The US economy is now a year and a half into its most distressing crisis since, depending on point of view, the Great Inflation of the 1970s or the Great Depression of the 1930s. We have enough history to make a reasonable assessment of how we got into trouble and where we stand now. First of all, it’s essential to understand and accept the basic fact that the crisis is Nobody’s Fault. No person, group, business, or government desired or worked to achieve it. But all sectors of society are complicit. This crisis was not caused by some alien shock, some meteor crashing into the Yucatan. Somehow our own wishes, philosophies, drives, and achievements unintentionally conspired to bring us down. With that background, it should be clear that a thorough analysis of the problem cannot be encompassed in one commentary. My hope is that interested readers will remember that the electronic channel is two-way and tell me what I have left out or where I have gone wrong.
The crisis is international, but it began in the United States. Three powerful currents in American life, previously separate, were brought together by one catalytic event, which, within a very few years, led to catastrophe. The first current is social. It is the belief that nearly every American household should own a home; in short, the American Dream. Initially, ownership meant free and clear possession. The Dream was realized only when the mortgage was paid off. Following World War II, the Dream subtly changed. It could be realized merely by living in a home with a mortgage instead of renting a home from a landlord. Later still, the Dream added a further dimension, that home ownership would generate wealth through ever-increasing appreciation of the home’s price. By the early part of this decade, the belief that home ownership was an unadulterated Good Thing had become firmly embedded in the American ethos. More than two-thirds of American households, an unprecedented percentage, were homeowners. But mortgage debt had risen to an all-time high while home equity had fallen to an all-time low.
The second current is the evolution of the mortgage business. The demise of the Savings & Loan industry in the early 1980s left a void in the business of mortgage origination that came to be filled by mortgage brokers, who had no direct stake in the mortgages. The mortgage brokerage model, in which all mortgages are sold as soon as they are made, is purely transactional. It is low-cost and derives all its income from up-front fees instead of interest paid over many years. The creditworthiness of the borrower and the value of the property are not intrinsic concerns. They matter only to the extent they interfere with the sale of the mortgage. Moreover, because mortgage brokers are not depositaries, they are very lightly regulated. In the run up to the crisis, no one was looking over their shoulders.
The third current is financial innovation. The growing volume of mortgages made to borrowers with less than sterling credit or on homes whose value was exaggerated was enabled by securitization. Large banks and investment firms bought the mortgages, packaged them, sliced them into classes with varying degrees of support against default, and sold them to investors. Later, these pools of securitized mortgages were recombined, re-tranched, and re-sold until even the most sophisticated investors were hard put to understand what they owned. (This begs the question of why “sophisticated” investors would buy securities they did not understand. There are two fundamental answers, each of which is a commentary in itself. First, they were over-reliant on the major credit rating agencies—Moody’s, Standard & Poor’s, and Fitch. Second, the investors were simply unable to imagine and hence did not model, a deep, prolonged, nationwide plunge in home values.)
The catalyst that brought the three currents together was the deflation scare of the early 2000’s. The inflation rate fell sharply following the 2001 recession. The Federal Reserve Board, and especially its Chairman, Alan Greenspan, had been deeply disturbed by Japan’s “Lost Decade” of the 1990s, when that country was wracked by a series of recessions and a seemingly unstoppable deflation. Now, deflation is not supposed to happen in modern economies whose governments can print money to virtually any extent. Nevertheless, the Consumer Price Index early in 2003 pointed to a real and dangerous possibility of deflation in the United States. (These statistics were later revised to show that the danger was not nearly as great as perceived at the time.) In response the Fed kept the overnight fed funds rate at 1.00% from June 2003 to June 2004. Even when the Fed began to raise rates, it did so slowly, in 25 basis point increments every six weeks.
This period of low short-term interest rates opened the door for adjustable rate mortgages with extremely low introductory or “teaser” rates, as well as other exotic mortgage products. Would-be homebuyers who could not have afforded mortgages at more normal rates could now move into homes with small monthly payments and minimal or no down payments. Public policy, while not directly encouraging the spread of subprime mortgages, certainly did not discourage it, and regulation was absent. Cheap money and easy terms also led existing homeowners to refinance multiple times, in effect turning their homes into lines of credit. The appetite of investment banks and their customers for more and more product to securitize made it all possible by providing the cash.
