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Dædalus coming up in Dædalus:

the meaning of Gerald Early, Henry Louis Gates, Jr., Glenda R. Carpio, David A. minority/majority Hollinger, Jeffrey B. Ferguson, Hua Hsu, Daniel Geary, Farah Grif½n, Dædalus Korina Jocson, Eric Sundquist, Waldo Martin, Werner Sollors, James Alan McPherson, Jeffrey B. Perry, Clarence Walker, Wilson Jeremiah Journal of the American Academy of Arts & Sciences Moses, Tommie Shelby, Amina Gautier, and others Fall 2010

race, inequality Lawrence D. Bobo, William Julius Wilson, Michael Klarman, Rogers Fall 2010: on the ½nancial crisis & economic policy & culture Smith, Douglas Massey, Jennifer Hochschild, Martha Biondi, Cathy Cohen, James Heckman, Taeku Lee, Pap Ndiaye, Alford Young, on the Benjamin M. Friedman Introduction 5 Marcyliena Morgan, Richard Nisbett, Jennifer Richeson, Daniel ½nancial & Robert M. Solow Sabbagh, Roger Waldinger, and others crisis & Benjamin M. Friedman Is our ½nancial system serving us well? 9 economic policy Robert M. Solow The bigger they are . . . 22 the modern American David Kennedy, Lawrence Freedman, David Segal, Lawrence Korb, Luigi Zingales Learning to live with not-so-ef½cient military Robert L. Goldich, Danielle Allen, Andrew Bacevich, James Sheehan, markets 31 Brian Linn, Deborah Avant, Renée de Nevers, Errol Morris, Thomas Jeremy C. Stein Securitization, shadow banking Mahnken, Jonathan Shay, Charles J. Dunlap, Eugene Fidell, Martha & ½nancial fragility 41 McSally, William J. Perry, and others Lucian A. Bebchuk How to ½x bankers’ pay 52 Nolan McCarty, Political fortunes: on ½nance plus protecting the Internet as a public commons, public opinion &c. Keith T. Poole, & its regulation 61 Thomas Romer & Howard Rosenthal C.A.E. Goodhart Lessons from the ½nancial crisis for monetary policy 74 Robert E. Hall Fiscal stimulus 83 Edward L. Glaeser Housing policy in the wake of the crash 95 Barry Eichengreen International ½nancial regulation after the crisis 107 Peter Temin The Great Recession & the Great Depression 115 Alexander Hamilton From his writings 125

poetry Alice Notley The Codex Eats Me 127

U.S. $13; www.amacad.org Cherishing Knowledge · Shaping the Future

Inside front cover: Traf½c passes by a ½nancial institution’s headquarters in New York on Tuesday, April 14, 2009. Photograph © Andrew Harrer/ Bloomberg via Getty Images.

A foreclosure sign is posted in front of a townhouse in Herndon, Virginia, November, 22, 2007. In the years following the housing market collapse of 2006 and 2007, banks and mortgage ½rms have ½led thousands of foreclosure notices against American homes. Photograph © Paul J. Richards/afp/Getty Images. Benjamin M. Friedman and Robert M. Solow, Guest Editors Phyllis S. Bendell, Managing Editor and Director of Publications D Micah J. Buis, Associate Editor Erica Dorpalen, Editorial Assistant

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Steven Marcus, Editor of the Academy

Rosanna Warren, Poetry Adviser

Committee on Publications Jerome Kagan, Chair, Jesse H. Choper, Denis Donoghue, Gerald Early, Linda Greenhouse, Jerrold Meinwald; ex of½cio: Leslie Berlowitz

Dædalus is designed by Alvin Eisenman.

The Academy dedicates this issue in memory of Carl Kaysen and Paul Samuelson, noted economists and active and esteemed members of the American Academy of Arts and Sciences. Dædalus Journal of the American Academy of Arts & Sciences

The pavement labyrinth once in the nave of Reims Cathedral (1240), in a drawing, with ½gures of the architects, by Jacques Cellier (c. 1550–1620)

Dædalus was founded in 1955 and established as a quarterly in 1958. The journal’s namesake was renowned in ancient Greece as an inventor, scientist, and unriddler of riddles. Its emblem, a maze seen from above, symbol- izes the aspiration of its founders to “lift each of us above his cell in the labyrinth of learning in order that he may see the entire structure as if from above, where each separate part loses its comfortable separateness.” The American Academy of Arts & Sciences, like its journal, brings together distinguished individuals from every ½eld of human endeavor. It was chartered in 1780 as a forum “to cultivate every art and science which may tend to advance the interest, honour, dignity, and happiness of a free, independent, and virtuous people.” Now in its third century, the Academy, with its nearly ½ve thousand elected members, continues to provide intellectual leadership to meet the critical challenges facing our world. Dædalus Fall 2010 Subscription rates: Electronic only for non- Issued as Volume 139, Number 4 member individuals–$43; institutions–$113. Canadians add 5% gst. Print and electronic © 2010 by the American Academy for nonmember individuals–$48; institu- of Arts & Sciences tions–$126. Canadians add 5% gst. Outside Securitization, shadow banking the United States and Canada add $23 for & ½nancial fragility postage and handling. Prices subject to change © 2010 by Jeremy C. Stein without notice. How to ½x bankers’ pay © 2010 by Lucian A. Bebchuk Institutional subscriptions are on a volume- The Codex Eats Me, from “Culture of One” year basis. All other subscriptions begin with (Penguin; forthcoming, March 2011) the next available issue. © 2010 by Alice Notley Single issues: current issue–$13; back issues Editorial of½ces: Dædalus, Norton’s Woods, for individuals–$16; back issues for institu- 136 Irving Street, Cambridge ma 02138. tions–$32. Outside the United States and Phone: 617 491 2600. Fax: 617 576 5088. Canada add $6 per issue for postage and han- Email: [email protected]. dling. Prices subject to change without notice. Library of Congress Catalog No. 12-30299 Claims for missing issues will be honored free of charge if made within three months of the isbn 978-0-262-75111-7 publication date of the issue. Claims may be Dædalus publishes by invitation only and as- submitted to [email protected]. Mem- sumes no responsibility for unsolicited manu- bers of the American Academy please direct all scripts. The views expressed are those of the questions and claims to [email protected]. author of each article, and not necessarily of Advertising and mailing-list inquiries may be the American Academy of Arts & Sciences. addressed to Marketing Department, mit Dædalus (issn 0011-5266; e-issn 1548-6192) Press Journals, 55 Hayward Street, Cambridge is published quarterly (winter, spring, summer, ma 02142. Phone: 617 253 2866. Fax: 617 253 fall) by The mit Press, Cambridge ma 02142, 1709. Email: [email protected]. for the American Academy of Arts & Sciences. Permission to photocopy articles for internal An electronic full-text version of Dædalus is or personal use is granted by the copyright available from The mit Press. Subscription owner for users registered with the Copyright and address changes should be addressed to Clearance Center (ccc) Transactional Report- mit Press Journals, 55 Hayward Street, ing Service, provided that the per-copy fee of Cambridge ma 02142. Phone: 617 253 2889; $12 per article is paid directly to the ccc, u.s./Canada 800 207 8354. Fax: 617 577 1545. 222 Rosewood Drive, Danvers ma 01923. The Printed in the United States of America by fee code for users of the Transactional Report- Cadmus Professional Communications, ing Service is 0011-5266/10. Address all other Science Press Division, 300 West Chestnut inquiries to the Subsidiary Rights Manager, Street, Ephrata pa 17522. mit Press Journals, 55 Hayward Street, Cam- bridge ma 02142. Phone: 617 253 2864. Newsstand distribution by Ingram Periodicals tn Fax: 617 253 1709. Email: journals-rights@ Inc., 18 Ingram Blvd., La Vergne 37086, and mit.edu. Source Interlink Distribution, 27500 Riverview fl Center Blvd., Bonita Springs 34134. The typeface is Cycles, designed by Sumner Postmaster: Send address changes to Dædalus, Stone at the Stone Type Foundry of Guinda 55 Hayward Street, Cambridge ma 02142. Peri- ca. Each size of Cycles has been separately odicals postage paid at Boston ma and at addi- designed in the tradition of metal types. tional mailing of½ces. Benjamin M. Friedman & Robert M. Solow

Introduction

The ½nancial meltdown of 2007 to 2009 folks. Apart from the sheer theater of it was surely a great spectacle. Mighty all, the main reason for caring about a names toppled like that statue of Saddam ½nancial crisis is the well-founded belief Hussein. Lehman Brothers, with a histo- that serious disturbance of the ½nancial ry spanning a century-and-a-half, just dis- system can impair the functioning of the appeared. Bear Stearns and even Merrill real economy, perhaps drastically. A well- Lynch–the same Merrill Lynch that had behaved ½nancial system makes the real taught generations of small investors to economy more ef½cient at producing be “bullish on America”–were sold off well-being for its inhabitants (though it at discounts suitable for used furniture. may parcel out income and wealth to spe- aig was rescued in the nick of time, but ci½c groups among those inhabitants in only with $182 billion of U.S. government ways that we and they may ½nd objection- assistance. Trillions of dollars of inves- able, and maybe even repugnant). But a tors’ wealth simply evaporated. One breakdown of the ½nancial system can could think, “Oh, well, easy come, easy inflict damage on the real economy, dam- go.” But still, trillions of dollars? It was a age that may last for years after the break- spectacle all right, but why did it really down has been repaired. And so it has. matter to the rest of us, who count our- These connections between the real selves merely as citizens of the republic? economy and the ½nancial system can be After all, the economic well-being of far from simple. In this issue of Dædalus, a society and its members depends on essays by Edward L. Glaeser of Harvard “real” outcomes: on the production and University and Jeremy C. Stein, also of distribution of current output, some of Harvard, show how an episode of over- it allocated to current consumption of building of houses, the sort of thing that goods and services and some to provision might normally lead to a run-of-the- for future consumption through capital mill slowdown or minor recession, can investment, research activity, and edu- be ampli½ed and complexi½ed by the cation (all net of depreciation, resource (mis)behavior of ½nancial institutions depletion, and environmental damage). and the spread of securitization. We That is what the economy delivers to us therefore end up with a disaster for the real economy–and for millions, or tens © 2010 by the American Academy of Arts of millions, of its inhabitants. Instead of & Sciences a recession that can be dealt with by rou-

Dædalus Fall 2010 5 Benjamin tine monetary and ½scal policy, we face tion of the assumptions that have stood M. Fried- the loss of more than eight million jobs behind a generation of Reagan/Thatcher man & Robert M. and years of lost output, not to mention “let the markets rule” policies–and the Solow the indirect social costs of prolonged intellectual framework behind those pol- on the ½nancial recession. It is all the more galling that icies, associated with Milton Friedman crisis & much of the damage is borne by innocent in an earlier era and Alan Greenspan economic bystanders, while many of the bad (or more recently–is enormous. policy stupid or greedy) guys do fairly well. A second, less obvious lesson is that an The meaningful story is about the in- elaborate ½nancial system, with its mys- teraction of ½nancial activity and the teries, its glamour, its possibilities for in- real economy. The mechanics of this stant wealth, can quietly distort the direc- connection are far from transparent. tion of the real economy; it can induce Many of the articles in this issue focus, the real economy to spend human and to varying degrees, on aspects of this material resources on activities that can dif½cult and important matter, and on lead to immense private pro½t for some the ways in which a society can hope to of those engaged while nonetheless mak- bene½t from a highly developed ½nan- ing little or no contribution to general cial system while protecting itself, more well-being. Some of the following arti- or less, against the damage that its pro- cles, in particular, essays by Benjamin M. clivity to malfunction can inflict. Essays Friedman, Lucian A. Bebchuk of Harvard by Luigi Zingales of the University of Law School, and Barry Eichengreen of Chicago Booth School of Business and the University of California, Berkeley, Peter Temin of the Massachusetts Insti- focus on these dangers and the search tute of Technology aim to elucidate the for public policies that can fend them intellectual apparatus that economists off with minimal handicap to ef½cient and students of ½nance have built to help ½nancial activity. them understand this complex piece of As we saw during the yearlong debate machinery. over what ½nally became the Dodd-Frank One important lesson, driven home Wall Street Reform and Consumer Pro- with great force by the breakdown itself, tection Act (passed by Congress in July is the potential of an elaborate ½nancial 2010), attempts to legislate effective lim- system like ours for instability, a subject itation and regulation of ½nancial activi- which Benjamin M. Friedman of Harvard ties–in the search for a viable combina- University, Robert M. Solow of the Mas- tion of ef½ciency and protection–run sachusetts Institute of Technology, and into the formidable lobbying power and Jeremy C. Stein each take up in their es- political clout of the ½nancial industry says. The crisis has dramatically demon- itself. In their essay, Nolan McCarty of strated that our kind of system, instead Princeton University, Keith T. Poole of of responding to errors and disequilibria the University of Georgia, Thomas Romer by self-correcting, gradually or quickly, of Princeton, and Howard Rosenthal of can magnify initial errors many times, New York University provide insight into and then spread them by contagion the challenge of regulating ½nance in throughout the ½nancial system and the face of political forces. Nor has the even to areas of the real economy that lobbying abated now that the numer- seem remote from the initial source: ous agencies charged by Dodd-Frank witness the path from housing bubble with making new rules, and otherwise to general crisis. The patent contradic- implementing the changes that the law

6 Dædalus Fall 2010 mandates, have begun their work. The to pay more explicit attention to the risk- Intro- widening inequality of income and wealth iness, as well as the volume, of assets held duction in the United States has consisted largely by the ½nancial sector. In the meanwhile, of an enormous increase in the incomes as of this writing, despite record-low long- of those at the very top of the heap, the term interest rates and no sign of infla- best-off 1 percent or (even more so) one- tion anywhere, many observers of U.S. tenth of 1 percent, with near stagnation monetary policy, especially in the ½nan- lower down. Those tippy-top incomes are cial markets, seem terri½ed that any move often pocketed by the leading ½gures in toward monetary expansion would soon the ½nancial services business. They are unleash irresistible inflationary forces. not likely to give them up without an all- The same fear paralyzed monetary policy- out ½ght; and those same deep pockets makers in Japan for more than a decade can generate a lot of political leverage, in following that country’s ½nancial crisis both parties. The optimistic view is that in the early 1990s, with the predictable we are lucky to have got as much as we result of ongoing economic stagnation. did by way of improved regulation out To conclude that, with short-term inter- of the stonewalling, horse-trading, and est rates at zero, monetary policy can do dependence on “contributions” that nothing further is arguable if not neces- pervade today’s Congress. sarily correct; to argue that monetary pol- With or without new regulation, dis- icy should do nothing further seems, under ruption in the ½nancial system will in- today’s circumstances, hard to fathom. evitably disrupt the real economy from The analysis of ½scal policy is, in many time to time. So will other disturbances, respects, the same no matter where the like the occasional sharp increase in shocks to the real economy come from. world oil prices or simply a turn toward But Robert E. Hall makes the important pervasive pessimism among business point that the hallowed tendency of most executives deciding on their ½rms’ cap- central banks to “lean against the wind” ital spending programs. Two of the fol- means that any expansionary impulse, lowing articles, by C.A.E. Goodhart of whether from ½scal policy or elsewhere, the London School of Economics and is likely to be partially resisted by the Robert E. Hall of Stanford University, Federal Reserve through an increase in reconsider the standard defenses against short-term interest rates. (One is entitled shocks to the real economy: monetary to ask why this should be so: aren’t the policy and ½scal policy. Now that the Federal Reserve and the ½scal authorities worst of the ½nancial crisis is behind us, in Congress part of the same government, and the debate over ½nancial reform has trying to do what is right for the same been consummated in the Dodd-Frank economy? Why should the right hand legislation, these policies have become undo what the left is doing?) In the after- the focus of much of the current eco- math of a ½nancial crisis like the one we nomic debate. have just experienced, however, when the Monetary policy, which today means Federal Reserve has pushed short-term mostly interest rate policy–the domain interest rates all the way to zero and pre- of the U.S. Federal Reserve System and sumably wishes they could go even fur- other central banks elsewhere–is natu- ther, this monetary policy reaction to any rally more directly connected to ½nan- ½scal stimulus seems unlikely. Fiscal pol- cial events; C.A.E. Goodhart thus argues icy therefore becomes a substantially that future monetary policy-makers need more effective tool in a deep recession.

Dædalus Fall 2010 7 Benjamin This insight makes the immediate state In the wake of the ½nancial crisis, it M. Fried- of affairs around the industrialized world is understandable that consumers and man & Robert M. more visibly dysfunctional. The United businesses, conscious of vanished wealth Solow States and the major European economies and uncertain about the future, would on the ½nancial have barely started to climb out of a seri- be reluctant to spend. As economists crisis & ous recession, and they have not even behave recognized since observing what economic gun to make good the two years of lost happened in the 1930s, such behavior policy growth. Unemployment and excess ca- may be individually rational, even if in pacity are still high and persistent. No- the aggregate it makes things worse for body believes that the next two years everyone. Governments, by contrast, look promising. One would think this are supposed to think about the health represents just the sort of circumstance of the economy as a whole, and to off- when ½scal policy is at its most potent, set, or more than offset, such tempo- and most needed. Yet most of the talk in rary de½ciencies in demand for what both the United States and Germany, the the economy normally produces. Today Western world’s two bellwether econo- they instead seem to be poised to re- mies, is, incomprehensibly, about ½scal inforce them. Four-legged lemmings contraction: about de½cit reduction, to be no doubt look on with astonishment. achieved via lower public spending and, possibly, higher taxes. True, the United States has a long- term budget imbalance that needs to be addressed (maybe even with legislation enacted now, to take effect later, when the economy has more nearly returned to full employment); but pursuing ½scal retrenchment now seems at best perverse, and in suf½cient force, a suicidal recipe for renewed and protracted economic downturn. In Europe, some countries– Greece and Portugal, for example–probably will have to undergo deep and last- ing recessions, not just because their tax and spending policies have got so far out of line with one another in recent years, but because their prices and costs have drifted far compared with those of other European economies and, as members of the common-currency (Euro) group, they cannot simply alter their exchange rates to correct the problem. But the likelihood of severe weakness in those Euro- pean economies that have to have it is all the more reason for those that don’t, like Germany, to remain strong; not for them to pursue recession-inducing policies, too, merely for their own sake.

8 Dædalus Fall 2010 Benjamin M. Friedman

Is our ½nancial system serving us well?

In 1772, at the height of Scotland’s worst trophe recur. When disaster is the result banking crisis in two generations, David of human action, the question at issue is Hume wrote to his close friend Adam not merely about containment; it is also Smith. After recounting the bank clo- a question of prevention. It is no surprise, sures, industrial bankruptcies, spread- therefore, that the recent ½nancial crisis ing unemployment, and even growing has prompted a flood of proposals to re- “Suspicion” of the soundness of the form the regulation of ½nancial markets Bank of England, Hume asked Smith, and ½nancial institutions in the United “Do these Events any-wise affect your States and elsewhere. The Dodd-Frank Theory?” Wall Street Reform and Consumer Pro- They certainly did. Smith’s analysis tection Act, which Congress passed in of the role of banking in The Wealth of July, made some of them into U.S. law. Nations, published just four years later, What is missing from this conversa- clearly reflected the lessons he took tion, however, is any signi½cant probing away from the 1772 crisis. In contrast to of the more fundamental aspects of how the doctrinaire antiregulatory ideology well our ½nancial system is serving us, with which he is usually associated by and at what cost. To date, the discussion today’s economists, Smith favored such has focused on the speci½c symptoms of measures as usury laws–speci½cally, no this particular episode of ½nancial mal- lending at interest rates above 5 percent function: the losses incurred by investors, –and restrictions on the obligations the need for taxpayer-½nanced bailouts, that banks could issue.1 the disruptions triggered by Lehman Large-scale and unusual events, espe- Brothers’ failure, and the like. Most peo- cially when they bring unwanted conse- ple are aware, too, that the associated quences, provide an opportunity to ask loss of jobs, incomes, and pro½ts was a basic questions. Even if no one is at fault result of what went wrong in the ½nan- for causing an event (an earthquake, for cial sphere. But no one seems to be relat- example), it is only natural to ask what ing these costly manifestations to the role might be done differently to mitigate that ½nancial markets should play in our the consequences should a similar catas- economy in the ½rst place or asking how well the markets are performing that role. © 2010 by the American Academy of Arts The crucial function of the ½nancial & Sciences markets in an economy like that of the

Dædalus Fall 2010 9 Benjamin United States is to allocate scarce invest- of gm and Chrysler stock fell to near zero, M. Fried- ment resources. Typically, about one-½fth and the interest rates on their bonds rose man on the of what the U.S. economy produces (in to record highs, in the months before ½nancial recent years the fraction has been some- those companies declared bankruptcy, crisis & economic what smaller) is devoted to investment of these ½rms had neither the incentive nor policy all kinds: factories and machinery that al- the ability to expand; without the govern- low our ½rms to produce physical goods, ment’s rescue they would have contracted of½ce buildings and computers to house –maybe all the way to nonexistence. and equip a vast service sector, homes for To be sure, modern ½nancial institu- a population of more than three hundred tions perform other important functions million, and inventories on the shelves as well. They provide checking accounts of supermarkets and clothing stores. No and other elements of the economy’s pay- one simply decrees that one-½fth of our ments mechanism, vehicles for families nation’s total output is the ideal share to to keep their rainy-day funds and to save invest for all these purposes. That out- for retirement, and group and individual come is the result of countless decisions life insurance, for example. But while made every day by individual businesses those services are essential to have, they and homeowners as they interact with are not essential to the make-up of a free- the banks, insurance companies, stock enterprise economy. In fact, there are nu- buyers, mortgage lenders, and other pro- merous models for providing them as a viders of the funds they need to carry public utility. out their desired investment programs. By contrast, the function of allocating Similarly, no central agency dictates that investment capital–determining the such-and-such a percentage of the over- economy’s aggregate amount invested, all investment should go into the com- as well as the allocation of that invest- puter industry, some percentage into ment across different industries, among opening new restaurants, and another different ½rms, between business instal- percentage into putting up new apart- lations and homebuilding–is essential ment buildings. That allocation is also to the make-up of a free-enterprise econ- the result of countless individual-level omy. This is what our ½nancial system is market interactions. supposed to be doing. We are therefore What guides these interactions and, entitled to ask how well or poorly it is therefore, what determines both the total performing this role, and at what cost. amount of investment our economy un- dertakes and the allocation of this total By now the main outlines of the recent among different potential applications is ½nancial crisis and the economic down- the combination of signals and incentives turn that it caused are well known. Begin- created by the prices set in the ½nancial ning in the late 1990s, and then more so markets. Is the price of computer com- once the relatively mild 2001 recession pany stocks high? Then ½rms in that in- had ended, house prices rose rapidly. In- dustry have both the incentive and the creasingly lax mortgage underwriting ability to issue more new shares and use standards–high loan-to-value ratios, the funds for further expansion. Is the back-loaded repayment schemes, little if interest rate on mortgages low? Then any documentation–were both a cause home buyers have the incentive and the and a consequence of the rise in prices. ability to take out more loans and buy Less onerous lending conditions spurred more houses. Conversely, when the price demand for houses while the rising value

10 Dædalus Fall 2010 of the underlying collateral lessened con- of invested capital that supported those Is our cerns for borrowers’ creditworthiness. assets–to record levels. Leverage of ½nancial system Securitization of a large fraction of the twelve- or ½fteen-to-one was not un- serving us newly issued loans further diminished the common among the big U.S. commer- well? originators’ interest in borrowers’ integ- cial banks, and many investment banks rity. In turn, investors that purchased the had ratios of twenty-½ve- or even thirty- created securities either deluded them- to-one. As a result, these ½rms had little selves (for example, by counting on rising cushion with which to absorb whatever housing prices to nullify the implications losses they incurred on their trading of borrowers’ lack of creditworthiness) or operations. were misled by rating agencies that car- Third, the ongoing development of the ried out shoddy analysis while also facing market for ½nancial derivatives–instru- serious conflicts of interest. Importantly, ments based on the value of other ½nan- many of the investors that bought these cial instruments, which in many cases ill-supported securities were non-U.S. themselves depended on the value of still entities. other ½nancial instruments–moved be- Three additional developments con- yond the role of enabling ½nancial insti- tributed to the vulnerability of the U.S. tutions and other investors to hedge their ½nancial system. First, within the bank- existing risk exposures; instead, the mar- ing system, the distinction between bank- ket provided vehicles for investors to take ing and trading had for the most part dis- on new, unrelated risks. As a result, many appeared. This development was not of the risks to which investors of all kinds simply a consequence of the formal re- became exposed bore little or no connec- peal of the Glass-Steagall Act in 1999; tion to fluctuations in any component of the Depression-era separation between the economy’s actual wealth, such as commercial banking and investment housing prices or the value of companies banking had largely eroded long before. issuing shares. More and more, the risks Most of the big commercial banks, seek- borne were merely one side or the other ing to raise their own capital in specu- of zero-sum bets. lative securities markets, increasingly In light of these vulnerabilities, it is not relied on trading pro½ts to enhance surprising that some catalyst would set their returns, in effect turning them- off a widespread crisis. The turnaround selves into hedge funds (otherwise they in housing prices–declines at nearly 20 would have had little reason to retain, percent per annum on average across the on their own balance sheets, shares of country, and far more in some states and the mortgage-backed securities that in many local residential markets–pro- they earned a fee from packaging and vided that catalyst. (Because what mat- selling). Meanwhile, most of the big ters for any individual mortgage is the investment banks, which already had speci½c house collateralizing that one signi½cant trading operations, increas- loan, greater dispersion of house-price ingly funded themselves by rolling over changes around a given average rate of short-term obligations. decline exacerbates the frequency of Second, the pressure to boost the re- default.) Delinquencies and defaults in- turns they provided to their shareowners creased rapidly, especially in the market led many of the largest institutions to for “subprime” mortgages. The value of increase their leverage–the amount of securities backed by packages of these assets they held compared to the base mortgages declined. Leveraged derivative

Dædalus Fall 2010 11 Benjamin claims against these securities declined and the Federal Reserve System together M. Fried- even more. The investors that held these put nearly $2 trillion into either rescuing man on the instruments took losses. Highly leveraged individual institutions ($182 billion for ½nancial ½nancial institutions saw their capital just one ½rm, insurance company aig) crisis & economic erode, in many cases to the point of prob- or buying private-sector obligations in policy able failure in the absence of government order to support troubled markets. With assistance. Banks stopped lending; the some luck, the government will get most market in which many companies regu- of that money back when the loans are larly issued commercial paper shut down. repaid and it sells off the assets that it Unable to borrow, businesses and fami- bought; any remaining losses will come lies cut their spending. out of taxpayers’ pockets. Public discussion of the economic Important though these losses are, fallout from these unfortunate events however, what this discussion has failed has focused on four components: the to address is the misallocation of the losses that homeowners suffered on economy’s resources that led to the cri- their houses, the losses booked by in- sis in the ½rst place. The lax mortgage vestors in mortgages and mortgage- underwriting standards and unsustain- backed securities, the recession that able expectations for ever-increasing the ½nancial crisis triggered, and the housing prices encouraged interest rates money put up by government on be- on many forms of mortgage lending to half of the taxpayers. All are important. be unrealistically low. Once housing From year-end 2006 to year-end 2009, prices started to decline, and borrowers U.S. households saw the value of their ran late with their payments and even real estate fall from $23 trillion to $17 began to default on their loans, the in- trillion (and the value of their holdings terest rates on those loans rose. This of corporate stock, including mutual upward adjustment of mortgage inter- funds, fall from $14 trillion to $12 tril- est rates, and the decline in the prices lion)–in all, a 13 percent reduction in of mortgage-backed securities that pro- their total net worth. Banks and other duced the losses suffered by banks and institutional investors suffered more other investors, were, in effect, the same than $4 trillion in losses on their hold- phenomenon. (For an instrument such ings of mortgages and mortgage-backed as a bond that promises a ½xed annual securities alone (roughly half of that payment, whether it is backed by mort- total outside the United States), not gages or not, the price and the effective to mention another $6 trillion in losses interest rate vary inversely. If a security from declining stock prices and further promises to pay $60 per year, the rate of losses that they have not yet tabulated return earned by the investor who buys on their non-mortgage loans. The reces- it for $1,000 is 6 percent; if the price falls sion held the expansion of total econom- to $800, the effective interest rate for a ic output in the United States to just 0.4 buyer at that price rises to 7.5 percent.) percent in 2008, followed by a 2.4 per- But the problem is not that the inter- cent decline in 2009; compared to a more est rates on these loans rose so much as normal economic trajectory with even that they were too low to begin with. The modest growth of 2.5 percent per annum, prices set in ½nancial markets provide the loss of production–and therefore of signals and incentives for investment be- incomes and pro½ts–was $1.3 trillion for havior whether or not they are right, and just those two years. The U.S. Treasury even whether or not they are sensible. In

