Bailouts, Hybrid Failures, and the Financial Identity Crisis of 2007 and Beyond

February 10, 2009

I started reading Robert Wright’s One Nation Under Debt: Hamilton, Jefferson, and the History of What We Owe* the other day. While reading it, I thought it would be cool to get Dr. Wright’s thoughts on the current credit crisis so I sent him an email this morning and asked him if he would consider writing a post for AFM. He was very gracious and sent me the following article earlier this afternoon. I have reprinted it in its entirety:

JLP,

Thanks for this opportunity to collect my thoughts on the financial crisis and bailout and state them in a short compass for a real audience. (My own blog is largely a deserted wasteland.) From the bursting of the subprime bubble in 2007 until Lehman Brothers’ failure in September 2008, I was too busy with curatorial duties for the Museum of American Finance and finishing and promoting my book One Nation Under Debt: Hamilton, Jefferson, and the History of What We Owe* to pay much attention to the financial crisis per se, although the book is obviously related to the government’s willingness and ability to respond to the crisis. For most of U.S. history the federal government ran up debts during wartime only to pay them down (and in the 1830s completely off) in peacetime. Even the debt incurred during the Reagan administration could be construed in those terms: after victory in the Cold War deficit hawks took over the government, tightened the budgeting process, and eventually created budget surpluses. The massive run up of the national debt (in nominal, real, per capita, and percentage of GDP terms) during the administration of Bush II, however, appeared to confirm Thomas Jefferson’s prediction that U.S. politicians would find “borrowing and spending” irresistible. What the Founders had feared was the creation of large peacetime debts that would cripple the nation’s ability to respond to crises. They mostly had wars and natural disasters in mind but the same reasoning applies to any economic shock, including a financial crisis. Like a fat guy in a small boat, a large national debt renders the economy perilously close to sinking, even in calm waters, and nearly impossible to save during a storm.

And what a storm! To continue this analogy perhaps further than I should, the government has been trying to bail out our economic boat by increasing the national debt, or in other words by having the fat guy drink the water that has settled in the boat’s bottom. That saves the boat from immediately sinking but does not bode well for the future. Compounding matters is that the boat is actually shrinking and may continue to do so for some time, rendering the fat guy an even bigger relative burden on buoyancy. Thankfully, the fat guy can drink a whole lot of water. Eventually, however, he is going to have to regurgitate (outright default on the debt), urinate (create inflation, thereby pissing on bondholders), or defecate (create hyperinflation, thereby shitting on bondholders and everyone else). These issues are discussed less graphically but more precisely in my edited book Bailouts: Public Money, Private Profit (SSRC/Columbia University Press, forthcoming). Contributors to that volume call for the government in the future to more proactively prevent financial crises. It is not clear that bailouts actually speed economy recovery and most bailouts redistribute wealth in an unsavory way, from taxpayers to risky private enterprises, so it is best to take pains to avoid them altogether.

Historically, the most successful bailouts followed Bagehot’s Rules (which, as I explain in One Nation and in my forthcoming America’s Revolutionary Troubles with Bubbles, were originally developed by Alexander Hamilton in response to the Panic of 1792), which stipulated that governments acting as lenders of last resort should lend to all who could post sufficient collateral at penalty rates of interest. The collateral requirement ensured that taxpayers would not suffer while the government provided liquidity to safe companies. The penalty rate ensured that only those who had to borrow from the government would do so. Companies without sufficient collateral were allowed to fail so the rules also limited moral hazard by punishing risky speculative activity.

