361497_PA364_1stClass:361497_PA364_1stClass 3/12/2009 9:08 AM Page 1
No. 634 March 23, 2009
Financial Crisis and Public Policy by Jagadeesh Gokhale
Executive Summary
This Policy Analysis explains the antecedents its implementation appears panicky—marked by of the current global financial crisis and critical- a knee-jerk trial-and-error process that may have ly examines the reasoning behind the U.S. heightened market uncertainty. Worse, current Treasury and Federal Reserve’s actions to prop interventions in market processes and institu- up the financial sector. It argues that recovery tions could become permanent, to the probable from the financial crisis is likely to be slow with detriment of the nation’s long-term economic or without the government’s bailout actions. prospects. With or without the bailout, the An oil price spike and a wealth shock in hous- ongoing recession is likely to be deep and long. ing initiated the financial crisis. Declines in From a philosophical perspective, any bailout stock values are intensifying that shock, threat- action provides a host of bad incentives. ening to deepen the current recession as U.S. Moreover, we should be mindful that future gen- consumers and investors cut their expenditures. erations already face massive debt burdens from An offsetting wealth injection from additional entitlement programs. Increasing those burdens risk-bearing investors could initiate a quicker by expanding the bailout program or enacting a recovery. Thus, supporters of government inter- massive fiscal stimulus will hasten the long- vention justify the bailout’s debt-financed fund anticipated crisis in entitlement programs. Thus, injections—in essence, they want to compel the ongoing economic crisis could usher in per- future taxpayers to join the group of today’s risk- manently higher taxes, greater government bearing investors. involvement in the private sector, and a pro- However, the bailout is poorly designed and longed period of slower economic growth.
______Jagadeesh Gokhale is a senior fellow at the Cato Institute and author of Social Security: A Fresh Look at Reform Alternatives (forthcoming).
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From a This Policy Analysis, however, examines the philosophical Introduction bailout from an economic perspective. Skep- tics of the bailout believe that struggling finan - perspective, any In October 2008, Congress approved a pro - cial firms should be left to fall into bankruptcy. bailout action posal by Bush administration Treasury secre - They believe that the sooner those firms col - provides a host of tary Henry Paulson and Federal Reserve chair - lapse and their assets are purchased by healthi - man Ben Bernanke to spend up to $700 billion er competitors, the sooner the financial sector bad incentives. of government funds to shore up the U.S. can restructure itself to restore normal credit financial system. The plan initially envisioned flows that are vital to maintaining the broader using those funds to buy financial assets— economy’s health over the long term. From this mostly mortgage-backed securities held by perspective, the congressional bailout plan will banks and other financial institutions—that only delay proper asset revaluation and have lost value in the wake of the housing bub - resumption of normal credit flows. Thus, it will ble. Uncertainties about how far home prices prolong the recession triggered by the bursting will continue to decline and about the likeli - of the housing bubble as government interven - hood of future mortgage defaults have made tion slows needed structural adjustments in those securities “toxic.” Financial market par - the financial sector. 1 Unless market forces are ticipants’ unwillingness to lend to or trade with allowed to eliminate insolvent financial com - institutions holding large amounts of such panies through bankruptcy, restructuring, and securities—especially those backed by subprime resale, there can be no lasting economic recov - mortgages with declining ratings—has disrupt - ery, say bailout skeptics. ed credit flows among bank and nonbank Most participants in the bailout policy financial institutions. The convoluted structure debate envision an eventual return to normal - of financial contracts for securitizing and cy—with bank balance sheets restored and insuring mortgage pools makes their valuation credit flows operating at customary levels. The difficult and has contributed to the decline in question is about which policies are appropri - market transactions in these securities. ate to the goal of making the intervening Paulson and Bernanke initially believed recession shorter and shallower. that government purchase of the securities at prices determined through auctions would refuel finance by replacing toxic assets with Recessions: Oil Shocks government cash. However, in the weeks fol - versus Financial Shocks lowing the congressional vote, the bailout evolved into a plan to spend at least $250 bil - Postwar U.S. recessions have usually been lion of the allocated money on purchasing the result of oil shocks combined with restric - preferred stock in banks and other financial tive monetary policies adopted by the Federal companies. That would not eliminate the tox - Reserve to prevent higher energy prices from ic assets from those firms’ books, but it would inducing a broader inflationary spiral. Oil infuse the firms with additional capital in the price spikes require firms and households to hope of reigniting credit transactions and implement structural adjustments: alter pro - restoring the financial sector to normalcy. duction technologies to economize on energy Regardless of the details, government use or shift to cheaper energy sources. Firms efforts to bail out the financial sector have that cannot adapt technologies to conserve met with sharp criticism. There is a strong energy inputs must scale back operations or sentiment among the public that their tax fold. Eventually, new firms emerge in less ener - dollars should not be used to shore up the gy-intensive sectors, especially services. Most health of financial firms that made poor eco - economists agree that in such an environ - nomic decisions. It is difficult to disagree with ment, allowing market price signals to facili - that sentiment. tate needed structural change, rather than
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Figure 1 World Spot Crude Oil Prices
160
140
120 l e r r
a 100 b r e p 80 s r a l l
o 60 D
40
20 Now, although 0 oil prices have 2000 2001 2002 2003 2004 2005 2006 2007 2008 pulled back Source: U.S. Energy Information Agency. substantially from peak levels, government-determined resource allocation, substantially from peak levels, the main force the main force is the best approach. propelling economic decline is the continued Although the price of oil has receded in devaluation of the nation’s housing stock. propelling recent months, the trend in oil prices has That decline is sustained by the now-large economic decline been positive so far during this decade inventory of unsold homes and gathering (Figure 1). Oil prices have been creeping momentum in mortgage defaults and home is the continued upward since December 2002 but did not foreclosures. 3 Figure 2 shows the Case-Shiller devaluation of interrupt the post-2003 surge in housing index of home values—a composite index the nation’s prices (Figure 2). The oil price increase was based on home price samples in 20 U.S. continual, however, through 2006—rising major metropolitan areas. It shows that housing stock. from $30 per barrel during late 2003 to home price changes had moderated for a few almost $70 per barrel by mid-2006. That sus - months during the spring of 2002. 4 Had that tained increase in oil prices is associated with moderation been maintained, home prices a declining trend in U.S. non-oil consumer might have remained close to their long-term spending growth and probably caused hous - trend through 2003, as shown in Figure 2. ing price increases to slow during 2006. 2 One reason for the rapid escalation in home After all, most new home construction in prices through 2006, which was far faster than major metropolitan areas was occurring in the long-term trend and happened despite ris - far-flung suburbs, and energy cost increases ing oil prices, was the populist political agenda meant households could no longer commit of promoting home ownership. The genesis of to lifestyles requiring high energy and com - a reinvigorated push for increased homeown - muting costs. The slowdown in home price ership can be dated to President Bill Clinton’s appreciation was tipped into a downturn by support, through the Department of Housing the subsequent, increase in oil prices that and Urban Development, for expanded home - lasted from early 2007 through mid-2008. ownership by first-time, low-income, and Now, although oil prices have pulled back minority homebuyers. Policymakers weakened
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Figure 2 Composite Case-Shiller Home Price Index
250 Trend through December 2003 Projected Trend 200 CoCmopmopsiotseitCeaCsea-sSeh-Silhleilrler HoomeePPrriicceeIInnddeex x e u l 150 a v x e d n I 100
50
0