12 Dædalus Fall 2010 this case, because mortgage rates were This misallocation of resources, be- Is our so low, and mortgage loans so accessible cause of what in retrospect were clearly ½nancial system even to noncreditworthy borrowers, incorrect prices set in ½nancial markets, serving us Americans bought and built far more is hardly unique to the recent housing well? houses than they otherwise would have. bubble. In the stock market boom of the On average, during the 1980s and 1990s, late 1990s–which lifted the Standard the U.S. construction industry built 1.4 and Poor’s 500 index from 542 on aver- million new homes per year. Although age in 1995 to a high of 1,553 in August the rate of new family formation re- 2000 and the Nasdaq index from 925 to mained roughly unchanged, by 2003 5,132–one of the hottest areas was tele- the industry was building 1.8 million communications. This surge in stock new houses; in 2004, 2 million; in 2005, prices did not apply just to highly specu- 2.1 million; in the ½rst half of 2006, still lative new companies but to large, well- 2 million at an annual rate. established ones, too. at&t stock, for Building all these extra houses used example, rose from 21 at the beginning resources in two parallel senses. First, of 1995 to 60 in 2000. Not surprisingly, the physical activity of constructing once the market turned, those same them absorbed labor and materials, stocks suffered some of the largest de- both of which are expensive. (Despite clines. By late 2002, at&t had returned the industry’s depressed state, last year to 21. As of mid-2010, it remained at 25; weekly earnings in construction aver- the anomaly was the run up to 60, not aged $852 versus $726 in manufactur- the subsequent fall. ing and only $389 for retail jobs.) Sec- The ensuing public discussion primar- ond, like any investment, homebuild- ily focused on the losses that investors in ing absorbs saving. If the prevailing these stocks had incurred. But in that epi- low interest rates on mortgages had sode as well, no less than in the recent not steered so much labor and material housing boom, losses on ½nancial assets and so much of the economy’s scarce were a reflection of wasted resources and saving into homebuilding, the United misallocated saving. In retrospect, $60 States could have deployed those re- per share was not the right price for sources for some other purpose–new at&t; other telecom stock prices were manufacturing plants, perhaps, or new too high as well. But the fact that the gasoline re½neries, airports, or school stock prices were too high meant that buildings. Furthermore, the allocation the cost of capital to the ½rms issuing the of too many resources to homebuilding shares was too low. Those ½rms therefore had consequences beyond the forgone had the incentive and the ability to issue uses to which they could have been put more shares than they should have. And at the time. Once the turnaround came, they used the proceeds to expand more the presence of all those extra houses than they should have: in the 1990s, tele- on the market pushed housing prices com ½rms laid hundreds of millions of down lower than they otherwise would miles of ½ber-optic cable that have never have fallen. It also depressed new home been lit and probably never will be. construction–to only ½ve hundred thousand in 2009–with a further con- As with any device that performs a sequent loss of jobs and lower sales of useful function–a car, for example, or a associated products such as furniture dishwasher or clothes dryer–the perfor- and appliances. mance of the mechanism that allocates

Dædalus Fall 2010 13 Benjamin our economy’s investment capital is best ½nancial ½rms’ share of total pro½ts rose M. Fried- assessed against some notion of what it to 22 percent. During the years 2001 to man on the costs. Everyone understands that a Chevy 2005–that is, until just before the surge ½nancial Aveo provides neither the pickup nor the in borrowing, securitization, and deriva- crisis & economic comfort, not to mention the styling, of a tives ½nance began to transform itself into policy Ferrari. But few people are willing to pay a world-class crisis–these ½rms’ share of what it costs to buy a Ferrari and then all U.S. pro½ts reached 34 percent. keep it running. Cost considered, the Although this astonishing drain on the cheaper option suits many people very pro½ts earned by U.S. business received well. a fair amount of attention at the time, it In the case of a mechanism for allocat- is far from the total cost of running the ing investment capital–where the whole economy’s ½nancial system. That cost point is that the capital, once allocated, be also includes the salaries ½nancial ½rms productive in the usual economic sense– pay to their workforce and the rents they there is a built-in benchmark against pay for their of½ce space (including the which to compare the associated cost: rental equivalent for ½rms that own their the return on the invested capital itself. own buildings), as well as more mundane If a new fertilizer or irrigation system elements–the associated utility bills, offers a farmer the prospect of a higher travel tickets, and advertising budgets, crop yield, it is only common sense for for instance. the farmer to compare the economic re- The large salaries and bonuses paid to turn from the enhanced harvest to the U.S. ½nancial executives have recently cost of achieving it. If what it costs to attracted ample public attention, espe- buy, transport, and spread the fertilizer cially once so many major ½rms found exceeds the sale price of the additional themselves floundering during the crisis. crops it helps to produce, then it’s a poor But the phenomenon extends beyond the investment for the farmer–despite the outsized incomes of a few individuals at enhanced technical ef½ciency. A ½nancial the top, which arouse public anger but system that allocates investment capital is count for little in the aggregate. Like its no different. Even if it allocates the econ- share of economy-wide pro½ts earned, omy’s capital more ef½ciently than some the ½nance industry’s share of all U.S. alternative, if it costs more to run than wages and salaries paid has also been ris- what the superior allocation produces, ing in recent decades. Fifty years ago it it’s only so much overpriced manure. was 3 percent; more recently it has been In recent decades, the U.S. economy’s 7 percent. The standard argument is that mechanism for allocating its capital has high salaries (including the eight-½gure been getting a lot more expensive, even bonuses for those at the top) are neces- compared to the total returns earned on sary to attract the talent that enables the capital being allocated. From the these ½rms to do their job. If this argu- 1950s through the 1980s, pro½ts earned ment is true, it means that the econo- by ½nancial ½rms (not counting insur- my’s capital allocation mechanism is ance companies and ½rms in the real inherently all the more expensive to estate business) represented 10 percent operate. The same principle applies to of all pro½ts earned in the U.S. economy the ½nancial sector’s other expenses. –hardly an excessive charge as long as It may be true that without lavishly fur- this capital allocation system delivered nished of½ces in choice locations, or modest bene½ts. In the 1990s, however, lots of prime-time television advertis-

14 Dædalus Fall 2010 ing, the capital allocation mechanism and most highly motivated young citizens Is our would not be able to serve its function. to the ½nancial sector constitutes the best ½nancial system If so, the necessary cost of running it is use of what is surely one of our nation’s serving us that much greater. most valuable resources. These young well? Here as well, the basic principle of a people could of course be doing some- market economy holds: expenses paid thing else. If they are not really needed are the counterpart of resources used. in the ½nancial ½rms that employ so The fact that ½nancial ½rms pay more many of them–if what they do there ac- than other companies do (not to men- tually adds little or no economic value– tion the government and the nonpro½t then something is seriously wrong with sector) means that, on average, they yet another market that allocates our attract the most talented and energetic economy’s resources (in particular, the workers. Workers in the ½nancial sec- labor market). But if the ½nancial sector tor have long been more likely to have a is the best place to use their talents and college education than those elsewhere energies, that need is yet another part of in the U.S. economy. In pace with the what makes our economy’s capital allo- widening wage differentials, the extent cation mechanism so expensive to run. to which ½nancial-sector workers are What makes these matters so perplex- more likely to be college-educated has ing, and potentially of such huge prac- more than tripled over the last thirty tical importance, is that the respective years. The changing pattern is easily cost and ef½ciency trends in capital allo- visible in our colleges and universities. cation in the United States seem to be At Harvard (where I teach), more than moving in opposite directions. Over a one-fourth of the graduates in recent long enough period of time–since World classes have gone to work at investment War II, say, or even longer–the U.S. econ- banks, hedge funds, private equity ½rms, omy’s growth and the rising living stan- and the like. dards this growth has brought certainly At the individual level, no one can suggest that a dynamic enough system blame any of these graduates. They are exists. The important role played by start- responding to the incentives presented up companies in that growth is further to them. Furthermore, these incentives evidence that whatever mechanism has are not merely a matter of how the for- been allocating the economy’s capital pro½t economy works. These young must have been doing a pretty good job. people are observant enough to under- Apple, Microsoft, and Google are only stand that despite their university presi- a few of the new entrants that over the dents’ pious pronouncements about the years have not only generated substantial value of humanitarian and other less- pro½ts for their owners, and incomes for well-paid careers, even their universities their employees, but also changed how will shower them with attention, and in the majority of Americans go about their time be more eager to admit their own daily activities. children, if they earn enough to become More recent trends have been less sizable donors. That so many top stu- reassuring, however. At the same time dents, acting individually, respond to that the ½nancial sector has been grow- such incentives can only be expected. ing more expensive to operate–absorb- The question, rather, is whether in the ing a larger fraction of the economy’s aggregate the direction of such a large frac- total pro½ts, claiming a larger share of tion of our most skilled, best educated, the most talented workers, and so on–

Dædalus Fall 2010 15 Benjamin the economy’s performance has been investment: all presumably play an im- M. Fried- disappointing. Even apart from the re- portant role. So, too, do influences from man on the cent housing bubble and all the econom- abroad, especially the often wide fluctu- ½nancial ic costs associated with its demise (costs ation in the price of oil and other com- crisis & economic that must be subtracted from the eco- modities (recall the years of chaos fol- policy nomic gains the ½nancial sector deliv- lowing the opec cartel’s 1973 and 1979 ers), there is less to cheer about in the price hikes) and the intensity of compe- gains accruing to capital investment. tition from foreign producers (such as In the ½rst quarter-century following Japan in the 1970s and China since the the restoration of a post–World War II early 1990s). peacetime economy (1948 to 1973), the But our inability to know what part of total output of U.S. nonfarm businesses the deterioration over time in the growth increased, on average, 2.8 percent per of productivity and living standards to annum faster than the growth of labor attribute to the performance of the U.S. input. During the next twenty years (1973 economy’s capital allocation mechanism to 1993), productivity growth in the non- does not imply that the capital allocation farm business sector slowed to just 1.4 mechanism is doing its job just as well as percent. Developments in the mid-1990s it always has. It does not mean that all of stirred hope that the spread of electron- the deterioration in ½nal outcomes can ic technology had brought a new era of be attributed to other causes. Not know- rapid productivity growth, but, more re- ing means not knowing. cently, the gains have been only mediocre. For 1993 to 2007 overall–that is, even To determine the adequacy of our cur- omitting the effects of the recession rent ½nancial system, the ½rst task is to brought on by the ½nancial crisis–pro- gain a well-grounded quantitative under- ductivity growth averaged 2.3 percent. standing of how successfully the ½nan- Although the correspondence is far from cial sector is allocating our economy’s exact, over time, movements in produc- investment capital and how much that tivity roughly correspond to movements allocation of resources costs. The more in wages and, therefore, in living stan- straightforward task–although no one dards. Allowing for price inflation, the (to my knowledge) has done it–is to average wage in the economy’s nonfarm measure the all-in costs of running the business sector increased by 2.7 percent capital allocation mechanism. Again, per annum during 1948 to 1973 but only those costs include not just the pro½ts 0.8 percent during 1973 to 1993 and 1.4 earned and the wages and salaries paid percent during 1993 to 2007. but also the building rents and all other No one believes that the performance costs of doing business in the U.S. ½nan- of the economy’s capital allocation mech- cial sector. (They exclude, however, costs anism is responsible for all of this varia- associated with providing other services tion. Indeed, a major part of the problem such as running the payments mecha- is that no one knows what part of this nism.) Just how large does this all-in cost variation to attribute to the performance bulk in relation to the total pro½tability of the ½nancial sector. Shifting trends in of capital of all kinds invested in the U.S. technology, in the education and training economy? What fraction of the overall of U.S. workers, in the regulation of busi- return to our invested capital are we pay- ness, and in tax and other government ing for the mechanism that allocates it? policies affecting the overall volume of Knowing the answer would be a useful

16 Dædalus Fall 2010 ½rst step. The calculation would require empty programs, and chronically corrupt Is our time and painstaking effort. But, concep- of½ce holders. But, so the argument went, ½nancial system tually at least, the task is clear-cut. Some- what was the alternative? Only the Com- serving us one–some part of the Commerce De- munists, and that was no alterative at all. well? partment’s statistical apparatus perhaps, In the wake of the recent ½nancial or a team of university-based researchers crisis, everyone is now keenly aware of –should be commissioned to provide an many of the shortcomings of our cur- answer. rent ½nancial system. But most people A somewhat more challenging task is also recognize the important role that to include in the overall cost estimate the ½nancial system plays and the credit the risk of the occasional meltdowns to it can rightly claim for fostering the dy- which our modern ½nancial system ex- namic, technologically ever-evolving poses us. Imagine that we wanted to buy economy that we have so highly valued insurance against the kind of losses–not during much of our nation’s past. What, just losses of paper wealth but forgone then, is the alternative? Even within the output and therefore incomes and prof- highly limited con½nes of the recent de- it–that the recent ½nancial crisis and bate over ½nancial regulatory reform, the its aftermath have entailed. How much usual argument is that genuinely binding would we be willing to pay for that in- regulation would stifle the markets’ abil- surance? Here, too, the quantitative ity to do their job, while softer attempts assessment would require serious work, at new regulation could drive our vital but the idea behind it is conceptually institutions to relocate in more lightly straightforward. policed jurisdictions offshore. The most challenging assignment is The more fundamental task of posit- to evaluate the performance side of the ing an alternative against which to as- relationship: how well is the ½nancial sess how well our ½nancial markets are sector allocating our economy’s invest- allocating our economy’s scarce capital ment capital? The challenges to this task is a far greater challenge. Surely no one are not just computational but concep- wants to contemplate central planning. tual. The chief problem is the absence The technological stagnation and grand- of an obvious counterfactual: how well scale dissipation of resources in econ- is the ½nancial sector allocating our economies that have tried that route are all omy’s capital compared to what? If we did too familiar. The resulting conceptual not rely on our banks, other private lend- challenge is to measure the ef½ciency ers, and stock and bond markets to allo- of our system for allocating investment cate our capital, with all the costs that capital in the absence of a clearly speci- they entail, how else would we perform ½ed alternative. Suppose, for example, this function? that the U.S. ½nancial sector had been In this respect, today’s protracted de- smaller, and in some speci½c ways. What bate over how to reform our creaky and if some speci½c market, or some ½nan- increasingly accident-prone ½nancial cial instrument–say, mortgage-backed system is eerily reminiscent of Cold collateralized debt obligations (cdos) War–era laments about the politics of –did not exist? What would have been many European countries. In some coun- different–other than the wages and sal- tries, even supporters of the then-domi- aries and rents saved? Would the total nant center-right parties readily acknowl- amount of capital we invested in our edged these groups’ sclerotic character, economy have been different? Would

Dædalus Fall 2010 17 Benjamin the allocation of our capital among the form of insurance premium; in effect, M. Fried- multitude of competing uses, and there- the issuing ½rm would be buying its man on the fore the performance of U.S. industry, “rescue insurance” from the market ½nancial have differed? The questions may seem rather than receiving it free from tax- crisis & economic relatively straightforward; the route to payers. policy shedding quantitative light on them is Critics of this proposal object that highly complex. some ½rms might not be able to make Yet another way to approach this ends meet if they had to ½nance them- challenging assignment is historical selves to some extent in this way. But comparison (pertaining to recent his- this argument is just another way of say- tory, that is): how has the result of the ing that a ½rm would be unable to sur- U.S. economy’s allocation of capital vive without the subsidy provided by over, say, the most recent twenty years taxpayers in the form of the rescue insur- stacked up against that of the prior ance that it now receives for free. In this twenty-year period? We know that our case, perhaps the ½rm should not be in capital allocation process has become business. Alternatively, if the service the much more expensive over the more ½rm provides is suf½ciently essential that recent period. But has it become more the taxpayers should subsidize it, the fact ef½cient, too? Might it even have be- that they are doing so bears potential im- come less ef½cient? Without the neces- plications for such matters as how the sary research, the only honest answer ½rm is allowed to price its product, how is that no one knows. the ½rm and the taxpayers share the returns when its bets go right, and how There are, however, at least a few con- the operators of a publicly subsidized crete steps we can take in the mean- activity are paid. while, in the absence of new empirical A second familiar proposal that does measurement and new conceptual think- not hinge on any profound new thinking ing that may provide suf½cient basis for or even any new measurements of costs some more fundamental reassessment. and bene½ts is to discourage some forms First, we can move the liability for the of trading activity that absorb large damage banks and other institutions amounts of resources, and expose the incur when their bets go wrong away economy to serious risks, but clearly from the taxpayer and onto the ½nancial serve little economic function. Perverse- sector’s account. Several recent propos- ly, at the same time that the costs of run- als (alas, none included in the recently ning the ½nancial sector have mounted enacted ½nancial reform legislation) in recent years–costs that include the have this aim. For example, one propos- absorption of ever more of the economy’s al would require ½nancial ½rms to issue best young talent–the highest rewards, at least some fraction of the liabilities and therefore the greatest attraction for with which they fund themselves in a this scarce human resource, have been form that would automatically be con- in some of the areas of ½nancial activity verted into equity shares in the event of that contribute the least. The leading a speci½ed erosion in the ½rm’s capital example in recent years is high-speed position. Presumably, these liabilities trading that exploits computer-based would be more expensive for ½rms to technologies to earn pro½ts from small issue than ordinary bonds or commer- and fleeting departures of securities cial paper. The cost difference would be a prices from normal patterns.

18 Dædalus Fall 2010 Given the salaries and bonuses that As is the case for many such regula- Is our ½rms in this line of business pay, it is no tions, a transactions tax of this form ½nancial system surprise that many of our country’s best would be dif½cult to implement unless serving us young mathematicians and physicists– other countries followed suit; no one well? graduates whose education has been paid wants to see U.S. ½rms merely move for mostly by either government funds offshore. But many other countries now or university endowments–flock to face these same problems, and therefore them. Yet the activity of resolving micro- have similar incentives to act. Interna- departures of securities prices within a tional coordination presents a challenge, nanosecond time frame adds little to the but it need not be a decisive impediment. ½nancial system’s ability to perform any Third, public policy could distinguish of its economic functions. At the same between losses incurred that are the ½- time, should one of these ½rms fall into nancial counterpart of genuine losses of major dif½culty, the ½nancial markets as wealth to the economy and losses that a whole are then exposed to substantial are merely the losing side of zero-sum risk. (In 1998, when Long-Term Capital bets (in which for every dollar lost by Management was unable to meet its one institution, someone else has won a obligations, the Federal Reserve ended dollar). This distinction could be reflect- up organizing a consortium of banks to ed in ½nancial ½rms’ accounting and cap- take over the ½rm; unlike in the more re- ital requirements, in how these ½rms are cent crisis, that rescue involved no direct taxed, and even in deciding which ones use of taxpayer money.) to rescue in the event of a crisis. One strategy for reducing this form of The U.S. economy’s total physical economically useless activity, proposed wealth, $57 trillion ($186,000 per per- years ago by Yale University economist son) at year-end 2008, consisted of the James Tobin, would be to impose a tiny houses, apartment buildings, factories, tax either on all transactions that are re- of½ce buildings, machines, inventories, versed within some stated period of time computers, software, automobiles, and or, more simply, on all ½nancial transac- other durable goods owned by all fami- tions. For an investor buying a stock in lies and businesses combined, as well as the hope that its price will move signi½- the of½ces, school buildings, hospitals, cantly higher over some period of time, military installations, and the military the tax would be a trivial subtraction from and civilian equipment owned by gov- the return to be earned. For a ½rm oper- ernment at all levels. Buildings, both ating a computerized trading system that private and government (excluding only moves in and out of thousands of com- the land value of government buildings), panies’ shares many times per day, the tax made up $44 trillion of this total. Equip- would be a signi½cant impediment. Fur- ment and software totaled $7 trillion, ther, the tax revenue could be used to re- consumer durables of all kinds $5 trillion, duce the tax rate on long-term capital and business inventories another $2 tril- gains (under current law, “long-term” lion. Intangible assets, such as the edu- means more than one year), thereby dis- cation that makes the U.S. workforce so couraging economically unproductive productive, scienti½c patents, and other trading while at the same time decreas- aspects of business know-how, are probing the burden of taxation on the kind ably just as important but are nearly im- of investment activity that presumably possible to measure in dollar terms. The does help allocate the economy’s capital. value of a corporation’s intangible assets

Dædalus Fall 2010 19 Benjamin is presumably built into its share price, of the debate surrounding the recent cri- M. Fried- but separating this component from the sis is about how these losses should be man on the rest of what a ½rm is worth–including divided among homeowners, banks, ½nancial the factories and machines that it owns– loan-purchasing investors, and the tax- crisis & economic is problematic not just practically but payers. But however the losses are divid- policy conceptually as well. ed, someone must bear them, and the In addition, of course, U.S. house- U.S. economy is poorer because of it. holds, businesses, and governments all By contrast, many of the largest losses own lots of ½nancial instruments–as of that U.S. ½nancial institutions sustained year-end 2008, $140 trillion of them. The in the recent crisis had nothing to do $16 trillion of corporate stock outstand- with losses of wealth to the economy. ing (down from $26 trillion just two years They were merely the losing side of zero- earlier) represented ownership of the un- sum bets, in which one side turned out derlying ½rms’ assets and earnings and to be right and the other wrong, and the thus constituted a claim against one key amount the winner won was identical to component of the economy’s overall what the loser lost. The most transpar- wealth. But most other ½nancial instru- ent example of this phenomenon, and ments traded in U.S. markets are not part the most important in the crisis, is credit of our overall wealth. The great majority default swaps. are debt instruments, representing one A credit default swap is a contract that party’s asset but another’s liability. They pays off if a designated company (nei- are wealth in the eyes of whoever owns ther of the two parties entering into the them, but for the economy as a whole, contract) defaults on its debt. When a the owner’s wealth is offset by the debt- bank that has lent money to a company or’s obligation. Even bank deposits are uses a credit default swap to protect itself not wealth for the economy as a whole: from the loss that it would incur if the they are assets to the depositors, to be company were to default on its loan, the sure, but liabilities to the bank. loss that the other party to the contract Following the events of the recent cri- incurs if the company defaults is a reflec- sis, the most obvious example of a loss tion of a loss of wealth to the economy– that constitutes a genuine loss of wealth the creditors’ share of the decline in the to the economy is a fall in the price of an company’s overall value. But in the case individual’s house. When the value of a of most credit default swaps traded in house falls, that is a loss of wealth to the the United States today, the volume out- economy as a whole. If the homeowner standing far exceeds the amount of debt continues to service the mortgage (or being insured. As of 2009, the value of owned the house free and clear), he or credit swaps outstanding in U.S. markets she bears the entire loss; the person’s net was $36 trillion–three times the entire worth is diminished by the full amount amount of bonds issued by all U.S. cor- of the price decline. If the homeowner porations combined and a far larger mul- defaults on the loan, then someone else– tiple of the indebtedness of the speci½c either the bank that originally lent the companies against which the swap con- money or some investor to which the tracts were written. The vast majority of bank has by now sold the loan–also bears these swaps, therefore, had nothing to part of the loss. If the government steps do with how participants in the ½nancial in and reimburses the bank or investor, markets spread the risk of genuine losses then taxpayers bear part of it, too. Much of wealth. Instead, their purpose was

20 Dædalus Fall 2010 simply to create gains for the ½rms that losing side of a zero-sum bet should mat- Is our bet correctly on how the contracts’ prices ter in deciding whether its situation mer- ½nancial system would move, exactly matched by losses its a taxpayer bailout. serving us for whoever bet incorrectly on the other These measures, and others like them, well? side. would discourage the ½nancial activities The distinction between losses that that seem least likely to contribute to the reflect actual declines in the economy’s economic function we look to the ½nan- wealth and what are instead merely the cial sector to perform. They would also losing side of zero-sum bets has a num- make the ½nancial sector less costly to ber of potentially important policy impli- operate, in that some parts of what our cations. There is no reason that either ½nancial ½rms currently do–parts that ½nancial accounting or the tax code need add little or no economic value–would treat the two in the same way. (Individ- be curtailed. Some of these measures ual taxpayers, for example, do not get would also help reduce the risk of events, the same deduction for their Las Vegas like the current crisis, that impose costs gambling losses that they do for losses in the form of either the incomes and on their stock portfolios.) The distinc- pro½ts lost during a resulting downturn tion should also matter for regulatory or the burden imposed on taxpayers. purposes. In particular, ½rms that might The more fundamental need, however, be eligible for taxpayer rescue if they get is to assess how well our ½nancial system into trouble should be restricted in how is performing its most basic function– much exposure to this kind of loss they allocating our scarce investment capital are allowed to take on. Finally, once a –and at what cost. Without that infor- ½nancial institution does become im- mation, neither a defense of the status paired, whether it has done so as a result quo nor the consideration of potential of sharing in genuine losses to the econ- alternatives has much basis. omy or merely from having chosen the endnotes 1 For an analysis of Smith’s views, see Hugh Rockoff, “Upon Daedalian Wings of Paper Money: Adam Smith and the Crisis of 1772,” nber working paper no. 15594 (National Bureau of Economic Research, December 2009). I ½rst became aware of Hume’s letter to Smith by reading Rockoff’s paper.

Dædalus Fall 2010 21 Robert M. Solow

The bigger they are . . .

Any discussion of ½nancial policy and much, or it invests in the wrong indus- regulation should begin with an urgent tries. If it is true today that many viable reminder that the ½nancial system is a businesses are unable to obtain credit on means, not an end. Otherwise, it is all reasonable terms, the system most likely too easy to become wholly engrossed in is not functioning well. the hopes and fears, successes and fail- The other socially useful function of ures, of ½nancial enterprises and the the ½nancial system is more complicated people who love them, as if that were and recondite. In the course of real eco- what really matters. nomic life, an enormous variety of risks arises. Bank A may have made a large loan One socially useful function of the ½- to company B, with the survival of both nancial system is to intermediate between of them depending on the uncertain suc- savers and investors. Many diverse indi- cess of B’s new line of products. A retired viduals, enterprises, and other institu- couple with no heirs has to allocate their tions save–spend less on their current accumulated savings over their uncertain needs than they take in–and it is eco- lifetimes; if they spend too much, they nomically important that their savings may run out of funds and suffer, and if be made available to those ½rms, govern- they spend too little, they may die with ments, investors, and other units in the useless wealth, having skimped their ½nancial system that can make the most golden years. pro½table (or otherwise valuable) use of Some individuals and institutions don’t such savings. Because most savers lack mind bearing economic risk because their the information and understanding they attitudes, their wealth, the nature of their would need and because they cannot incomes, or their ability to diversify makes easily diversify, ½nancial institutions it relatively easy. There are also those perform this function for them. When whose circumstances make substantial something hinders the performance of risk-bearing painful or intolerable. The the ½nancial system, the “real” economy ½nancial system can arrange to transfer of production and employment suffers. many risks from the second group to the The economy invests too little or too ½rst, with appropriate compensation all around. Consequently, the real economy © 2010 by the American Academy of Arts works better. Company C may have the & Sciences ideas and the skills to undertake some-

22 Dædalus Fall 2010 thing potentially very valuable but can- the house, and the contract could not The bigger not bear the inevitable risks; something be enforced. The dictionary de½nition they are . . . useful may happen only if the risks can of “insurable interest” is an interest (as be off-loaded. based on blood tie or likelihood of ½nan- But a complication arises: a ½nancial cial injury) that is judged to give an insur- system that is elaborate enough to do ance applicant a legal right to enforce the this job of reallocating the risks of real insurance contract against the objection economic life is also capable of creating that it is a wagering contract and there- risks that have no connection to real fore contrary to public policy. economic life, rather like gambling at a With this background in mind, I turn casino or betting on football games. For to policy issues and the “too big to fail” instance, recall the “credit default swap” (tbtf) question. Economic policy is of- (cds) that played such a central role in ten more complicated than it looks. Any the aig debacle. Suppose that lender D signi½cant policy action creates winners has made a large loan to the company C and losers, even if the distributional ef- mentioned earlier. The loan seems worth fects are not part of the intended purpose making, but the risk of default is more of the policy. For analytical purposes, than D can bear. The cds is a way of economists usually avoid these distribu- spreading that risk around. D pays E, F, tional side effects by imagining that they G, and so on a ½xed annual fee, and E, F, can be canceled by a well-chosen set of G each agree to pay something to D if and lump-sum taxes and transfers. Lump- only if C defaults. The risks associated sum taxes and transfers are those that with C’s business have been transferred cannot be avoided or enhanced by any to a willing home with E, F, G. This form deliberate act of the taxpayer or bene- of insurance allows the real economy to ½ciary; there are no incentive effects on take advantage of opportunities that behavior. But this is a purely imaginary might otherwise go to waste. ½x. Lump-sum taxes and transfers are Once the concept of the CDS is avail- implausible in practice. able, there is nothing to prevent H and J The vehement backlash provoked by from writing the same contract: H pays J the taxpayer-½nanced bailout of large a ½xed premium and J pays H if C defaults ½nancial institutions in the course of the on its loan from D. Now H and J are sim- recent meltdown and the ensuing reces- ply making a bet on the outcome of the sion illustrates this problem. Even if the C-D transaction, though neither of them bailout was necessary to fend off a much has any connection with C’s business more damaging economic collapse, inno- venture. This is called a “naked cds,” cent bystanders resent seeing taxpayers’ and there have been many of them. The money in the pockets of the very bankers, functioning of the real economy is in no stockholders, and creditors whose greed, way improved by this transaction, which shortsightedness, and overcon½dence has merely created a risk that was not brought on and deepened the recession. there before, and would go away if this Such political-economy considerations transaction were canceled. Moreover, are an ever-present constraint on practi- such a transaction would likely not be cal economic policy. valid in a normal insurance context. I All of this is relevant to a discussion of could not buy insurance against the pos- the issue familiarly summarized by the sibility of a ½re destroying someone else’s catch phrase “too big to fail.” In the run- house; I have no “insurable interest” in up to the recent bailouts, the responsible

Dædalus Fall 2010 23 Robert M. federal agencies were faced with the lot in order to acquire assets in amounts Solow potential failure (inability to meet con- that far exceed their own capital. They on the ½nancial tractual obligations) of some very large hope to pro½t from the difference be- crisis & ½nancial institutions that were intercon- tween the cost of borrowing and the economic policy nected with other large and small ½nan- higher return on the assets they acquire. cial institutions through lender-borrow- Since higher return usually goes along er and analogous relations. The threat of with greater risk, there is potential for their falling into default can so threaten trouble. Suppose that a bank with thirty- the solvency of their creditors (and their to-one leverage–unexceptional by re- creditors, and so on) that much of the ½- cent standards–has $1 billion in capital nancial machinery might grind to a halt, and has borrowed $29 billion to acquire and with it much of the economy. These $30 billion in at least slightly risky assets. institutions, and some non½nancial cor- It takes only a $1 billion loss to wipe out porations, were regarded as so central to the owners of the bank; a loss of $2 bil- the economic life of the country that lion renders the bank insolvent. On the they could not be allowed to fail. upside, a gain of $1 billion doubles the owners’ money, which explains why How can the likelihood of such situa- leverage is so attractive. tions be eliminated or minimized in the As part of their function in mediating future? A necessary ½rst step is to consid- between savers and investors, banks are er closely what makes a ½nancial institu- typically engaged in “maturity transfor- tion tbtf.1 Size, certainly, is part of the mation.” They borrow at short term be- picture. The insolvency of a few small cause savers generally want quick access banks or nonbank ½nancial institutions to their money. But they make longer- does not threaten a breakdown of the term loans because they are ½nancing system that provides credit for viable real business investment. The persistent businesses and redistributes the risks of question, then, is about liquidity, or the real economic activity. Given the exis- ability to convert even sound assets into tence of federal deposit insurance, the cash when necessary. In parlous times, potential losers in the failure of a small- liquidity problems can become solvency er bank are mainly the stockholders and problems when the soundness of assets the nondeposit creditors; prudence is uncertain. Even without much lever- should impel these parties to take into age, troubles may arise; greater leverage account the possibility of such contin- signals a clear possibility of cascading gent business losses when they buy stock disaster. and make loans. In practice, the regula- The dif½culty with very large banks is tor of a “problem bank” often arranges not only that they are big, but that they for it to be taken over by a stronger neigh- are interconnected with other ½nancial bor, thus minimizing disruption. institutions. When large institutions are Should nature be allowed to take its highly leveraged, the interconnectedness course in the case of very large banks looms as a danger to the whole system. and nonbanks? If they are too big to be The lenders to a large bank regard those taken over, should they just be allowed loans as assets. If bad news about the to go broke? A practical obstacle has borrowing bank’s assets threatens its stood in the way, at least in the past. solvency, then its lenders see their own Large banks often operate with large balance sheets deteriorating; the value leverage; in other words, they borrow a of those putative “assets” becomes

