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:
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 Brothersâ€™ 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 governmentâ€™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 Jeffersonâ€™s prediction that U.S. politicians would find â€œborrowing and spendingâ€ irresistible. What the Founders had feared was the creation of large peacetime debts that would cripple the nationâ€™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 boatâ€™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 Bagehotâ€™s Rules (which, as I explain in One Nation and in my forthcoming Americaâ€™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 Americaâ€™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 â€œgreed,â€ 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 â€œthis time will be different,â€ investors often invent historical â€œfactsâ€ 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 itâ€™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? Didnâ€™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 liarâ€™s (no documentation) loans. Didnâ€™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 governmentâ€™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 todayâ€™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