7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 8 8 8 9 9 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 0 0 1 1 9 9 9 9 9 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2 2 Source: Federal Reserve Bank of St. Louis. regulations governing mortgage loan eligibili - menced. It shows that although the decline in ty—including income and asset adequacy, cred - housing prices since the spring of 2006 has it history, and personal interview require - been substantial, prices remain well above their ments—to expand homeownership. 5 The Bush pre-2003 trend level. As Figure 2 suggests, administration, explicitly committed to pro - home prices can remain off their trend level for moting an “ownership society,” failed to reverse considerable periods of time. Thus, based on those policies. The result was a boom in the their past behavior, home price declines may homeownership rate from 64 percent during continue even after home prices have returned the early 1990s to almost 68 percent by 2000. to their long-term trend path, as shown in The White House and Congress encouraged Figure 2. With increasing the giant, government-sponsored mortgage Now, rates of mortgage delinquency, frequency during firms Fannie Mae and Freddie Mac to expand defaults, and foreclosures are increasing for all 8 the early 2000s, into riskier subprime and “Alt-A” mortgage types of home-loan contracts (Figure 3). markets by purchasing mortgage-backed paper Unlike the earlier oil price shocks, the housing lenders granted containing contracts originated under the now wealth shock has resulted in a near collapse of mortgage loans fragile borrower-review process. 6 With increas - the financial sector. Investment banking, ing frequency during the early 2000s, lenders which quintessentially defined the “Wall Street with little or no granted mortgage loans with little or no mon - financial firm,” has been disbanded. The assets money down, ey down, zero closing costs, and/or sparse doc - of erstwhile investment banks have been trans - zero closing costs, umentation of borrowers’ ability to pay. 7 ferred wholesale through Fed-guaranteed deals Fueled by the expanded availability of mort - to other banks or reconstituted as commercial and/or sparse gages, home prices began to accelerate sharply banks with access to the Fed’s emergency lend - documentation in 2003, generating the bubble evident in ing facilities. Only one investment bank— of borrowers’ Figure 2. The figure also shows the trend in Lehman Brothers—was allowed to fail, and it home prices through December 2002, just was dismembered and sold to other financial ability to pay. before sustained home-price acceleration com - firms. Moreover, threats of bank runs because
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Figure 3 Deliquency Rates on Residential Mortgages with Commercial Banks (seasonally adjusted)
6.0
5.0
4.0 t n e
c 3.0 r e P 2.0
1.0
0.0
91 2 3 4 5 96 7 8 9 00 1 2 3 4 5 06 7 8 9 9 9 99 99 9 9 99 99 0 0 0 00 00 00 0 0 00 1 19 19 1 1 1 19 1 1 2 20 20 2 2 2 2 20 2
Source: Board of Governors of the Federal Reserve System. The U.S. of deteriorated asset positions have forced the vicious downward economic spiral. economy now failure of a few large commercial banks since Thus, an important difference between the appears ensnared mid-2007. current episode and previous postwar reces - sions is that this time around, the financial sec - in a vicious tor has been massively disrupted. During earli - downward Too Big to Fail? er recessions, a well-functioning financial sector played a key role in facilitating the eco - economic spiral. Many other banks and nonbank financial nomic recovery: it channeled funds to more companies have weakening asset positions and profitable enterprises and curtailed credit to are running short on reserves. The net result is economically inefficient ones. What are the that credit flow volumes within the financial implications of a disrupted financial sector for sector have been decimated and credit flows the ensuing recession? Should the logic applied toward nonfinancial sectors—mainline busi - in earlier crises to nonfinancial firms—of allow - nesses in transportation, communications, ing insolvent ones to become bankrupt—be retail trade, and so on—are declining sharply. applied to financial firms in the current Apart from directly weakening bank bal - episode? ance sheets, the housing wealth shock has Until the adoption of the bailout plan, reduced consumer spending. Both factors—a efforts by the Treasury and the Fed to buttress constriction of credit flows and slower con - the financial system have been piecemeal, with sumer demand—are causing production slow - government rescues being offered only to downs. In turn, layoffs are likely to trigger addi - firms considered “too big to fail”—that is, tional mortgage defaults, reduced home prices, firms whose failure would have dire implica - and further weakening of bank balance sheets, tions for the financial system as a whole. This making it difficult for credit flows to resume. “systemic risk” threatens the extension of The U.S. economy now appears ensnared in a credit to nonfinancial firms and could deepen
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the current recession. Minimizing systemic likelihood of a successful government bailout. risk is a key goal of all federal financial regula - Financial institutions have failed at regular tory institutions—the Federal Reserve, the intervals since 2007—beginning with Country- Securities and Exchange Commission, the wide Bank in July 2007 through the Treasury Comptroller of the United States, and the backstopping of Citigroup in November 2008. Federal Deposit Insurance Corporation. In the intervening period, Bear Stearns, In the current episode, there is plenty of IndyMac, Lehman, AIG, Fannie and Freddie, blame to go around. Bank regulators, the Merrill Lynch, Washington Mutual, Wachovia, White House, and Congress all bear some Citigroup, and other financial firms have been responsibility: the housing wealth shock has propped up via public fund injections, taken negatively affected almost all financial firms over by better-capitalized private firms or fed - holding depreciating mortgage-backed securi - eral agencies, or otherwise restructured or split ties. But those securities were promoted most up and resold. Goldman Sachs and JPMorgan intensely by the mortgage giants Fannie Mae Chase have been redefined as commercial and Freddie Mac, both of which enjoyed access banks. Most of the investment banks, along to government borrowing and maintained with Fannie and Freddie, have now been some of the highest leverage ratios in funding restructured, taken over by the federal govern - The irony is that and securitizing mortgages, including sub - ment, or redesignated as commercial banks. Fannie and prime ones. The irony here is that, despite the However, the failure of Lehman—which the Freddie’s governmental mandate to lower households’ Fed and Treasury chose not to protect—had costs of homeownership and regardless of the catastrophic consequences. Policymakers actions were systemic risk posed, Fannie and Freddie’s allowed the firm to fail because they believed primarily actions were primarily motivated by maximiz - that market traders had plenty of time to note 9 motivated by ing their shareholders’ profits. its shaky financial prospects and protect their Declining home values and rising default assets. Despite such advance knowledge, maximizing their rates mean that financial companies that pos - Lehman’s counterparty traders did not act— shareholders’ sess large amounts of mortgage-backed securi - perhaps they expected a government bailout as ties are losing value. Weak and worsening in the case of Bear Stearns. Hence, when profits. assets on their balance sheets make lenders Lehman went under, counterparties’ balance fearful of renewing loans. Compounding the sheets were disrupted. More importantly, uncertainty among creditors are opaque deriv - financial traders panicked. Lehman’s failure ative structures of securities held by financial signaled that the government might refuse companies. Those portfolios are now difficult assistance to other financial companies that to evaluate in terms of their prospective encountered liquidity shortages or became returns. 10 Creditors’ unwillingness to renew insolvent. The latter fear triggered a global lending is similar to a “bank run” on financial credit freeze—precisely the outcome that feder - companies’ liabilities—pushing them first into al regulators are supposed to prevent. 11 illiquidity, and eventually, to insolvency and Concerned Fed officials now believe that bankruptcy. Lehman’s trades and obligations should have With a considerably weaker financial sec - been sustained, even at taxpayer costs, as were tor, however, the possibility that financial those of Bear Stearns. bankruptcies could exacerbate and lengthen Why did Lehman’s failure compound the the vicious downward economic spiral financial sector’s problems into a panic? strengthens the theoretical case for a govern - After Lehman’s failure, the fear that debtors ment bailout. However, the case for govern - with poor assets may not be around to pay ment intervention requires more than simply back borrowed funds—especially as the Fed positing the possibility of a vicious economic and Treasury signaled that bailouts were not spiral. It must demonstrate the existence of a assured—worsened an already alarming “market failure” in the financial sector and the financial situation into a panic. The word
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“panic” sounds overdramatic but appears to two previous recessions in 1991 and 2001. The word be justified: key indicators of credit risk—for “panic” sounds instance, the difference between interest rates on three-month European interbank loans Remedies overdramatic but and three-month U.S. government debt, bet - appears to be ter known as the “TED spread”—had already The case for government intervention is achieved historic highs and were at many based on the argument that, unlike earlier justified. times their normal levels during mid-2007. recessions, the current crisis involves a massive During mid-October 2008, however, their disruption of the financial sector that may not level shot up still further. 12 The Treasury be cured by market forces alone. This and the bailout and the Fed’s injections of vast following section examine the reasoning in amounts of liquidity into the financial mar - favor of a government bailout of the financial kets have reduced credit-risk spreads from sector. However, the balance of this Policy their October 2008 highs, but they remain Analysis argues that such government inter - many times higher than their normal (pre- vention is unlikely to be implemented effec - 2007) levels. Lending and borrowing activity tively and would only compound the United remains paralyzed within the financial sector States’ grim long-term financial outlook. and is constraining economic activity in non - Indeed, as of this writing, many observers are financial businesses (Figure 4). As a result, bemoaning the unsatisfactory implementation the current economic recession is much of the Treasury bailout. deeper and has lasted much longer than the A negative wealth shock normally induces a
Figure 4 Non–Financial Sector Borrowing as a Percent of GDP
25
20
t 15 n e c r e P 10
5
0 2003 2004 2005 2006 2007 2007-Q1 2007-Q2 2007-Q3 2007-Q4 2008-Q1 2008-Q2
Total Household Nonfinancial business Federal Gov't. State and Local Gov't.
Source: Board of Governors of the Federal Reserve System.