24 Dædalus Fall 2010 uncertain. But the lending banks have although it occurs regularly, even in the The bigger also borrowed, and so a third layer of absence of crisis. A bank or other ½nan- they are . . . banks is caught up in uncertainty and cial institution that is perceived as tbtf pessimism about asset values. can borrow in the market at a lower in- This combination of sheer size, inter- terest rate than other, otherwise similar, connectedness, and leverage can endan- banks. Compensation for default risk is ger the ½nancial system’s ability to per- built into any interest rate; default-free form its socially useful functions. The U.S. Treasury bonds, for instance, carry temptation for large, highly leveraged a lower interest rate than corporate bonds ½nancial institutions to engage in “wa- of the same maturity. Thus, tbtf banks gering contracts contrary to public poli- are subsidized every day by the taxpayer. cy,” using borrowed money, adds to the The subsidy is not borne by taxpayers in potential for systemic instability without the form of a continuing cash outlay; it contributing anything to the ef½ciency takes the shape of an implicit promise of the real economy. These circumstances to bail out a tbtf bank when it might impel–or force–governments to bail otherwise have to default. out the banks, essentially to guarantee This experience, now so clear in the the value of the assets of ½nancial insti- collective memory, is not only costly to tutions that are considered tbtf. taxpayers, but also hair-raising to workers and small businesses whose liveli- It is now widely understood that this hoods hang by a thread when the econ- kind of situation is fraught with “moral omy threatens to dissolve, and irritating hazard.” Highly leveraged purchases of to those who do not like to see high-level risky assets create opportunities for vice and stupidity rewarded. Attempts to spectacular pro½ts on the relative small improve the regulation of the ½nancial amount of own capital invested. They system are in development in the United also create opportunities for disasters States and Europe. Included in these blue- so large and extensive as to threaten the prints for reform are various proposals functioning of the system. If this threat for dealing with the tbtf problem. forces governments to bail out the occasional disasters to protect the creditors, It may be useful to start with the (hope- then the opportunities for large pro½ts lessly) idealized laissez-faire solution. belong to the risk-takers and the worst After all, this is what former Chairman of the occasional losses belong to the of the Federal Reserve Board Alan Green- taxpayers. Banks are encouraged, or span famously believed in, only to be rather driven by competition, to take shocked by the grim reality. Suppose those system-threatening risks, and nothing were tbtf; suppose the govern- other banks are encouraged to lend to ment could credibly state that it would them for that purpose. They have little bail out no failing bank, no matter how or nothing to lose, and a lot to gain. And big or how interconnected with others. the successes probably add little or nothing to In principle, this stance warns potential the ef½ciency of the real economy, while the creditors that lending to a large (or small) disasters transfer wealth from taxpayers to bank with a risky balance sheet is itself ½nanciers. This reality is “heads I win, an act with considerable downside risk. tails you lose” writ very large. If the borrowing bank defaults, the cred- There is another cost of the tbtf itors will take the loss. Lenders to banks, phenomenon that is even less visible, especially big lenders to big banks, are

Dædalus Fall 2010 25 Robert M. sophisticated, knowledgeable people. risky part of its business, or shrink its Solow They know how to read a balance sheet balance sheet to an acceptable size in on the ½nancial and understand complex securities. They some other way, once the bank exceed- crisis & will not endanger their own capital by ed a prede½ned limit. The goal would be economic policy lending large amounts to a large bank to achieve a landscape in which any bank that will use the borrowed capital to buy that seems about to fail could be allowed excessively risky assets. In this view, to fail because, by de½nition, that failure banks that are too big to fail will not would not threaten the satisfactory func- fail or, if they do, their failure will not tioning of the system. endanger the system. This proposal is premised on the belief There are a few problems with this that the expansion of a bank beyond the picture. Perhaps the most important is acceptable size limit brings at best negli- that governments cannot credibly ab- gible gains in ef½ciency for the real econ- jure bailouts. In a capitalist system, even omy: even if the achievement of tbtf a reasonable balance sheet will carry size adds to the private pro½tability of a some risks. When a large bank is on the ½nancial institution, this private gain verge of defaulting, thereby threatening does not correspond to any net contri- the viability of the ½nancial system, a re- bution to society. This argument seems sponsible government cannot step aside plausible. Indeed, recent history suggests –c’est la vie!–and let the real economy that the main consequence of megasize tumble into depression. Preventing the may be unmanageability. I, for one, have collapse of the ½nancial system does not not seen any convincing arguments for imply weakness; the government is doing real economies of scale at extreme size. what has to be done. The notion that the The unmanageability of very large long run is best served by letting two or banks reflects something deeper than three catastrophes happen cannot be mere bureaucracy: there is a fundamen- taken seriously. tal incentive problem. Individual traders Second, there is evidence that those in a large institution can enrich them- potential creditors are not always as selves fantastically by taking on risks sophisticated and knowledgeable–or whose downsides endanger not them- as effective–as presumed. They may be selves but the ½rm. Not many individual prone to act on foolishness, incompe- bankruptcies have made the headlines. tence, laziness, greed, overcon½dence, Better-aligned incentives would help, and the herd instinct. Granted that our but such restructuring is not easy in a observations come from a world of mor- large, variegated organization run by al hazard induced by the tbtf doctrine, clever individuals. one would not be quite comfortable bet- Nevertheless, there are genuine prob- ting the health of the real economy on lems with this approach to tbtf. If the the unfailing intelligence and self-disci- largest acceptable size is still fairly large, pline of real-world ½nanciers. The laissez- as I imagine it would be, then even if no faire solution, therefore, is probably a single bank is tbtf, the threatened fail- nonstarter–and for good reason. ure of two or three large banks would The most direct solution to the tbtf still require the bailout response that the problem would be to disallow the exis- scheme is designed to prevent. Alterna- tence of banks that are tbtf in the ½rst tively, the cut-them-down-to-size pro- place. A regulatory body could require posal may be interpreted as the parti- a bank either to divest or sell off some tioning of a large bank into many small

26 Dædalus Fall 2010 banks. In that case, (a) some genuine fundamental problem. Extreme leverage The bigger economies of scale in saving-investment underlies extreme bigness. The mega- they are . . . intermediation and risk allocation may banks would not be nearly as oversized, be lost; and (b) the failure of many small or as interconnected in the relevant sense, banks–as happened in the 1930s–can without leverage ratios of twenty-½ve to be a problem as well. Deconstructing a one, thirty to one, or greater. Therefore, large ½nancial institution into a number the best way to control the tbtf prob- of small ones does not create a cluster of lem may be to control leverage–which statistically uncorrelated banks, such that is no easy task. mass failure is unlikely. The danger is not In principle, limitations on leverage analogous to tossing a separate success- should be conditioned on the riskiness or-failure coin for each bank; rather, it of the assets to be acquired. Any assess- stems from the fact that all or most of ment of riskiness will inevitably contain them are hit simultaneously by a com- a large element of judgment, presumably mon shock–such as the burst of a hous- to be exercised by a changing cast of reg- ing bubble–and tend to fail together. In ulators: some strong, some weak, some this context, imposing a size limit on strict, some lax. Practice is likely to be banks that would otherwise be tbtf can even more unreliable. Any collection of be a helpful and not very costly assist, but speci½c criteria and regulations, espe- is unlikely by itself to solve the problem. cially if embalmed in statute or code, will be vulnerable to the attentions of The dif½culty is that size is functioning clever lawyers and creative accountants. as a symptom of something else, and it is Regulators are usually unable to keep up that underlying factor that really creates with the athleticism of the highly moti- the problem. Imagine a bank or ½nancial vated. Thus, controlling leverage neces- institution that simply invests its owners’ sarily involves three steps: it must be cut wealth or capital in a collection of busi- back sharply, regulated closely, and safe- ness ventures of varying risk. The owners’ guarded against evasions and loopholes. pro½t is the return on those investments What form could those fail-safe prepa- minus any administrative costs. The size rations take? This is perhaps a good place of such an institution is of little conse- to mention the Volcker Rule, which has quence. It would not “fail” unless all or been on the radar since it was proposed most of its investments failed. Even if by Paul Volcker, Chairman of the Eco- that unlikely event were to happen, the nomic Recovery Advisory Board under only consequence would be that the President Obama. The general idea of owners (shareholders) would have lost Volcker’s proposal is that “true” banks, their stakes. That might be hard on their that is, institutions that accept deposits heirs, but not on the ½nancial system. and make loans, should be prohibited The bank is interconnected in the sense from trading in securities for their own that it has lent to many enterprises, but account (though they might be permitted not in the relevant sense that its debts to do so as agents for their customers). appear as assets on the balance sheets of This proposal has implications for “true” other banks. In the limiting case that it commercial banks. has no debts, its leverage ratio would be First, if implemented, the Volcker Rule one to one. would effectively control the leverage as- In fact, it is leverage–borrowing in sumed by depositary institutions. Some order to buy risky assets–that is the leverage is necessary: a bank that subsists

Dædalus Fall 2010 27 Robert M. by taking deposits and making loans ry requirements can be gamed. So from Solow earns its pro½t only through the differ- time to time banks that are tbtf will be on the ½nancial ence between the interest rate it charges headed for failure. The real economy has crisis & for loans and the (lower) rate that it pays to be protected from damaging disrup- economic policy its depositors. Unless its earning assets tion. Is there an alternative to bailing out (its loans) exceed its capital, it probably the banks’ uninsured creditors at the ex- cannot earn a high enough return on its pense of the taxpayers, with all the moral capital to keep itself in business. But such hazard problems that a bailout entails? banks are thoroughly regulated already; an overextended bank would be reined There is broad agreement that nontriv- in by its regulator. In any case, what ial costs must be routinely inflicted on tempts a bank to leverage itself exces- creditors to take away their free ride and sively (that is, to borrow in the capital induce them to exercise some discipline market) is the prospect of large trading on the risk-taking of large banks to which pro½ts, which would be forbidden un- they lend. Ordinary bankruptcy serves der the Volcker Rule. There is not much as a deterrent–in the laissez-faire pro- pro½t in borrowing at risk-adjusted capi- cess mentioned earlier–but it is plausi- tal-market rates in order to lend at what bly argued that ordinary bankruptcy is would be roughly risk-adjusted capital- a process so lengthy and its outcome so market rates. uncertain that it makes the real economy Second, there is particular reason to vulnerable to disruption. Several schemes limit the leverage of commercial banks. have been suggested that would deal with The danger of high leverage is that a small tbtf by prepackaging and automating adversity can bankrupt a highly levered a form of bankruptcy-equivalent that institution. If that institution is a com- would progress quickly and predictably. mercial bank, there is automatic disrup- One class of such schemes comes tion of an important channel through under the picturesque heading of a which ordinary businesses–and con- “living will.” This provision would re- sumers–routinely obtain credit to carry quire that every large ½nancial institu- out standard activities. Thus, adverse tion–and maybe some non½nancial effects on the real economy are immedi- ½rms–½le a detailed, binding statement ate. When Gary Stern, then-president of of how its assets will be allocated in case the Federal Reserve Bank of Minneapo- of impending default: after allowing for lis, published his book Too Big to Fail in insured creditors, like ordinary deposi- 2004, he was thinking entirely in terms tors, the ½rm would designate which of commercial banks. Today, the tbtf party has ½rst claim on the remaining problem is much more a matter of non- assets, which party comes next, until the bank ½nancial institutions–investment common equity shareholders bring up banks, insurance companies, and so on– the absolute end of the line and presum- which would not come under the Volcker ably get nothing at all. Rule. The Volcker Rule would be a useful If suf½ciently large, leveraged, and part of a comprehensive attempt to pro- interconnected banks were to fail, even tect the real economy from ½nancial in- with living wills, the tbtf problem would stability, but it cannot be the whole story, not quite go away. Many creditors would nor did Paul Volcker intend it to be. ½nd their own balance sheets damaged, Suppose we accept the inevitable: reg- and therefore so would their creditors, and ulators are fallible or worse, and statuto- so on. Healthy ½nancial activity could be

28 Dædalus Fall 2010 inhibited. The idea behind the living will in the case that a “systemically impor- The bigger is that with the consequences de½ned in tant” (that is, tbtf) bank were moving they are . . . advance and without ambiguity, poten- toward default. The authority would es- tial creditors would shy away from high- sentially take over the bank, replace some ly leveraged, risky borrowers and either or all of the management, wipe out some refuse to lend or demand such high inter- or all of the equity, and impose necessary est rates that the borrowers themselves losses on creditors. would ½nd the game unpro½table. The The goal would be a quick dispatch proposal is fundamentally an attempt to that would keep the bank operating with make market control of leverage more little or no interruption and allow it to effective. emerge as a viable institution. To this Another version of this general idea is end, the authority might need to have sometimes called “bailing in.” Instead the resources to inject new capital into of the government holding the bag, each the bank, acquiring an ownership inter- class of creditor, preferred-stock owner, est in return–preferred, convertible, or and so on would be contractually obli- even common shares–that could later gated in a certain order and under cer- be sold in the market when the resolved tain conditions to convert its claim to (that is, newly solvent) bank’s prospects common equity. When the original com- have been restored. The authority would mon stockholders are wiped out, the need money, perhaps in hefty amounts. next designated class would walk the The bill that originally passed the House plank. Eventually, the lowest-ranked proposed to fund the resolution authori- surviving class of creditors would be- ty by levying a fee on the (risk-adjusted) come the equity owners of the business. assets of large ½nancial institutions. In Again, as with the living will, the proce- that way, the ½nancial system would bear dure is presumed to have adequate clar- the costs of its own risk-taking. This stip- ity and visibility to discourage the capi- ulation would make borrowing more ex- tal market’s willingness to accept highly pensive for all ½rms. Why not? Those leveraged risk-taking. extra borrowing costs are a measure of Yet another version would require what taxpayers are bearing now. banks, in addition to holding a certain The House proposal has attracted much proportion of equity capital against their opposition; at this writing it looks as if it liabilities, to issue a certain proportion will disappear. The Obama administra- of contingent bonds–contingent in the tion did not favor it. Critics have argued sense that they automatically convert to that the very existence of such a fund, equity shares when the wolf appears at even a very small one, appears to validate the door. This proposal has the advan- the idea of bailing out the tbtf banks. tage that such contingent bonds would My own hypothesis is that this fund is certainly bear a higher rate of interest not important enough to justify the up- than bonds without the contingency. roar (which may be mainly decoy, any- Borrowing banks with higher leverage way). The point of the fund is that once would incur a higher cost of ½nance. a really big domino–a tbtf domino–is The last proposal of this general class about to fall, enough money will be found differs from the others because it involves to prevent collapse of the real economy. the federal government directly. In this If that outcome is to be avoided, the real scheme, a regulatory body would have defense must occur at an earlier stage. A the “resolution authority” to step in early functioning resolution authority seems

Dædalus Fall 2010 29 Robert M. like an excellent idea. At a minimum, it cy of the real economy, then we should Solow could backstop the more market-oriented cheerfully let it shrink. (If a reduced ½- on the ½nancial schemes described earlier. nancial sector leads more clever graduat- crisis & My own (weak) preference is for a ing seniors to materials science and fewer economic policy combination of the contingent-bond to investment banking, all the better.) device and a federally operated resolu- There are several kinds of regulatory tion authority. It would be useful to reform that could place limits on lever- have the interest cost of risky behavior age, preserve the essential functions of quoted daily (rather than having to be ½nance, and diminish the burden on tax- inferred) as a clear signal to lenders and payers. Some of them are more market- borrowers. In addition, wherever a fail- oriented, others more state-oriented. A safe is possible, it should exist, provided well-designed system could make use of that a resolution authority enforces the several of them, as long as priority is clear. measure in a somewhat orderly way. One reason for welcoming the presence of several layers of protection is that lais- The above discussion centers on only sez-faire won’t do, paper regulations are one aspect of stabilizing the ½nancial vulnerable to the creation and exploita- system, not on the full range of consider- tion of loopholes, and the political pro- ations. Still, the tbtf phenomenon was cess will sometimes lead to neurasthenic a critical part of the recent economic regulators. We are probably better off downturn and, as a result, deserves care- with defense in depth, even with the risk ful attention. What are the main lessons of some bureaucratic interference. to be gleaned from the tbtf problem? It is worth adding that international Excessive leverage appears to be the key cooperation and alignment are necessary destabilizer, and limiting it is the main in a globalized world. The temptation to remedy. Limiting leverage will tend to set up pseudo-shop in places where regu- shrink the ½nancial system, but if, as I lations are feeblest would be irresistible suspect, there is a sizable amount of ½- –in which case the alternative to tough nancial activity that adds little or nothing international agreement could be the (or perhaps less than that) to the ef½cien- Cayman Islands.

endnotes 1 In this essay, I indiscriminately refer to ½nancial institutions as “banks,” ignoring the distinction between commercial banking–taking deposits and making loans–and investment banking, as well as differences between other kinds of ½nancial ½rms that play a role in the economy’s flow of credit, such as insurance companies. When the distinctions are important, I refer to them explicitly.

30 Dædalus Fall 2010 Luigi Zingales

Learning to live with not-so-ef½cient markets

For most non-economists, the biggest fected in their faith by the 2007–2008 intellectual casualty of the 2007–2008 ½nancial crisis or by the evidence col- ½nancial crisis is the ef½cient market lected in the intervening twenty years. theory (emt). Newspapers and talk Yet the increasing proportion of academ- shows have analyzed the theory’s appar- ics who question the emt have found in ent demise; new books with titles like the recent crisis a painful example of the How Markets Fail, The Myth of the Rational costs of ignoring potential market inef½- Market, and A Failure of Capitalism abound. ciencies. A major rethinking of the valid- Yet, in academia, the emt has been chal- ity of the theory’s implications is all but lenged since the 1987 stock market crash, inevitable. and the theoretical and empirical short- From courtrooms to boardrooms, from comings of the theory have been well policy cabinets to classrooms, the emt established. The marginal contribution provided the intellectual foundation for of the 2007–2008 ½nancial crisis was to an entire generation. The current debate weaken the already-losing side of hard- has thrown this foundation into question. core believers in the emt. Rethinking the theory, however, does Thus far, the recent crisis has not pro- not mean abandoning it: the approach vided any crucial new evidence on the still holds many useful insights. Because deviations of markets from fundamen- it has provided a coherent framework tals, only evidence of the costs of these with great practical value, rethinking the deviations, especially when coupled with emt will be painful; nonetheless, it is very high leverage. The rise and collapse necessary. This journey will inevitably of the real estate market, with all the con- be full of mistakes, but the biggest mis- sequences these events produce, are much take of all would be not to undertake it. easier to explain as the result of variation in fundamentals than is a 22.6 percent While its intellectual origin can be stock market drop in a day with no major traced back to the early twentieth cen- news. Hence, those who have remained tury, the emt hypothesis gained impor- unchanged in their beliefs since the 1987 tance in academia in the mid-1960s. In stock market crash have been little af- its early formulation, the emt was simply the idea that if prices adjust rapidly © 2010 by the American Academy of Arts to new information, they should be un- & Sciences predictable. This hypothesis, validated

Dædalus Fall 2010 31 Luigi by economist Eugene Fama’s disserta- tion: that is, a market in which ½rms can Zingales tion at the University of Chicago in 1965, make production-investment decisions, on the ½nancial has three very important implications. and investors can choose among the secu- crisis & First, if prices are unpredictable, then rities that represent ownership of ½rms’ economic policy all technical analysis, which uses past activities under the assumption that secu- price behavior to predict future trends, rities prices at any time “fully reflect” all is useless. Second, if prices are unpre- available information.1 dictable, then investors should not pay This implication proved dif½cult to test for investment advice and active money because one needs a model of fundamen- management, but should simply buy tal values in order to test whether prices mutual funds that passively track the are equal to fundamentals. Yet if one re- stock market index. Last but not least, jects this equality, it is unclear whether if future prices are unpredictable, cur- that entails rejecting the asset-pricing rent prices are the best available esti- model that assesses the fundamental mate of the true value of any asset. If value or rejecting the emt. This joint this were not the case, so the theory hypothesis problem has made it dif½- goes, speculators would intervene to cult to reject the most important impli- drive prices equal to fundamentals. cation of the emt: that current prices Early on, the emt enjoyed wide em- are the best estimate of future funda- pirical support. Subjected to rigorous mental values. testing, most technical rules for invest- Since Friedrich von Hayek’s work, ing in the stock market, it was found, economists have recognized the im- did not outperform a random strategy. portance of prices in aggregating infor- On average, actively managed mutual mation and in directing the allocation funds did not outperform a stock mar- of resources. Financial markets play a ket index, and there was no evidence crucial role in this respect: stock prices of any persistence among the winners. provide a major indicator of where re- The only evidence of persistence in mu- sources should be allocated. In the late tual funds’ performance was in the neg- 1990s, seasoned executives abandoned ative domain: this year’s laggards were their corporate positions and M.B.A. likely to be next year’s, too, because students their classrooms to join Inter- they were charging above-average fees. net start-ups because of the high valua- If one combines a random performance tions these ventures commanded in the with above-average fees, statistically marketplace. Thus, market ef½ciency is the consequence is an abnormally low not just about how dif½cult it is to make after-fee performance! money in the stock market, but how the The only implication of the emt that stock market provides useful informa- was dif½cult to test was the last one: that tion about how resources should be al- stock prices are the best available estimate located. of fundamentals. Fama, the main support- In 1978, empirical support for the emt er of the emt, said in 1970: was such that Michael Jensen, one of the The primary role of the capital [stock] most prominent researchers in ½nance, market is allocation of ownership of the wrote that “there is no other proposition economy’s capital stock. In general terms, in economics which has more solid em- the ideal is a market in which prices pro- pirical evidence supporting it.”2 In sci- vide accurate signals for resource alloca- ence, however, hypotheses cannot be

32 Dædalus Fall 2010 proved, only rejected. As soon as the of the underlying assets, which is report- Learning to emt became widely accepted, research- ed daily, because their assets are traded live with not-so- ers began gathering evidence against it. stock. Even more puzzling is the fact that ef½cient By 1983, the Journal of Financial Economics, the difference between price and net as- markets the primary journal in ½nance, dedicated set value oscillates over time, with occa- an entire issue to ½nancial “anomalies,” sional premiums and more frequent dis- a politically correct term for violations counts, often reaching 30 percent. This of the emt. evidence, however, was not considered a The ½rst challenge to the emt arose clear rejection of the emt, since the dif- from the fact that prices are not unpre- ference between closed-end funds prices dictable. With longer and more frequent and net assets value could reflect some time series, researchers established that unique ability of the closed-end fund there is some predictability in prices in manager (when this difference is posi- the very short term and even in the very tive) or some value appropriated by the long term. (These latter ½ndings, how- manager (when negative). ever, were less statistically robust, due to The emt was also attacked from a the- the lack of long-term time-series data.) oretical point of view. If prices indeed As is typical of scienti½c progress, these reflect all available information–as the initial ½ndings led to modi½cation of the emt claims–there are no incentives for emt rather than its rejection. In an envi- market participants to collect any infor- ronment where investors are risk averse, mation. How can the market reflect all today’s prices do not simply reflect ex- available information if no one has any pected future prices; rather, they reflect interest in collecting it? In this respect, the expected value for the investors of the emt was modi½ed to resist the chal- these future prices. Because investors are lenge. Prices, it was argued, should re- risk-averse, this expected value reflects flect information up to the point where not only the expectation of future prices the marginal bene½ts of acting on the but also their variability, which impacts information (the expected pro½ts to be investors’ utility. Hence, if spikes in risk made) do not exceed the marginal costs aversion (intense moments of panic) are of collecting it. followed by reversals, today’s change in Finally, the link between the various prices can predict tomorrow’s change in implications was broken. Unpredictabil- prices without violating the emt. Risk ity of stock prices does not equate with aversion is hard to observe and measure, prices equal to fundamentals; the differ- and this justi½cation has protected the ence can be a slow-moving fad that can- emt from being clearly rejected. not be easily detected with the short The second blow to the emt came time series available. from the few cases in which fundamental value can be measured without refer- As economists Andrei Shleifer and ence to an underlying asset-pricing mod- Larry Summers, two of the main critics el. The primary case is closed-end mutu- of the emt, wrote in 1990, “The stock al funds. Unlike the more popular open- in the ef½cient markets hypothesis–at ended mutual funds, closed-end mutual least as it has traditionally been formu- funds cannot be redeemed daily for their lated–crashed along with the rest of net asset value; they can only be bought the market on October 19, 1987 and its and sold in the stock market. Their price, recovery has been less dramatic than however, tends to differ from the value that of the rest of the market.”3 emt

Dædalus Fall 2010 33 Luigi stock crashed because of the lack of any remain irrational far longer than you or Zingales plausible theory of the stock market I can remain solvent,” as John Maynard on the ½nancial crash. What fundamental news could Keynes remarked, then rational but risk- crisis & have caused aggregate stock prices to averse individuals may choose not to un- economic policy drop 22.6 percent in one day? Even after dertake some arbitrage, even when these a very aggressive search, the worst the arbitrages, carried over a suf½ciently long supporters of the emt could ½nd were period of time, are risk free. Consider the a potential announcement of a larger- case of closed-end mutual funds selling than-expected trade de½cit, the revela- at a discount with respect to their net as- tion that a key committee of the U.S. set value. If carried over until the fund is Congress would support the elimination liquidated, buying the closed-end fund of tax bene½ts for leveraged buyouts, and selling short its assets represent risk- and press speculation that the Federal less arbitrage, that is, a way to make Reserve would raise its discount rate. money without any risk. Yet in any one How could this news have changed period, the arbitrageur can incur losses fundamental values by 22.6 percent if the deviation widens before it shrinks. in a day? This single fact in isolation If the risk that the difference between accounted for more than all the empir- a closed mutual fund price and its net as- ical evidence against the emt collect- set value widens is not correlated with ed up to that point. the risk that other deviations widen, then Not surprisingly, shortly after the this risk can be diversi½ed away by cre- 1987 stock market crash the intellec- ating large portfolios of these trades. If tual foundations of the emt were chal- these events are correlated, though, this lenged. Besides empirical evidence, the diversi½cation will not work, and this strongest argument in favor of the emt risk can prevent rational traders from was the logical argument originally ad- bringing prices back to their fundamen- vanced by Milton Friedman. When tal levels. prices deviate from their fundamental The other direction of attack concen- value, rational investors can pro½t from trated on potential arbitrageurs’ access these deviations by buying the underval- to funds. Few investors are as rich as ued asset and selling the overvalued one. George Soros; most need to raise other The very act of buying undervalued as- people’s money to trade. In allocating sets and selling overvalued ones pushes their money to various potential trad- prices closer to their fundamental val- ers, though, the investors look at their ues. No matter how many irrational performance. This induces a very short traders there are in the marketplace, as horizon even among farsighted ration- long as there is a suf½cient number of al traders. If a trader risks seeing the rational investors with access to large money he invests withdrawn every time pools of money, they will drive prices his performance deteriorates for a few close to fundamentals. Where but Wall months, his time horizon shrinks to a Street can you expect to ½nd smart, ra- few months. Furthermore, if his per- tional people with access to plenty of formance is judged vis-à-vis an index, money? the trader will become very cautious in The theoretical counterattack to Fried- deviating his investment away from his man’s argument took place along two benchmark index. In other words, if an directives. First, even rich and rational equity fund’s performance is bench- agents are risk averse. If “[m]arkets can marked against the S&P 500 index, the

34 Dædalus Fall 2010 manager will be very cautious about tak- in the space of a few seconds with mini- Learning to ing any arbitrage opportunity that in- mal transaction costs. But if a real estate live with not-so- duces him to tilt his portfolio away from developer thinks that house prices in the ef½cient S&P 500 stocks. By staying mostly invest- suburbs are overvalued, the only oppor- markets ed in S&P 500 stocks, he faces very little tunity he has to make money is to build risk. If those stocks go down, so does his more houses in that area. This operation benchmark; therefore, it is dif½cult for will take years, not seconds, and will in- him to be ½red. If he feels that the S&P volve sizable transaction costs. Thus, 500 stocks are overvalued with respect Friedman’s argument does not apply to similar stocks outside the index, he to the housing market. will be reluctant to try to arbitrage that Second, most economists were already difference away. Even if he is right, but willing to admit that prices could drift the deviation increases for a few months away from fundamentals, and the faith before it decreases, he will run the risk of the remaining economists could not of being ½red. Benchmarking, while op- be shaken by the spectacular rise and fall timal from an investor’s point of view, in real estate prices, even if the housing might reduce the willingness of traders market were similar to the equity mar- to lean against broad movements of ket. The reason is that staunch support- stock prices away from fundamentals. ers of the emt are very creative in devis- ing rational explanations for the most Long before the recent crisis, a majori- extreme events. Even the Internet boom ty of academic economists–at least those and bust, which most non-economists trained after the 1987 stock market crash see as the quintessential bubble, has been –were ready to admit that stock prices justi½ed as the rational expectation of a could deviate from fundamental value few of those stocks turning into the new for extended periods of time. The spec- Microsoft. If a 22.6 percent drop in a day tacular rise and fall in real estate prices with no news does not shake their be- that characterized this recent crisis did liefs, what could? very little to change the opinion of aca- The dramatic drop in mortgage-backed demic economists on market ef½ciency. securities prices during the crisis can- For one, even the strongest believers in not be considered very strong evidence the ef½ciency of the equity market are of market inef½ciency either. With the ready to concede that there is not a simi- bene½t of hindsight, it looks incredible lar presumption for the housing market. that securities backed by mortgages Unlike the equity market, the housing offered to the riskiest part of the U.S. market is not populated by smart traders population could be considered safe, trying to arbitrage away possible differ- granted the best rating, and priced ac- ences from fundamentals; most of the cordingly. Yet short of a generalized buyers and sellers in this market are un- drop in house prices throughout the sophisticated in their market knowl- United States (an event that had not edge. And unlike in the equity market, occurred since the Great Depression), in the real estate market sophisticated those securities appeared to be priced traders face very high cost of arbitrage. correctly. For markets to be ef½cient, If one trader thinks that Microsoft’s they do not need to be perfect. Thus, stock is overvalued with respect to Apple, one mistake over the occurrence of he will buy Apple and sell short Micro- a very rare event is hardly evidence soft. This operation can be completed against market ef½ciency.