In my contribution to Bailouts and in my forthcoming Money and Banking textbook, which will be available free of charge from Flat World Knowledge beginning in March 2009, I explain that the current crisis is simply the most recent of America’s many financial crises. In fact, six other U.S. mortgage securitization schemes blew up, all between the Civil War and World War II, and one has been implicated in the Great Depression. More generally, financial crises stem from asset bubbles, periods when the price of one or more assets such as stocks, bonds, commodities, or real estate rapidly increase to unsustainable heights, usually with the aid of ubiquitous cheap credit. During bubbles, people borrow to buy the appreciating asset with the expectation of selling it, repaying the loan, and making a tidy profit. (Hence the constant carping about “greed,” which even some of my MBAs at the Stern School of Business resort to. The problem with evoking greed as a causal variable is that it is a constant.) All is well until the asset stops appreciating, as of course it must. (To trick themselves into believing that “this time will be different,” investors often invent historical “facts” out of thin air. One such claim was that housing prices always go up. While it is true that they trend upward over time they are far from monotonic. Just ask Willy Loman.) Leveraged buyers suddenly cannot sell for a profit so they all try to sell simultaneously precisely when nobody wants to buy. The price of the asset begins to plummet rapidly, banks have to eat bad loans, and the crisis spreads to the entire financial system, which we call a system, by the way, because it’s all interconnected. Credit markets seize up, hurting the real economy by causing uncertainty and unemployment, which increases defaults and shocks the financial system yet again.

Except for the panics that followed the British sack of Washington, D.C. during the War of 1812 and the great San Francisco earthquake, every major financial crisis in U.S. history, from the real estate meltdown of the 1760s that helped to cause the American Revolution to the subprime crisis of 2008, followed that same basic pattern. The obvious question therefore is: How could we allow this to happen again? The simple answer is that people usually do precisely what they are rewarded to do and a combination of government policies and market forces rewarded people for taking excessive risks. The crisis is a prime example of what I call a hybrid failure, a complex intertwining of market (asymmetric information, externalities, public goods, etc.) and government (see below) failures. (For another example, see Broken Buildings, Busted Budgets.)

Consider, for example, that millions of people borrowed more money than they should have. Or did they? Didn’t the government pressure lenders into lowering standards for poorer borrowers with policies like the Community Reinvestment Act? Banks eventually complied, in spades, with NINJA (no income, no job or assets) and liar’s (no documentation) loans. Didn’t the government also reward people for borrowing with various tax laws, including the mortgage interest tax deduction? Due to that deduction, which has grown in importance as marginal income rates and nominal incomes have risen, Americans tend to stay heavily mortgaged rather than building equity in their homes as they did in the nineteenth and first half of the twentieth centuries. Favorable tax treatment of retirement savings exacerbated the situation by rewarding Americans for investing in the stock market rather than paying down the principal on their mortgage. (For starters, employers generally match the former but not the latter.)

Similarly, the government’s Too Big to Fail policy worsened corporate governance, which gave far too much power to managers, by essentially providing big, complex financial institutions, from Fannie Mae to Citigroup, with free implicit guarantees. In other words, our system rewarded managers for taking on huge risks, then seemed surprised when some of their big bets soured. It did not help matters that everyone from mortgage originators to middle managers at investment banks to CEOs received bonuses well before the effects of their bets were known or even knowable.

For further discussion of these and similar issues, I highly recommend a book forthcoming in March from Wiley that was written by over 30 Stern School professors, including yours truly, called Restoring Financial Stability: How to Repair a Failed System. If the book has a flaw it is that it does not address the incentives of regulators, which are generally weak. As I argued in the most recent issue of Central Banking, we have to think long and hard about how regulators are compensated. They are mostly salaried bureaucrats rewarded for following procedures rather than creating innovative ways of monitoring businesses, be they humungous financial supermarkets or peanut butter manufactures. The government could pay them bonuses comparable to what they would receive in the private sector without engorging the fat man in the boat (the national debt, remember him?) if it would back away from areas of the economy where it is clearly not needed, like providing transportation infrastructure. We are better served by a government that does a few key things well than one that does many things, most orthogonal to its main mission, poorly.

That brings me back to One Nation Under Debt*. Hamilton was not an advocate of big government and a perpetual national debt and Jefferson should not be cited by those today who desire small government and little debt. Compared to today’s Democrats and Republicans (almost all except for Ron Paul and a handful of others), both Hamilton and Jefferson were proponents of tiny government and rapid debt repayment. Both would be appalled at the statist assumptions that infect public discourse. The financial crisis in this view is about more than mortgages, derivatives, and other technical matters. It is a crisis of identity. Will Americans continue to become mere wards of the state or will they re-assert their independence, not from Mother England but from Uncle Sam?

———————-

Thanks, Dr. Wright.

Thoughts? Additional questions (I’ll see if I can get Dr. Wright to answer them for you)?

I can say that all that has been going on makes me want to study up on financial history.