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Figure 5 Household Debt as a Percent of GDP
Total Home mortgages Consumer credit Other
120
100
t 80 n e c r
e 60 P
40
20
0
3 4 5 6 7 1 2 3 4 1 2 0 0 0 0 0 0 0 0 0 0 -Q -Q -Q -Q -Q -Q 2 2 2 2 2 07 7 7 7 8 08 0 0 0 00 00 0 2 20 20 2 2 2 Source: Federal Reserve Board of Governors. decline in output and consumption. Main- step in with sufficient capital to resolve the cri - Unfortunately, taining them at the pre-shock levels requires sis. Foreign savers have already lent substantial foreigners are that someone lend additional funds to com - amounts to U.S. firms and households in the unlikely to step in pensate for the negative wealth shock. Those past and the global nature of the current funds could be used to sustain current con - downturn shows that they are not immune to with sufficient sumption and purchase new assets—say, more a contraction in U.S. consumption. Their capital to resolve oil drilling equipment instead of houses—that financial institutions are also exposed to the can be used to restore the nation’s output and downturn in U.S. home prices and they, too, the crisis. consumption growth. And the additional debt will need to conserve cash. And they are just as and capital infusions would be repaid from fearful of the toxic and impenetrable mort - production and profits in the future. gage-related securities on U.S. financial firms’ New funding sources require an expansion balance sheets as any other potential creditors. of the pool of risk-bearing creditors. But few of If foreign firms are unwilling to lend as those creditors can be found domestically; U.S. much as is needed because of risk considera - households’ budgets are stretched to the limit, tions, why don’t interest rates increase to com - because of their hitherto high-consumption pensate them for larger loan amounts and and low-saving lifestyles. Americans are over - higher risks? The answer is that rate increases burdened with debt (Figure 5) and are now only work up to a point. Issues of risk, trust, experiencing declining asset values (Figure 6). and reputation are difficult for creditors to One potential source of additional capital is evaluate and, beyond a point, those attributes foreign savers. By extending more credit to us, may be negatively associated with larger loan they would bear additional financial risk as the amounts. Recall that oil magnates and other U.S. economy undergoes its structural reorga - foreign funds extended some additional capital nization—say, shifting away from housing and to some U.S. financial firms a few months ago, toward energy exploration, from financial but only under very generous returns and guar - engineers toward regular ones, and so on. antees. 13 They probably possess more loanable Unfortunately, foreigners are unlikely to funds, but they won’t extend more credit to
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Figure 6 Household Assets as a Percent of GDP
350
300
250 P D G
f 200 o t n e c
r 150 e P 100
50 Financial assets Tangible assets 0
3 4 5 6 7 1 2 3 4 1 2 00 00 0 0 0 Q Q Q Q Q Q 2 2 20 20 20 ------7 7 7 07 08 8 00 0 0 0 0 00 2 20 20 2 2 2 Source: Federal Reserve Board of Governors.
U.S. financial firms, even under still-more- est rates on a larger loan itself constitutes a lucrative terms. negative signal of creditworthiness. In most markets—take oranges as an exam - Both adverse selection and moral hazard ple—the exchange of goods for money is potentially play a role in credit and capital simultaneous and the characteristics of both markets, causing their failure during times of are easily observable. In credit markets, how - high market uncertainty. Adverse selection ever, transactions are nonsimultaneous. refers to the phenomenon where the riskiest Delivery of funds from creditor to debtor, and borrowers—those with the smallest likeli - repayment with interest, are separated in time. hood of servicing and repaying loans—would Lending thus requires prior creditor confi - be the ones willing to offer higher interest dence in borrower creditworthiness. Such con - rates. And moral hazard refers to (changes in) Both adverse fidence arises only when the creditor has good borrowers’ behavior that makes loan service knowledge about the borrower’s financial and repayment less likely (and defaults more selection and condition—the asset side of the balance sheet. likely) after obtaining loans under onerous moral hazard Today, however, with many financial com - terms. Being concerned about these phenom - potentially play a panies carrying toxic assets on their balance ena, creditors generally refuse to commit sheets, potential lenders are unable to verify more than a maximum amount of funds no role in credit and borrowers’ creditworthiness. Many potential matter how high the loan interest rate is. 14 capital markets, lenders are also concerned about needing cash Indeed, as interest rates increase, lenders may causing their reserves themselves in the future and are seek - reduce the amounts that they are willing to ing to conserve liquidity. After a point, as high - lend. This aspect of credit transactions is dif - failure during er demand for loans and smaller supplies of ferent from the normal market for oranges, times of high cash reserves cause borrowers to increase their wherein supply increases without limit (in interest rate offers, total loan supply may principle) in response to higher prices. market decline, rather than increase, in response. It should be noted that the problems of uncertainty. That’s because willingness to pay higher inter - adverse selection and moral hazard caused by
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The current asymmetric information in credit markets also However, future generations cannot directly financial crisis have private market solutions. Firms specializ - extend this credit because they, and their ing in producing information on credit and wealth, do not yet exist. This reflects a form of is characterized borrower quality, security ratings and risk pro - market incompleteness that prevents a solu - by the evident files, and industry performance measures tion to the current financial market failure. 16 failure of ratings emerge to perform the necessary evaluation That failure provides theoretical justification and monitoring tasks that are too costly for for government to step in and effectively trans - agencies to individuals, and even institutional investors, to fer resources from future generations to those provide reliable undertake. However, the current financial crisis alive today 17 —assuming that this transfer will is characterized by the evident failure of ratings be effective in preventing or reducing econom - information on agencies to provide reliable information on the ic harm from the financial crisis. the quality of quality of mortgage-backed securities. Bailout supporters point to two reasons to mortgage-backed Restoring their reputations and functions will believe that the bailout might help to resolve require evidence of better performance that can the financial crisis. First, they claim the current securities. only be accumulated over the long term. version of the bailout would broadly recapital - Under the current financial market envi - ize banks and revive borrowing and lending ronment, creditors are especially nervous activity. It is tempting to think that capital about their counterparties’ creditworthiness, injections should be limited only to financial and especially about how much their future firms that made reasonable investments but asset positions will deteriorate because of suffered illiquidity because of a widening declining house prices. Indeed, a credit freeze financial panic, not to those near insolvency indicates extreme fear about borrowers’ because of high exposure to toxic mortgage- cred it worthiness. Today, the maximum loan related securities. In general, this principle amounts, beyond which market price signals should be followed. However, judging which fail to induce additional credit supply, are very banks deserve help and which should be termi - near zero. That reasoning probably explains nated may be very difficult and time-consum - why foreign savers and oil-rich sovereigns ing, given the broad and deep penetration of won’t extend additional capital to support U.S. housing-related asset failures. Separating the financial companies. good from the bad would involve unwrapping many layers of complex derivative instruments and the imposition of arbitrary (nonmarket) The Call for Intervention asset valuations. It would create wasteful lob - bying activity by financial firms, a strong incen - As the U.S. financial crisis persists, policy - tive for corruption, and require intense public makers feel compelled to act. They seek to (congressional) scrutiny. counter the housing-wealth shock by extend - Second, direct capital injections by the U.S. ing the pool of risk-bearing creditors. With oil government may induce private wealth hold - magnates and other wealthy foreigners unlike - ers and foreign savers to commit additional ly to provide sufficient capital injections to funds to U.S. financial institutions. That private U.S. firms, policymakers are turning to inflow of capital could prevent the credit crisis another group of prospective creditors: future from developing into an economywide credit U.S. generations, who can be “forced” to lend crunch. Such complementarities in alternative through a debt-financed government bailout investment sources might occur simply plan. Intervention proponents can argue that because the commitment of future taxpayer future generations, were they around, should funds could reduce foreign investors’ percep - and would be willing to sacrifice some of their tions of credit risks among U.S. financial firms (eventually larger) resources to help current and stimulate additional lending. generations (and themselves) to dig out of a The foregoing discussion suggests that the potentially prolonged economic downturn. 15 government should tailor public policies to the
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causes and symptoms of particular recessions. market drops like a stone. Since its peak in fall Thoughtful proponents of government inter - 2007, the S&P 500 stock index had lost nearly vention would argue that recessions arising 45 percent of its value by the end of 2008. from shocks to input prices—such as oil prices— Underlying the losses is a near-total collapse of that are limited to nonfinancial sectors require financial intermediation—the availability of restructuring by private firms through techno - credit, especially short-term and unsecured— logical change. That’s best achieved through an on a global scale. Not surprisingly, the main - unfettered operation of market forces. In con - line U.S. economy, other than construction trast, they argue, recessions involving a large (which was already in decline)—transporta - wealth shock—in this case, declining home val - tion, communications, agriculture, and so ues—that results in a broad financial sector col - on—is being forced to operate under tighter lapse require a different approach. Given the credit constraints and many companies are crucial role of the financial sector in greasing beginning to downsize. As a result, the civilian the economy’s wheels, and given the significant unemployment rate has spiked by more than potential for market failure (a credit freeze 2 percentage points since January 2008. because of asymmetric information and inten - The Federal Reserve has provided hundreds sified adverse selection and moral hazard), the of billions of dollars in liquid cash reserves to recapitalization of financial intermediary firms commercial and noncommercial financial There are reasons requires borrowing from abroad and from institutions. It is also offering to purchase non - to believe that future generations. New government borrow - financial firms’ commercial paper to support the bailout will ing could induce more investment by foreign - credit