Dædalus Fall 2010 35 Luigi Paradoxically, the aspect of the crisis the emt hypothesis can be, especially Zingales that has shocked economists the most when combined with very high lever- on the ½nancial has been the diffuse violations of funda- age. Very few doubted that violations crisis & mental arbitrage conditions during the existed. But as long as the documented economic policy peak of the crisis. Take the covered inter- violations were limited to the fact that est rate parity, for example. If I borrow stock with positive returns today tend in yen, exchange the proceeds in dollars, to have a bit of positive momentum in invest them in dollars, and then buy yen the next six months, or that closed-end with delivery when my debt is due to cov- funds can trade at a 30 percent discount er my exchange rate risk, I should not be with respect to their net asset value, this able to make any money. If I can consis- is hardly earth-shattering. For most prac- tently do so, I have found a money ma- tical purposes, markets can be consid- chine. For an economist, the violation ered as if they were ef½cient. of this (and other) riskless arbitrages is These minor violations were the eas- tantamount to observing numerous $100 iest ones to document empirically. Un- bills on a crowded sidewalk and people fortunately, the deviations that really passing by without collecting them. matter–like whether the level of stock During Fall 2008, many such funda- prices in general is close to fundamental mental relations were violated. The values–are the most dif½cult to prove emerging consensus is that these vio- because of the joint hypothesis problem: lations were due to a lack of capital in we can always claim that we do not have the hands of smart arbitrageurs. Having the adequate model of fundamental val- faced major losses and even larger cap- ues. In other words, this implication of ital withdrawals by scared investors, the emt is not a good theory in the Pop- smart traders who knew how to exploit perian sense (after philosopher Karl these differences were running out of Popper) because it is almost impossible available money. And when there are to reject. This is the sense in which the many opportunities to make money crisis started to change the perspective but very little time and money to ex- of people inside and outside academia ploit, smart traders focus on the most about the costs associated with ignor- pro½table one. In other words, if I am ing these possible deviations. running to put out a ½re in my house, I In 1996, then-Federal Reserve Chair- might rationally choose to leave $100 man Alan Greenspan questioned wheth- bills on the sidewalk. er some “irrational exuberance” had While the conditions in Fall 2008 were taken the stock market to too high a extreme, they illustrate the importance level. The Shiller price-earnings ratio, of access to capital and the limits of the based on the average of earnings of arbitrage process. If limited access to cap- the previous ten years, was at 25 when ital can prevent smart traders from ex- Greenspan delivered that speech. It ploiting simple, risk-free opportunities, rose 77 percent, to 44.2, at the end of it is not hard to imagine that it might pre- 1999, before it started to drop. Dur- vent, even in more normal times, the ing those three years, many commen- exploitation of complex and risky oppor- tators ridiculed Greenspan’s remarks. tunities. Thus, limited access to capital The lesson Greenspan learned was is a major flaw in Friedman’s argument. how politically costly it was to lean What the recent crisis did change is against the wind. He dutifully applied the sense of how costly the violations of this lesson when real estate prices rose.

36 Dædalus Fall 2010 In fact, he elevated the lesson to a prin- son why lawyers use stock price move- Learning to ciple (the Greenspan Doctrine) that ments to assess damages. It is the reason live with not-so- it was not a responsibility of a central why corporate boards judge and com- ef½cient banker to try to lean against the for- pensate their executives on the basis of markets mation of potential bubbles. In acade- changes in stock prices. It is the reason mia, the staunchest supporter of this why in most business schools M.B.A.s approach was a Princeton University are taught that any active investment macroeconomist little known in the management is a waste of time and re- political world at that time: Ben Ber- sources and that chief ½nancial of½cers nanke! In a 1999 article with fellow should not try to outguess the market economist Mark Gertler, Bernanke in their ½nancing decisions. analyzed the impact of monetary policy when prices move away from fun- Besides the intellectual appeal of Fried- damentals. That this contingency was man’s argument and the supporting em- the object of their analysis illustrates pirical evidence, the emt was also very how the emt was losing ground. Their attractive for its practical implications. conclusion, however, was that the Fed By providing an objective metric for per- should not intervene, not only because formance, the shared belief in ef½cient it is dif½cult to identify the bubbles but markets made everyone’s life easier. It also because “our reading of history is was not one expert’s opinion against that asset price crashes have done sus- another’s: the market was the absolute tained damage to the economy only in and impartial judge. cases when monetary policy remained Once we lose this objective criterion, unresponsive or actively reinforced de- we are back in the world of self-interest- flationary pressures.” Thus, the case ed opinions. All corporate executives against intervention was not based on will argue that the market undervalues the idea that the market always gets it their stock and that any drop in their right, but on the premise that the costs stock price is due to market irrational- of these deviations are relatively minor, ity (while any increase is entirely justi- with respect to the cost of wrong inter- ½ed by their actions). All politicians ventions. will claim that the rise in the yield of This is what the 2007–2008 ½nan- their government’s bonds is not the re- cial crisis has changed: the comfortable sult of their profligacy, but of evil spec- belief that even if the emt is not exactly ulation or market irrationality (while true, it is a suf½ciently close approxima- ready to take credit for any reduction tion to reality that we can safely use it in the yield). Finally, all charlatans for most practical approximations. This will feel entitled to claim that they realization is not limited to academia; have an investment strategy that can it is mostly shared by an entire genera- beat the market systematically. This tion of ½nancial economists, account- is the uncharted territory where the ants, and lawyers who have been trained crisis leaves us: a world where con½- in the fundamental belief that market dence in the rationality of the market prices reflect the best estimates of fun- is shaken but where there is no clear, damentals. This belief is the reason why viable alternative. accountants like to use market prices as Eventually, a grander theory will much as possible in compiling compa- emerge, one that will enable us to un- nies’ ½nancial statements. It is the rea- derstand when we should expect mar-

Dædalus Fall 2010 37 Luigi ket prices to deviate from fundamentals. the bidder. Over several days, one ex- Zingales At the moment, we can grasp only some pects this deviation to be corrected, but on the ½nancial elements of this theory. Unfortunately, at the announcement of the bid, the crisis & this quasi-emt will be less elegant and imbalance can be very strong and can economic policy less clear-cut, making its day-to-day ap- temporarily alter relative prices. These plication more dif½cult. As a synthesis temporary misalignments have no seri- between the original emt and some of ous impact on the ef½ciency with which the arguments against it, this emerging market prices direct the allocation of re- theory will displease both sides. It will sources; still, they must be considered be considered apostasy by true believers when we make inferences from events in the emt, while radical opponents will studies. view it as too conservative. Neverthe- When it comes to the absolute level less, it is not only the right compromise, of prices, however, or the relative price it is the only reasonable way forward. between very different asset classes, we The necessary starting point is always cannot have the same level of con½dence Friedman’s argument that deviations of in market ef½ciency. Arbitrages between prices from fundamentals create money- asset classes or directional arbitrages making opportunities. Yet this argument against the overall level of the markets should be tempered by the understanding are extremely risky for any trader. Only that these opportunities are not as easy a very self-con½dent trader, one whose to capture as $100 bills on the sidewalk. job is not at risk because he bets mostly Even in the simplest cases, lack of capi- with his own money, can afford to en- tal can prevent arbitrageurs from doing gage in these arbitrages. Warren Buffett their job, particularly when it comes to is one of the few investors who ½t this leaning against the entire market. description. Not surprisingly, he has an In normal times we can expect relative amazing record of performance. The prices across similar securities to reflect paucity of this type of arbitrageur should differences in fundamental values. If the give us pause in taking the overall level price of Google rises while the price of of the market at face value. Yahoo drops, we can be fairly con½dent That markets may deviate from funda- that the fundamentals of the two compa- mentals does not necessarily imply that nies have moved accordingly. Neverthe- they always do or that it is easy to spot less, in the short run, relative prices can deviations when they occur. The scarcity deviate from their relative fundamentals, of investors with long-term success in especially when institutional or techni- timing the market (like Warren Buffett) cal factors create a signi½cant imbalance suggests the extreme dif½culty of this between demand and supply. Consider, task. The very reasons that push market for instance, the case of acquiring com- prices away from fundamentals–irra- panies. It is well known that on average tional exuberance, lack of capital for ar- the stock price of companies engaged bitrage, or a combination of the two– in large acquisitions drops. Historically, are likely to affect the market timer as this drop has been interpreted as a signal much as the rest of the market. (One has that the market values most of these ac- to be very rich, live in Omaha, Nebras- quisitions negatively. In fact, this drop ka, and not use the Internet to be a good could be due, at least in part, to the sell- contrarian.) A quasi-emt, thus, would ing pressure of merger arbitrageurs, who have practical advice very similar to the buy the target and hedge by selling short emt when it comes to ½nancial invest-

38 Dædalus Fall 2010 ment strategy. Yet its implications for market rather than in the absolute ef½- Learning to real resource allocation would be very ciency. Similarly, before making any in- live with not-so- different. Without the con½dence that ference from an event study, it is neces- ef½cient the market always provides the best sary to adjust the price changes for tem- markets guess, the risk that resources will be porary order imbalances that might have misallocated is very real. temporarily moved the price. Once we recognize these occasional As for ½nancial reporting, the faith deviations we should not disregard mar- in marking to market (that is, assessing ket information, but adjust it or com- the accounting value of assets at their plement it with fundamental analysis. market price) should be less absolute. It is safe to start by assuming that mar- That most of the arguments against ket prices reflect fundamentals, but we marking to market are self-serving ones must be open to changing this assump- aimed only at covering bad performance tion when there is overwhelming evi- does not imply, however, that marking dence to the contrary. While a price- to market is always the right choice. In earnings ratio of twenty-½ve might not this respect, providing two valuations be irrationally high, it is hard to explain in ½nancial statements, one marked to a price-earnings ratio of forty-½ve–just market and another based on fundamen- as it is dif½cult to justify that the land tal analysis, with clear description of the underneath the imperial palace in Tokyo underlying hypotheses, can be a useful could cost as much as the entire state of compromise. California, as was the case at the peak of Even when market prices deviate from the real estate bubble in Japan. While fundamental values, they still provide our current knowledge does not provide useful information about the demand of us with the certainty that these situations various assets, information that should are bubbles, it does suggest that com- not be ignored. When closed-end funds pletely disregarding these indicators is of a particular sector, for example, start very risky and leads, on average, to bad selling at a large premium with respect decision-making. Faced with these aber- to their net asset value, we should infer rations, central bankers would be foolish that the demand of small investors (the not to lean against the wind, especially main buyers of closed-end funds) for after seeing the costs a bubble’s burst that sector is booming and is likely to can have on the real economy. drive the stock prices of the ½rms in that At the same time, in designing execu- sector above their fundamental value. tive compensation one should recognize Market prices are a very important the limitations of stock-based perfor- source of information. Our only mistake mance. In fact, a signi½cant component was to consider them the only source of of change in a company’s stock price is information, in any moment in time, re- due to variations in the market risk pre- gardless of the conditions under which mium, not in the actual fundamentals those prices were obtained. The way for- of the company that can be influenced ward is not to dismiss market prices, but by its executives. The change in the price to consider them in context. of a company relative to the change of an index of its competitors is a much When the de½nitive history of the emt better measure of the actual perfor- is written, the 2007–2008 ½nancial cri- mance, because we have more con½- sis will not emerge as a major turning dence in the relative ef½ciency of the point, only a catalyst of an intellectual

Dædalus Fall 2010 39 Luigi journey that started at full speed after ampli½ed by high leverage. This realiza- Zingales the 1987 stock market crash. Rather than tion is forcing experts both inside and on the ½nancial demonstrating market inef½ciency, the outside academia to rethink the robust- crisis & 2007–2008 ½nancial crisis stands out as ness of the implications of the emt and economic policy an example of the potential costs that openly accept the possibility of some deviations of assets’ prices from funda- inef½ciency. While just beginning, this mentals can have on the real economy, process promises to be very challeng- especially when these deviations are ing but, eventually, very useful.

endnotes 1 Eugene F. Fama, “Ef½cient Capital Markets: A Review of Theory and Empirical Work,” The Journal of Finance (May 1970): 383. 2 Michael Jensen, “Some Anomalous Evidence Regarding Market Ef½ciency,” Journal of Financial Economics 6 (2–3) (1978): 95–101. 3 Andrei Shleifer and Lawrence H. Summers, “The Noise Trader Approach to Finance,” Journal of Economic Perspectives 4 (2) (1990): 19.

40 Dædalus Fall 2010 Jeremy C. Stein

Securitization, shadow banking & ½nancial fragility

Many of the most dramatic and quarter of 2008, following the bankrupt- memorable moments of the recent ½- cy of Lehman, total issues in this catego- nancial crisis involved the failures or ry fell to slightly more than $2 billion. near-failures of some of the nation’s Given that banks were suffering their biggest ½nancial institutions: Bear own problems and were not easily able Stearns, Lehman Brothers, and aig, to step into the breach, the disappear- to name a few. Much of the subsequent ance of this market represented a major policy response has been shaped by a contraction in the supply of credit to desire either to avert such failures in consumers, and may well have played a the future–for example, by imposing central role in the steep drop in aggre- higher capital requirements on system- gate consumption that occurred at this ically important ½nancial ½rms–or to time. The traditional abs market only lessen the adverse consequences of fail- began to rebound in mid-2009, with the ures if they do occur–for example, by implementation of the Federal Reserve’s improving the methods available to re- Term Asset-Backed Lending Facility, or solve large institutions in distress. talf, which made tens of billions of dol- Yet from the perspective of credit lars of Federal Reserve loans available on creation and impact on the rest of the attractive terms to investors seeking to economy, one of the most damaging as- buy newly issued consumer abs. pects of the crisis was not just the prob- In what follows, I explore the role that lems of these big ½rms, but also the col- the abs market plays in the broader lapse of an entire market, namely the mar- process of credit creation, focusing on ket for asset-backed securities (abs). four sets of issues. First, I describe how For example, the market for so-called the market works: how pools of loans traditional or consumer abs–those (for example, mortgages or credit-card based on credit-card, auto, and student and auto loans) are packaged and struc- loans–averaged between $50 and $70 tured into abs and how investors such billion of new issuance per quarter in as hedge funds, pension funds, and bro- the years leading up to the crisis. (The ker-dealer ½rms ½nance the acquisition total issuance for calendar year 2007 of these abs. Second, I outline the eco- was $238 billion.) However, in the last nomic forces that drive securitization; these include both an ef½ciency-enhanc- © 2010 by Jeremy C. Stein ing element of risk-sharing and a less

Dædalus Fall 2010 41 Jeremy C. desirable element of banks trying to of the pecking order and is a very risky Stein circumvent regulatory capital require- security. The second most junior tranche, on the T ½nancial ments. Third, I discuss the factors that 2, regains its money if nine or more of crisis & appear to have contributed to the mar- the loans are repaid; equivalently, it gets economic policy ket’s fragility during the crisis period. wiped out if there are two or more de- Finally, I suggest some policy reforms faults. At the top of the hierarchy stands that might help mitigate this fragility T10, the most senior tranche, which is going forward. very well protected and loses only if all ten of the loans in the trust go bad. Suppose you buy a new car and take As the example suggests, the senior- out a $10,000 loan to ½nance the pur- most tranches of securitizations are chase. This loan could come from a likely to have high credit quality. That bank or from the ½nancing arm of an is, they experience losses only under auto company. After the loan is made, rare circumstances, when a large frac- the lender has two options: it can hold tion of the loans in the underlying pool on to the loan it has originated, or it is hit with defaults. One reflection of can securitize it and thereby sell it off. this tendency is the aaa rating typical- In the ½rst step in the securitization pro- ly assigned to these senior-most tranch- cess, known as pooling, the lender gath- es by the rating agencies. This rating in ers your loan with tens of thousands of turn makes them attractive investments other loans like it–from other cars sold for institutional investors that are look- around the country at about the same ing for safe places to put their money but time–and assembles these loans togeth- are either unable or unwilling to expend er in a trust. The cash payments coming the resources required to do loan-level from all the designated loans from that due diligence. Such institutions may not point forward go into the trust. have the expertise to evaluate individual The second step in the process is tranch- applicants for auto loans, but given the ing. Tranching involves designating dif- reduction in credit risk associated with ferent classes of claimants on the cash the process of pooling and tranching, flows to the trust, some of whom are giv- may be comfortable buying the senior en higher priority than others. Said dif- tranches of auto-loan securitizations ferently, tranching spells out who loses even after relatively little investigative money and under what conditions if effort. some of the loans that make up the pool While the subprime crisis has called go bad. Consider this simpli½ed exam- into question the whole idea of turning ple: a pool of ten loans of $10,000 each risky loans into apparently near-riskless all come due at the same time. Each bor- aaa-rated abs–a process many have rower can either pay off his loan in its dubbed “alchemy”–the flaw is not so entirety, or default and pay nothing. much with the basic concept of securi- One possible structure would divide the tization, which has been around for a pool into ten layers, or tranches, each of long time, but rather with the reckless which is owed $10,000. The most junior and excessively complex way in which it or lowest priority tranche–call it T1– was applied to subprime mortgage loans. would recoup its money only if all ten The problem in the subprime sphere was loans were repaid; if even a single loan not that the most senior T10-like tranch- went bad, T1 would see its investment es of subprime pools were rated aaa; it wiped out. Thus, T1 stands at the bottom was that many of the less well-protect-

42 Dædalus Fall 2010 ed tranches (say the T3s) were as well, of only days or weeks and therefore Securiti- though only after a series of machina- had to be rolled over frequently. Anoth- zation, shadow tions that were less than transparent er example came from the hedge funds banking & to most market participants.1 and the broker-dealer ½rms (like Bear ½nancial Figure 1 provides some perspective Stearns and Lehman Brothers) that fragility on this point. It plots quarterly issuance ½nanced their holdings of abs with of abs over the period 2000 to 2009, repurchase agreements (commonly broken into two categories. The ½rst known as “repo”), which are a form category, “traditional” abs, comprises of overnight collateralized borrowing. securitizations based on consumer cred- Collectively, the various investors it: auto, credit-card, and student loans. that acquire abs and ½nance them with The striking characteristic of this series short-term borrowing are often referred is how stable it is in the several years pri- to as the shadow banking system. Just as or to the crisis; one gets the sense of a traditional commercial banks invest in market that has functioned steadily and long-term loans and ½nance these loans unremarkably, with only modest trend by issuing short-term deposits, the shad- growth, for a long period of time. The ow banking system invests in securities second category, “nontraditional” abs, based on the same sorts of long-term includes securitizations based on sub- loans (for example, mortgages or auto prime mortgage loans as well as second- loans) and ½nances this investment by and third-generation resecuritizations, in issuing short-term claims such as com- which the collateral going into the trust mercial paper or repo. On the one hand, is not a pool of actual loans, but rather a the shadow banking system performs collection of tranches created from earli- an economic function that looks much er rounds of securitizations of subprime like that performed by the traditional loans and other assets.2 This latter, more banking system: it borrows on a short- highly engineered market shows the signs term basis to fund longer-term loans; of a bubble, with the volume of issuance this is what is meant by maturity trans- growing explosively in the period 2003 formation.3 On the other hand, it does to 2007, before completely collapsing not face the same set of regulations be- during the crisis period. cause the institutions involved are gen- Beyond pooling and tranching, a ½- erally not banks per se. And it does not nal important element in the securiti- bene½t from the same safety net. For zation process is maturity transforma- example, unlike bank deposits, the tion. Often, the investors that purchase short-term ½nancing used by shadow abs tranches rely heavily on borrowed banks is not federally insured. Nor do money, with much of this borrowing shadow-banking players typically have being very short-term in nature. In the the right to borrow from the Federal period leading up to the crisis, entities Reserve’s discount window. known as “structured investment vehi- Not all investors that hold abs ½nance cles” (sivs) or “conduits” were promi- these holdings with short-term borrow- nent examples of this behavior. These ing. Anecdotal evidence suggests that entities, which in many cases were af- pension funds and insurance companies ½liated with sponsoring commercial tend to hold these securities on an unlev- banks, held abs tranches and ½nanced ered basis, that is, without borrowing those holdings by issuing commercial against them. Remarkably, however, lit- paper, which typically had a maturity tle is known about the relative magni-

Dædalus Fall 2010 43 Jeremy C. Figure 1 Stein Quarterly Issuance of Asset-Backed Securities, 2000–2009 on the ½nancial crisis & economic policy

Figure created using data from Thompson sdc.

tudes. In particular, as far as I am aware, ing on the risks entirely themselves. This there are no good empirical estimates improved risk-sharing represents a real to address the following question: what economic ef½ciency and lowers the ulti- fraction of the aaa-rated abs in a given mate cost of making the loans. Moreover, loan category (credit cards, for example) as noted above, the pooling and tranch- is owned by investors that ½nance their ing process, if done properly, makes the holdings of these securities primarily senior tranches of abs relatively easy to with short-term debt? This is an impor- evaluate, even for nonspecialized invest- tant question because, as argued below, ors that do not have much ability to judge the heavy use of short-term debt ½nanc- the credit quality of the individual loans ing by abs investors contributes to the that underlie these securities. Therefore, fragility of the market. it is particularly conducive to expanding the buyer base. With securitization, loans originated According to this story, the securitiza- by banks are packaged and sold off to a tion of consumer loans and mortgages variety of other end investors. What eco- closely parallels the natural transition nomic forces encourage banks to off- that many growing companies make load their loans in this way, as opposed when they reach a certain size and repu- to keeping them on their books? There tation and begin to shift their borrowing are two broad stories that one can tell. away from exclusive reliance on banks The ½rst, more benign story depends and toward the corporate bond market. on the principle of risk-sharing. When In either case, if the securities in ques- banks sell their loans into the securitization (either abs or corporate bonds) tion market, they distribute the risks as- can be easily evaluated by a broader set sociated with these loans across a wider of investors, it makes sense to tap into range of end investors, including pen- this broader market, as opposed to rely- sion funds, endowments, insurance coming exclusively on the banking sector panies, and hedge funds, rather than tak- for ½nancing.

44 Dædalus Fall 2010 While this wholesome-sounding sto- extent that bank regulation is burden- Securiti- ry undoubtedly captures some of what some, it creates a powerful pressure for zation, shadow drives the securitization market, it is banking assets to be securitized and to banking & also incomplete. It has become apparent migrate out of the formal banking sys- ½nancial in recent years that another important tem. Absent some form of harmoniza- fragility driver of securitization activity is regulation that puts shadow banks and tradi- tory arbitrage, a purposeful attempt by tional banks on more of an equal regu- banks to avoid the rules that dictate how latory footing, this pressure is likely to much capital they are required to hold. intensify as capital requirements on Particular attention in this regard has fo- banks are raised in the wake of the crisis. cused on the bank-sponsored sivs and conduits mentioned above, vehicles that Figure 1 illustrates the complete melt- held various types of abs and ½nanced down of the abs market during the ½- these holdings largely with short-term nancial crisis, with issuance in both the commercial paper. What is striking about traditional consumer (auto, credit-card, these shadow-banking vehicles is that and student loans) and nontraditional many of them operated with strong guar- (subprime) categories falling essentially antees from their sponsoring banks. In- to zero. The nontraditional market start- deed, when the sivs and conduits got ed to come apart ½rst, in August 2007, as into trouble, the banks honored their the extent of losses on subprime loans guarantees, stepping up and absorbing became more apparent. The traditional the losses. consumer market held up better for a This outcome runs counter to the spir- time, but then also disappeared in the it of the risk-sharing story, since rather wake of the failure of Lehman Brothers than widely distributing the risks asso- in September 2008. ciated with the abs they created, banks While less spectacular from a quan- retained them, albeit in an opaque, off- titative perspective, the decline of the balance-sheet fashion. The most obvi- traditional consumer abs market is ous alternative explanation is that banks in many ways the more challenging exploited a regulatory loophole: if they phenomenon to explain. The demise held the loans directly on their balance of the subprime-related abs market sheets, they faced a regulatory capital re- represented the deflation of a classic quirement on these loans; but if they se- bubble; many of the loans involved curitized the loans and parked them in were so poorly underwritten that they an off-balance-sheet vehicle (albeit one should never have been made in the with essentially full recourse to the banks ½rst place. Not surprisingly, when mar- in the event of trouble), the regulatory ket participants ½nally began to under- capital requirement was much reduced.4 stand this point, the issuance of new While this particular loophole will no subprime loans dried up. doubt be closed going forward, the more It is more surprising that abs issu- general concern remains. Securitization ance related to auto, credit-card, and and the shadow banking system enable student loans was hit so hard. There is bank-like maturity-transformation activ- much less reason to believe that these ities–speci½cally, the pairing of long- were bad loans to begin with: again, term assets with a short-term funding the super½cial evidence in Figure 1 structure–to take place out of the reach does not suggest a bubble in this part of traditional banking regulation. To the of the market. Indeed, overall lending in

Dædalus Fall 2010 45 Jeremy C. these categories did not completely van- declines. Once under way, this vicious Stein ish in the same way that it did in the sub- cycle is very dif½cult to arrest. on the ½nancial prime area; rather, some fraction of this One concrete manifestation of the crisis & lending reverted back to being done in dramatic withdrawal of short-term economic abs policy a nonsecuritized fashion by the banks, lending to the market comes from which suggests that they still viewed the the behavior of what are called “hair- loans as worth making. However, given cuts” in repurchase agreements. When the limited capacity of the banks, whose an investor borrows from the repo mar- capital by this point was badly impaired, ket to ½nance its holdings of abs, it is the inability to securitize and thereby required to post a margin, or down payoff-load some of their loans no doubt ment; this is the haircut. Haircuts on contributed to a sharp contraction in abs were extremely low prior to the cri- the overall supply of credit available sis, on the order of 2 percent. What this to consumers. means is that if, say, a hedge fund want- If the underlying auto, credit-card, and ed to acquire $1 billion of auto-linked student loans were still worth making, abs, it only needed to put up $20 mil- what caused the market for abs based lion of its own capital as a down pay- on these loans to contract so sharply? A ment. The other $980 million could be prominent emerging hypothesis is that, borrowed on an overnight basis in the effectively, there was the analogue of a repo market; in many cases, the ulti- widespread bank run on the shadow mate lenders of this short-term mon- banking system.5 Recall that many abs ey were money-market mutual funds investors ½nance their positions with looking to ½nd slightly higher yielding short-term borrowing, either in the short-term investments than, for exam- form of commercial paper or overnight ple, Treasury bills. repurchase agreements. In this sense, In the midst of the crisis, haircuts sky- they are very much like banks, which rocketed. Even haircuts on traditional ½nance long-term loans with short- consumer abs–those not linked in any term deposits. But unlike bank depos- direct way to the housing and subprime its, the short-term ½nancing that sup- problems–rose to more than 50 percent.6 ports the abs market is not insured From the perspective of the hedge fund by the government. This difference holding $1 billion of auto-linked abs, makes the shadow banking system vul- suddenly it could borrow only $500 mil- nerable to something that looks like a lion, and instead of having to post a $20 classic bank run from the days before million down payment, it now had to post deposit insurance: as short-term lend- $500 million. If it did not have the cash on ers lose con½dence and refuse to roll hand, it was forced to liquidate its hold- over their loans, investors in abs are ings. These forced liquidations, and the forced to liquidate some of their hold- powerful impact they had on both the ings to come up with cash. The liquida- level and volatility of abs prices, in turn tions in turn depress the price of these justi½ed the increased skittishness of the abs via a “½re sale” effect. Moreover, lenders in the repo market, because their short-term lenders view abs as less protection was entirely predicated on the attractive collateral as their prices fall collateral value of the assets they were and become more volatile. The lenders lending against. then pull back even further, leading to The bank-run analogy offers what feels another round of liquidations and price like a compelling account of the fragility

46 Dædalus Fall 2010 of the securitization market. However, it interesting ways. For example, what be- Securiti- would be premature to call it a fully em- gins as a simple strike on the part of un- zation, shadow pirically validated explanation for why levered buyers may evolve into a run-like banking & the market dried up so dramatically dur- phenomenon since the buyer’s strike ½nancial ing the crisis. For one, as emphasized puts downward pressure on abs prices, fragility above, it is not known what fraction of making the position of short-term lend- abs was held by investors that ½nanced ers more precarious and thereby encour- themselves in a vulnerable bank-like way aging these lenders to withdraw from –that is, largely with short-term debt. the market. If the fraction turns out to have been, say, 40 percent instead of 80 percent, To frame the policy issues with respect this ½nding would temper the force to securitization and the shadow bank- of the theory. ing system, it is useful to begin by em- There is an alternative, more behav- phasizing three key points. First, we are ioral hypothesis for the fragility of the almost certainly heading in the direction securitization market that does not rely of imposing signi½cantly higher capital on a predominance of short-term debt requirements on large banks. Second, ½nancing.7 This alternative hypothesis while this is undoubtedly a valuable and begins with the observation that a large much-needed reform, and one that holds proportion of abs tranches–in both the promise of making the banking sec- the traditional and subprime sectors– tor itself more robust in future episodes was rated aaa. The aaa rating may have of ½nancial volatility, it will also have the encouraged investors such as pension effect of encouraging more credit-cre- funds or insurance companies to think ation activity to migrate away from the of these securities as essentially riskless banks and toward the shadow-banking and therefore to treat them as equivalent sector, in an effort to evade the burdens to Treasury bonds when constructing associated with more stringent regula- their portfolios. When the problems in tion. Third, we have seen that the shad- the subprime area became apparent, this ow-banking sector can be a powerful premise was utterly destroyed, and in- source of fragility in its own right, one vestors that were determined to allocate that can lead to damaging disruptions a fraction of their portfolios to safe as- in the flow of credit to households and sets realized that they had to dump their businesses. Thus it would be a mistake holdings of aaa-rated abs and buy ac- to pursue a set of policies that focuses tual Treasuries instead. Thus, instead heavily on insulating our large banks of a short-term-debt-driven bank run, but that pays insuf½cient attention to we have what might be called a wide- potential vulnerabilities in the rest of spread buyer’s strike. In this account, the ½nancial system. Rather, the goal the rating agencies’ failures with re- should be a balanced approach that ad- spect to the subprime market under- dresses all elements of the system in mined their credibility more generally, an integrated fashion. so that any aaa-rated tranche of an What concrete steps might be taken in abs, be it linked to subprime or credit this regard? I present three speci½c ideas cards, was no longer considered a vir- for regulating the securitization and shad- tually riskless asset. ow-banking markets. To be transparent Of course, the two theories are not about my own prejudices, I label the mutually exclusive, and may interact in ideas the good, the bad, and the maybe.