* Affiliate Link

15 responses to Bailouts, Hybrid Failures, and the Financial Identity Crisis of 2007 and Beyond

  1. And now, right before dinner I have the image of a fat man in a little boat, shitting, pissing, and puking, essentially on me. I hope he has a high metabolism and can process it all internally. A very interesting perspective on a very hot topic.

  2. Yeah, I didn’t edit that part…lol. Sorry for ruining your dinner.

  3. Excellent article Dr. Wright, and thanks JLP for the initiative.

    My question is: why does the current and previous administrations think that this recession is any different and are risking debasing the currency (ala bailouts) to prevent the natural ebb and flow of this one?

    The borrowers / banks / stockholders that took on these risks should fail, via bankruptcy if necessary. To prevent such a thing goes against the heart of capitalism.

  4. I did a double take when I read that the government is clearly not needed for providing transportation infrastructure. However, after skimming the first few pages of the linked paper (I don’t have time to read it now but I saved it for later), I admit my ignorance. I really like the idea of private-public transportation and just didn’t ever think that it is a possibility. If private ownership of public transportation utilities is realistic in this day and age, I would go for that.

  5. Wow, I just found a new favorite author.

    Our forefathers were truly wise men. Alexander Hamilton had the right idea of stiff penalties for borrowing.

  6. What a fabulous guest post; thank you.

    Jefferson, of course, his opinions of government notwithstanding, one could say he really *was* a forefather of modern Americans in his private habits of living far beyond his means, in perpetual debt, to maintain the standard of living that he felt fit his position! Great writer though 😉

  7. Interesting. I’m a little confused though when he states:

    “For most of U.S. history the federal government ran up debts during wartime only to pay them down … in peacetime…. The massive run up of the national debt during the administration of Bush II, however, appeared to confirm ….”

    He states the second part as if the Bush II terms were during peacetime. It seems to me that the run up in spending falls plainly into the first scenario, specifically that of war time/crisis spending.

    And was anyone else bothered by the fact that he cites a fictional character ( Willy Loman) in his otherwise reasonable explanation of asset bubble collapse?

    Otherwise, I think he makes excellent points! I’d also like to add that the founders would be sickened by the career politicians in congress, as they originally intended the job of senator and representative to be part time! Oh how far we’ve fallen!

  8. Responding to Joe : I’m not sure what you mean by “part-time”. Ie, they only worked those several months of the year as their position when they were in session? Given the realities of travel in that era, there would be no practical way for them to be “part-time” in any modern sense of the word. If you mean in the sense of “only working those few months when they were in session”, well, that’s also a little unfortunate, since it restricts the positions solely to men of leisure who have the economic ability to afford it.

    Also, honestly, if they could see the modern world, I really would hope they would have written the commerce clause in a more flexible fashion. Modern transportation and information infrastructure fail!

  9. This article was very interesting. I was never interested inpolitics or the economy until this crisis.

  10. This paragraph caught my attention:

    “Didn’t the government also reward people for borrowing with various tax laws, including the mortgage interest tax deduction? Due to that deduction, which has grown in importance as marginal income rates and nominal incomes have risen, Americans tend to stay heavily mortgaged rather than building equity in their homes as they did in the nineteenth and first half of the twentieth centuries. Favorable tax treatment of retirement savings exacerbated the situation by rewarding Americans for investing in the stock market rather than paying down the principal on their mortgage. (For starters, employers generally match the former but not the latter.)”

    If I understand him correctly, then it is the mortgage deduction and 401k employer match that is providing incentives for people to buy stock instead of paying down their mortgages. I am apparently hard of hearing for wanting to pay down my mortgage. (To be fair, I am also nearly maxed out on my 401k contributions.)

  11. @LOL, I’d like to try to answer this:
    “My question is: why does the current and previous administrations think that this recession is any different and are risking debasing the currency (ala bailouts) to prevent the natural ebb and flow of this one? ”
    My guess it’s two things. One is the tight credit that is hurting all businesses not just banks. Another is deflation.