transactions in the economy, and now ers, promoting a quicker restoration of bank pledges “unlimited” liquidity provision and be ineffective— capital and an eventual return to normal levels guarantees interbank lending. The Federal most importantly of financial intermediation. Deposit Insurance Corporation has increased In short, bailout proponents have met a nec - limits on deposit insurance. And Congress because it essary condition for government intervention: passed a $700 billion bailout bill to fund pur - is being there is a financial sector failure that could chases of toxic assets by the Treasury in the implemented impede the market’s self-correcting mecha - hope of easing the credit crisis. The Treasury nisms, resulting in considerable harm to the has dedicated up to $250 billion of that $700 badly, despite nation’s—and the world’s—economy. More- billion to purchase preferred shares and war - the best efforts over, there are some theoretical grounds to rants in financial companies. All of these of government believe the bailout plan could address the cred - unprecedented actions have been taken in the it crisis and reduce the severity of the looming hope of preventing financial sector illiquidity officials. recession. However, there are several reasons to from becoming a widespread credit crunch and believe that the bailout will be ineffective—most triggering a global economic recession. importantly because it is being implemented The most poorly understood aspect of the badly, despite the best efforts of government financial sector crisis is “contagion”—the officials. Moreover, the Treasury bailout plan— spread of balance sheet weakness and defaults and any giant new fiscal stimulus plan cobbled across a swath of financial firms just because a together by the Obama administration and small segment of the mortgage market (sub - Congress—will worsen the nation’s already prime loans) soured and one large financial bleak long-term fiscal outlook. firm (Lehman) was allowed to fail. The keys to understanding contagion are the roles played The Psychology of Contagion in the housing bubble by mortgage under - The financial crisis is causing distress writers, securitizers, and insurers; investment among many who are not directly involved in banks; ratings agencies; and foreign and the financial sector and panic among those domestic investors—banks, pension and who are. Many people are seeing the value of mutual funds, and individuals. The complex their retirement savings dissolve as the stock and convoluted interrelationships among
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them have brewed a financial “perfect storm.” long-term loans, although less liquid, earn What is the nature of these interrelationships, higher returns than the interest rates paid on and why would the collapse of one sector— short-term deposits. Whereas banks are sub - housing—trigger a nationwide financial col - ject to limits on how large their loan portfolios lapse and threaten a global recession? (i.e., assets) can be relative to bank capital, Financial innovations during the last three- investment banks and other nonbank finan - and-a-half decades utilized all of the profes - cial institutions face no such limits. 20 They sions listed above. State-licensed mortgage borrowed up to 30 times as much as their own finance companies and commercial banks capital to invest in long-term illiquid assets originated mortgage contracts for a fee. Loan such as mortgage-backed securities. But high- originators pooled and securitized mortgages. leverage ratios come with the risk of having Mortgage service payments accruing to the too little capital to fall back on when creditors pool were divided into different categories— become skittish and demand evidence that the tranches—with varying default risks. The pay - firm can meet its obligations. The decline in ment streams were connected to bond issues stock market values of investment banks trig - of different ratings for sale to investors. gered just such concerns among creditors. National ratings agencies gave high grades Failures loomed as assets could not be sold at to the bonds supported by the safest cash “fair” values commensurate with their long- flows. 18 About 80 percent of the securities term return prospects. The resulting illiquidi - issued received the highest rating, on par with ty was compounded, because, at a time of low those of Treasury securities, the world’s safest confidence among market participants, most financial paper. Indeed, mortgage-originating were also interested in selling assets them - banks held the safest mortgage-backed securi - selves, thus exacerbating market price ties in their own portfolios, the remaining declines. 21 being “adversely selected” for sale to other As many investors are now painfully aware, investors. Investors seeking higher returns the risk-pooling and risk-spreading functions purchased the securities backed by riskier of mortgage-backed securities involved a third tranches. Such securitization of mortgages effect: concealment from investors of the was intended to distribute the risk of mort - sources and locations of those risks in the gage underperformance or nonperformance financial firms’ balance sheets. The fact that across a broad range of investors—according mortgages with high default risks are hidden to their preferences and tolerance for bearing deep within complicated derivative instru - financial risks. ments would not matter if home prices were Mortgage securitization served to both still increasing. On balance, such financial pool and spread risks. The pooling aspect securities would still garner handsome prof - combined mortgages from different locations its—loan servicers acting on behalf of creditors to achieve a low correlation between their would simply foreclose on the homes and default rates. Risk spreading was achieved by pocket the capital gain. But in a housing price issuing and selling securities backed by such downdraft, investing in such securities mortgage pools to many investors, each of requires prior confidence that they are not whom bore a small part of the risk of any giv - backed by highly risky mortgages. en pool. 19 With the broad-based decline in housing Mortgage A second element in financial firms’ opera - prices, creditors’ confidence in the solvency of tions was the placement of highly leveraged highly leveraged financial firms declined and securitization bets. As is commonly known, financial firms, caused the creditors to curtail lending to firms served to both including banks, borrow for short durations holding mortgage-backed securities in their and lend over longer ones. The gap in maturi - portfolios. The continued decline in home pool and ty lengths on the asset and liability side of the prices has affected mortgage-backed securities spread risks. balance sheet is a means of earning income— well beyond the subprime housing loan sector,
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spreading much more broadly among banks, useful as they collectively reveal information It’s not pension funds, and other investors. and beliefs that individual market participants surprising that Why are risks across balance sheets of so possess about the likelihood of various finan - many firms in different areas within the finan - cial market outcomes. For instance, if CDSs in most financial cial sector so highly correlated? Is there not a a certain security were suddenly to become firms and ratings functional division of labor among financial more expensive, it would indicate that the mar - firms whereby some specialize in funding ket believes the security has become riskier agencies were mortgage-backed assets, others in commercial than previously thought. unable to judge ventures of different kinds, while yet others So why didn’t CDSs and other derivatives properly the provide insurance services, and so on? Why used to hedge against mortgage defaults indi - should so many bank and nonbank financial cate the growing risks in the home finance risk/return firms become embroiled, all together, in a market? Part of the reason might be that ana - characteristics of housing-related financial panic? lysts simply underestimated that risk. However, firms’ portfolios. Those questions point to the second ele - at least part of the reason is the increasingly ment of financial innovations involving mort - complex and opaque world of finance. gage-backed securities. It involves a key finan - Mortgage-backed bonds, their insurance and cial discovery: the Black-Scholes formula for reinsurance—using derivative instruments like dynamic hedging. This formula shows how CDSs—and their sequestration in special-pur - portfolio managers could minimize their expo - pose “off balance-sheet agencies” (called “struc - sure to price risks of securities in their portfo - tured investment vehicles”) created a convolut - lios. It calls for selling the correct amount of ed network of counterparty assets, insurance options against securities held in their portfo - contracts, and liabilities in which global invest - lios to diversify away—or hedge—each security’s ment banks, hedge funds, and commercial price risk. 22 For instance, suppose an investor banks became involved. All of it was motivated holds an asset that will likely increase in value, by first pooling, and then spreading, mortgage but there is a small chance the asset may fall in and other investment risks widely among value. If the investor is unwilling to expose investors across the globe. himself to the risk of loss, he can sell an option Given the complexity of financial instru - on the asset such that the asset buyer would ments and associated interrelationships bet- receive part of the gain if the asset experiences ween financial firms, it’s not surprising that a large increase in value. In return, the original most financial firms and ratings agencies were investor receives an up-front premium from unable to judge properly the risk/return char - the option buyer that offsets the original acteristics of firms’ portfolios—cash reserves, investor’s risk that the asset will decline in stocks, bonds, mortgage-backed securities, price. The Black-Scholes formula, if imple - CDSs, and other derivative contracts. Directors mented correctly through time, will almost of most large financial, insurance, and even completely eliminate the original investor’s mainline manufacturing companies are fre - price risk. In the words of the original Black- quently unaware of the nature and extent of Scholes study, “the return on the (dynamically) their firms’ involvement in a wide array of hedged position becomes certain.” 23 financial transactions, including mortgage- The real world counterparts to dynamic backed assets, CDSs, and other derivatives. hedging are instruments called credit default The bottom line: no one was in a position to swaps (CDSs). These are contracts through judge the buildup of “systemic risk”—that is, to which one party pays another a fixed amount take account of risk magnification for the for the right to receive a pre-specified payment financial system as a whole—from a reversion in depending on the occurrence of a specific home price appreciation. As mentioned earlier, event—say, the failure of a firm or a security, the the location and distribution of problem mort - change in a security’s price beyond a certain gages may not be important for investors when threshold, and so on. Such transactions are housing and most other sectors of the econo -