Dædalus Fall 2010 47 Jeremy C. The good: regulation of haircuts in the Such a requirement is nothing conceptu- Stein abs market. To mitigate the incentives ally new and should not be dif½cult to on the ½nancial for regulatory evasion, and to help re- enforce; indeed, it is closely analogous crisis & duce the fragility of credit creation no to the initial and maintenance margin economic policy matter where it takes place, a systemat- requirements that are currently applica- ic effort must be made to impose simi- ble to investors in common stocks. lar capital standards on a given type of If well structured, these haircut re- credit exposure, irrespective of wheth- quirements have two important bene- er it is a bank, a broker-dealer ½rm, a ½ts. First, they go a long way toward hedge fund, or any other entity that achieving harmonization across organi- ends up holding the exposure. This zational forms, in that there would no is not an easy task, but one tool that longer be an obvious regulation-avoid- would help is broad-based regulation ance motive for moving the consumer of haircuts (that is, minimum margin loan off the balance sheet of the bank requirements) on abs.8 and into the shadow-banking sector. Consider the case of a consumer loan. This bene½t is especially important as If this loan is made by a bank, it will be we move toward signi½cant increases subject to a capital requirement; that in the capital requirements imposed is, the bank will have to put up some on banks. The goals of these higher amount of equity against the loan, rath- bank-capital requirements are likely er than borrow all the money. Now sup- to be partially frustrated if they drive pose instead that the loan is securitized signi½cant amounts of activity outside by the bank and becomes part of a con- the banking system. sumer abs whose tranches are distrib- Second, for that portion of credit- uted to various types of investors. The creation activity that does end up re- regulation I have in mind here would siding in the shadow-banking sector, stipulate that whoever holds a tranche haircut regulation can help dampen of the abs would be required to post a the bank-run-like crisis dynamics de- minimum down payment against that scribed above. The problem is that if tranche–with the value of the haircut haircuts begin at 2 percent before the depending on the seniority of the tranche, crisis, and then jump to more than 50 the quality of the underlying collateral, percent during the crisis, this increase and so forth. creates a powerful forced-selling pres- For example, before the current crisis, sure on the owners of abs. If the hair- market-determined haircuts on aaa- cuts are instead set at a more prudent rated consumer abs tranches were very value before the crisis–again, say 10 low, in the neighborhood of 2 percent. percent–so that investors are required With no further regulation, they are like- to put up more of their own cash at the ly to return to these levels as markets re- outset, this forced-selling mechanism, normalize. However, the new regulation and the vicious spiral it unleashes, might instead impose a minimum hair- might be substantially attenuated. cut requirement on aaa-rated consum- The bad: extension of the federal safety er abs of at least 10 percent, indepen- net to shadow banks. Some observers have dent of market conditions. That is, any taken the analogy between the tradition- investor in such a security would be real commercial banking sector and the quired to post and subsequently main- shadow banking system one step further, tain a 10 percent margin at all times. arguing that in order to prevent run-like

48 Dædalus Fall 2010 panics in the latter, it should be covered cisely as a means of gaming the rating- Securiti- by the same federal safety net as the for- agency formulas. Thus, although a gov- zation, shadow mer. This coverage would entail giving ernment insurance agency would not banking & shadow-bank entities access to the Fed- face the same overt conflicts of interest ½nancial eral Reserve’s discount window, as well as the rating agencies, it seems reason- fragility as possibly insuring some of their short- able to worry about how it would fare term debts. Thus, when a specialized in- when pitted against Wall Street’s best vestment vehicle is set up to buy a port- ½nancial engineers. folio of abs ½nanced largely with short- With this bit of pessimism in mind, term commercial paper borrowing, the I would argue that in order to enter- commercial paper issued by the invest- tain the idea of expanding the safety ment vehicle might be explicitly feder- net, one would have to believe that the ally insured, much as some bank depos- short-term debt claims created by the its are today. Instead of trying to lean shadow-banking sector are of substan- against the private market’s propensity tial social value–so much so that sus- to ½nance abs with large amounts of taining them with moral-hazard-prone short-term debt–as the haircut regula- insurance, rather than trying to con- tion described above would do–this al- strain them with haircut regulation, is ternative approach amounts to embracing a ½rst-order imperative. I don’t think the use of such short-term ½nancing and that we have nearly enough empirical attempting to use government insurance evidence to meet this burden of proof. to make the world safer in its presence. Hence I would be strongly inclined to What makes this policy unattractive steer clear of any expansion of the safe- is the moral hazard that it invites, as pri- ty net. vate actors seek to exploit government- The maybe: limiting the creation of “pseu- provided insurance by using it to ½nance do-riskless” securities. As discussed above, riskier-than-expected activities. This con- an alternative theory for the fragility of cern is particularly acute when the insur- the abs market during the crisis is that, ance is attached to the kinds of highly even absent short-term debt ½nancing engineered ½nancial products that were of abs positions, the proliferation of so held by some shadow-banking investors many “pseudo-riskless” securities is in- prior to the current crisis–products for herently dangerous. By pseudo-riskless, which risks are often not easily under- I mean aaa-rated securities that appear stood or accurately measured ahead of so safe in good times that investors are time. For example, one can imagine a lulled into a sense of complacency where- government insurer trying to devise a by they treat these securities as equiva- formula for risk-based pricing of the in- lent to truly riskless Treasuries. Only in a surance it provides to a specialized in- crisis do investors discover that this was vestment vehicle, in an effort to deter a false equivalence, which leads them to excessive risk-taking. But should we ex- panic and dump their holdings of the pect any such formula to do better than aaa-rated securities.9 those of the rating agencies, which so If one takes this point of view, it is spectacularly misjudged the risks em- tempting to think about ways to con- bedded in complex abs based on sub- strain the production of those abs prime mortgages? Indeed, one can argue tranches that can be represented to in- that the mind-bending complexity of vestors as being near-riskless. One way some of these structures emerged pre- might be to require the credit-rating

Dædalus Fall 2010 49 Jeremy C. agencies to use a coarser set of ratings hand, they highlight the logical impli- Stein when evaluating abs than when they cations of taking a more behavioral per- on the ½nancial evaluate corporate bond issues. For ex- spective on the abs market’s fragility– crisis & ample, instead of a ½nely tuned scale of positing a world in which investors economic aaa aa aa aa policy that goes from to +, , -, are overly prone to seek out pseudo-risk- a+, and all the way down to ccc, the less investments and in which ½nancial ratings for abs might be restricted to innovators actively try to exploit this one of three broad buckets: a, b, or c.10 tendency. On the other hand, the spe- While this idea admittedly has a bit of ci½c proposals I have sketched raise the feel of deploying the language police, some fairly obvious flags as well. For it might prevent any abs tranche from example, restricting the vocabulary being thought of as near-riskless, since available to the rating agencies may even the highest rating category would have meaningful effects in the short now encompass securities with a wide run, but over time it is easy to imagine range of credit qualities. industry conventions evolving so as An alternative approach would be to to work around any such restrictions. leave the current ratings categories in If so, it would be a mistake to place place but to impose on the creators of much long-term faith in this approach. any abs an upper limit on the amount of highly rated securities that they could The overarching goal of ½nancial manufacture from any given underly- reform must not be only to fortify a ing pool of loans. For example, one rule set of large institutions, but rather to might be that only a maximum of 50 reduce the fragility of our entire system percent of the dollar value of tranches of credit creation. This system involves coming from any pool of consumer a complicated interplay between banks loans could ever seek a rating of aa or and non-banks and between tradition- higher; all other subordinate tranches al forms of lending and securitization. would have to be targeted at lower rat- Thus far, more effort has been devoted ings categories. to the banking side of the equation. This I put this last set of ideas in the “maybe” imbalance is perhaps not surprising giv- category because I view them as interest- en the accumulated expertise of many ing and worthy of further thought, but I of the regulators involved in the reform am not at this point con½dent that their process. But the dif½cult issues associat- virtues outweigh their potential for un- ed with securitization and the shadow intended consequences. On the one banking system demand equal attention.

endnotes 1 More precisely, the riskier lower-rated tranches of subprime securitizations were themselves used as the raw material (in place of the original mortgage loans) to create second- and third-generation resecuritizations. Many of the biggest problems in the crisis arose from the fact that large fractions of these resecuritized vehicles were also rated aaa, in spite of the dubious collateral supporting them. This is where the most extreme alchemy can be said to have taken place. For a discussion, see Joshua Coval, Jakub Jurek, and Erik Stafford, “The Economics of Structured Finance,” Journal of Economic Perspectives 23 (2009): 3–25.

50 Dædalus Fall 2010 2 The data in the ½gure come from Thompson sdc. While the “nontraditional” category Securiti- includes securitizations based on subprime mortgage loans, it does not include securitiza- zation, tions based on prime mortgage loans, such as mortgage-backed securities guaranteed by shadow banking & the government-sponsored enterprises Fannie Mae and Freddie Mac. I am grateful to ½nancial Sam Hanson, who put together the data and shared it with me. fragility 3 See Gary Gorton and Andrew Metrick, “Securitized Banking and the Run on Repo,” nber working paper 15223 (National Bureau of Economic Research, 2009). 4 For a detailed study of this phenomenon, see Viral Acharya, Phillip Schnabl, and Gustavo Suarez, “Securitization without Risk Transfer,” nber working paper 15730 (National Bu- reau of Economic Research, 2010). 5 The bank-run hypothesis is articulated in Gorton and Metrick, “Securitized Banking and the Run on Repo,” as well as in Daniel Covitz, Nellie Liang, and Gustavo Suarez, “The Anatomy of a Financial Crisis: The Evolution of Panic-Driven Runs in the Asset-Backed Commercial Paper Market,” working paper (Board of Governors of the Federal Reserve, 2009). 6 For more detail on the evolution of repo-market haircuts during the crisis period, see Gorton and Metrick, “Securitized Banking and the Run on Repo.” 7 A version of this hypothesis is presented in Nicola Gennaioli, Andrei Shleifer, and Robert Vishny, “Financial Innovation and Financial Fragility,” working paper (Harvard Universi- ty, 2010). 8 Such haircut regulation is discussed in John Geanakoplos, “The Leverage Cycle,” discussion paper 1715R (Cowles Foundation, 2010); and in Jeremy Stein, “Monetary Policy as Financial-Stability Regulation,” working paper (Harvard University, 2010). 9 Again, see Gennaioli, Shleifer, and Vishny, “Financial Innovation and Financial Fragility,” for elaboration on this argument. 10 This scale is used by both Standard and Poor’s and Fitch. The other major rating agency, Moody’s, has a somewhat different alphanumeric convention, albeit with similarly ½ne- grained categories: Aaa, Aa1, Aa2, Aa3, A1, A2, etc.

Dædalus Fall 2010 51 Lucian A. Bebchuk

How to ½x bankers’ pay

The ½nancial crisis has highlighted Standard pay arrangements have incen- the importance of discouraging exces- tivized and rewarded short-term results. sive risk-taking by ½nancial ½rms. The Jesse Fried and I warned about this prob- extent to which ½rms take on risks can lem and its consequences in our book be expected to depend partly on their Pay without Performance: The Unful½lled executives’ incentives. In the aftermath Promise of Executive Compensation, pub- of the ½nancial crisis, G20 leaders an- lished six years ago.4 Under the standard nounced their commitment “to imple- design of pay arrangements, executives ment strong international compensation have been able to cash out large amounts standards aimed at ending practices that of compensation based on short-term lead to excessive risk-taking.”1 But how results, which has provided executives should bankers’ pay be ½xed? The devil, with incentives to seek short-term gains as is often the case, is in the details. even when doing so creates excessive Below I sketch some key principles for risk of a later implosion. reforming bankers’ pay, drawing on my Modern pay packages are largely per- academic work2 as well as on written tes- formance-based, consisting of both equi- timonies before the Financial Services ty-based compensation (such as options Committee of the House of Representa- and restricted stock) and bonus compen- tives.3 I describe two distinct sources of sation. Such provisions are intended to risk-taking incentives: ½rst, executives’ provide incentives for improved perfor- excessive focus on short-term results; and, mance. In the past, however, these criti- second, their excessive focus on results cal components of standard pay arrange- for shareholders, which corresponds to ments have also produced perverse a lack of incentives for executives to con- incentives. sider outcomes for other contributors of Bear Stearns and Lehman Brothers, capital. I discuss how pay arrangements the ½rms whose respective meltdowns can be reformed to address each of these ushered in the current ½nancial crisis, problems and conclude by examining are illustrative of the problem. Various the role that government should play in observers, including New York Times and bringing about the needed reforms. Wall Street Journal columnists,5 largely assumed that the wealth of these ½rms’ executives was wiped out, together with © 2010 by Lucian A. Bebchuk that of their ½rms. This “standard narra-

52 Dædalus Fall 2010 tive” led commentators to dismiss the these bonuses evaporated in 2008. But How to ½x potential role of flawed pay arrangements the ½rms’ pay arrangements did not bankers’ pay in the ½rms’ risk-taking. Assuming that contain any “claw-back” provisions that the executives’ wealth was wiped out would have enabled the ½rms to recoup alongside the shareholders’, these com- bonuses that had already been paid. mentators inferred that the ½rms’ risk- Combining the ½gures from equity taking could not have been an upshot of sales and bonuses, we ½nd that, during deliberate choices produced by perverse 2000 to 2008, the top ½ve executives incentives; rather, it must have been the at Bear Stearns and Lehman pocketed result of the executives’ failure to per- about $1.4 billion and $1 billion, respec- ceive risks–or their hubris. Alternative tively, or roughly $250 million per exec- pay structures, they argued, would not utive. The ceos–James Cayne of Bear have made a difference. Stearns and Richard Fuld of Lehman In our study “The Wages of Failure: Brothers–pocketed about $380 million Executive Compensation at Bear Stearns and $520 million, respectively. These and Lehman Brothers 2000–2008,”6 cash proceeds are substantially higher Alma Cohen, Holger Spamann, and I ex- than the value of the holdings that the amine this standard narrative and ½nd it executives held at the beginning of the to be incorrect. We piece together the period. Thus, while earnings for their cash flows derived by the ½rms’ top ½ve ½rms’ long-term shareholders were executives using data from Securities largely decimated, the executives’ per- and Exchange Commission ½lings. Our formance-based compensation kept analysis indicates that, notwithstanding them in positive territory. the 2008 collapse of the ½rms, the bot- The divergence between how the top tom lines of those executives for the executives and their companies’ share- 2008–2009 period were positive and holders fared raises a serious concern that substantial. the aggressive risk-taking at Bear Stearns Most important, the ½rms’ top exec- and Lehman (and other ½nancial ½rms utives regularly unloaded shares and with similar pay arrangements) could options and thus were able to cash out have been the product of flawed incen- much of their equity before the stock tives. The concern is not that the top ex- price of their ½rms plummeted. Indeed, ecutives expected their aggressive risk- the top ½ve executives unloaded more taking to lead to certain failure for their shares during the years prior to their ½rms, but that the executives’ pay ar- ½rms’ meltdowns than they held when rangements–in particular, their ability disaster came in 2008. Altogether, during to claim large amounts of compensation 2000 to 2008, the top executive teams based on short-term results–induced at Bear Stearns and Lehman cashed out them to accept excessive levels of risk. through equity sales about $1.1 billion and $850 million, respectively.7 To address the problem of short-term These payoffs to top executives were focus, ½nancial ½rms should reform com- further increased by large bonus compensation structures to ensure tighter pensation. During 2000 to 2007, the top alignment between executive payoffs executives’ aggregate bonus compensa- and long-term results. Senior executives tion reached $300 million at Bear Stearns should not be able to collect and retain and $150 million at Lehman. Of course, large amounts of bonus compensation the earnings that provided the basis for when the performance on which the

Dædalus Fall 2010 53 Lucian A. bonuses are based is subsequently sharp- Some shareholder proposals and com- Bebchuk ly reversed. Similarly, equity incentives pensation experts have called for allow- on the ½nancial should be subject to substantial limita- ing executives to cash out shares and op- crisis & tions aimed at preventing executives tions only upon retirement from the ½rm. economic policy from placing excessive weight on their Such a “hold-till-retirement” require- ½rm’s short-term stock price. Had such ment, however, would provide executives compensation structures been in place with a counterproductive incentive to at Bear Stearns and Lehman, their top leave the ½rm in order to cash out their executives would not have been able portfolio of options and shares and diver- to derive such large amounts of perfor- sify their risks. Perversely, the incentive mance-based compensation for man- to leave will be strongest for executives aging these ½rms in the years leading who have served successfully for a long up to their collapse. time and whose accumulated options Equity-based compensation is the pri- and shares are especially valuable. Simi- mary component of modern pay pack- lar distortions arise under any arrange- ages. Under standard arrangements, ment tying the freedom to cash out to equity-based awards vest gradually over an event that is at least partly under an a period of time. Once they vest, however, executive’s control. To avoid this prob- executives typically have unrestricted lem, ½rms should adopt limitations on freedom to cash them out and, indeed, unwinding that are not a function of often unload such equity incentives such events. quickly after vesting. This right to free- In particular, unwinding should be ly cash out vested equity incentives has subject to a combination of grant-based contributed substantially to the crea- and aggregate restrictions. Grant-based tion of short-term distortions. limitations would require executives to In a recent article, Jesse Fried and I, hold equity incentives awarded as part of building on the approach we put forward a given grant for a ½xed number of years in Pay without Performance, proposed a after vesting. For example, an executive detailed blueprint for preventing equity- receiving an equity award could be pre- based compensation, the primary com- vented from unwinding any awarded ponent of modern pay packages, from equity incentives for two years after vest- producing an excessive focus on short- ing, with each subsequent year freeing term results.8 To begin, it is desirable another 20 percent of the awarded incen- to separate the time that options and tives to be unloaded. restricted shares can be cashed out from These grant-based limitations, how- the time in which they vest. As soon as ever, might not be suf½cient to secure an executive has completed an addition- adequate long-term focus. With only al year at the ½rm, the options or shares grant-based restrictions in place, long- promised as compensation for that time executives might amass large year’s work should vest; it should be- amounts of equity incentives that they long to the executive even if he or she could immediately unload, which could immediately leaves the ½rm. The exec- induce them to pay excessive attention utive, however, should not be free to to short-term prices. Therefore, grant- cash out these vested equity incentives; based limitations should be supplement- rather, he or she should be permitted ed with aggregate limitations restricting to do so only after a substantial passage the fraction of an executive’s otherwise of time. unloadable equity incentives that could

54 Dædalus Fall 2010 be sold in any given year. To illustrate, ex- Master for tarp Executive Compensa- How to ½x ecutives could be precluded from unload- tion Kenneth Feinberg required compa- bankers’ pay ing, in any given year, more than 10 per- nies subject to his jurisdiction to adopt cent of their total portfolio of otherwise such an anti-hedging requirement.10 unloadable incentives. By construction, This approach should also be followed such limitations would ensure that exec- by public ½rms in general. Whatever utives would not place substantial weight equity-plan design is chosen by a given on short-term stock prices. company’s board, executives should not Finally, ½rms must adopt robust limita- be allowed to unilaterally use hedging tions on executives’ use of hedging and and derivative transactions that undo the derivative transactions, a practice that incentive consequences of this design. can weaken the connection between ex- In addition to equity compensation, ecutive payoffs and long-term results. An bonus plans also must be redesigned. executive who buys a “put” option to sell Under standard pay arrangements, exec- his or her shares at the current price, as utives have been able to cash bonus com- executives are generally free to do under pensation based on short-term results standard pay arrangements, is “insured” and retain it even when those results were against declines in the stock price below reversed. To address the short-term dis- current levels. Empirical evidence indi- tortion arising from such arrangements, cates that executives engage in a signi½- bonuses should not be cashed right away; cant amount of hedging, and that such instead, the funds should be placed in a hedging is at least partly motivated by company account for several years and 9 their inside information. Furthermore, adjusted downward if the company sub- the adoption of signi½cant limitations sequently learns that the bonus is no on unwinding would likely increase exec- longer justi½ed. The need for such a utives’ incentives to engage in hedging downward adjustment is not limited and derivative transactions, as doing so to ½rms in which ½nancial results are could neutralize the effects of those lim- restated. Even if results for a given year itations. Indeed, if executives continued were booked consistent with account- to enjoy the freedom to engage in such ing conventions, executives should not transactions, the practical impact of be rewarded for pro½ts that are quickly limitations on unwinding would be reversed. Rewarding executives for much reduced. short-term results distorts their incen- Whether or not they are motivated by tives and should be avoided by well- the use of inside information, executives designed compensation arrangements. should not be at liberty to use hedging and derivate transactions to undo the ef- Thus far, I have focused on the insula- fects of equity-pay arrangements put in tion of executives from long-term losses place by their ½rm’s board at a cost to to shareholders–the problem that has shareholders. Rather, executives should received the most attention following be precluded from engaging in any hedg- the recent crisis. However, as Holger ing or derivative transactions that would Spamann and I analyze in detail in recent reduce or limit the extent to which de- work,11 there is another type of distor- clines in the company’s stock price would tion that should be recognized: payoffs lower executive payoffs. In Fall 2009, fol- to ½nancial executives have been shield- lowing the anti-hedging approach that ed from the consequences that losses Jesse Fried and I advocated, the Special could impose on parties other than share-

Dædalus Fall 2010 55 Lucian A. holders. This source of distortion is dis- i½ed percentage of the aggregate value of Bebchuk tinct from the “short-termism” problem the common shares, the preferred shares, on the ½nancial discussed above and would remain even and all the outstanding bonds issued by crisis & if executives’ payoffs were fully aligned either the bank holding company or the economic policy with those of long-term shareholders. bank. Because such a compensation struc- Equity-based awards, coupled with the ture would expose executives to a broad- capital structure of banks, tie executives’ er fraction of the negative consequences compensation to a highly levered bet on of risks taken, it would encourage greater the value of banks’ assets. While bank prudence in evaluating risky choices. executives expect to share in any gains The structure described above would that might flow to common shareholders, not by itself cause bank executives to in- they do not expect to bear (in the event ternalize fully the adverse consequences losses exceed the common shareholders’ that risk-taking might have for the inter- capital) any part of losses borne by pre- ests of the government as guarantor of ferred shareholders, bondholders, depos- deposits. Achieving such fuller internal- itors, or the government as a guarantor ization would require broadening further of deposits. This state of affairs leads the set of positions that aggregate value executives to pay insuf½cient attention executive payoffs are tied to. One could to the possibility of large losses sustained consider, for example, schemes in which beyond the shareholders’ equity; it thus executive payoffs were tied not to a given incentivizes excessive risk-taking. percentage of the aggregate value of the Insulation of executives from losses to bank’s common shares, preferred shares, parties other than shareholders can be and bonds at a speci½ed point in time, expected to produce at least two types of but rather to this aggregate value minus risk-taking distortions. First, it encour- any payments made by the government ages executives to make investments and to the bank’s depositors, as well as other take on obligations that can contribute payments made by the government in to “tail” scenarios, in which the bank support of the bank, during the speci½ed suffers losses exceeding the shareholders’ time period. capital. Second, it creates reluctance to Alternatively, executive payoffs could raise capital and fosters excessive will- be tied to the aggregate value of the bank’s ingness to run the bank with a capital common shares, preferred shares, and level that provides inadequate cushion bonds at the speci½ed time minus the ex- for bondholders and depositors. The pected value of future government pay- more thinly capitalized banks are, the ments as proxied by the product of (i) the more severe these distortions become. implied probability of default inferred from the price of credit default swaps at How could pay arrangements be re- the speci½ed time, and (ii) the value of designed to address this distortion? To the bank’s deposits at that time. Even the extent that executive pay is tied to if such schemes are not used, however, the value of speci½ed securities, such pay tying executive pay to the aggregate value could be tied to a broader basket of secu- of common shares, preferred shares, and rities, not merely common shares. Thus, bonds would by itself produce a signi½- rather than tying executive pay to a spec- cant improvement in incentives com- i½ed percentage of the value of the compared with existing arrangements. mon shares of the bank holding compa- Similarly, in ½rms where executives re- ny, compensation could be tied to a spec- ceive bonus compensation tied to speci-

56 Dædalus Fall 2010 ½ed accounting measures, bonuses could The new Dodd-Frank bill, the Wall How to ½x be linked instead to broader metrics. For Street Reform and Consumer Protection bankers’ pay example, the bonus compensation of Act, introduced “say on pay,” which en- some bank executives has been depen- ables shareholders to express their views dent on accounting measures that are of on the pay arrangements of public ½rms interest primarily to common sharehold- in advisory votes. To the extent that di- ers, such as return on equity or earning rectors would seek to avoid a negative per common share. Such plans could be say on pay vote, the introduction of such redesigned to be based on more expan- votes could help prevent some egregious sive measures, such as earnings before cases. But advisory votes by themselves any payments made to bondholders. cannot ensure that directors are suf½- Ensuring that executives internalize ciently attentive to and focused on share- perfectly the expected losses that choices holder interests. To provide directors would impose on contributors of capi- with such incentives, a broader reform tal other than shareholders is far from is necessary–and indeed long overdue. straightforward. But doing so imperfect- Shareholders in the United States have ly would likely be better than not doing long had weaker rights than they have in so at all. Requiring ½nancial executives the United Kingdom and other common to expand their focus beyond consequen- law countries. As I discuss in detail in a ces for shareholders would signi½cantly series of recent articles,12 shareholder improve their risk-taking incentives. rights should be strengthened in two important ways. To begin, the power of Having discussed changes in pay ar- shareholders to replace directors should rangements that would curtail incentives be turned from myth into reality. Exist- for banks and other ½rms to take exces- ing rules and arrangements provide in- sive risks, I turn to the question of what cumbent directors with a substantial ad- role, if any, the government should play vantage over outside challengers. For in implementing reform. Some will argue example, whereas challengers from out- that, however desirable such reforms may side the ½rm must bear their campaign be, introducing changes should be left to expenses themselves, incumbents have the marketplace. According to this stand- their expenses fully covered by the com- point, private players can be fully expect- pany. Moreover, the boards of many com- ed to draw lessons from past problems panies are “staggered,” which requires and adopt whatever reforms are desirable. challengers seeking to gain control of In my view, however, the government has the board to win two elections one year two important roles to play. apart. Such existing impediments to The ½rst function the government shareholders’ ability to replace direc- should perform–both in the ½nancial tors should be dismantled. ½rms that are the focus of this essay and In addition, shareholders should have in other public ½rms–is to improve gov- the power to propose and vote to adopt ernance arrangements. In particular, the “rules of the game” decisions–that is, government should ensure that share- decisions to amend the corporation’s holders have suf½ciently strong rights to governance arrangements. Current discourage choices adverse to their inter- arrangements give directors the sole ests, including the adoption of pay ar- power to initiate changes in the com- rangements that insulate executives from pany’s charter or state of incorporation, long-term losses of shareholder value. and severely limit the scope of bylaw pro-

Dædalus Fall 2010 57 Lucian A. visions that shareholders may initiate and hazard problem provides a basis for Bebchuk adopt. This state of affairs gives directors the extensive body of regulations that on the ½nancial an unwarranted role in determining the restrict the choices of ½nancial ½rms crisis & rules that regulate their own conduct. with respect to investments, lending, economic policy Shareholders should be given the power and capital reserves. to shape governance arrangements. Aligning the interests of executives A reform that strengthens shareholder with those of shareholders, which some rights would limit deviations from share- governance reforms seek to do, could holder interests. Among other things, it eliminate risk-taking that is excessive would discourage pay arrangements that even from the shareholders’ perspective. reward executives for short-term gains But it cannot be expected to get rid of and insulate them from losses to long- incentives for risk-taking that are exces- term shareholder value. This develop- sive from a social standpoint but not ment would help eliminate risk-taking from the shareholders’ perspective. incentives that are excessive even from Shareholders’ interest in greater risk- the shareholders’ perspective. Still, there taking implies that they stand to bene½t would remain the problem of risk-taking when bank executives take excessive incentives that are favored by sharehold- risks. Given the complexities of modern ers but that, once the interests of other ½nance and the limited information and stakeholders are taken into account, are resources of regulators, the traditional undesirable from a society’s standpoint. regulation of banks’ actions and activi- This point brings us to the second role ties necessarily is imperfect. Regulators that the government should play. are often one step behind banks’ executives. Thus, executives with incentives Outside the ½nancial sector, the gov- to focus on shareholder interests can use ernment should limit itself to strength- their informational advantages and what- ening shareholder rights; it should not ever discretion traditional regulations intervene in the substantive terms of leave them to take excessive risks. pay arrangements. In the case of banks, Because shareholders’ interests favor however, the government’s role should incentives for risk-taking that are social- extend beyond governance reforms: ½- ly excessive, substantive regulation of nancial regulators should monitor and the terms of pay arrangements–that is, regulate ½rms’ compensation structures. limiting the use of structures that reward Such pay regulation is justi½ed by the risky behavior–can advance the goals of same moral hazard reasons that underlie banking regulation. Regulators should the long-standing system of prudential focus on the structure of compensation– regulation of banks. not the amount–with the aim of discour- When a bank takes risks, shareholders aging excessive risk-taking. By doing so, can expect to capture the full upside, but regulators would induce bank executives part of the downside may be borne by the to work for, not against, the goals of government as guarantor of deposits. banking regulation. Because bank failure imposes costs on the The regulation of bankers’ pay could government and the economy that share- well supplement and reinforce the tra- holders do not internalize, shareholders’ ditional direct regulation of banks’ ac- interests may be served by greater risk- tivities. Indeed, if pay arrangements taking than is in the interest of the gov- are designed to discourage excessive ernment and the economy. This moral risk-taking, direct regulation need not