Still, and this is a key point, the volume of subprime mortgages was not nearly enough to cause a major crisis. Only about $1.2 trillion of true subprime mortgages were originated. They have not all defaulted and the underlying properties of those that have are not all worthless. Delinquency rates of 40% or 50% of subprime mortgages initiated in 2004-07 would, by itself, be a serious social problem, but, to repeat, it could not possibly have touched off a global financial meltdown.
It’s a mistake to speak of a single crisis. We have experienced a series of interlocking and self-reinforcing crises. The first crisis began in the summer of 2007. As subprime mortgage delinquencies rose, investors began to question the value of the securitized instruments that held the mortgages. But because the instruments had become so complex and because it had become so hard to identify exactly who owned what, all non-government guaranteed securitized assets fell under suspicion. As a result, the securities’ market value dropped precipitously. Even this would not have been so terrible if the securitized assets were simply held in investors’ portfolios.
But—or rather, BUT—they weren’t just sitting in investors’ portfolios. They had been used as collateral for borrowing, usually in the form of repurchase agreements or “repo.” And not just once, but over and over again; that is, an entity that held securitized assets as collateral for a loan it made used that same collateral to borrow from some other entity and so on. In all, about $10 trillion of repo was outstanding in the summer of 2007. In repo transactions, borrowers have to post collateral in excess of the amount they wish to borrow. The difference is called a “haircut.” The more unsecure the lender feels about the borrower or the collateral, the bigger the haircut. The loss of confidence in securitized non-government-guaranteed loans meant that haircuts suddenly jumped from 2-3% to 30%, 40%, or even more. Many who borrowed on short-term repo did not own and did not have the resources to buy this much extra collateral. The resulting shakeout led to the demise of Bear Stearns, several high-profile hedge funds, and numerous Special Investment Vehicles (SIVs) that large banks held off their balance sheets. This was the first crisis.
Note that this was a crisis of confidence within the financial system itself. There were losers outside the system, such as, famously, the town of Narvik in northern Norway that put a major portion of its funds in subprime pools. At this stage, most people felt unaffected by the crisis, and the mantra among community banks was, “We don’t have to worry; we didn’t make those kinds of loans.” But, once lost, confidence is not easily regained. All sorts of loans that had previously been sold and securitized—jumbo mortgages, car loans, credit card receivables, student loans—no longer had a market. And if they couldn’t be sold, they couldn’t be made because banks, in contrast to global investors, did not have the liquidity to hold them on their balance sheets. Put very simply, banks were unable to take up the slack left by the sudden and nearly absolute shutdown of the securitization machine.
By mid-2008, a vicious cycle was emerging. New private securitization had stopped and the market for older, outstanding securitized loan pools was moribund. Banks and other investors with large inventories of these securities were forced to write them down to their extremely depressed market values. The result was a drain on capital, in some cases—Fannie Mae, Freddie Mac, Lehman Brothers, Washington Mutual, and Wachovia—to unsustainably low levels. These American institutions and others in similar circumstances in Western Europe were effectively insolvent. Because they were deemed too big, too complicated, or too important to fail, various government re-capitalization and merger programs were implemented. This was the second crisis, and it only served to intensify the first.
Not the least of the consequences was that the public’s confidence in the financial sector was severally shaken. The lack of confidence extended to stock markets, which by the end of 2008 had lost more than $30 trillion worldwide from their peak in October 2007, a massive destruction of wealth. If that weren’t bad enough, more than $3 trillion was sliced from the equity of Americans’ homes. The loss of equity meant that fewer people could afford to sell their homes and fewer could borrow against them. With fewer sales, fewer new homes were built and fewer homes were remodeled. As a result, the many industries dependent on housing, including construction, timber, appliances, and furniture to name just a few, began to falter taking their jobs with them. Another vicious cycle developed in which falling home sales led to falling home prices and job losses, which in turn led to higher delinquencies and foreclosures and even more homes being dumped on the market at fire sale prices. And, it wasn’t just housing. Car loans could no longer be securitized, so fewer cars could be sold. Student loans could not be securitized, so fewer students could afford to go to college. Job losses are now feeding on themselves, destroying purchasing power, reducing sales, and creating more unemployment. This is the third crisis.