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my are booming. Positive performance by those with a low capital base. 26 most loans would offset the likely minimal In this regard, a key issue is whether policy - losses on problem home loans. The risk of makers themselves understand that once a default would remain low as homeowners systemic shock is in motion—a process of continued to benefit from surging home deleveraging by withdrawing, recalling, or sell - prices and homes backing distressed mort - ing the financial firm’s investments to obtain gages could be sold easily and at a profit. With cash and consolidate its capital base— the bursting of the house price bubble, howev - investors and other market participants are er, the exposure of mortgage-backed securities especially sensitive to news about the financial to problem loans underwent a quantum sector’s and the economy’s prospects. Any increase, and the location of such loans sud - announcements that market and economic denly became very important for investors and prospects are worsening can become self-ful - insurers. filling. Thus, recent high-visibility press con - Now, underperforming mortgages could ferences and speeches by policy officials to dis - potentially dominate positive performers, and cuss how the current financial crisis places the investors need to know where the former are economy at great risk probably exacerbated located to maintain confidence in their overall the problem considerably. Recent high- lending operations. The lack of knowledge of visibility press the overall distribution and locations of risky conferences and assets across financial firms can itself lead to Will the Bailout Plan risk magnification. 24 It occurs because all speeches by Restore the Economy’s investors simultaneously (and rationally) re- Health? policy officials evaluate their counterparties’ risk exposure and creditworthiness and reduce their lending. The original Treasury plan to purchase tox - probably Very few market participants, if any, can antici - ic mortgage-related assets from firms’ balance exacerbated pate and assess the consequences of an imme - sheets has morphed into one where the gov - the problem diate upward reevaluation by all participants of ernment directly injects capital into financial their own and other participants’ risk expo - firms by purchasing stocks and warrants in considerably. sures on account of a joint negative shock to those firms. In addition, the Federal Reserve is their asset values. This process can become self- expanding liquidity through “quantitative eas - fulfilling: constrained credit flows to financial ing” measures, guaranteeing interbank loans, and mainline firms worsen economic perfor - purchasing commercial paper, and guarantee - mance and fulfill creditors’ prior expectations ing housing-related obligations of financial of increased default risks. 25 companies. The capital injections and added Under the ongoing housing price decline, it liquidity are intended to restore confidence in may be that most investors and financial com - financial markets, thaw frozen lending within panies are exposed to only a small amount of the financial firms, and ease credit conditions risky (subprime) mortgage-backed securities. for nonfinancial sectors. So far, the results have But firms’ portfolio compositions are not been disappointing, and it remains unclear public information. The possibility that one’s whether they will ever work as desired. If they financial counterparty (options trader, bor - remain unsuccessful, future taxpayers will be rower, insurer, and so on) may be exposed to exposed to additional debt burdens to the tune significant housing-sector risks stimulates a of many hundreds of billions of dollars with - behavioral change in financial firms’ willing - out inheriting a robust economy. ness to lend. And when firms are highly lever - Economists are split among multiple aged, sudden adverse market conditions and groups on the wisdom of a government bailout creditor demands that borrowers demonstrate of the financial sector. Opponents of the their ability to service debts can trigger a bailout cite many reasons against it: it would scramble for cash that can prove disastrous for unfairly compensate those who made risky
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investments, take too much time to imple - ity differences) had declined by 17 percent ment, impose losses on taxpayers, push the from mid-2007 when household real estate financial sector onto an irreversible path wealth peaked at $20 trillion. That implies a toward socialism, and so on. Supporters of the wealth loss of about $3.4 trillion. 29 The decline bailout think it can still succeed, with some in stock market wealth over the same period, modifications. However, it is likely that a mod - including corporate equities, mutual funds, ified bailout will do little to alter the ultimate and pension funds, is estimated at $9.7 trillion, length or severity of the recession. 27 based on a 40 percent decline in stock values The economy has experienced a negative since mid-2007. 30 Even if some stock market wealth shock. The housing assets we invested losses are recouped as the market rebounds in are worth less than we thought, as reflected from its current lows, the total wealth loss will by a marked and continuing decline in home likely remain larger than the bailout fund and prices. The realization that we are not as expansion of the Federal Reserve’s portfolio. wealthy as we once thought will modify our Moreover, the implementation of equity economic behavior. We’ll consume less and injections is taking inordinately long and it’s save more. That change is likely to prolong not clear that they will effectively thaw frozen housing price declines as potential homebuy - credit flows. Despite the injections currently ers stay away and homeowners opt to delay or under way, credit risk indicators remain elevat - discontinue servicing their mortgages. But ed. The latest Treasury initiative of purchasing higher saving rates may not generate higher preferred bank stocks of financial firms, broad - total saving if incomes decline simultaneously ly defined, is being justified on grounds that because of the credit crunch. As a result, finan - they can be implemented speedily and would cial sector balance sheets may continue to be more effective at restarting credit flows in weaken and credit conditions for nonfinancial the economy. However, government purchases sectors may continue to tighten. Eventually, of equities, rather than poorly performing the credit squeeze is likely to reduce total out - assets from banks, hold other dangers, as put, cause job losses, and result in further described in the next section. declines in home prices. A compounding factor is the associated decline in companies’ share prices, again weakening financial sector bal - Good Intentions on the ance sheets—and so on. Road to Hell The remedy for a large wealth shock is a large wealth injection, financed either by for - It’s difficult to predict whether the U.S. eigners or by future generations in the form of Treasury’s initiative to purchase equity stakes deficit-financed asset swaps with financial in financial firms will succeed in quickly firms. 28 The magnitude of the required asset quelling the current financial panic. What is swaps would have to be much larger than the worse, it sows the seeds for a new financial $700 billion ammunition provided to the U.S. collapse by repeating and compounding the Treasury by Congress. The Fed’s portfolio of moral hazard problem that has already bank - Treasury securities (currently about $1.8 tril - rupted Fannie Mae and Freddie Mac. lion) is also being brought to bear. Consider, The Treasury has injected $250 billion in however, that during the stock market implo - exchange for preferred stocks in financial It is likely that a sion in 2000, household losses in stock values firms. Equity injections were forced on nine of modified bailout were offset by housing price increases. The cur - the largest financial firms—even well-capital - rent episode is characterized by wealth losses in ized ones, bringing into question the need for will do little to both housing and stocks. As of the second such support in the first place. 31 The purchase alter the ultimate quarter of 2008, home prices (based on the of preferred equities is a sharp departure from nationally representative Case-Shiller home the Treasury’s initial proposal to purchase tox - length or severity price index, which also controls for home qual - ic assets from financial companies that wished of the recession.
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The remedy for a to unload them. What happened? Perhaps the service for initially financing the equity pur - large wealth Treasury didn’t receive sufficient bids from chases, and additional business risks. The equi - financial firms to unload bad assets. That ty premium over debt-service costs that tax - shock is a large would not be surprising, because accepting payers receive will cause marginally greater wealth injection, government help would be associated with volatility in federal receipts, which in turn will executive compensation limits and forced occasion greater volatility in taxes and larger financed either lending to insolvent homeowners. And it fluctuations in Treasury bond prices because by foreigners or would signal weak asset positions, causing of larger variability in annual federal deficits. by future potential private creditors to flee. Perhaps the most important argument Quite likely, actions by the UK government against purchasing equity of private compa - generations in the and European Union to inject equity capital in nies is the example of Fannie Mae and Freddie form of deficit- their financial sectors forced the U.S. govern - Mac. The two government-sponsored enter - financed asset ment’s hand. Without similar measures, U.S. prises expanded rapidly and obtained cheaper banks would be perceived as being riskier and financing because of an implicit government swaps with would lose business to European banks. guarantee. Last summer, the federal govern - financial firms. Whatever the short-term reasons for such a ment was forced to make the implicit guaran - move, partial nationalization of financial tee explicit when Fannie and Freddie’s opera - companies is a bad idea in both the short and tions grew too bloated with questionable long terms. mortgage-backed securities, and private The difference between debt purchases and investors refused to refinance their highly injecting equity capital into financial compa - leveraged portfolios. Purchasing equity stakes nies is profound. Debt purchases would limit in many more private firms will magnify this the government’s direct involvement with pri - moral hazard problem. Having invested in vate asset ownership through the point of debt financial companies, the government would maturity simply because the debt’s value will be forced to prop them up with additional eventually be resolved. Either the government capital injections rather than allow them to (taxpayers) will make a profit on the debt fail, thereby risking another financial panic. because its value turns out to be larger than the The $250 billion equity injection is sup - discounted price paid for it, or it will make a posed to be temporary. However, if the ratio - loss if the value of the debt turns out to be nale for its implementation in the United worth less. In either event, the government’s States is that many other countries have adopt - direct involvement in the private sector is lim - ed it, we (and correspondingly, foreign govern - ited to the term of debt maturity. ments) are effectively locked into this policy. In contrast, equity infusions into private Unilateral sales of the U.S. government’s equi - financial firms will appear as a capital outlay by ty positions would create an advantage for for - taxpayers. The advantage of an equity infusion eign banks that continue to be backed by their is that it can be implemented relatively quickly governments—just as implicit government and it enables taxpayers to share in the upside guarantees to Fannie and Freddie conferred a of troubled firms’ operations after credit flows pricing advantage to those agencies among resume normalcy—more so than through pur - home-loan investors. chases of bad debt from financial firms. 32 The In the future, continued government involve- problem is that once the financial crisis has ment in financial firms may be justified by passed, there’s no guarantee that the govern - Congress on several grounds: financial compa - ment will sell its equity stakes in private finan - ny failures must be prevented to avoid financial cial companies. Continuing government co- panics; a Republican administration, no less, ownership would be justified for recovering acquiesced in implementing this initiative; for - returns on earlier taxpayer investments and as eign banks otherwise would be unduly advan - a way of keeping taxes low. Taxpayers will bear taged, and so on. Chances are, however, that two additional costs as well: additional debt despite promises of stricter regulation of finan -