58 Dædalus Fall 2010 be as stringent as would otherwise be more demanding than that which is req- How to ½x necessary. Conversely, as long as banks’ uisite to regulators’ direct intervention bankers’ pay execu-tive pay arrangements are uncon- in investment, lending, and capital deci- strained, regulators should be stricter in sions. Furthermore, setting pay arrange- their mon-itoring and direct regulation ments should not be left to the uncon- of banks’ activities. strained choices of informed players in- At a minimum, when assessing the side banks; these players do not have in- risks posed by any given bank, regula- centives to take into account the inter- tors should take into account the incen- ests of bondholders, depositors, and the tives generated by the bank’s pay arrange- government. ments. When the design of compensa- Third, opponents may also argue that tion encourages risk-taking, regulators bankers will flee–that is, pay regulation should monitor the bank more closely will drive talent away, and ½nancial and should consider raising its capital ½rms will lose valuable employees. As I requirements. stressed, however, regulation of pay in ½nancial ½rms should focus on pay struc- Before concluding, it is necessary to re- tures, not on limiting compensation lev- spond to the main objections that could els. (Prudential regulation may, of course, be raised against a government role in impose such limits to the extent that this area. First, pay regulation in banks compensation level might result in cash could be opposed on grounds that it’s outflows that would leave the bank with the shareholders’ money; the government insuf½cient capital.) Indeed, the bill does not have a legitimate interest in passed by the House of Representatives, telling bank shareholders how to spend and the Federal Reserve Board’s proposed their money. Choices of compensation guidance, explicitly rules out intervention structures, it might be argued, inherently in pay levels. Thus, to the extent that the belong to the province of private busi- use of pay structures that eliminate per- ness decisions where regulators should verse incentives would be less attractive not trespass. This objection is not per- to some executives, banks would be able suasive, however, because the govern- to compensate those executives with ment does have a legitimate interest in higher levels of expected pay. Even when the compensation structures of private such an increase proved necessary, how- ½nancial ½rms. Given the government’s ever, providing more ef½cient incentives interest in the safety and soundness of would be worthwhile. the banking system, intervention here would be no less legitimate than the gov- To reduce the likelihood of future ½nan- ernment’s established involvement in cial crises, we should not only constrain limiting banks’ investment and lending what banks may do but also pay close decisions. attention to the incentives provided to Second, opponents of regulating exec- the executives who will make choices utive pay in banks could also argue that within these constraints. There are sim- regulators know less–that is, regulators ple but useful ways to induce executives will be at an informational disadvantage to focus on long-term rather than short- when setting pay arrangements. But the term results, and to take into account the knowledge required of regulators to consequences of their decisions for all effectively limit compensation structures those contributing to the bank’s capital, that incentivize risk-taking would be no rather than only for shareholders. Mon-

Dædalus Fall 2010 59 Lucian A. itoring and encouraging such compensa- ulators. Fixing bankers’ pay would reduce Bebchuk tion structures should be an important the likelihood and costs of future ½nan- on the ½nancial instrument in the toolkit of ½nancial reg- cial crises. crisis & economic policy endnotes 1 See Leaders’ Statement: The Pittsburgh Summit, September 24–25, http://www.pittsburgh summit.gov/mediacenter/129639.htm. 2 Lucian A. Bebchuk and Jesse M. Fried, “Paying for Long-Term Performance,” University of Pennsylvania Law Review 58 (2010): 1915–1960; Lucian A. Bebchuk and Holger Spamann, “Regulating Bankers’ Pay,” Georgetown Law Journal 98 (2) (2010): 247–287; Lucian A. Bebchuk, “Fixing Bankers’ Pay,” The Economists’ Voice (November 2009). 3 Lucian A. Bebchuk, written testimony, hearing on compensation in the ½nancial industry, January 22, 2010, Committee on Financial Services, U.S. House of Representatives; Lucian A. Bebchuk, written testimony, hearing on compensation structures and systemic risk, June 11, 2009, Committee on Financial Services, U.S. House of Representatives. 4 Lucian A. Bebchuk and Jesse M. Fried, Pay without Performance: The Unful½lled Promise of Executive Compensation (Cambridge, Mass.: Harvard University Press, 2004). 5 Jeffrey Friedman, “Bank Pay and the Financial Crisis,” The Wall Street Journal online, Sep- tember 28, 2009; Floyd Norris, “It May be Outrageous, But Wall Street Pay Didn’t Cause this Crisis,” The New York Times, July 31, 2009. 6 Lucian A. Bebchuk, Alma Cohen, and Holger Spamann, “The Wages of Failure: Execu- tive Compensation at Bear Stearns and Lehman 2000–2008,” Yale Journal on Regulation 27 (2010): 257–282. 7 All dollar ½gures are in 2009 dollars. 8 Bebchuk and Fried, “Paying for Long-Term Performance.” 9 Carr Bettis, John Bizjak, and Swaminathan Kalpathy, “Insiders’ Use of Hedging Instru- ments: An Empirical Examination,” unpublished manuscript (March 2010), http://ssrn .com/abstract=1364810. 10 See testimony of Kenneth R. Feinberg, the Special Master for tarp Executive Compen- sation, before the House Financial Services Committee, February 25, 2010, http://www .ustreas.gov/press/releases/tg565.htm. Feinberg reports that one of the principles incorporated in evaluating pay at subject ½rms was that “employees should be prohibited from engaging in any hedging, derivative or other transactions that undermine the long-term performance incentives created by a company’s compensation structures.” 11 Bebchuk and Spamann, “Regulating Bankers’ Pay.” 12 Lucian A. Bebchuk, “The Case for Increasing Shareholder Power,” Harvard Law Review 118 (2005): 833–914; Lucian A. Bebchuk, “Letting Shareholders Set the Rules,” Harvard Law Review 119 (2006): 1784–1813; Lucian A. Bebchuk, “The Myth of the Shareholder Franchise,” Virginia Law Review 93 (2007): 676–732.

60 Dædalus Fall 2010 Nolan McCarty, Keith T. Poole, Thomas Romer & Howard Rosenthal

Political fortunes: on ½nance & its regulation

The ½nancial crisis of 2008, as well as particular. Policy is swayed by the self- many earlier crises, had an important interest of ½nancial ½rms and, more political dimension.1 Government not broadly, creditors and debtors. So- only failed to intervene to restrain a bub- called independent regulators, includ- ble but also directly abetted the expan- ing the Federal Reserve, respond not sion of the bubble. After the bubble only to their own ideology and exper- popped, political considerations limited tise but also to elected of½cials with and delayed appropriate policy changes. political power over them. Both during and after bubbles, politi- The crisis of 2008 followed the latest cal outcomes reflect the same forces that in a long history of real estate bubbles operate in normal times. Such forces in- in the United States. Bubbles often spill clude decision-making based on ideolo- over into other sectors, so that a pop in gies: free market conservatism, egalitarian asset bubble frequently engenders a anism, and populism. Political decisions banking crisis. (and non-decisions) also reflect checks and balances across branches of the fed- Before 2008, the most recent example eral government and across layers of of a real estate bubble’s devastating ef- government in a federal system, as well fect on ½nancial institutions was the sav- as institutional checks, such as bicamer- ings and loan (S&L) crisis of the 1980s. alism and ½libusters. Interests favoring This earlier crisis differed in important current arrangements bene½t from the respects from the 2008 crisis. First, the status quo bias inherent in our political political system was substantially less institutions. How these forces operate is polarized than it is today. Second, the greatly influenced by how ideology has economic shock was much smaller. contributed to polarization between the These two factors contributed to a less two major political parties. contentious eventual resolution of the These forces are part of the normal crisis. Moreover, the crash in real estate flow of politics in our democracy. Politi- prices at that time was much more geo- cians respond to the politically active– graphically concentrated than in the campaign contributors and lobbyists in 2000s, and the thrifts (as the ½rms in the S&L industry were called) were more © 2010 by the American Academy of Arts Main Street than Wall Street. Nonethe- & Sciences less, the interaction between the ½nan-

Dædalus Fall 2010 61 Nolan cial and the political sectors strongly junk bonds, and other risky invest- McCarty, foreshadowed the events of 2008.2 ments.3 Moreover, the fslic was not Keith T. S L Poole, Prior to the late 1970s, the & s had a granted additional funding authority, Thomas specialized niche: for the most part, they which ensured a policy of regulatory Romer & Howard took in short-term deposits and offered forbearance against failing thrifts. Rosenthal long-term ½xed-rate mortgages. Trouble The pro½tability of some S&Ls tempo- on the might arise if the interest they had to pay rarily improved. But the extra risk-taking ½nancial crisis & to attract depositors rose above the rates encouraged by regulatory forbearance economic on older mortgages, but market condi- soon took its toll. By 1987, the magnitude policy tions and government regulation of de- of the industry’s insolvency problem had posit interest rates helped S&Ls avoid increased dramatically, yet political ac- the potential losses that might result tion enshrined continued regulatory for- from a mismatch between the short and bearance by extending the use of lenient long terms. A serious mismatch did arise accounting rules and weakened capital after the ½nancial innovation of money standards. At the same time, legislation market mutual funds in the 1970s; the reaf½rmed the “full faith and credit” funds drew deposits away from S&Ls backing of fslic-insured deposits with- and eroded their pro½tability. out providing the agency additional ½- The interest rate mismatch became nancing authority to act aggressively critical as a consequence of the abrupt against the owners of essentially bank- increase in interest rates initiated by rupt S&Ls.4 Equity holders and manage- the Volcker Fed and the ensuing severe ment in such insolvent ½rms bore vir- recession of 1981 to 1982. Real estate val- tually no downward risk. But, as long ues collapsed, especially in the Oil Patch as they were allowed to operate, they and the Farm Belt. By 1982, more than would bene½t from any success of risky two-thirds of the thrifts had become gambles that restored pro½tability.5 unpro½table. In the aggregate, the S&L These “zombie thrifts” continued to industry had negative net worth by the stay open, making increasingly risky regulatory capital standards of the time. bets as they gambled for resurrection. The industry’s regulator, the Federal Congress and the White House opted Home Loan Bank Board (fhlbb), rec- for forbearance for two related reasons. ognized the situation; however, the de- First, ending the S&L debacle required posit insurer, the Federal Savings and an unplanned and unbudgeted expendi- Loan Insurance Corporation (fslic), ture. The funds could come either from had insuf½cient funds to shut down the assessments on the industry or from insolvent S&Ls. general government taxes and borrow- The political response to the severe ing. Sick thrifts had a strong interest in economic shocks facing the thrifts continued forbearance; the remaining was to relax regulatory standards and healthy thrifts resisted the additional expand the scope of assets that thrifts fees that they may have been assessed could hold. The key elements of the under a recapitalized fslic. The imme- legislation affecting S&Ls in the early diate bene½ciaries of lax regulation were 1980s were deregulating interest rates; politically active. They pressed elected allowing for adjustable-rate mortgages of½cials to support their case with the (arms); and permitting S&Ls to ex- regulators and in framing legislation. pand their loan products from home There was no signi½cant constituency mortgages to commercial real estate, in favor of confronting the full magni-

62 Dædalus Fall 2010 tude of the S&L problem when it was longed it. The media coverage of the Political still relatively small, or of curtailing– S&L crisis in full bloom focused on fortunes: on ½nance rather than extending–forbearance. colorful stories of malfeasance and al- & its regu- Importantly for connecting the dots to leged political corruption (most nota- lation the current crisis, these looser regula- bly Charles Keating of Lincoln Savings tions remained in effect even after the and Loan and his ½ve senators, includ- S&L meltdown. ing future presidential nominee John Second, incumbents of both parties McCain). But the true highlight tape were concerned that dealing with the should recognize that most of the S&L crisis through a large recapitalization gambles were completely legal actions of fslic would look like a bailout and in the regulatory environment created would be unpopular with the voters by elected of½cials responding to inter- in the November 1988 elections. Both est-group pressures and to electoral parties supported banking deregula- concerns with the mass public. tion and regulatory forbearance. Even though experts both inside and outside The resolution of the S&L debacle did the Beltway widely recognized the grav- not include tightening the looser regu- ity of the S&L industry’s situation, the lation of interest rates and other dimen- candidates mostly avoided discussing sions of the home mortgage industry. the crisis during the presidential elec- Not surprisingly, then, ½nancial markets tion campaign. witnessed an explosive growth of ½nan- By early 1989, the need to shut down cial innovation in a generally permissive failed S&Ls and to recapitalize the deregulatory environment. Before the 2008 posit insurance fund could no longer be meltdown, this ½nancial innovation was put off. Relatively rapid congressional generally seen as a positive force that de- action produced the Financial Institu- livered real bene½ts. The pace of innovations Reform Recovery and Enforce- tion accelerated during a period of glob- ment Act of 1989 (firrea), which Pres- al economic growth and, in particular, ident Bush signed that August. firrea the American economic ascendancy of led to a bailout of depositors and dispos- the 1990s. Financial sector pro½tability al of the assets of failed thrifts by a new rose and ½nancial sector pro½ts became entity, the Resolution Trust Corporation a much larger share of total corporate (rtc). The fhlbb was folded up and a pro½ts. Financial sector wages increased new regulator, the Of½ce of Thrift Super- much faster than wages in other sec- vision (ots), put in place. The ots rep- tors.7 Highly skilled individuals flocked resented a soft reform: by the 2000s, it to ½nancial engineering. was a regulatory venue of choice for mort- While the ½nancial sector often attrib- gage institutions seeking to escape the uted this innovation and growth to the stricter regulatory arm of the Fed. A con- virtues of unbridled capitalism and free cession to the industry in 1989, ots in markets, the shadow of politics was nev- more recent years accommodated the er far behind. First, much of this innova- likes of Washington Mutual, IndyMac, tion was designed to create instruments and aig.6 that would optimize pro½ts around reg- In brief, unintended consequences of ulatory constraints. Notably, banks in- ½nancial innovation and deregulation vented off-balance-sheet vehicles that produced a crisis; interest-group politics created leverage without violating the and populist abhorrence of bailouts pro- Basel I capital requirements.8

Dædalus Fall 2010 63 Nolan Second, the importance the industry cratic Party, which had majorities in McCarty, placed on maintaining a favorable po- both the House and the Senate. Follow- Keith T. Poole, litical environment is underscored by ing the 1994 elections, there was a large Thomas a massive increase in political involve- shift in contributions to the newly em- Romer & Howard ment. Between 1992 and 2008, political powered Republicans. Following the Rosenthal campaign contributions from the ½nan- Democratic takeover of Congress in on the cial sector nearly tripled, even after ad- 2006, the money switched back to ½nancial crisis & justing for inflation. (Only the legal pro- about where it was in the early 1990s. economic fession had a faster growth rate of con- But even during the period when it policy tributions.) The current magnitude of had relatively little power in Washing- giving is also remarkable. Four subsec- ton, the Democratic Party did well with tors of ½nance (securities and invest- the securities and real estate industries. ments, real estate, insurance, and mis- From the party’s perspective, ½nance cellaneous ½nance) are now in the top makes an almost ideal money wing ten of all industry contributions, and (almost as good as Hollywood). Unlike two of them (securities and investments, many other industries with potential real estate) have dominated the growth claims on political attention, ½nancial in contributions.9 sector ½rms do not pollute the environ- Although Republicans and Demo- ment (at least not directly) and do not crats both have been blessed with con- have especially contentious labor rela- tributions from the ½nancial sector, the tions. During normal times and during implications for the Democratic Party economic booms, these facts make for have been especially signi½cant. Over much less conflict with other Democrat- the past forty years, voting behavior ic constituencies like environmentalists and partisan identi½cation in the Unit- and labor unions. Of course, an ideal ed States have become highly structured alliance in good times is not necessarily by income. The Republican Party has one that can survive a bust. fared somewhat better among voters with middle income and higher, while In a Washington epitomized by Alan the Democratic Party has received the Greenspan’s nearly nineteen-year tenure majority of the votes from those with as Fed chairman, regulatory constraints lower incomes.10 But even as the Dem- were viewed in a dim light. There was ocrats were depending more heavily either bipartisan support for a hands-off on the votes of lower-income citizens, policy or lack of a winning coalition that the party came to rely more on the ½- would revamp regulation to address a nancial resources of wealthier support- new and highly complex environment. ers and interest groups. Consequently, Indeed, a considerable amount of ½nan- the Democratic Party now has two dis- cial deregulation occurred through agen- tinct wings: the “money wing” and the cy decisions and legislation during the “votes wing.” The ½nancial services sec- Clinton administration. In 1998, Brook- tor has become an increasingly impor- sley Born, Clinton’s appointee as chair tant part of the money wing. of the Commodity Futures Trading Com- Like many corporate contributors, the mission (cftc), proposed regulating ½nancial sector tends to shift its campaign off-exchange trades in swaps and other contributions based on which party con- derivatives. Her initiative was shot down trols Congress. From 1987 to 1994, a ma- by Greenspan, Treasury Secretary Robert jority of the money went to the Demo- Rubin, Deputy Secretary Larry Summers,

64 Dædalus Fall 2010 and Securities and Exchange Commis- premise–that accounting ½rms, Wall Political sion (sec) Chairman Arthur Levitt. Street analysts, and rating agencies would fortunes: on ½nance The Commodity Futures Moderniza- provide unbiased and transparent infor- & its regu- tion Act of 2000 (cfma)–passed by mation to investors–was false. None- lation an overwhelming 377 to 4 roll-call vote theless, the spirit of deregulation contin- in the House and a voice vote in the Sen- ued relatively unabated. Much like fir- ate–codi½ed the marginal role of the rea, the Sarbanes-Oxley Act (2002) did cftc and facilitated active expansion not address forms of accounting arbi- of over-the-counter derivatives markets. trage, such as off-balance-sheet vehicles Previous executive and deregulatory that avoided capital requirements, em- measures of the ½nancial sector culmi- ployed by ½nancial institutions as they nated in the Financial Services Modern- marched toward the 2008 crisis. During ization Act of 1999, which also passed the George W. Bush administration, the with large bipartisan majorities.11 It re- sec essentially eliminated its capacity pealed the Glass-Steagall Act of 1933, to inspect investment banks and weak- which had separated commercial banks, ened its enforcement.14 Ignoring the investment banks, and insurance com- warning signals of the turn of the centu- panies; it also explicitly prohibited the ry was facilitated by continued econom- sec from regulating securities-based ic growth. The crisis of 2008 arrived in swap agreements. During the decades an environment where most ½nancial when these boundaries were contested, transactions were unregulated and reg- commercial banks, investment banks, ulated activities were largely unmoni- and insurance companies were frequent- tored. ly on different sides of disputes over ½- nancial regulation. The eventual ero- By 2000, the foundation had been laid sion of legal and regulatory boundaries for a housing market bubble that would between segments of the ½nancial sec- reflect the alignment of two disparate tor also removed some of the political ideologies: free market conservatism conflicts over economic turf within the and redistributive egalitarianism. The sector. As deregulation took these is- foundation consisted of a crazy quilt sues off the table, previously separated of legislative, executive, and judicial de- parts of the sector now had more close- cisions in the 1980s and 1990s that are ly aligned interests.12 overwhelming in their details. A brief The turn of the century was not with- recap would note that (1) a variety of ½- out warning that deregulated ½nancial nancial institutions were permitted en- markets posed dangers. The collapse of try into various loan and insurance mar- the hedge fund ltcm in 1998 revealed kets, (2) usury laws were stripped away, the potential for global contagion and and (3) the ability of states to regulate systemic risk. A second warning shot ½nancial products, like credit cards, of- was ½red in 2001 with the failure of En- fered by out-of-state ½rms was largely ron, WorldCom, and other ½rms with eliminated while other features, such accounting scandals. It became apparent as loan-to-value limits, remained with that the speci½cs of deregulation were the states. States could also compete in designed to bene½t ½nancial and corpo- the chartering of banks. The result was rate interests–such as the “Enron loop- the expansion of predatory lending prac- hole” in the cfma.13 There was also evi- tices, loans that would be quickly under- dence that deregulation’s fundamental water if housing prices declined, and

Dædalus Fall 2010 65 Nolan another round of “zombie” banking that an entitlement like food stamps and McCarty, encompassed institutions large–Wash- Medicare, political pressure and eco- Keith T. Poole, ington Mutual, for example–and small, nomic incentives encouraged lenders Thomas including forty Georgia banks eventually in the mortgage market to accomplish Romer & fdic 15 Howard forced into receivership by the . egalitarian goals. Promoting egalitari- Rosenthal A Republican twist to free market cap- anism through a market led by govern- on the italism was a belief in the political ad- ment-guaranteed enterprises Fannie ½nancial crisis & vantages of the “ownership society.” Mae and Freddie Mac appealed not economic In brief, homeowners were thought to only to the Democratic base but also policy be more likely to vote Republican than to highly compensated Democrats. The renters.16 The post-1980 support for ceo of Fannie Mae from 1991 to 1998 low- and moderate-income housing by was James Johnson, an executive assis- Republicans represented a historical tant to Vice President Walter Mondale, shift. In 1977, conservatives, supported member of the John Kerry vice presiden- by lenders, had mustered considerable tial selection team, and cashiered mem- backing for a Senate amendment that ber of the Obama vice presidential se- unsuccessfully sought to delete Title lection team.18 From 1998 to 2004, Fan- VIII, the Community Redevelopment nie Mae was headed by former director Act, from the housing bill that passed of the Of½ce of Management and Bud- that year. The later shift away from par- get during the Clinton administration, tisanship on housing policies came after Franklin Raines.19 Raines presided over the deregulation of the 1980s and 1990s Fannie Mae during a major accounting created a pro½table market in loans to scandal; his executive compensation low-income families.17 By the adminis- has been extensively criticized.20 tration of George H.W. Bush, there was Housing policy was one area largely bipartisan support for legislation such devoid of partisan conflict in an era as the National Affordable Housing Act characterized by highly polarized poli- (1990), which included a variety of initia- tics.21 The American Homeownership tives directly aimed at expanding home- and Economic Opportunity Act of 2000 ownership among low-income house- –directed at easing the ½nancing of mort- holds, and the Federal Housing Enter- gages, including reverse mortgages, and prises Financial Safety and Soundness increasing ½nancial assistance for home- Act (1992), which set minimum percent- ownership by the poor, elderly, and dis- age-of-business targets for Fannie Mae abled–was passed by voice vote in the and Freddie Mac purchases of mortgages House and unanimous consent in the issued to low-income households. Senate. The American Dream Downpay- On the Democratic side, redistributive ment Act of 2003 was passed by unani- egalitarianism sought to increase home- mous consent in the Senate and without ownership among the poor and minori- objection in the House.22 President Bush ties. Fannie Mae stated in its 2003 Annu- enthusiastically signed the act into law, al Report, “[A]s long as there is a gap in as a measure that would build the “own- minority and non-minority homeowner- ership society” by providing “$200 mil- ship rates, Fannie Mae and Countrywide lion per year in down payment assistance will continue to make sure all Americans to at least 40,000 low-income families.”23 have the chance to realize the dream of Both “American” acts relaxed standards homeownership.” While it was not polit- for lenders. In contrast to these measures ically feasible to make homeownership directed at expanding homeownership,

66 Dædalus Fall 2010 from 2000 to 2006 only one of sixteen vote on ½nal passage in the House showed Political legislative bills aimed at curbing pred- a sharp ideological split, with unanimous fortunes: on ½nance atory lending and enforcing other as- support from Democrats, support from & its regu- pects of consumer protection passed more moderate Republicans, and oppo- lation the House; none passed the Senate; and, sition from conservative Republicans. of course, none became law. Lobbying Salient local issues can at times trump against these bills came disproportion- ideology, lobbying, and contributions ately from riskier lenders that originat- from out-of-constituency interests. In ed mortgages with high loan-to-income the ahrfpa case, Republican House ratios, used securitized instruments, and members also proved sensitive to the had fast-growing mortgage loan portfo- extent of foreclosures in their districts, lios.24 As in the S&L ½asco, lenders in especially foreclosures in Republican the weakest economic condition were voting areas of the districts.26 ahrfpa, most likely to lobby against regulatory however, left so much discretion to lend- constraints.25 ers that it did little to avoid foreclosures. The bubble de½nitively popped with The “What, me worry?” approach to the failure of Lehman Brothers in Sep- regulation had been made possible by tember 2008. Political circumstances the agreement of free market capitalists strongly influence how the executive and redistributive egalitarians on policy and regulatory branches handle a pop. in the mortgage market. This coalition The S&L crisis did not endanger the en- was blown apart by the unraveling of the tire economy; for electoral considera- housing bubble that preceded the ½nan- tions, both the Reagan administration cial crisis. Housing prices started to fall and the Democrat-controlled Congress in 2006, subprime mortgage bonds plum- chose to sweep the crisis under the rug meted in early 2007, and residential fore- in 1987–1988. It is instructive to com- closures accelerated. Dealing with the pare the 2008 crash with the stock mar- foreclosure problem meant moving from ket crash of October 1929 that occurred the “win-win” scenario of the pumped- just seven months into the four-year up housing market to the hard choices term of Herbert Hoover. His adminis- involving helping borrowers through an tration, largely personi½ed by Treasury on-budget bailout or forcing lenders to Secretary Andrew Mellon, responded take a haircut via a moratorium or an passively. In a European parliamentary imposed reduction in either principal system, Hoover would not have been or interest. expected to survive for four years. The Making these choices took place in a American institution of four-year terms far more polarized political environment may well have contributed to the sever- than was present at the time firrea re- ity of that crisis. (The Democrats did solved the S&L crisis. Partisan “blame capture the House in the 1930 midterm game” politics prevailed over any grand elections.) crisis coalition in the national interest. In contrast to the setting of the Depres- The ½rst move in this game was the Amer- sion, the crisis of 2008 occurred less than ican Housing Rescue and Foreclosure two months before an election and less Prevention Act (ahrfpa), signed into than four months before the inaugura- law by George W. Bush in July 2008, after tion of the new president. Not only was he had threatened to veto an earlier bill the incumbent president a lame duck, passed by the House in May. The July his presidency was tarnished by Iraq

Dædalus Fall 2010 67 Nolan and other events. Bush had very limited Scott Brown, demanded and obtained McCarty, sway over Republicans in a Democrat- modi½cations to the conference report Keith T. Poole, controlled Congress. In the push for the on the 2010 reform bill. The modi½ca- Thomas ½nancial reform bill that passed in July tions bene½ted such ½nancial institu- Romer & Howard 2010, President Obama was out front, tions as State Street Corporation and Rosenthal with Treasury Secretary Geithner in a Fidelity Investments, headquartered in on the supporting role and Fed Chairman Ber- Brown’s home state of Massachusetts.27 ½nancial crisis & nanke largely off-stage. But when the Not only is polarization problematic in economic housing bubble popped, Treasury Secre- initial reform efforts, the gridlock it pro- policy tary Henry Paulson and Bernanke were duces impedes the routine legislative front and center. In the absence of pres- maintenance required for a robust regu- idential leadership, Paulson and Bernan- latory environment.28 Any reform legis- ke were especially concerned that their lation that may be forthcoming will un- actions be legitimated by Congress–or doubtedly need such future ½ne-tuning. at least not overly attacked. The ½nancial markets’ response to the initial failure of Ideally, regulators would have the re- the Troubled Asset Relief Program bill sources and expertise to monitor close- (tarp, “the bank bailout”) showed that ly developments in the regulated sector those markets could be roiled by either and the incentive to promulgate and im- the capitalist right, ½xated on moral haz- plement policies that are in the public’s ard, or by the progressive left, bothered interests. The conditions for such regu- by the distributional implications of a latory performance are hard to meet in bailout. any domain, but the problem of regula- Opposition from both extremes of the tory capacity is particularly acute in the liberal-conservative spectrum, reelec- case of ½nancial regulation. tion concerns, and a proposal from a Re- The most obvious dif½culty stems publican administration facing a Demo- from the complexity of modern ½nance. cratic Congress combined to blur ideo- Armies of rocket scientists are employed logical voting on the tarp bill in Fall to develop and implement increasingly 2008. When the auto bailout bill was complicated ½nancial products and trad- voted on in December, there was strong ing strategies. Many of the products are ideological polarization, a pattern that not well understood by Wall Street ex- reached perfection when the stimulus ecutives, much less outside regulators. bill was considered early in the Obama This problem might be mitigated some- administration. In the House, there was what if the regulatory agencies could perfect party separation, except for six, easily draw from the same talent pool as nonpivotal Democrats who were “al- Wall Street. But the salary differentials lowed” to defect. In the Senate, there make this dif½cult. The highest paid ½- was perfect ideological separation; the nancial regulators (the president of the administration made just enough con- New York Fed and the chairman of the cessions to buy the votes of the three Fed) make a fraction of a middling trad- least conservative Republicans: Arlen er’s annual bonus. Even where regulato- Specter, Olympia Snowe, and Susan ry agencies can hire individuals with the Collins. This pattern, likely to reappear background to understand the intrica- on all aspects of ½nancial reform, was cies of modern ½nance, such individuals again manifest when Edward Kennedy’s are usually on their way from or their replacement, moderate Republican way back to Wall Street. Such a revolving