The question now is, will there be a fourth crisis. The most likely candidate is a steep decline in the value of commercial real estate with corresponding losses in this sector. So far CRE has held up surprisingly well, but the recent bankruptcy of General Growth Properties, a real estate investment trust that owns more than 150 major shopping centers throughout the country, is not a good omen. Of even greater concern is, or should be, the effect of the crisis on the developing world. Just as community banks were in denial in 2007, some developing countries refused to acknowledge the risk to themselves in 2008. But recent drastic declines in their main source of revenue, exports to more developed countries, have alerted the developing world to its danger. At risk are not only their emerging middle classes, but even those whose connection to international finance is the most tenuous, the poorest of the poor.
On the other hand, the regulatory stress tests of the 19 largest US banks and similar tests in Europe may finally restore confidence in the banking sector. A total capital gap of $75 billion, affecting about half the 19 banks, has been identified. These banks have all expressed assurances that they will be able to meet the challenge, and the government has pledged to make up any shortfall. The Obama administration was elected in the belief that it would actively intervene to restore economic health. Government activism is not everyone’s political cup of tea, but so far the majority of the public supports it. There is absolutely no reason to imagine that this administration and Congress, with its strong Democratic majority, will back off, particularly if evidence of success mounts.
At best, we are far enough into the financial turmoil to suggest a coherent explanation of how it started and how it has developed to date. It is unfortunate and not a little scary that we cannot be similarly confident about how and when it will end.




Of Spirits, both Animal and Human
Patsy’s spontaneous reaction was spot on. There is very little that’s rational about economic decision-making, or any other kind of decision-making for that matter. In his new book, Human: The Science Behind What Makes Us Unique, cognitive neuroscientist Michael S. Gazzaniga describes patients with injuries to a part of the brain that rendered them unemotional. One patient, for instance, “tested normally in intellectual ability, social sensitivity, and moral sense, and could devise appropriate solutions and foresee consequences to hypothetical problems, but he could never make a decision.” Gazzaniga’s conclusion from this study and much additional research is that “pure reason was not enough to make a decision. Reason made the list of options, but emotion made the choice….Even though we humans like to think of ourselves as being able to make non-emotional decisions, emotions play a part in all decisions.” (pp. 72-73)
Like Patsy and Dr Gazzaniga, we all know this. We know that even our most basic economic decisions about food, shelter and clothing—the things we need to stay alive—are heavily influenced by non-rational forces. Otherwise, who would ever wear high heels? Decisions about finance and business are no different. “Jack Welch’s phrase ‘straight from the gut’ sums it up: decisions that matter for investment are intuitive rather than analytical.” (p.144)
The authors of this assertion are George A. Akerlof and Robert J. Shiller. Akerlof is a Professor of Economics at the University of California, Berkeley. He won the Nobel Prize for Economics in 2001 and is married to Janet Yellen, the former President of the Federal Reserve Bank of San Francisco. Shiller is Professor of Economics at Yale and co-creator of the influential Case-Shiller Home Price Index. Earlier this year they published Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. The book’s premise is that the current economic crisis “was caused precisely by our changing confidence, temptations, envy, resentment, and illusions—and especially by changing stories about the economy.” (p. 4) The authors call these emotional forces “animal spirits” following John Maynard Keynes, the famous British economist who coined the term in the 1930s. Keynes believed that animal spirits, or “the spontaneous urge to action,” are the essential motivation behind business decisions. But while Keynes’s economic prescriptions form the heart of the global financial rescue plan, and his description of how capitalist economies function is more or less gospel, his conclusions about how decisions are made have been largely discarded.
Although purportedly written for a general audience, Shiller and Akerlof are not really focused on lay readers. Their true target is academic economists. The book is filled with what can only be called blatant rebukes to the profession. Here is just a sampling:
“Natural rate theory (the idea that there is a sustainable level of unemployment that keeps inflation in check) is now economists’ conventional wisdom. It is accepted by the vast majority of economists—but we do not believe it to be true. And it has also been the justification for economic policy of great foolishness.” (p 107)
“Over the years economists have tried to give a convincing explanation for aggregate stock price movements in terms of economic fundamentals. But no one has ever succeeded.” (p.131)
“The theories economists typically put forth about how the economy works are too simplistic.” (p.146)
“The real problem, as we have repeatedly seen in these pages, is the conventional wisdom that underlies so much of current economic theory.” (p.167)
I could go on, but you get the point.