    “The borrowers / banks / stockholders that took on these risks should fail, via bankruptcy if necessary. To prevent such a thing goes against the heart of capitalism.”
    Again, as bank fail, there is less money available for lending. With no access to financing, other businesses fail and more people are laid off. Not to mention tens of thousands, even hundred of thousands of people laid off by banks themselves. BTW – most of banks’ employees had nothing to do with these risks, for example, those working in IT support. A lot of tech companies, for example, e.g. Microsoft are laying people off as well.

    With so many people laid off and nobody spending money, the prices go down. It’s great if you have a job, but when the businesses don’t earn money, they lay off people. Hence, deflation is a larger problem than inflation: It’s a vicious cycle. People aren’t spending money – they are afraid to, they also believe they’d be able to buy the same thing for less later. This leads to more businesses failing, and even more people on the street. This is a cycle which is difficult to break. This is what makes this recession dangerous. Keep in mind that only the Second World War got the US out of the Great Depression, not the capitalism by itself. Hence they are trying to have the same kind of spending as they did during the Second World War to avoid the deflationary cycle.

    There is also a lot of uncertainty and no end in sight for the banks’ problems. There are a lot of these CDOs on bank books, and no bank has any idea what other banks’ books look like. Hence they don’t want to lend to each other. Another is they don’t know how much money they themselves will need for losses.

    Normally banks keep about 10% of their deposits in reserve. Now, some of them keep over 100%: all deposits and government money, simply because they are afraid to lend both because of fear of their own future losses in CDOs value and because of the fear of insolvency of other banks. People keep saying how the first bailout didn’t work, but last October the Libor was at 4.5% and AAA bonds of good, solid companies like Johnson & Johnson were yielding as much as junk bonds. Now the Libor came down, and the bond spreads narrowed. Last October, McDonald couldn’t get a loan for expansion. Now at least companies like McDonald and Johnson and Johnson can get credit.

    I am not saying that I like the stimulus package in its current form – I don’t see that much there that actually stimulating. I’d rather see tax breaks for businesses that actually employ people. But I do think that some kind of help is needed. Keep in mind that unemployed people don’t pay taxes, so people losing jobs also increases the deficit.

  12. @LOL:
    One other thing. It’s not exactly accurate to say that we got out from other recessions without any help from the government. For example, Reagan’s lowering tax rates got us out from the recession and high inflation of the Carter era. Yes this increased the deficit, but it was a whole lot better than double-digit inflation we had then.

    The issue of course is what kind of intervention is needed.

  13. Clearly the CDOs are the problem. I have been hoping for months that the “BAD BANK” would be created and that it become not just a “warehouse bank” but a “workshop bank” where these CDOs could be shredded and reanalyzed. Rate them, repackage and sell them for true value. Then repeat with fresh supply. Eventually this process will become so efficient that these instruments will be safe investments relative to their rating.

  14. I’m so glad that I posted! As I mentioned, my blog gets very little traffic and hence no extended discussions such as this.

    For Joe, I guess I should have cited Bob Hormats’ book, which essentially argues that Iraq and Afghanistan are not major wars fiscally speaking but more akin to the various Indian Wars, the Mexican War, the Spanish-American War and Philippines insurgency, and other conflicts that we no longer remember. The War on Terror has cost “only” $1 to $3 trillion, depending on who you asked, so it accounts for only 10 to 30% of the debt and much less of annual GDP. That’s a blip compared to WWII, the Civil War, etc.

    You’re right, Joe, that Willy Loman was a fictional character but he was representative of people hurt by falling real estate prices during the Great Depression. If you follow the time line in the play carefully (which isn’t easy as it is scattered throughout), Willy bought at the top of the market in the 1920s. He didn’t default during the Depression but remained “under water” on his mortgage (mortgage > market price of house). That constrained his ability to move closer to his territory in New England, which hurt his relationship with his family, which led to his affair and family dysfunction. One reason the play was a success c. 1949 was that people saw the story as plausible. When I taught the play at Temple U. in the 1990s, though, I had to explain all this context to the students so they did not dismiss it as unrealistic.

    If you want some hard numbers, see Eugene White’s paper on the 1920s real estate market on his Rutgers University website.

    As far as early politicians go, they were part-timers in the sense that most of them had other jobs, sometimes several other jobs, as farmers, planters, attorneys, merchants, and occ. professors, doctors, etc.

  15. My favorite grad school professor on my favorite blog! WOO HOO!