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cial companies, politicians’ power and incen - ital injections will be less effective at preventing tives to expand home loans and other credit to a broader credit crunch than appears at first those with poor credit records will be strength - glance. ened—setting the stage for a future financial Furthermore, the bailout package imposes panic—because, rather than in spite of, the counterproductive executive compensation Treasury’s initiative. limits on firms that participate in government Further, capital injections in financial firms assistance programs. According to the Treasury raise the prospect of similar injections in non - bulletin on the capital injections program, financial firms in the future, if and when those incentive compensation for senior executives sectors face difficulties. This Policy Analysis should not encourage unnecessary and exces - has acknowledged that because of informa - sive risks that threaten the value of the financial tional asymmetries inherent in credit transac - institution; any bonus or incentive compensa - tions and the potential for contagion, thought - tion paid to a senior executive based on state - ful bailout proponents could theoretically ments of earnings, gains, or other criteria that justify government intervention to restore are later proven to be materially inaccurate proper functioning of the financial sector and should be clawed back; golden parachute pay - avoid systemic risks to the economy. But this ments to senior executives would be prohibited; argument is not widely appreciated by the pub - and executive compensation in excess of Perhaps the lic and it can be misappropriated by supporters $500,000 for each senior executive would no most important 33 of broad government intervention in the econ - longer be tax deductible for corporations. argument against omy. Unprecedented government capital injec - Similar conditions apply to the Treasury’s tions into the financial sector may provoke Troubled Assets Relief Program. But executive purchasing future calls for similar interventions in autos, compensation limits threaten to make these equity of private airlines, and other nonfinancial sectors were programs less effective. They provide additional they to encounter negative shocks. Indeed, at motivation for the financially healthiest firms companies is the the time of this writing, the government has to avoid the stigma of participation: potential example of proffered support to two financially troubled private creditors would deem participating Fannie Mae and Detroit automakers. firms as having weaker balance sheets and may Furthermore, a policy of capital injections— avoid lending to them. If the government’s Freddie Mac. forced by international policy competition or involvement continues over the longer term—as otherwise—may prove self-defeating even in the appears likely—executive compensation limits short term. Sound asset positions are a prereq - may siphon off talented executives to nonfi - uisite for normal lending by financial compa - nancial firms and leave a key sector with rela - nies to mainline businesses. We are witnessing tively less qualified and experienced managers. how deteriorating assets of financial compa - nies cause cutbacks in credit flows, both with - in the financial sector and to nonbank busi - Long-term Implications nesses. We also know that bank assets include a significant stock market component—direct The National Bureau of Economic Research investments and loans collateralized using pri - has declared that the financial crisis has trig - vate company stocks. The Treasury’s purchases gered a recession—which commenced during of preferred stock in troubled financial firms the last quarter of 2007. Contrary to what many (a) dilute the value of existing shares, and (b) set pundits suggest, this recession may last a while, a precedent for a similar potential dilution in even beyond 2009. If it does, it will mark the other sectors. That expected dilution is likely to beginning of an era of permanently higher tax es have contributed to declining stock market val - and slower economic growth in developed ues and it implies a further weakening of bank countries. And it will hasten the impending fis - balance sheets, especially if stock values fail to cal crisis in entitlement programs. recover quickly. This feedback implies that cap - Stock markets declined in reaction to both
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the initial failure, and the eventual passage, of ment, an economy in recession won’t provide the U.S. bailout plan. They have continued to sufficient opportunities to many, leading to decline despite coordinated efforts by the excess worker supply and stagnant wage world’s finance ministers and the decision of growth. 36 The current recession could make the U.S. Treasury to purchase bank equity this phenomenon quite intense. After the U.S. instead of just distressed assets. As home prices economy emerges from the recession, howev - decline, financial institutions’ balance sheets er, a gradual erosion of labor quality will per - continue to weaken and the crisis spreads. sist, at least for another two decades, until the Broad-based bailouts of financial companies boomers are fully retired. are being implemented in Europe and replicat - American consumers, who are widely ed in the United States. But it remains uncer - viewed as drivers of global growth, have cut tain whether ongoing fiscal and monetary ini - back on spending. Last year’s oil price surge tiatives will succeed and how quickly. slowed spending on non-oil goods. Although The past two U.S. recessions were mild, and oil prices have receded because of the global global economic growth was interrupted only economic slowdown, other factors will contin - briefly. The hope is that bailouts will keep the ue to restrain consumer spending growth. 36 As current economic recession short-lived and the baby boomers approach retirement, con - shallow. But what is the likelihood that it will cerns about the viability of public retirement be so? As of this writing, for example, stock programs, recently devalued 401(k) accounts markets the world over had declined by 40 to from stock market declines and reduced job 50 percent from peaks one year ago. As men - security from rising unemployment, may tioned earlier, those declines place additional induce many households to increase their strains on financial company balance sheets rates of saving. and may prolong tighter credit conditions. Slower consumption growth among devel - The two previous recessions in 1991 and oped economies could be replaced by faster 2001 occurred under sound economic fun - consumption growth in developing ones, damentals: highly productive workforces, especially China and India. Trade has been the strong consumption growth, continued one silver lining for the U.S. economy during advances in global trade, and low taxes. This 2007–2008: as the dollar depreciated, bur - time around, however, those fundamental geoning exports sustained growth in U.S. out - forces appear to be considerably weaker. put. But that might change with bleaker glob - Consider, first, earnings growth. The most al economic prospects. Indeed, an improving experienced baby-boomer cohorts of U.S. and current account balance during 2007 reversed Unprecedented European workers are now retiring. Although during the first two quarters of 2008. government a larger-than-anticipated percentage of older Thus far, China’s rapid economic growth U.S. workers have remained in the workforce has resulted from high domestic saving and capital injections in recent years, a prolonged recession could investment geared toward infrastructure, man - into the financial reverse this incipient trend. Credit shortages ufacturing, and exports. With slowing global sector may and diminished consumption are forcing consumer spending, China may encourage firms to cut costs or downsize. 34 Those pres - faster domestic consumption growth to sus - provoke future sures are likely to hit older workers the hard - tain its manufacturing sector. Some of the calls for similar est, with layoffs forcing earlier-than-planned increase in Chinese spending would be on non- retirements. Forced or voluntary exits by the Chinese goods and would benefit developed interventions in most experienced workers in the labor force economies’ exports and earnings. However, autos, airlines, will reduce overall labor quality and slow pro - China’s policymakers might raise trade barriers and other ductivity and earnings growth. That leads to in an effort to insulate their economy from a the conundrum that, as many boomers realize global recession. India is less exposed to a glob - nonfinancial the need to extend their careers to avoid sharp al recession because of its higher import con - sectors. living standard declines during eventual retire - trols and tariffs, but a severe recession in west -
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ern countries could provoke a more protec - over the next 75 years amount to more than The hope is tionist posture from India and other develop - $40 trillion. 38 And Medicaid spending, which that bailouts ing countries. has features similar to entitlement programs, Overall, slowing global consumer demand, will cost another $16 trillion. In addition, will keep the labor productivity, and, potentially, trade growing imbalances in regional and state gov - current economic growth, worsen the prospects for private ernment budgets will require steep cuts in ser - recession investment spending. In the United States, vices and/or much higher taxes. Unless govern - growth in gross private domestic investment ment entitlements and other commitments short-lived and has exhibited a negative trend since 2005 can be significantly reduced, the current raging shallow. (Figure 7). Together, those forces will make it financial crisis could very likely become a difficult to recover quickly from the ongoing watershed moment, marking a shift to an era recession. If the bailout measures in the United of permanently higher taxes and, therefore, States and abroad do not soon restore financial permanently slower economic growth in the stability—and there are powerful reasons to United States. doubt that they will—policymakers are likely to intensify debt-financed rescue efforts and increase fiscal burdens on future taxpayers. Conclusion Indeed, as of this writing, Congress is consider - ing an unprecedented debt-financed economic This financial crisis and the ongoing eco - stimulus package. 37 nomic recession were triggered by oil price Future generations’ earnings are already sig - shocks that began in late 2002 and intensified nificantly burdened by government obliga - in 2007. However, the seeds of the crisis were tions to pay public pension and health care planted years earlier, as policymakers purpose - benefits to aging baby boomers. According to fully altered financial market regulations with government actuaries, unfunded obligations the intention of promoting U.S. homeowner - on account of Social Security and Medicare ship. That policy prompted financial innova -
Figure 7 Growth in Private Domestic Investment (Quarterly growth at an annualized rate)
30
25
20
15
10 t n e
c 5 r e P 0
-5
-10
-15
3 4 5 6 7 8 0 0 00 0 00 0 20 20 2 20 2 20 Source: U.S. Bureau of Economic Analysis.