68 Dædalus Fall 2010 door undermines the autonomy of regu- ulators (such as the creation of the Of½ce Political latory agencies from the industry they of Financial Research in Treasury) and fortunes: on ½nance are supposed to regulate. Even if such by enhancing accountability mechanisms & its regu- regulators are not motivated by a future (especially those relating to the Federal lation Wall Street payout, they may still be in- Reserve, including presidential appoint- clined to share Wall Street’s worldview. ment of the head of the New York Fed The most direct implication of low reg- and restriction of the Fed’s emergency ulatory capacity is that it will be hard lending authority with increased over- to sustain a regulatory regime that de- sight by the Government Accountabili- pends too heavily on the delegation of ty Of½ce). But there are strong reasons discretionary power to regulators. This to believe that these reforms by them- concern speaks directly to the debate selves will not signi½cantly improve ½- about whether a council of super-regula- nancial regulation. Better information tors can monitor the ½nancial sector for and policy analysis can go only so far if emerging systemic risks and react effec- agencies lack the resources to act effectively with new capital requirements, tively on that information and analysis. leverage limits, or conversion of contin- The lack of expertise and information gent bonds. Such a system requires that also reduces the value of increasing regu- regulators have very high levels of infor- latory capacity. Why increase the ability mation and expertise as well as the in- of an agency to implement uninformed centive to act in ways that may be ad- policies? Expertise and capacity are com- verse to the ½nancial services industry. plements; this creates a bureaucratic The recognition of low capacity argues “reform trap.”29 against sophisticated discretionary regu- A reform trap also exists with respect latory management of the industry and to improving oversight and account- in favor of blunter approaches such as ability. Investing in greater oversight of banning the most systematically danger- agency decisions is most valuable when ous products and practices or capping the links between agency policy and out- the size of ½nancial institutions. Blunter, comes are the most transparent, because less complex, and less lengthy legislation it is then easier to detect policies Con- would not only reduce opportunities for gress does not approve of. Since low ca- ½nancial innovators to ½nd loopholes pacity distorts the relationship between but also focus the attention of regulators. policies and outcomes, more oversight is Beyond the technical problems that not very helpful. Conversely, when over- plague low-capacity agencies, there is sight mechanisms are poor, raising ca- important political feedback. Low capacity is not very valuable since the po- pacity makes it harder to hold agencies litical overseers do not bene½t from the accountable to congressional and presi- increased transparency of the policy- dential oversight because it is harder to outcome link. Reforms, therefore, might distinguish between bad policies and well consider restrictions on ½rm behav- poor implementation. This may cause ior that would simplify rather than ex- elected leaders to be reluctant to endow pand regulatory authority. For example, agencies they cannot control with sub- a relatively limited (and visible) menu stantial discretionary power. of exchange-traded derivatives might Recently enacted legislation strives to be preferable to a giant (but semi-secret) mitigate these problems by strengthen- smorgasbord of over-the-counter spe- ing the informational capabilities of reg- cial orders. Similarly, bank supervision

Dædalus Fall 2010 69 Nolan might bene½t from the Volcker Rule, ulatory reform legislation, many of the McCarty, which, among other things, would pro- key decisions will be made by regulators Keith T. Poole, hibit banks from running private-equity months and years afterward–when ½- Thomas and hedge funds. nancial regulation is not nearly so salient Romer & Howard –and therefore can be expected to be Rosenthal Although the current economic situ- much more deferential to the industry on the ation is much more complex than that than the spirit of the legislation. ½nancial crisis & of the S&L crisis, there are some simi- Second, because political polarization economic larities. There is conflict between large appears to decline and rise with income policy and small banks and between interests inequality,31 and income inequality in that were cashiered (Lehman Brothers, turn partly reflects the strong increase Washington Mutual) and those that in ½nancial sector pro½ts and income,32 were rescued (Citicorp, Bank of Ameri- future efforts at dealing with U.S. ½nan- ca). Both crises were influenced by regu- cial crises are likely to continue to occur latory venue shopping. Existing regula- in a highly polarized environment. Po- tors have fought to maintain their turf, larization inhibits timely and effective without regard to competency. Both responses, both by causing legislative crises were influenced by “zombie seek- gridlock and by increasing the willing- ing” of high returns without due regard ness of those out of power to block all to risk. The reluctance to deal with the change until they get back in, rather S&L crisis when the 1988 elections were than compromise on centrist policies. on the horizon appears to be paralleled Intensive lobbying from affected inter- by a failure to address reform of Fannie ests further reinforces ideological op- Mae and Freddie Mac before the 2010 position. elections. More generally, the inadequa- Third, ½nancial markets are now cy of the S&L reforms gives pause as to extremely complex, with myriad prod- the effectiveness of the recently passed ucts. Regulatory incentives, staffs, and Dodd-Frank Wall Street Reform and budgets are not aligned toward success- Consumer Protection Act. ful monitoring and enforcement.33 Con- There are several dif½culties in the sequently, even if ½nancial products are political process and in a “regulatory- limited and regulated, private parties ½nancial complex” that present severe will continue to innovate within the hurdles to effective regulation of the ½- constraints of existing regulation. Tech- nancial sector. First, we should keep in nological change, as in data processing mind an observation made by the polit- and mathematical models, will bring ical scientist E. E. Schattschneider: in forth innovations. Regulators, in con- normal times, policy reflects the balance trast, are unlikely to be proactive with of political clout among moneyed inter- respect to innovations. ests; but if an issue becomes broadly sa- Fourth, there is a taboo against rigor- lient, as after an economic crisis, then ous enforcement. In his remarks at the all bets are off. Politicians care about be- Pittsburgh G20 meeting in 2009, Presi- ing reelected, so if the “folks” get upset dent Obama spoke of the ½nancial cri- the politicians will cater to their wishes sis as the result of the “reckless few.” (or at least what the politicians perceive After Enron and WorldCom, President these to be). Once an issue sinks back Bush claimed “a few bad actors can tar- below the surface, the moneyed interests nish our entire economic system.” And reassert themselves.30 With the new reg- following the Panic of 1907, President

70 Dædalus Fall 2010 Roosevelt comforted the public by de- Cohen, Reagan White House advisor Political claring, “Dishonest dealing and specu- and Harvard economist Martin Feld- fortunes: on ½nance lative enterprise are merely the occasion- stein, Ford Housing and Urban Devel- & its regu- al incidents of our real prosperity.”34 opment Secretary and Bush trade rep- lation Once the immediate crisis has passed, resentative Carla Hills, Ford “energy there is little continued political payoff czar” Frank Zarb, American Museum in either stating or acting on the premise of Natural History President Ellen Fut- that most of those in the ½nancial sector ter, and public television executive will, at best, bend the rules as much as George Miles. Feldstein, Futter, Hol- they can and push politicians to get rid brooke, Miles, and Zarb served on the of the rules when the rules are incon- board for all or part of the years 2005 venient. to 2008. Over that period, their individ- Finally, not only have ½nancial mar- ual compensation as director ranged kets become more interconnected, so from $792,000 to $1,136,000.35 Again, have the worlds of ½nance, politics, phi- once the crisis is past, criticism of the lanthropy, and academia. For example, ½nancial sector from government, aca- the outside directors of aig between demia, and nonpro½ts is likely to be 2005 and 2008 included Obama and muted. We appear to be stuck with the Clinton diplomat Richard Holbrooke, regulatory-½nancial complex. Clinton Defense Secretary William endnotes 1 Poole thanks his colleagues at the University of Georgia for offering many helpful comments. Romer is grateful to the United States Studies Centre at the University of Sydney, where he was on sabbatical leave during the North American winter months of 2010, for its gracious hospitality. It was an excellent environment for stimulating conversations about the global ½nancial crisis. Rosenthal thanks his colleagues at the California Institute of Technology in the spring quarter of 2010, especially Peter Bossaerts and Jean-Laurent Rosenthal, for discussion and comments, as well as participants in conferences at Colum- bia University and Università Cattolica del Sacro Cuore. 2 Our summary of the politics of the S&L crisis is based on Thomas Romer and Barry R. Weingast, “Political Foundations of the Thrift Debacle,” in Politics and Economics in the 1980s, ed. Alberto Alesina and Geoffrey Carliner (Chicago: University of Chicago Press, 1991). 3 The two principal pieces of legislation were the Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn-St. Germain Depository Institutions Act of 1982. 4 Competitive Equality Banking Act of 1987. 5 See David H. Pyle, “The U.S. Savings and Loan Crisis,” in Handbooks in Operations Research and Management Science, vol. 9, Finance, ed. Robert A. Jarrow et al. (Amsterdam: Elsevier, 1995). 6 The rtc is now generally thought to have done a good job, though it had some rocky years. In disposing of the assets of failed thrifts, the rtc faced conflicting political mandates (including social policy objectives such as minority contracting and affordable housing, as well as getting the highest value for the assets). See Lee Davison, “The Resolution Trust Corporation and Congress, 1989–1993. Part II: 1991–1993,” fdic Banking Review (2006), http://www.fdic.gov/bank/analytical/banking/2007apr/article1/index.html.

Dædalus Fall 2010 71 Nolan 7 Thomas Philippon and Ariell Reshef, “Wages and Human Capital in the U.S. Financial McCarty, Industry: 1909–2006,” nber working paper 14644 (National Bureau of Economic Keith T. Research, 2009). Poole, Thomas 8 See Markus K. Brunnermeier, “Deciphering the Liquidity and Credit Crunch 2007–08,” Romer & Journal of Economic Perspectives (Winter 2009). Howard 9 Rosenthal Lawyers and law ½rms, considered a separate industry, contributed $126 million in 2008. on the Many of these contributors may also have had interests in ½nancial sector regulation. ½nancial 10 crisis & See Nolan McCarty, Keith T. Poole, and Howard Rosenthal, Polarized America: The Dance economic of Ideology and Unequal Riches (Cambridge, Mass.: mit Press, 2006). policy 11 The law is more commonly known as the Gramm-Leach-Bliley Act, after its three Repub- lican cosponsors. 12 See Luigi Zingales, “Capitalism After the Crisis,” National Affairs (Fall 2009): 30–31. 13 Certain energy derivatives contracts were exempt from regulation by the cftc. One of these exemptions was for trades conducted over electronic trading platforms such as the one developed by Enron; hence, the “Enron loophole.” See Mark Jickling, “The Enron Loophole,” report RS22912 (Congressional Research Service, 2008). 14 Ross Levine, “An Autopsy of the U.S. Financial System,” nber working paper (National Bureau of Economic Research, April 2010). 15 http://www.fdic.gov/bank/individual/failed/banklist.html (accessed July 21, 2010). 16 This belief extended to support for self-directed de½ned contribution pension plans and privatization of Social Security. 17 See Edward M. Gramlich, Subprime Mortgages: America’s Latest Boom and Bust (Washing- ton, D.C.: The Urban Institute Press, 2007), 5. 18 Johnson resigned his position on the selection committee after it was revealed that he received a loan on very favorable terms from Countrywide Financial Corporation, Fannie Mae’s largest mortgage provider and a key player in the subprime lending crisis. See John M. Broder and Leslie Wayne, “Obama Aide Quits Under Fire for His Business Ties,” The New York Times, June 12, 2008. 19 Clinton also named former Arizona Senator Dennis DeConcini to the Freddie Mac board, where he served from 1995 to 1999. DeConcini was one of the Keating Five and was formally criticized in 1991 by the Senate Ethics Committee for improperly interceding with the fhlbb on Charles Keating’s behalf. 20 See Lucian A. Bebchuk and Jesse M. Fried, “Executive Compensation at Fannie Mae: A Case Study of Perverse Incentives, Nonperformance Pay and Camouflage,” The Journal of Corporation Law (2005). 21 See McCarty, Poole, and Rosenthal, Polarized America. 22 Some conservative groups, such as the Heritage Foundation, opposed the bill as “½scally irresponsible.” See http://www.heritage.org/Research/Reports/2003/12/American-Dream -Downpayment-Act-Fiscally-Irresponsible-and-Redundant-to-Existing-Homeownership -Programs (accessed April 22, 2010). 23 See remarks of President George W. Bush, December 16, 2003, http://www.presidency .ucsb.edu/ws/index.php?pid=64935 (accessed April 22, 2010). 24 See Deniz Igan, Prachi Mishra, and Thierry Tressel, “A Fistful of Dollars: Lobbying and the Financial Crisis,” working paper 09/287 (International Monetary Fund, 2009). 25 The development of the subprime mortgage market can also be traced back to the deregulation of the early 1980s. Subprime mortgages were based on charging higher interest rates and offering arms to risky, often low-income and minority, borrowers. If borrowers had

72 Dædalus Fall 2010 been informed of the risks, then allowing for the “freedom to choose” among a wider va- Political riety of mortgage products would make sense. Instead, naive borrowers were faced with fortunes: predatory, fraudulent, and unsupervised mortgage originators. See Gramlich, Subprime on ½nance Mortgages. & its regulation 26 Conservative Republicans, ideologically opposed to government intervention, were less likely to be swayed by economic conditions in their districts than were their more moderate colleagues. See Atif Mian, Amir Su½, and Francesco Trebbi, “The Political Economy of the U.S. Mortgage Default Crisis,” American Economic Review (forthcoming). 27 Damian Paletta, “Finance Bill Close to Passage in Senate,” The Wall Street Journal, July 13, 2010. 28 For example, although Glass-Steagall is now often hailed as instrumental in maintaining ½nancial stability through the 1980s, the regulatory regime it created needed to be patched and extended by other important pieces of legislation, such as the Public Utility Holding Company Act of 1935, the Investment Act of 1940, and the 1956 Banking Act. 29 John Huber and Nolan McCarty, “Bureaucratic Capacity, Delegation, and Political Re- form,” American Political Science Review (2004). 30 Elmer Eric Schattschneider, The Semisovereign People: A Realist’s View of Democracy in America (New York: Holt, Rinehart and Winston, 1960). 31 McCarty, Poole, and Rosenthal, Polarized America. 32 Philippon and Resheff, “Wages and Human Capital in the U.S. Financial Industry.” 33 In the context of investigating the one thousand-point plunge of the Dow Industrial Aver- age on May 6, 2010, sec Chairman Mary Schapiro stated that “the technology for collecting data and surveilling our markets is . . . as much as two decades behind the technology currently used by those we regulate.” See “Warp-speed Trades Outpace sec,” Politico .com, June 1, 2010. 34 President Barack Obama, press conference, September 25, 2009, http://www.white house.gov/the-press-of½ce/remarks-president-g20-closing-press-conference; President George W. Bush, weekly radio address, June 29, 2002, http://www.whitehouse.gov/ news/releases/2002/06/20020629.html; President Theodore Roosevelt, October 24, 1907, in The Letters of Theodore Roosevelt, vols. 1–8, ed. Elting E. Morison (Cambridge, Mass.: Harvard University Press, 1952), 839, cited in Robert F. Bruner and Sean D. Carr, The Panic of 1907: Lessons Learned from the Market’s Perfect Storm (Hoboken, N.J.: Wiley, 2007). 35 From aig’s DEF14A ½lings, available at http://www.sec.gov. For 2006, 2007, and 2008 we used aig’s pricing of the value of stock grants and options. For 2005, we priced stock grants at the closing price on December 30, 2005. We did not include a value for 2005 stock options. Much of the value of stock awards was erased in the ½nancial crisis.

Dædalus Fall 2010 73 C.A.E. Goodhart

Lessons from the ½nancial crisis for monetary policy

The years preceding the ½nancial crisis this policy was termed “inflation tar- that began on August 9, 2007, were in getry.” Although policy in the United many respects the most economically States was managed in very much the successful in human history. These years same way as elsewhere, the objectives have been called the Great Moderation, for the Federal Reserve Board’s policy as output growth, inflation, unemploy- had been established earlier, in the ment, and interest rates stabilized at Humphrey-Hawkins Act of 1978, and comfortable levels and remained steady. included a requirement that the Federal Most developed countries experienced Reserve System maintain maximum sus- remarkably little volatility. Japan’s lost tainable output as well as stable prices. decade was an exception to the several In practice, this difference in stated other emerging Asian countries–espe- objectives made little difference to policy cially China, but also South Korea, India, outcomes. Changes in the rate of infla- and Indonesia–that grew even faster, tion are believed to be determined by taking millions out of poverty. whether output–otherwise called the Expert commentators awarded much of pressure of demand–is above the “nat- the credit for this improved performance ural” level the economy can generate to a new regime of monetary policy. In when employment/unemployment is at academia, the extent to which the bet- a normal level, or equilibrium. The mar- ter outcome was the result of good policy, gin between actual and equilibrium out- good luck (for example, the effect China’s put is called the output gap, though this entry into world markets had on limiting is not accurately measured, and there inflation), or yet other factors is still de- are continuous disputes about the size, bated. Under this new regime, a nation’s sometimes even the sign, of this gap. central bank raised interest rates when- Thus, whether a country (like most) ever inflation was forecast to rise above was an explicit inflation targeter or not a predetermined low target level, and (like the United States), the standard lowered them if inflation was expected operational behavior of central banks to fall below that level. Indeed, in most was essentially the same. Central banks countries–excepting the United States– raised interest rates whenever the output gap (actual minus equilibrium) was © 2010 by the American Academy of Arts positive and inflation was expected to & Sciences be above target. Rates were generally

74 Dædalus Fall 2010 calibrated by a Taylor reaction function, bility was under control, and a few, in- Lessons named for John Taylor, the Stanford cluding the Bank of England (BoE), even from the ½nancial University economist. In the Taylor deemphasized their ½nancial stability crisis for reaction function, the current interest divisions. Generally forgotten was the monetary rate decision responds to the output analysis, developed earlier by economist policy gap–as the gap will drive inflation fur- Hyman Minsky, that price and macro- ther up (or down) if output is assessed economic stability do not equate to ½- to be above (or below) its equilibrium nancial stability; rather, the former may level–and to the deviation of inflation have an inverse effect on the latter. Min- from its target level. sky argued that con½dence in ½nancial This policy relied on the general as- markets incentivizes ½nanciers to take sumption that as long as the monetary on additional leverage and more risk, authorities (that is, central banks) kept while sometimes failing to notice the the macroeconomy stable, then broad existence of such risks. Margins and li- and ef½cient ½nancial markets could be quidity ratios decline so much that when expected to monitor ½nancial stability. something goes wrong (such as the sub- Although most economies, including the prime mortgage crisis in 2007), the sys- United States, had remained remarkably tem lacks suf½cient equity and liquidity stable over the ½fteen years from 1992 buffers to absorb the loss and the system to 2007, experience had shown that even becomes overextended. Banks are forced in stable macroeconomic conditions, ½- to sell assets into unwilling markets in nancial markets can be subject to waves order to restore their own liquidity; these of optimism and pessimism, greed and sales so reduce the market value of other fear, bubble and bust. Indeed, the ½nan- banks’ assets that they, too, come under cial climate oscillated even during the pressure to sell their own assets. This Great Moderation: the information tech- scenario and similar factors converge nology (it) and nasdaq bubble-and- to amplify the collapse. Earlier serious bust cycles of 2000 and 2001 are the most ½nancial collapses (such as the Great recent and perhaps best remembered. Depression in 1929 and Japan’s collapse Prior to the start of the ½nancial crisis in the 1990s) were also preceded by per- in August 2007, the monetary authorities, iods of strong growth, enhanced con- notably the Fed, were able to defang the ½dence, and rising asset prices. “bust” in each case and limit its virulence Prior to the recent recession, more- by a program of quick and aggressive in- over, there had been a long-term trend terest rate reductions. These swift reac- of credit expansion growing faster than tions gave most people in ½nancial mar- retail bank deposits. Banks and invest- kets con½dence not only that the general ment houses had ½nanced the credit ex- economy would remain more stable than pansion by reducing holdings of public in the past, but also that any residual ½- sector liquid assets; relying more heavily nancial tremors would soon be righted by on (short-term) borrowing from whole- a vigilant and powerful Federal Reserve sale markets; and selling earning assets System; Chairman of the Federal Reserve to various other nonbank ½nancial inter- Board Alan Greenspan would always sup- mediaries. The latter is known as securi- port ½nancial markets in any collapse, so tization (the originate-to-distribute mod- the belief went. el). The start of the crisis was marked by Central bankers, like most of us, be- a malfunction in the wholesale money lieved in this context that ½nancial sta- market, whereby banks could access such

Dædalus Fall 2010 75 C.A.E. funds only at elevated spreads or costs, I favor the second approach. As of Goodhart if at all, and by halting securitization. 2010, the idea of relaxing adherence on the ½nancial Thus the banking system had become to an inflation target has little support. crisis & steadily more fragile. High reported Many fear the likelihood of severe de- economic policy pro½ts disguised this decline during the flation, sharp inflation, or even one fol- preceding asset price boom, a façade lowed by the other. The extraordinary enhanced by changes in accounting stimulus to both ½scal and monetary practices that allowed bank assets to policies, the sharply rising debt ratios be revalued at current market prices (both public and private), and intensify- (mark-to-market accounting). Neither ing political dif½culties for most incum- bankers nor regulators were really aware bents at a time of economic recession of the fragility underlying the ½nancial and high unemployment all provide a system (though some evidence suggests fertile basis for an inflationary upsurge. that bankers had miscalculated risk and At the same time, the (broader) money were not, in fact, cynically betting on stock and bank lending continue to de- a taxpayer bailout). A combination of cline as banks, under pressure from pub- untoward con½dence in the strength lic and regulatory authorities, seek to of the ½nancial system; an unfortunate retrench and reduce their dependence coincidence of an inflationary bubble on (wholesale market) debt ½nance in commodity prices, notably in oil; (deleveraging). Both the public and pri- and excessive concern about moral vate sectors are also trying to raise sav- hazard led central banks around the ings and pay off debt. The crisis is not world to delay aggressive cuts in inter- over, particularly as evidenced by the est rates until after the sky fell, on debacle in Greece, and further debt or September 15, 2008, with the Lehman deflation remains possible. Against this Brothers bankruptcy. background of uncertainty and the fear of both inflation and deflation, it is now We have learned that the achievement more than ever important to provide of price stability does not in itself guaran- reassurance that monetary policy will tee ½nancial stability: these are two sep- remain focused on achieving price arate objectives for central banks. How stability. can they be simultaneously achieved, and Identifying unsustainable asset price what changes, if any, should this assess- bubbles at the time they occur is extreme- ment make for the conduct of monetary ly dif½cult–although it always looks easy policy? after the fact. Asset prices could not go to There are two, not necessarily mutual- such heights if there were not large parts ly exclusive, main adjustments that have of the market that expected them to go been proposed. The ½rst is to relax the higher yet, and there are always persua- focus on targeting the price inflation for sive reasons why they might. During their current goods and services and to give expansionary phase, asset price bubbles more weight to asset prices, a strategy are extremely popular, not only with al- termed “leaning into the wind.” The most everyone in the market, but also second recommendation is to devise a with politicians, who see the rise in asset second set of macro-prudential, counter- prices as the due market response to their cyclical regulatory instruments that can own successful policies; when you be- be directly deployed to diminish asset lieve that you have abolished boom and price bubbles and busts. bust, as then-Prime Minister Gordon

76 Dædalus Fall 2010 Brown announced in 2008, you would rowers. In a recession, especially one Lessons expect a stronger market. triggered by a ½nancial collapse, most from the ½nancial It would take an extraordinarily self- borrowers seem considerably riskier. crisis for con½dent and brave central banker to Consequently, the margin–or spread– monetary raise interest rates at a time when in- of average borrowing rates above the policy flation seemed under control simply be- riskless rate, say, on U.S. Treasury bills cause he felt that some asset price was and bonds, increases. In extreme cases, too high. Increasing interest rates often the average rate facing private sector depresses the real economy, while likely borrowers may rise at the same time having little effect on the asset market in that of½cial rates fall. question. And even if those asset prices In the standard macroeconomic mod- did subside, the event would provide els employed up until 2007, however, ammunition for claims that the initial the risk (of counter-party default) was rise in asset prices was not so dangerous assumed to be low–in effect, zero–and after all. In my assessment, “leaning into constant. In practice, under the influence the wind” never amounts to much in of bubble con½dence, increased leverage, practice–not enough to make a differ- and enhanced competition for business, ence, at least. The central bank that came risk margins were gradually pared down closest to leaning into the wind was the over the course of 2002 to midsummer European Central Bank (ecb), which, 2007. Thus, effective rates facing private because it paid greater attention to time sector borrowers were declining over trends in the monetary aggregates (its the years 2002 to 2006 while some com- second monetary pillar, the ½rst pillar mentators (again John Taylor) had al- of its analysis being the usual forecast ready criticized the Fed for keeping of- of current inflationary developments ½cial rates too low. The fact that such within the eurozone), appeared to have risk margins reached their nadir in a generalized concern about ½nancial Summer 2007, just before the ½nancial expansion; close observers of the ecb system entered into crisis, should also have, however, doubted whether follow- temper faith in the wisdom of markets. ing the movements of this pillar ever After the start of the crisis, and espe- made more than a difference of twenty- cially after the Lehman bankruptcy in ½ve or, at most, ½fty basis points (a basis September 2008, risk margins spiked point is equal to one one-hundredth of a higher; so did the effective cost of cap- percentage point) to the ecb’s interest ital to private sector borrowers. If cen- rate judgment. tral banks had placed more emphasis This is not to state that there is no on risk-adjusted rates, and less on the case for any alterations in the practice basic of½cial rate, they might have raised of inflation targeting. One consideration of½cial interest rates earlier and faster raised by the recent crisis is whether the before August 2007, and then lowered interest rate entered into central banks’ them more quickly and by a larger Taylor reaction function should be a risk- amount in the period from August 2007 adjusted short-term interest rate, rather to October 2008. During its ½rst few than the of½cial rate. The primary risk in months, the crisis was generally (but this case is that a borrower may default, mistakenly) seen as a pure liquidity that is, not be able to pay back the loan. emergency, rather than as a solvency In order to offset that risk, lenders will problem as well. A liquidity crisis oc- increase the interest rate charged to bor- curs when a ½rm does not have suf½-

Dædalus Fall 2010 77 C.A.E. cient ready cash to meet a payment that tion, Ben Bernanke, Greenspan’s succes- Goodhart is due; a solvency crisis arises when the sor as chairman of the Fed, acknowledged on the ½nancial value of a ½rm’s liabilities is greater than that the Fed was partially to blame for crisis & that of its assets. Such crises tend to oc- the debacle of 1929 to 1933 and promised economic policy cur together because ½rms known to be that (his) Fed would not allow that to clearly solvent can almost always bor- happen again: “I would like to say to row money to meet upcoming payments. Milton and Anna [Schwartz]: Regarding Moreover, there was never any shortage the Great Depression. You’re right, we of overnight liquidity. Instead, bankers did it. We’re very sorry. But thanks to were concerned with how they might you, we won’t do it again.” What is odd replace their one- or three-month whole- about this statement is that Friedman sale market borrowing once it matured and Schwartz, in their epic Monetary His- and likely might not be rolled over in a tory of the United States, primarily blamed crisis, largely because of lurking con- the Fed for allowing the (broad) money cerns about default. supply to diminish sharply during 1929 For the foreseeable future–two or to 1933. Meanwhile, as of Spring 2010, three years ahead at most–banks will the Fed ceased credit expansion at a be under pressure to reduce their reli- time when bank lending to the private ance on wholesale funding, to delever, sector has been declining, and broad to become safer and smaller. As a result, money supply appears almost stagnant. they will be stricter and more cautious (The monetary aggregate M2 declined in extending new credit. This prudence from an annual rate of 8 to 9 percent in will be evidenced by higher margins Spring 2009 to just over 1 percent in between loan rates and the of½cial rate. 2010.) Certainly, current methods of in- Whatever the level of of½cial rates, the terpreting the monetary data are prob- risk-adjusted effective rate that private lematic. But if inflation and deflation sector borrowers face will be higher than are monetary phenomena, central banks in the past. Put differently, the “equilib- must put more effort into data interpre- rium” (real) of½cial interest rate likely tation. Focusing on the transmission of will need to be lower in the next few years of½cial interest rates into real expendi- than it should have been in 2001 to 2007 tures, and then inflation, without con- in order to keep average private-sector cern for ½nancial intermediation along borrowing rates at a level consistent with the way, is no longer a suf½cient means a recovery to economic equilibrium. of analysis and should be discarded. The standard macroforecasting and This is not to suggest that analyzing analytical models used up until 2007 de- monetary developments is easy or can ½ned no role for banks, ½nancial inter- be reliant on a single statistic from one mediaries, money, or default and risk. or another of the several monetary and Precisely how the economics profession credit aggregate statistics, which only allowed itself to be sidetracked into this rarely move in lockstep. extraordinary dead end will be a subject But whether or not central banks of fascination to students of the history choose to increase their focus on risk- of thought for decades. Be that as it may, adjusted interest rates, they should con- the implication is that central banks tinue to set rates with the primary objec- should have a continuous concern for tive of maintaining price stability and monetary developments. At Milton providing an anchor for the private sec- Friedman’s ninetieth birthday celebra- tor’s inflation expectations. Given that

78 Dædalus Fall 2010 inflation expectations are now accorded economy be a current account surplus Lessons a key role in determining how the eco- (that is, with the rest of the world run- from the ½nancial nomic system works, the achievement ning a de½cit). But across the global crisis for of ½nancial stability must be realized by economy as a whole, current accounts monetary other means, namely, a combination of sum to zero. So the counterpart to the policy ½nancial structure reform and the intro- greater private sector surplus has to be duction and use of speci½c macro-pru- a larger public sector de½cit. The only dential controls, such as counter-cyclical real question is whether this relation- required capital ratios. ship is achieved by deflation, via reducing tax receipts and private sector sav- In the 1960s, when almost everyone, ings, or by Keynesian ½scal stimulus, including Richard Nixon, professed to thereby maintaining income levels. Be- being believers in Keynesian theory, sides Hyman Minsky, the other great governments generally tried to steer the intellectual winner from this crisis has economy with ½scal policy. They were been John Maynard Keynes. skeptical of the effectiveness of mone- The problem herein is that the private tary policy (apart from its influence on sector’s shift into surplus has been so international capital flows), and pre- great in scale that its counterpart, the ferred to keep interest rates low and public sector de½cit, has ballooned to steady to encourage productive invest- levels never before seen in peacetime. ment. Between then and 2007, Keynes- Moreover, the aging population and its ian theory went out of fashion. Mone- associated medical needs offer a dire tary policy–via setting the of½cial inter- outlook for public sector de½cits in the est rate –was to be steered so as to keep longer term; in the immediate future, the ship of state on the straight and nar- the crisis has left the ½nancial system row, while ½scal de½cits were to be kept so weakened that the economic recov- low and stable, once again, to encourage ery is expected to be slow and hesitant. productive investment in the private In these circumstances, the so-called sector. An extreme version of this latter sovereign risk of public sectors is every- dogma was incorporated in the Stability where under strain, especially in coun- and Growth Pact in Europe, which pro- tries, such as Greece, and subsidiary posed that eurozone countries should states, such as New York and California, never run a de½cit greater than 3 percent that are not fully “sovereign,” insofar as of gdp, a limit that has been regularly they do not have their own independent transgressed, and by most of the coun- currencies and cannot, at an inflationary tries hardest hit in the current recession. pinch, print more of it to meet the inter- The 2007 crisis led simultaneously to est on their debt. a collapse in private sector investment, How soon, then, must states begin to especially in housing, and to a realiza- rein in the extent of ½scal de½cit? Too tion among consumers that they had soon and one risks a “double dip” defla- overextended their indebtedness, trig- tion; too late, and markets, notably the gering a rise in the desired savings ratio. bond and foreign-exchange market vigi- The private sector surplus of savings lantes, will take fright, as they already over investment escalated sharply. Of have in Greece, and thereby deliver a course, all policy-makers would like to “double dip” deflation by another route. see the counterbalance to the net sav- With respect to monetary policy, the ings of the private sector in their own various arms of policy, ½scal and mone-