So why do academic economists refuse to take animal sprits into account? Why do “they fail to consider the most important dynamics underlying economic crises”? (p. 167) Shiller and Akerlof get part of the answer to these questions, but they too are part of the academy and they cannot or will not follow their conclusions to the source.
The part they get is that economists have insisted on a theory based on rational behavior because it can be quantified and modeled. “In their (that is, economists’) attempts to clean up macroeconomics and make it more scientific, the standard macroeconomists have imposed research structures and discipline by focusing on how the economy would behave if people had only economic motives and if they were also fully rational.” (p. 168) Dear reader, I will make you a deal. I know there are a lot of quotations in this commentary, but I promise not to include any more if you re-read this one slowly and carefully.
Good. Now, what Shiller and Akerlof don’t get is why economists wanted to “clean up macroeconomics and make it “more scientific.” For the answer we have to go back to 1957. In that year, the Soviet Union successfully launched Sputnik, the first artificial satellite. It was the height of the Cold War, and America was stunned. The Federal Government responded in the best American tradition: It threw massive amounts of money at universities for mathematical and scientific research so that we would not lose the Space Race. Suddenly, brand new physics and chemistry buildings sprang up on campuses across the country. Professors got grants for all the equipment and graduate students they wanted. The liberal arts had to make do with the dowdy old buildings the scientists abandoned. The message was obvious. Science equals money, power, and prestige. Economists realized that if their field became a science, a Social Science, they could cash in too.
There were two problems with this change of direction. Since the discovery of relativity and quantum mechanics in the first quarter of the 20th century, the advances in the hard sciences have required increasingly more difficult and abstruse mathematics. The math has made it all but impossible for non-scientists to follow new developments, which is why so many books and articles on physics and biology for laymen are published every year. Scientists want their discoveries understood by the widest possible audience. Altruism and a desire for recognition undoubtedly play a role in this spate of publications, but scientists know that without public support, their funding could be threatened. An informed public is clearly in their interest. Economists faced exactly the opposite situation. The father of economics, Adam Smith, did not include any calculations or statistics in his 1776 masterpiece, The Wealth of Nations. Things didn’t change much in the next two hundred years. Economics was a qualitative discipline that required no special mathematical knowledge. It was more or less accessible to any reasonably well educated person. To become a “real” science, Economics (with a capital E) had to become less accessible and more quantitative.
That led to the second problem. At some level, economists knew just as well as everyone else that economic decisions aren’t rational. But you can’t be a scientist unless you can make mathematical models, and irrationality is extremely hard to model. So economists made models using assumptions of rational behavior in hopes that they would be close enough to reality to be useful.
But they aren’t. Economists have been no better at predicting the economic future than anyone else. Oh sure, a few predicted the 1987 stock market crash, and a few predicted the long boom of the 1990s, and a few predicted the dot-com bubble, and a few predicted the spectacular rise in home values, and a few predicted the housing debacle that followed. But nobody predicted all or even most of it. And economists aren’t even very good about predicting the past; the causes of the Great Depression remain a subject of debate.
It may seem that I am specifically attacking the economics profession for short-sightedness, greed, or vanity. Not really. I have singled out economists only as an example. The heart of the matter is categorization. The 20th Century was all about putting things into categories, creating specialties, and making experts. Economics, considered as specific academic discipline is as artificial as Sputnik, and so are chemistry, Russian literature, and playing the clarinet. Perhaps no one person can be proficient enough to earn PhDs in all these fields, but that simply speaks to our limitations as human beings. The fields themselves are all parts of the human and universal condition. They are not inherently discrete, and many people have a good understanding of and keen interest in them all and more besides. Twenty-first Century communications, globalization, and the interactive Internet community are rapidly breaking down the barriers between disciplines that were so painstakingly erected in the previous century. In this century “doing the math” will only be a part, and small part of understanding economics. A full understanding will require “doing” and blending the cognitive science, the psychology, the sociology, the history, the linguistics and maybe even clarinet playing. Welcome to the Fun House.
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