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tions to pool and spread mortgage risks and and failure, government debt-financed inter - channeled the global surge in saving into U.S. vention should be temporary, intended to mortgage-backed assets, especially into sub - restore markets to health and not permanent - prime and Alt-A home loans. Those innova - ly supplant market operations with govern - tions were tailored to reduce investors’ expo - ment management. Instead, current initiatives sure to the risk of localized real estate appear panicked and poorly designed, threaten downturns. However, the innovations simulta - to deplete talented financial sector personnel, neously hid the extent and location of those and suggest a trial-and-error process, which risks within financial firms’ asset portfolios only injects more uncertainty into markets and magnified the risks of a broad financial rather than restoring participants’ confidence. sector failure. Consequently, a downturn in The government initiatives being implemented home prices since 2006, increasing mortgage are biased toward introducing permanent defaults, rising foreclosure risks, difficulties in interventions in market processes and institu - evaluating the quality of mortgage-backed tions to the probable detriment of the nation’s securities, and high leverage of investment long-term economic prospects. banks made creditors extremely fearful of lend - The bias toward making the government’s ing to financial institutions with high risk expanded role in economic management per - Unless exposures to mortgage-related securities. manent is emerging because the current finan - government Investment banks failed at regular intervals cial mess is being unjustly blamed on market entitlements during 2007 and 2008. Short-term credit flows forces rather than on prior government policies. collapsed, jeopardizing funding for mainline Politicians of both parties paid lip service to and other businesses and spawning a sustained negative reforming home-loan institutions—Fannie Mae commitments can economic spiral. Financial sector disruptions and Freddie Mac—in order to make their port - have reduced consumer confidence. Now, low - folios and operations financially sustainable. be significantly er consumption is reducing output, employ - Instead, policymakers commenced aggressive reduced, the ment, and stock market values, further weaken - promotion of home lendi ng volumes since the current raging ing consumer and financial market confidence. 1990s. Absent policies to promote homeowner - Eventually, trade flows may also be negatively ship among poorly qualified borrowers, non - financial crisis affected if a global recession provokes anti-trade bank financial firms may have followed more could very likely policies as emerging economies seek protection prudent lending policies to minimize risk expo - become a for domestic producers and workers. sures during the 1990s and early 2000s. And Sustaining consumption and investment in global investors might have redirected their watershed the face of a housing wealth shock requires funds to other sectors and countries to generate moment. supplementary resources and an expansion of more balanced risk exposures and sustainable the pool of risk-bearing investors. Only foreign increases in U.S. home values. savers and future generations could play this The fallout from the financial crisis will be role. Indeed, U.S. government debt-financed the forced increase in future generations’ debt wealth injections financed by future genera - burdens to fund the financial bailout plan and tions could encourage foreign savers to boost a massive economic stimulus package that the their capital investments in U.S. financial firms U.S. Congress appears very likely to enact soon. and restore the financial sector’s health. The increased government borrowing will add The appropriate manner of channeling to the already massive implicit debt burden debt-financed government assistance to finan - that future generations face on account of fed - cial firms, however, poses a difficult challenge. eral entitlement programs. Conventional wis - The multifarious fiscal and financial initiatives dom holds that fiscally responsible public pol - of the U.S. Treasury and Federal Reserve, icy reforms of entitlement programs won’t respectively, have not worked so far and are emerge until a budgetary crisis becomes immi - unlikely to restore market confidence. Under nent. If the current financial crisis metastasizes, the theory of financial market incompleteness the tax base shrinks, and tax rates become per -
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manently higher, economic growth will be 7. The Bush administration repeatedly urged reforms for Fannie and Freddie, but not suffi - slowed and the entitlement crisis will be upon ciently vigorously to result in any legislation us sooner than we have been expecting. before 2006, when Republicans enjoyed majori - ties in both houses of Congress. The push for expanded homeownership through the actions of Fannie and Freddie received bipartisan support Notes throughout the early 21st century, and calls for 1. The National Bureau of Economic Research’s reforming the two financial institutions were Business Cycle Dating Committee has not derided as creating an “artificial issue.” See Barney declared the start of an official recession as of yet, Frank, “GSE Failure, A Phony Issue,” American but recent data on broad-based output and Banker , April 21, 2004. employment declines imply that the official dec - laration of an economic recession beginning in 8. According to the National Association of the third quarter of 2008 is highly likely. Realtors, delinquency rates increased across the board on a year-over-year basis. Seasonally adjusted 2. See Lutz Killian, “The Economic Effects of delinquency rates moved up 120 basis points for Energy Price Shocks,” Journal of Economic Literature prime loans, 385 basis points for subprime loans, 5 46, no. 4 (December 2008). Killian suggests that basis points for FHA loans, and 67 basis points for the primary impact of higher energy prices is VA loans from the second quarter of 2007. transmitted through changes in consumer and firm demands for goods and services—a decline in 9. See Wayne Passmore, “GSE Implicit Subsidy and aggregate demand and a shift in demand away the Value of Government Ambiguity,” Finance and from energy-intensive goods, for instance, autos Economic Discussion Series 2005–05, Federal Reserve and homes, that ripples through the economy. Board, 2005, http://www.federalreserve. gov/Pubs/ feds/2005/200505/ 200505pap.pdf. 3. According to the National Association of Real- tors, total housing inventory at the end of July 10. For a more detailed discussion, see Gary 2008 increased by 3.9 percent to 4.67 million exist - Gorton, “The Panic of 2007,” National Bureau of ing homes available for sale, which represents an Economic Research working paper no. 14357, 11.2-month supply. This includes condos, single-, October 2008. and multi-family homes. 11. In an October 15, 2008, speech to the City 4. Data for the Case-Shiller composite index are Club of New York, Fed Chairman Ben Bernanke taken from the St. Louis Federal Reserve’s website suggested that, like AIG, Lehman was “large, com - using their economic data download service plex, and deeply embedded” in the financial sys - known as FRED. tem, but the firm could not provide assurance that a Fed loan would be repaid. Neither did the 5. See David Streitfeld and Gretchen Morgenson, Treasury have authority to absorb losses from “Building Flawed American Dreams,” New York underwriting Lehman’s weak assets. That justifi - Times , October 19, 2008. The article documents cation for allowing Lehman to fail is curious how “as the Clinton administration’s top housing when considered in light of other, almost apolo - official in the mid-1990s, Mr. Cisneros [head of getic, statements that financial firm failures must the federal Department of Housing and Urban be prevented when they pose systemic risks and Development since 1993] loosened mortgage that the Fed will work closely with other authori - restrictions so first-time buyers could qualify for ties to minimize such risks. loans they could never get before.” 12. The TED spread’s normal range is between 0.2 6. Alt-A mortgages are those that do not satisfy all and 0.4 percent. During early August of 2007, its criteria to qualify as “conforming” mortgages value doubled from 0.44 to 0.87 within the span guaranteed by government-backed home loan of five days. It continued to fluctuate between agencies like Fannie Mae and Freddie Mac. The 1.00 and 2.00 percent during the entire year. nonconforming features could include poor docu - However, in mid-September 2008, it skyrocketed mentation of assets and income, high total bor - to above 3.0 percent and continued to climb. rower debt-to-income ratios, too many problems During October 2008, at the time of this writing, in the borrower’s credit history, or too high loan- the spread has remained consistently above 4.0 to-value ratio for the mortgage under considera - percent—nearly 10 times its normal level. tion. Alt-A borrowers have considerably better qualifications on those criteria than subprime 13. See Robin Sidel, “Abu Dhabi to Bolster borrowers. Citigroup, with $7.5 Billion Capital Infusion,” Wall Street Journal, November 27, 2007. See also
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Edward Evans, “Merrill Lynch Gets $6.6 Billion into firms rather than using the funds for addi - from Kuwait, Mizuho,” Bloomberg , January 15, tional consumption. As such, the injections are 2008. These capital infusions are considerably expected to be substantially recouped once the smaller than the $700 billion recommended by financial sector is restored to health. If the addi - Treasury Secretary Henry Paulson and appropri - tional borrowing were intended to fund increased ated by Congress. Bloomberg data available at current consumption, then interest rates and gov - http://www.bloomberg.com/apps/news?pid=new ernment debt service costs would increase. Note sarchive&sid=aDmQ66OoJbfw shows that, glob - that the previous footnote’s argument implies ally, write-downs by financial firms on account of that future generations would not care how the credit losses far exceed the amount of new capital funds were used so long as they successfully raised, as of August 2008. restored the efficient operations of financial mar - kets and the economy. 14. See Joseph E. Stiglitz and Andrew Weiss, “Credit Rationing in Markets with Imperfect 18. The three main nationally recognized statisti - Information,” American Economic Review 71, no. 3 cal research organizations are Moody’s, Standard (June 1981): 393–410. and Poor’s, and Fitch.
