the quality of the loans. What you have to realize is that as long as home prices kept going up, it didn’t matter: no matter how deadbeat the borrower, the underlying collateral would ensure the loan would be money good.

Many people also say that regulators failed to properly police the banks and the mortgage market, and that is true. But the single biggest public policy failure of this country is one to which we all contributed. We have long associated home ownership with civic virtue. Some contemporary historians attributed the North’s victory in the Civil War to its higher rate of home ownership. Bush used to say every American should own their own home. On even cursory examination, that statement is ludicrous. Many people move too often, earn too little or have too little job security to assume the cost of owning and maintaining a home. Yet we nurtured the notion that home ownership is the fulfillment of the American Dream with favorable treatment in the tax code and extensive guarantees for mortgages. Just as important, we were inclined not to question to anyone in the   mortgage industry that was ready to lend to a low income family to buy a home no matter how weak their qualifications, especially since it didn’t seem to cost taxpayers anything. 

So there you have the three ingredients that produced our financial crisis: a multi-decade growth in leverage in our economy and financial system, a global saving glut, and a housing bubble. When everyone believes home prices will never decline, they will keep buying homes at ever higher prices until a decline is guaranteed. When the decline came, it yanked the bottom out from the pyramid of leverage in our financial system.

The most surprising feature of this crisis is its virulence, the daisy chain of companies and markets that have succumbed, many of which I did not know existed: first standalone mortgage finance companies, then interbank loans, then structured investment vehicles, auction rate securities, bond insurers, the investment banks and now finally our largest commercial banks.

            Our policy makers were hamstrung in their response by an inability to properly diagnose what they were dealing with. Initially, the Fed thought we were dealing with a liquidity crisis. Banks did seem well capitalized and the losses on subprime mortgages manageable. It concluded that if it lent enough money to the banks, the crisis would subside.

But it is very hard to tell the difference between a liquidity crisis and a solvency crisis. A bank will always say it is illiquid even when it’s really insolvent. Sometimes the bank itself doesn’t know it’s insolvent until it tries to sell some assets and finds no buyers. The distinction is crucial. Consider a bank with $9 in debt and assets it thinks are worth $10. If those assets are actually only worth $8, the bank is insolvent and lending it more money will only increase its debts: it will not make it solvent. To become solvent again it needs $2 of new equity. Major banking crises around the world have almost always required the public to inject new capital into the banking system to replace what has been wiped out by loan losses.

            It took a long time for our policy makers to come to that conclusion. In part that is because they did not see that how large and leveraged the shadow banking system was. Second, as the crisis deepened and the economy fell into recession, many loans that, unlike many subprime and exotic mortgages, were sensibly underwritten were becoming impaired. Markets believe our banks have far less capital than they claim to have.

            The Fed and Treasury recognized this fact in October and began groping around for a way to recapitalize our banking system. But valuable time was lost. It is no longer sufficient simply to recapitalize the banking system. We need to cushion the overall economy and unemployment, or even more loans will become impaired, requiring even more public capital.

The challenges are profound and I am, frankly, pessimistic. Almost all post-war recessions were the result of the Fed raising interest rates to squelch inflation. Ending the recession usually only required that the Fed lower rates enough. Well, the Fed has lowered rates to zero and we have to look elsewhere for salvation. That is why Obama and Congress are trying to pass the largest fiscal stimulus in history. In theory it should work, but there are constraints. One is financial: our debts are so large that investors may legitimately wonder whether we will eventually turn to printing money to pay them off,  that is letting inflation rise so that the debts are paid with depreciated dollars. If that were to happen, it would lead to sharply higher interest rates and increased difficulty borrowing. The other constraint is political: people in Congress are struggling to explain to voters why they are giving money to the people who got us into this mess. Worse, they are being tempted to take actions that hurt our trading partners, sparking the risk of beggar-thy-neighbor trade and financial policies. This is even though their economic advisers know better.

             I am pessimistic but not fatalistic. I think we’ll get out of this mess. I even see a few tentative signs of a turnaround. Credit markets have started to get better, companies can issue bonds again, and the economic news, while still bad, is no longer consistently worse than expected.

            The more interesting question is how will this crisis change our economy for the long term? As with our attitude to national security post 9/11, our attitudes about economic risk have changed profoundly. We will not be able to conceive in the future letting people routinely buy homes with no money down. Americans can no longer rely on their homes as a bridge to retirement or as an ATM. The country’s saving rate will rise. We should, as a country, spend less on our homes, cars and other consumer goods and our savings will be channeled into productive investments to pay for our retirement and to pay back all the money foreigners have lent to us. However, this cannot happen unless China, Japan and other countries learn to reorient their economies away from exports and stop shoveling their excess savings into our capital market.

            We will tolerate more government intervention in our economy, certainly in the financial sector. Most of the shadow banking system is gone – the companies are either bankrupt, taken over, or have become banks. During world war two, the government imposed wage and price controls so that it could ramp up war production without causing inflation. One of the results was a compression between executive and worker salaries and the introduction of employer provided health care. I would not be surprised if the trauma of this crisis is a catalyst for a change in our attitudes about pay disparities as well. Obama is using this crisis as an opportunity to press forward longstanding social goals, such as redressing the disparity in income between most working families and the wealthy at the top and expanding health care coverage.

            Our tolerance of government intervention is proportionate to the scale of the challenge we face. Assuming we do avoid a second Great Depression, I do not think our society will change profoundly. We will not embrace socialism. Obama does not want to run our banking system any longer than he must.

            In the months after 9/11, our country was on edge. So was I. At night the roar of patrolling F-16s would sometimes wake me up. On flights to Reagan airport, no one could stand up for the last half hour. In the wake of the anthrax attacks, I opened my mail with latex gloves. Every time a plane crashed, the Dow dipped and my heart raced as everyone wondered if the next attack had come. But as time went by and there were no further terrorist attacks, life returned for the most part to normal and some of these more extreme measures went away. The remaining security measures – taking my shoes off at the airport, working occasionally from a backup site – don’t intrude much. But in the background, the world is different. Our soldiers are still fighting and dying in Afghanistan and Iraq and may for many years yet. Our drones patrol the frontier regions of Pakistan. A vastly enlarged security apparatus watches over us at home, and a huge fence is going up along the Mexican border. Occasionally as I head home on the subway, I look around and nervously remember the attacks on the transit systems of London, Madrid and Mumbai.

            I think something similar is in store for us economically. Things will, eventually, return to normal, but in the background, our financial system will be more heavily policed and more risk averse than before. And that nagging feeling of financial insecurity – that our 401 k’s, our homes, even our bank accounts aren’t the source of college and retirement savings we thought – may never go away.

 

*This title may have been partly inspired by an article in the Washington Post Outlook section called “9/11 Was Big. This Is Bigger,” by David Rothkopf

 

 

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Written by gregip

February 11, 2009 at 12:29 pm

One Response

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  1. Sadly, the nation’s financial houses are apparently able to squeeze out even a credible voice that is no longer in their financial interest. I am much less surprised to find this going on, than that Barak Obama and those he has selected as his advisers are represented here as being on the side of the financial culprits. A case of cooptation, I believe. I’m assuming that Barak wants a second term pretty bad and is willing to… (you know) I just posted on this, in case you are interested.
    Nice post!

    euandus

    October 21, 2009 at 1:19 pm


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