15. Note, however, that it is only an assumption 19. For a more detailed discussion, see Gorton. that future generations will be wealthier than cur - rent generations. Borrowing excessively from 20. See Ben Protess, “‘Flawed’ SEC Program Failed future generations to bail out current genera - to Rein in Investment Banks,” ProPublica (October tions—by bequeathing a large debt burdens to 1, 2008), http://www.propublica.org/article/ future taxpayers—may negate that assumption flawed-sec-program-failed-to-rein-in-investment- because debt service may necessitate very high banks-101/. Protess documents how the SEC’s future taxes. Given the already sizable fiscal “consolidated supervised program” relaxed mini - imbalances implied under current federal and mum capital requirements for firms that submit - state government fiscal policies, borrowing addi - ted to SEC oversight—a program that is believed to tional funds from future generations risks signif - have allowed the tremendous increase in leverage icantly reducing future economic growth ratios of erstwhile investment banks. prospects. The last section of this Policy Analysis discusses prospects for future economic growth 21. For a good discussion, see William Poole, in more detail. “Fundamentals of the Financial Crisis: Misman- aging Risk” (speech to Delaware Captive Insurance 16. A clear distinction between market incom - Association, October 2008). pleteness and market failure needs to be main - tained. Were current generations and their wealth 22. Options are contracts that provide the holder around today (that is, were markets complete), with the right to purchase (or sell) securities at a they would share potential foreign lenders’ fear predetermined price and by a preset date. See the about current generations’ creditworthiness and description by Robert C. Merton in his article on the market failure would persist. However, options in the New Palgrave Dictionary of Economics , because under market incompleteness, future 2nd ed. (2007). generations’ welfare depends on the economic success of current ones, it is assumed that they 23. See Fischer Black and Myron Scholes, “The would willingly extend support to current gener - Pricing of Options and Corporate Liabilities,” ations without regard to considerations of credit - Journal of Political Economy 81, no. 3 (1973): 637–54. worthiness and returns on their “loans.” That is, they would ignore the causes of current financial 24. The idea of risk magnification may have moti - market failure in helping to overcome it. vated a famous comment by Warren E. Buffet: “In our view . . . derivatives are financial weapons of 17. Private companies cannot perform this func - mass destruction, carrying dangers that, while tion because, were they to attempt it—say, by now latent, are potentially lethal.” See (annual let - increasing pension commitments to current ter to shareholders of Berkshire Hathaway Inc., workers—those additional liabilities would be February 21, 2003), http://image.guardian.co. immediately and fully offset by the companies’ uk/sys-files/Business/pdf/2008/09/15/2002 reduced share prices. The government, on the pdf.pdf. other hand, suffers little adverse effects on its creditworthiness from deficit-financed capital 25. A question that remains is why investors in injections into firms today because government securitized mortgage assets did not price the risk has the power to levy taxes or spend less in the appropriately. Some argue that this mispricing future to service its debts. Note that the lack of emerged as a result of “agency problems”—the adverse impact is predicated on injecting capital undervaluation of risks by rating agencies was not
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adequately monitored or questioned by investors. versus the Housing Market,” Berkeley Electronic See Charles W. Calomiris, “The Subprime Turmoil: Press 5, no. 1 (2005). The large number of unsold What’s Old, What’s New, and What’s Next,” homes and the decline in home prices reflects a (mimeo, October 2008). Ratings’ agency officials, reduction in our valuation of homes that are however, claim that their ratings were adequately already built. The decline in stock market values “stress tested” and that investors mistakenly took also does not reflect any immediate decline in the ratings “point estimates” as investment advice nation’s overall productive capacity today. rather than just one factor among many they However, it does reflect market participants’ views should have considered when making investment of how efficiently and profitably we’ll use that decisions. See remarks by Deven Sharma, president capacity in the future, given the financial sector’s of Standard and Poor’s Ratings Agency, disruption. Moreover, the decline in stock market http://www2.standardandpoors.com/spf/pdf/me wealth is likely to negatively affect households’ dia/Sharma_FDIC_Final.pdf. consumption, saving, investment, and risk-taking behavior. That may further impede the full use of 26. Indeed, AIG’s trading strategy in the CDS the nation’s tangible productive assets. market was predicated only on key characteristics of the assets being insured. It did not take 31. This announcement may be intended to account of the risk that creditors would demand deflect attention from the fact that those who additional collateral as evidence of creditworthi - receive bailout funds would have the weakest bal - ness in a declining housing market. See Carrick ance sheets among healthy financial firms—to Mollenkamp, et al., “Behind AIG’s Fall, Risk prevent others from refusing to conduct business Models Failed to Pass Real-World Test,” Wall Street with them. Journal , November 3, 2008, A-1. 32. Another advantage claimed by proponents of 27. See Ben Bernanke (speech before the City Club capital injections compared to purchases of bad of New York, October 15, 2008). Chairman assets from financial firms is that the former is Bernanke hints that the economy will take a long associated with a larger credit multiplier. It is not time to recover even if the financial sector returns clear that this claim is correct. Under the former, to relative normalcy in the near future as a result of for each extra dollar of capital that the firm government actions among developed countries. receives, it can support multiple dollars of loans. But the toxic mortgage-backed assets would 28. Some observers have recommended that remain on firms’ balance sheets, which must use homeowners should be directly helped via debt up some firm capital to limit leverage ratios and renegotiations to prevent escalating foreclosures. which may continue to hinder borrowing and This step is politically popular but if it results in lending activity because traders continue to wor - keeping unqualified homeowners in their ry about the soundness of their counterparties’ homes—those with sub-prime and Alt-A mort - balance sheets. Purchases of toxic assets would gages who are now unable to service their mort - occur at a discounted price and would provide gages—it could worsen the incentives of other less than a dollar of loanable funds for each dol - homeowners to continue servicing their mort - lar of such assets sold to the government. Hence, gages. The market failure is in the financial sector, the credit multiplier will create a smaller dollar where normal credit flows need to be restored. amount of extra loans. But the government’s Hence, most of the bailout funds should be chan - bailout budget is bounded at $700 billion. Under neled toward the financial sector. Indeed, direct - either strategy, financial firms as a whole would ing the funds to directly bailing out poorly quali - receive the same total increment in loanable fied homeowners compounds and extends the funds. Under the latter, however, toxic assets initial error of aggressively pushing for increased would be eliminated along with traders’ worries homeownership instead of sustaining and about the soundness of their counterparties’ bal - strengthening regulations against imprudent ance sheets. mortgage lending. See Edward Glaeser and Joseph Gyourko, “The Case against Housing Price 33. See the Treasury Department’s announce - Supports,” Berkeley Electronic Press 6, no. 5 (2008). ment on Executive Compensation Rules under the Emergency Economic Stabilization Act, 29. See Jordan Rappaport, “A Guide to Aggregate http://www.ustreas.gov/press/releases/2008 House Price Measures,” Federal Reserve Bank of 101495019994.htm. Kansas City Economic Review 2007 , no. 2. 34. See “GDP and the Economy: Final Estimates 30. The same method of estimating total stock for the Second Quarter of 2008,” Bureau of Labor market capitalization is followed by Karl E. Case, Statistics, Survey of Current Business, October John M. Quigley, and Robert F. Shiller in 2008, http://www.bea.gov/scb/pdf/2008/10%20 “Comparing Wealth Effects: The Stock Market October/1008_gdpecon.pdf.
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35. A recent demographic and economic simula- 36. See Killian. tion by the author suggests that the retirement of the boomers is likely to introduce a long phase of 37. See Paul Krugman, “Let’s Get Fiscal,” New York sluggish productivity and wage growth in the Times, October 17, 2008. United States. See Jagadeesh Gokhale, Social Security: A Fresh Look at Reform Alternatives (Chicago: 38. See the Annual Reports of the Social Security University of Chicago Press, forthcoming). and Medicare Trustees, 2008.
STUDIES IN THE POLICY ANALYSIS SERIES
633. Health-Status Insurance: How Markets Can Provide Health Security by John H. Cochrane (February 18, 2009)
632. A Better Way to Generate and Use Comparative-Effectiveness Research by Michael F. Cannon (February 6, 2009)
631. Troubled Neighbor: Mexico’s Drug Violence Poses a Threat to the United States by Ted Galen Carpenter (February 2, 2009)
630. A Matter of Trust: Why Congress Should Turn Federal Lands into Fiduciary Trusts by Randal O’Toole (January 15, 2009)
629. Unbearable Burden? Living and Paying Student Loans as a First-Year Teacher by Neal McCluskey (December 15, 2008)
628. The Case against Government Intervention in Energy Markets: Revisited Once Again by Richard L. Gordon (December 1, 2008)
627. A Federal Renewable Electricity Requirement: What’s Not to Like? by Robert J. Michaels (November 13, 2008)
626. The Durable Internet: Preserving Network Neutrality without Regulation by Timothy B. Lee (November 12, 2008)
625. High-Speed Rail: The Wrong Road for America by Randal O’Toole (October 31, 2008)
624. Fiscal Policy Report Card on America’s Governors: 2008 by Chris Edwards (October 20, 2008)
623. Two Kinds of Change: Comparing the Candidates on Foreign Policy by Justin Logan (October 14, 2008)
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