Dædalus Fall 2010 79 C.A.E. tary in particular, must move in coordi- the recovery of ½nancial markets, from Goodhart nation. The more slowly and timidly ½s- their low point in March 2009 to the hes- on the ½nancial cal policy is retrenched, the faster and itant recovery in the real economy in the crisis & more robustly interest rates will have to middle quarters of 2009 (Q2 and Q3). economic policy be normalized and credit (or quantita- Studies have indicated that these quan- tive) easing reversed. Per contra, any titative- and credit-easing measures reduction in ½scal stimulus must be off- succeeded in bringing about some fur- set by further, even enhanced, easing in ther easing in longer-term interest rates monetary policy. and revivifying those private sector mar- A problem with ½scal policy is that it kets, such as the mortgage-backed secu- is far less flexible and reversible than rities (mbs) market, at which they were monetary policy. Fiscal easing, either via targeted. extra expenditures or lower taxes, tends The additional unconventional mea- to create perceived entitlements. It often sures were, therefore, partially success- takes a long time to shift from announce- ful. But they were not as successful as ment to economic effect; there are few some may have initially hoped, though “shovel ready” projects on hand. Given the prior experience of Japan–in which the lags and dif½culties of getting ½scal similar measures were applied in 2001 retrenchment under way, together with to 2006–should have given warning not the market risks of not doing so, my own to expect too much. These measures pri- preference (which is influenced by con- marily involve open-market operations, ditions in the United Kingdom) falls on whereby a country’s central bank buys the side of making an early start on ½scal assets of one kind or another and pays retrenchment; in this case, the adverse for them by writing a check on itself. effects on incomes and expenditures must These checks are paid into commercial be offset by further monetary expansion. banks, which then hold the receipts as But is monetary policy capable of offset- deposits with the central bank, thereby ting ½scal retrenchment? Now that inter- increasing the commercial banks’ own est rates have effectively dropped to zero, cash reserves. Under normal circum- would any additional attempt at mone- stances, when a commercial bank re- tary expansion be “pushing on a string”? ceives extra cash reserves, it uses them The zero interest rate bound (or zero to make an extra loan, or to buy some interest rate policy [zirp]) was reached other additional earning asset. But in fairly quickly after the ½nancial panic in the crisis conditions, the banks sat on September to October 2008. Fortunately, the additional reserve base. Despite a this event did not mark the limit of ex- vast increase in the banks’ cash base, pansionary monetary policy. As ½nancial the increase over the same period in markets and the economy weakened pro- their holdings of either private or public gressively until March 2009–in a down- sector assets was minute; the multiplier turn worse than that of 1929– central had failed to work. banks turned to unconventional policy There were, of course, reasons why measures: long-term loans by the ecb, the banks were happy to accumulate quantitative easing by the BoE, and credit cash reserves rather than putting them easing by the Fed. Although other (½scal) to work. During this recession, many stimulatory policies were introduced corporations preferred to strengthen concurrently, the timing of these addi- their balance sheets by repaying bank tional monetary policies coincided with loans. In general, a recession makes

80 Dædalus Fall 2010 projects offered to banks by prospective that central banks have, in general, not Lessons borrowers seem, almost by de½nition, yet learned how to make full and best from the ½nancial riskier. In view of the size and expected use of this capacity. crisis for persistence of the ½scal de½cit, the in- Central bankers are sensitive to the monetary terest rate (and inflation) risk of buying criticism that, in the past, they reacted policy longer-term government debt remains to each ½nancial bust by encouraging, palpable, while the yield available on via aggressive and maintained cuts in shorter-term debt has been exception- interest rates, a new asset price bubble. ally low. The interest rates are expected Eventually, so the argument goes, the to rise in the future, the more so if infla- super-credit cycle became so top-heavy tion should also experience an uptick. that interest rate cuts could no longer When interest rates rise, bond values cope; public sector (taxpayer) support fall commensurately. Banks that hold was needed. But the capacity and the such bonds suffer a capital loss. willingness of the public sector to pro- This relative failure was in part due to vide further support to the ½nancial policy errors made by the central bank. sector are now exhausted. Against this In particular, because the aim was to in- background, the unconventional mea- duce the banks to make use of the cash sures of monetary expansion are being base that the central bank created, it phased out by the ecb, BoE, and Fed, was a mistake to offer an attractive de- (though not in Japan, where the govern- posit rate on such holdings. When the ment is pressing the Bank of Japan to Fed activated the permission to pay a restart such measures). positive interest rate to commercial What we have currently is a continu- banks on their deposits held at the Fed ation of the ½scal stimulus (until the itself in October 2008, the move could recovery is fully established) and a not have come at a worse time. Just as cessation of the unconventional mon- the Fed increased required reserve ra- etary measures (though the zirp is tios in 1936, fearing the possible infla- being maintained at least for the time tionary consequences of banks’ “excess” being). My own preference, as earlier reserves (now perceived as a mistake), indicated, would be for the reverse, the Fed in 2008 likewise began to pay a with some early ½scal retrenchment positive interest rate on bank deposits, offset by continuing–indeed, re- fearing the same potential inflationary inforced–monetary expansion. consequences. Indeed, the exact oppo- Monetary expansion will, however, site policy–seeking to impose a slight be hard to achieve at a time when every- penalty on deposits, above requirements one wants to reform the banks into safer –would have been desirable (though and smaller entities. Financial regulators also somewhat unfair, since the banking (and even the general public) are like system in aggregate cannot avoid hold- generals poised to ½ght the last war over ing the cash base that the Fed creates). again, especially since that battle ended The ability to set and vary the upper in a major defeat. As a result, banks will limit of rates at which banks can obtain be faced with: cash from the central bank, and the low- 1) New taxation on a base (whether on er limit at which the banks can place pro½ts, assets, wholesale borrowing deposits with it–a “corridor system”– or transactions) and at a rate still to is a new, useful, and flexible tool. But the be determined; experience of the last two years indicates

Dædalus Fall 2010 81 C.A.E. 2) Higher required capital ratios; ½scal policy has, however, returned to Goodhart center stage. How, then, must the coor- on the 3) More restrictive leverage ratios, dination of the two arms of policy be ½nancial especially in Europe, which previ- crisis & achieved? I believe a quick start to ½scal economic ously had no such restrictions; and policy retrenchment offset by continuing, pos- 4) Enhanced liquidity requirements. sibly enhanced, monetary easing is the best available approach. This tack, how- In this context, and after the traumatic ever, is unlikely to be adopted for several shocks of the crisis, which will also make reasons: it more dif½cult to ½nd creditworthy borrowers, the banking system is likely to 1) The unconventional expansionary shrink. The forthcoming bank tax–what- monetary policy measures have not ever its details–will be quite popular and been as effective as might have been will seem, super½cially, almost painless, hoped. but will actually be paid mostly by depos- 2) It is so dif½cult to claw back ½scal itors, in the guise of lower deposit rates, expansion, especially when the re- and through higher charges to borrowers. covery remains so hesitant, that it This scenario, together with the neces- will not happen soon, except under sity of enacting ½scal retrenchment and extreme external pressure, as in the remaining debt overextension in Greece. the personal sector, points to a sluggish recovery at best. Monetary policy will 3) The imposition of extra regulatory need to remain expansionary for a con- constraints on banks, while fully siderable amount of time into the future. understandable in view of past excesses, is hardly calculated to en- The basic monetary policy regime of courage current monetary expansion. inflation targetry, achieved by adjusting The implication of delayed ½scal re- the of½cial interest rate, should remain. trenchment is that economic recovery However, it should be subject to the fol- will be slow-moving at best. The ½nan- lowing technical changes: cial crisis is not behind us; there could a) In Europe, housing prices should be easily be further alarms. It is likely that included in the relevant index. monetary policy will have to remain in its expansionary mode for longer than b) Central banks should target a risk- most commentators now appreciate. adjusted interest rate rather than the of½cial rate. c) More attention should be paid to a range of monetary aggregates, despite the undoubted dif½culty of interpret- ing their signals. In recent years, the macroeconomy has been in large part steered by monetary policy adjustments, with ½scal policy primarily aimed at longer-term struc- tural objectives. During the recent crisis, Keynesian demand management via

82 Dædalus Fall 2010 Robert E. Hall

Fiscal stimulus

During the calm period in recent U.S. of stimulus is usually public construc- macroeconomic history, from the mid- tion, called “public works” in the past 1980s to mid-2000s, stabilization policy and now known as “infrastructure.” I relied mainly on monetary policy to deal include all levels of government in in- with recessions, which were mild and frastructure stimulus because it is com- many years apart. Besides relatively small mon for the federal government to pay tax rebates, there seemed to be little need for projects that state and local govern- for ½scal stimulus. The government did ments build. I will refer to the ½rst arm not launch major public works or infra- as infrastructure stimulus, though I will structure projects to try to restore full show that the federal government deliv- employment. Even monetary policy fell ered almost no increase in infrastructure short of its full stimulus: the Federal spending and that state and local govern- Reserve did not push its target interest ments cut spending during the recession. rate all the way to zero in either of the A greater effort on the part of the feder- recession years 1991 or 2001. It wasn’t al government to prevent the decline in until the extraordinary conditions facing state and local purchases would have the incoming Obama administration in served the purpose of the stimulus effort. January 2009 that monetary policy was The second arm of ½scal stimulus pays at its maximal stimulus in terms of the increased bene½ts to the public. Expand- traditional tool, the Fed funds interest ed unemployment insurance is a leading rate. The bottom had fallen out of the form, but many other types of public ben- economy in the last months of 2008. e½ts grow during recessions as well. The The new administration made ½scal second arm also includes tax rebates and stimulus a key part of its program for other tax cuts that put more cash in the saving the economy. hands of the public. I do not include tax Fiscal stimulus has two arms. One is cuts in this article, however, because the the government’s direct purchase of modest tax rebate in 2008, though a re- goods and services. Though the govern- sponse to the mild contraction that start- ment buys a huge variety of products and ed at the beginning of 2008, was not an employs millions of workers, the focus important part of the government’s response in 2009 to the Great Recession. © 2010 by the American Academy of Arts One simple measure of the effective- & Sciences ness of ½scal stimulus–the multiplier–

Dædalus Fall 2010 83 Robert receives the most attention from econ- the infrastructure multiplier is one and E. Hall omists and often enters public debate 0.6 in deep recession when the infra- on the ½nancial as well. The multiplier records the num- structure multiplier is two. crisis & ber of dollars of increase in total national economic policy output and income per dollar of stimulus Before plunging into a discussion of spending. Much of this article reviews the sizes of the various multipliers, I current thinking among economists consider the amount of infrastructure about the size of the multiplier. A weak and bene½ts stimulus the United States consensus holds that in normal times, actually applied during the Great Reces- including earlier recessions, the infra- sion. Infrastructure spending is part of structure multiplier is about one: each total government purchases of goods dollar of infrastructure stimulus boosts and services. Therefore, the multiplier output by a dollar. Put differently, when for infrastructure need not be separated the government buys more highways from the multiplier for other goods and and schools, output rises by enough to services that the government purchases. permit other categories of spending– I begin by looking at total purchases, such as consumption and private invest- which make up one of the major cate- ment–to remain unchanged. In times of gories of government spending; the extreme recession, such as 2009, there other categories are bene½ts and inter- is widespread agreement that the infra- est on debt. structure multiplier is higher–perhaps My approach here is to examine gov- twice its normal value. ernment purchases as they actually played A multiplier greater than one occurs in out, rather than trying to isolate the pur- an economy with strong feedback effects. chases that resulted from the stimulus The feedback effect stressed in elemen- program. For example, I explore the de- tary macroeconomics is the increase in tails of a surge in federal military spend- consumption that results from higher ing in 2008 that provided a well-timed income when production is higher. More stimulus but certainly was not part of complete macro models describe the in- any stimulus program. terplay of a variety of feedback effects, Figure 1 shows the amount of extra some positive and some negative. The federal and state-local government pur- positive effects are more likely to prevail chases in constant 2007 dollars from the in a severely depressed economy. onset of the Great Recession at the end Any consensus about the multiplier re- of 2007 to the ½rst quarter of 2010.1 I de- lating bene½ts spending to total output is ½ne “extra” as the amount in excess of even weaker than that of infrastructure an extrapolation of purchases from the spending. An increase in bene½ts has a end of 2007 at the growth rate recorded ½rst-round effect on spending from the from 1999 to 2007. Two facts are imme- fraction of the increase that recipients diately apparent: only the federal gov- spend rather than save. Evidence on this ernment contributed to the stimulus fraction is truly mixed. The bene½ts mul- from government purchases, and even tiplier is reduced in comparison to the that stimulus was not very big. infrastructure multiplier by this fraction. Federal purchases escalated as soon as For example, if 30 percent of a bene½ts the recession began at the end of 2007. increase is consumed and the remaining The initial expansion was almost as rapid 70 percent is saved, the bene½ts multipli- as it was immediately after the passage of er is roughly 0.3 in normal times when the stimulus bill a year later at the outset

84 Dædalus Fall 2010 Figure 1 Fiscal Extra Purchases by the Federal Government and State-Local Governments, 2007 Q4 to 2010 Q1 stimulus

Source: U.S. National Income and Product Accounts, as adjusted by author. of the Obama administration. Both fed- that effect. Throughout the recession and eral and state-local purchases plunged early recovery, state and local purchases at the beginning of 2009 and then ex- fell below their normal trend path, drag- panded to their highest levels soon after ging down the economy compared to the stimulus bill was enacted in Febru- their normal effect. State and local gov- ary 2009. At that time, economists ex- ernments lack the federal government’s pressed concern that the bill’s extra in- authority and ability to borrow aggres- frastructure spending would ramp up sively to raise spending at the same time slowly, with a much larger increase in that revenue collapses. By the fourth 2010 than in 2009. Instead, the peak in quarter of 2009, the decline in state-local purchases occurred in mid-2009. The purchases relative to trend was enough perspective shown here is quite different to offset the federal stimulus more than from that taken by the bill’s proponents; fully. Taken together, all levels of gov- the ½gure illustrates the excess of all cate- ernment were retarding the recovery. gories of government purchases over its All the changes in government pur- trend path, not just the speci½c projects chases shown in the ½gure are small in that the bill funded. comparison to the overall size of the U.S. Although the bill was intended to boost economy. The peak of an extra $66 billion state and local government-infrastructure in purchases was less than one-half of spending, the negative force of large de- one percent of total output of goods and clines in state and local revenue swamped services. The stimulus from government

Dædalus Fall 2010 85 Robert Table 1 E. Hall Extra Government Purchases, by Category, in 2009 Q3 on the ½nancial crisis & Extra Spending, economic Category Billions of 2007 Dollars policy Federal Nondefense, Noncapital 13.7

Federal Nondefense, Capital 3.6

Federal Defense, Noncapital 34.2

Federal Defense, Capital 14.4

State and Local, Capital -34.6

State and Local, Noncapital -8.5

Source: U.S. National Income and Product Accounts, as adjusted by author.

purchases could not have had a visible support continued consumption spend- effect on the overall economy. ing in the face of recession-induced de- Table 1 breaks down extra government clines in earnings. A leading example of purchases by government level and type an automatic bene½t increase is the rise of spending. Noncapital spending con- in unemployment compensation that re- sists primarily of wages and salaries of sulted from the doubling of the unem- public employees but also includes mate- ployment rate during the recession. And rials and supplies that are used quickly a leading example of a special increase is and do not become part of government the extension of unemployment bene½ts capital stock. Capital spending denotes to long-term unemployed who would spending on buildings, equipment, and have lost their bene½ts sooner under the software. The table shows that by far the standard formula. The data I review in- largest spending category was noncapi- clude both automatic and legislative tal defense purchases–a rather different increases in bene½ts. outcome than the authors of the stimu- During the Great Recession, bene½t lus bill had intended. The single biggest increases added substantially to dispos- negative factor was the decline, relative able income. Figure 2 is derived from the to trend, in state and local noncapital same approach as was applied in Figure 1 purchases. to determine the extra spending on bene- ½ts beyond the normal upward trend. The The other type of ½scal stimulus pro- measure combines the automatic increas- vides income to families in the form of es, which pushed bene½ts above trend, government bene½ts. Part of the stimu- and the legislated increases, which added lus comes from the automatic operation to the automatic ones. The total extra of the bene½t systems, without special contribution to disposable income ex- features, and part from special increases ceeded the rate of $200 billion per year legislated to help stressed families and starting in the second quarter of 2009.

86 Dædalus Fall 2010 Figure 2 Fiscal Extra Government Bene½ts to Individuals, 2007 Q4 to 2010 Q1 stimulus

Source: U.S. National Income and Product Accounts, as adjusted by author.

This spending made an important con- other end of the spectrum is the view tribution to plugging the hole in total that various ampli½cation mechanisms disposable income excluding bene½ts, result in an increase in output several which exceeded $500 billion per year times greater than the government’s di- in the ½rst quarter of 2009 and rose to rect purchase of output. It is convenient more than $700 billion in the ½rst quar- to express these opinions in the form of ter of 2010. the multiplier: the number of dollars worth of total output that a one-dollar How does ½scal stimulus raise output increase in infrastructure spending and employment? The Great Recession causes. Thus, assessments of the mul- revived long-standing debates among tiplier range from zero to perhaps four. economists on this point. I will start There is, however, a concentration of with the analysis of an infrastructure estimates in the range from one to two, stimulus.2 One polar view maintains together with some agreement that that an increase in public use of resources whatever the value of the multiplier, it must inevitably displace an equal amount is higher when the economy is extreme- of private activity, so that an increase in ly slack and monetary policy has spent infrastructure spending has zero effect its expansionary power by driving the on total output and employment. On the short-term interest rate to zero.

Dædalus Fall 2010 87 Robert Professional discussions of the multi- The ½nancial press equates the term E. Hall plier include its dynamics. First, most Keynesian to advocacy of ½scal stimulus on the ½nancial views hold that the expansionary effect to offset recessions, while among econo- crisis & of an increase in infrastructure spending mists, Keynesian refers to the adoption economic policy depends on how it is distributed over of some principles of behavior of the time. Second, the effects on output and aggregate economy that are not neoclas- employment continue past the end of sical. There are plenty of Republican the stimulus program. The later effects Keynesian economists these days. Even are likely to be negative: if the stimulus libertarians–numerous among econo- cuts into private capital formation, as mists if not in the population in general many believe it will, the economy will –can be Keynesian. The popular and have lower productive capacity once the professional meanings interact. Because stimulus is removed than it would have Keynesian principles lead to higher esti- had absent the stimulus. I avoid these mates of multipliers, ½scal stimulus is issues by focusing on the immediate– more effective in a Keynesian than in a that is, ½rst-year–effects of a stimulus neoclassical world. like the one that occurred in 2009 as a It is useful to start with the neoclassi- temporary burst of extra government cal analysis of the effect of infrastructure purchases. stimulus in order to illustrate its limi- My discussion will enter the territory tations and the need for Keynesian fea- of what many economists call Keynesian tures. The neoclassical model gives prices properties of the economy. Among pro- and wages free rein to cushion against fessional economists, the term Keynes- shocks and prevent unemployment. An ian has lost most of its political overtones. increase in infrastructure spending raises We use the term to mean properties of the interest rate, which causes workers the aggregate economy that depart from to choose longer hours of work. The the economic principles we emphasize future tax increase that will ½nance the in our accounts of individuals and mar- spending also raises hours of work be- kets. The opposite of Keynesian is not cause workers choose to offset some of conservative, but rather neoclassical, the loss of purchasing power due to high- meaning that aggregate economic be- er taxes by raising their earnings. Invest- havior is analyzed according to the ac- ment and consumption fall because of cepted principles for individuals or indi- the tax and interest-rate effects. Total out- vidual markets. As neoclassical principles put rises, but by only a fraction, about have it, prices and wages are flexible and 30 percent, of the increase in infrastruc- markets always clear. Unemployment is ture spending. The multiplier is just 0.3. absent. In the face of events during the Displacement of private spending by pub- Great Depression that de½ed neoclassi- lic spending is a substantial issue, though cal principles, John Maynard Keynes was it is not complete, as some economists a pioneer in exploring alternatives, some have claimed. The critique that appears of which have made their way, with im- in The Wall Street Journal whenever ½scal portant alterations and improvements, stimulus is under consideration is on into modern macro analysis. In particular, point in a neoclassical economy: stimu- contemporary theory includes Keynes’s lus spending drives up the interest rate observation that prices and wages are not and displaces private investment. flexible in the short run, so markets are What is wrong with the neoclassical not clear and unemployment can occur. model? First, it neglects unemployment.

88 Dædalus Fall 2010 It has taken a long time, but modern eco- contracts. In effect, the economy be- Fiscal nomics ½nally has a theoretically respect- comes more competitive. Rewards to stimulus able and empirically reasonable view of labor and capital improve and the econ- unemployment. Adding unemployment omy expands more than it would in the to the neoclassical model has the expect- neoclassical model, where prices are ed effect of raising the multiplier. A pri- flexible. Without invoking an unreason- mary reason for the low neoclassical mul- able extent of price stickiness, a model tiplier is that, in the neoclassical econo- that includes both unemployment and my, stimulus results in more output be- sticky prices can deliver a multiplier cause people feel that they are worse off around one. under the burden of taxation and because Are prices suf½ciently sticky to gener- a higher interest rate rewards immediate ate substantial ampli½cation? Research work by increasing the amount of de- on this topic has been intense in the past ferred consumption from an hour of decade. The Great Recession has gener- current work. Neither of these effects ated a raft of new evidence on how prices is strong, according to a large body of respond to slack, as the economy had research on household behavior. Factor- unprecedented slack in 2009. In a flexi- ing in unemployment, governed by a ble-price economy, prices should fall in model that emphasizes employers’ in- times of slack, as merchants cut prices centives for job creation, adds a power- to take business away from their rivals ful third force. A stimulus draws work- and to take advantage of the lower cost ers out of unemployment and puts them of inputs. But prices hardly fell at all as to work. The multiplier is substantially the economy collapsed. Table 2 presents larger with this important modi½cation, data for categories of output that declined at around 0.6. from the end of 2007 to the end of 2009. The second reason that the neoclassi- The most striking example of a sticky cal model delivers a low multiplier is price is in the category of business equip- that it lacks an ampli½cation mechanism ment: although output declined at 9.1 based on sticky or rigid prices. Sticky percent per year, the price actually rose prices are the hallmark of modern think- slightly. ing that calls itself Keynesian. (In fact, to Although prices seem to be quite sticky, distinguish itself from older ideas, this research has not so far been able to docu- vibrant modern school calls itself New ment that market power increased during Keynesian.) Ampli½cation works in the this or earlier contractions. Evidence that following way: At all times, the economy the economy becomes less competitive is held back because of pervasive market in a recession is only circumstantial. power. The suppliers of productive inputs We teach college freshmen quite a dif- –labor and capital–receive inef½ciently ferent version of the Keynesian explana- low rewards because businesses extract tion of the multiplier. There is no men- pro½ts derived from market power prior tion of unemployment, variable market to passing on their revenue to labor and power, or interest rates. Instead, when capital suppliers. At all times, the econo- the government spends more on infra- my produces less than it could. But when structure, income rises, consumers spend a stimulus expands the economy and more, income rises further, and so on. drives up the rewards to labor and capi- The multiplier expresses the cumulation tal while prices do not respond because of this process; it depends on the feed- they are sticky, the price/cost margin back operating through the propensity

Dædalus Fall 2010 89 Robert Table 2 E. Hall Annual Rates of Output and Price Changes, 2007 Q4 to 2009 Q4 on the ½nancial crisis & Annual Rate of Annual Rate of economic Category Output Change (%) Price Change (%) policy

Consumer Durables -4.1 -1.3

Business Structures -12.2 -1.2

Business Equipment -9.1 0.4

Homebuilding -16.9 -3.4

Goods Exports -1.9 -1.0

Service Exports -2.5 0.6

Source: U.S. National Income and Product Accounts, as adjusted by author.

of consumers to spend more when their put rises by between 50 and 70 percent incomes rise. A high propensity to con- of the amount of increase in government sume is not required for a modern model, purchases. The evidence, however, is by based on the two key elements of unem- no means dispositive; many other factors ployment and ampli½cation, to generate influenced output during those periods. a reasonable multiplier. Some investiga- In particular, during World War II the tors have included fairly high values of government held back private spending the propensity to consume in their mod- with rationing and direct controls, and els, but the mechanism described in during the Korean War heavy taxes may freshman economics has little to do with have inhibited expansion. A reasonable the numerical value of the multiplier in conclusion is that the two wartime expe- most models in use today. riences do not refute a multiplier of one. Recent interest in the infrastructure More recent experience in the United multiplier has caused researchers to re- States or other advanced countries cer- evaluate the direct evidence on how total tainly does not refute that value. output is affected when the government buys more output. It has been more than The year 2009 was unique in post- ½fty years since the government made a Depression U.S. experience because the sudden change in its purchases; since short-term safe interest rate that the Fed the end of the Korean War, government uses as its policy instrument–the Fed purchases have grown smoothly along funds rate–was at its most expansionary with the overall economy. The Vietnam value of zero throughout the year. The War and the Reagan military buildup multiplier was larger than under normal were gradual and small. Direct evidence, circumstances, when the Fed has the then, derives from spending changes capacity to adjust its policy. The Fed, during World War II and the Korean along with other properly managed War. These rapid buildups and build- central banks, steers the economy by downs show fairly clearly that total out- adjusting the interest rate. By appropri-

90 Dædalus Fall 2010 ate adjustments, the Fed accomplishes reserves had a negative rate–if banks Fiscal its mission of delivering low and stable had to pay to hold reserves–they would stimulus inflation in the longer run and leaning simply convert reserves to bills. against recessions in the shorter run. The Taylor rule (so named for econo- The Fed sets a higher interest rate if in- mist John Taylor) calls for the Fed to raise flation is above the target of 2 or 3 per- the interest rate when a ½scal stimulus cent annual inflation. The Fed sets a goes into effect. The higher rate would lower interest rate if unemployment is offset part of the expansionary effect of above 6 percent. Thus, if the economy the stimulus. But if the interest rate is enters a boom with low unemployment pinned at zero when the Taylor rule asks and high inflation, the Fed sets a high for a negative rate, the Fed will keep it at interest rate to cool off the economy. zero unless the ½scal stimulus is so effec- Conversely, in a recession with high un- tive as to raise the interest rate–dictated employment and low inflation, it sets a by the rule–to a positive level. In 2009, low rate to stimulate. In stagflation, with the Taylor rule yielded a deeply negative both inflation and unemployment above rate, but in the absence of practical ½scal target, the Fed balances one goal against policy that would raise the rate above the other. The Fed has to make an intel- zero, the best the Fed could do in the ligent compromise when high inflation face of ½scal expansion was to keep the calls for restraint and high unemploy- rate at zero. Consequently, the Taylor ment calls for expansion. rule ceased to inhibit ½scal expansion. In normal times, if ½scal policy tries to Thus, in an economy where the central expand the economy with an infrastruc- bank is governed by a Taylor rule (or a ture stimulus, unemployment will fall central bank that raised interest rates for and inflation will rise. The Fed, follow- any reason during economic expansion), ing its stabilization principles, will raise the bank’s reaction to the expansionary its interest rate and contract the econo- effect of ½scal stimulus blunts the effect. my. The models supporting the conclu- The infrastructure multiplier is lower in sion that the normal value of the infra- an economy with a responsive central structure multiplier is one describe the bank than in an economy with a central behavior of an economy where the cen- bank that keeps the interest rate constant. tral bank responds to all forces, includ- A number of investigators have studied ing ½scal policy, that alter inflation and the elevation of the infrastructure multi- unemployment by following these stabi- plier when the interest rate is pinned at lization principles. zero. All have concluded that it is sub- Sometimes, as in 2009 and 2010, the stantially larger than the value of around stabilization principles call for a negative one that is the weak consensus for the interest rate. If unemployment is high multiplier in normal times. The range and inflation is low, a great deal of ex- of estimates for the zero-interest-rate pansion is desirable. But the Fed is inca- multiplier is wide, even within the same pable of making its interest rate nega- study, because it is sensitive to the tim- tive, for the reason that the interest rate ing of the stimulus and the duration of the Fed controls is the rate at which banks the period when the interest rate will borrow and lend reserves. Banks have remain pinned at zero. That said, a value the right to convert reserves to hundred- for the zero-interest-rate multiplier of dollar bills in unlimited amounts. The around two is representative of recent rate that the bills pay is zero, so if the research.

Dædalus Fall 2010 91 Robert The bene½t multiplier is quite another –or even roughly–at the household E. Hall matter. If the government can induce the level. A baseline model of consumption- on the ½nancial public to consume more by providing smoothing implies that families will crisis & higher bene½ts, the effect of higher con- spread the spending resulting from a economic policy sumption purchases is, as far as can be one-time receipt of income over many determined, equal to the effect of higher future years. In other words, the house- government purchases. As I noted above, hold will consume only 5 to 10 percent in the bene½t multiplier is the product of the ½rst year and save the rest to boost the marginal propensity to consume and future consumption. Some ingenious the infrastructure multiplier. The new studies have focused on showing that central issue in measuring the bene½t people tend to consume more than 10 multiplier, then, is determining the pub- percent of small cash injections from tax lic’s propensity to consume out of in- rebates and other distinctively one-time creased bene½ts. sources. These studies do not generally A large number of observers, including ½nd 100 percent-immediate consump- many economists, believe that most of tion. Another generalization from a large an increase in bene½ts goes straight into number of studies is that the bigger the higher household spending. Given that a amount of a sudden cash receipt in rela- substantial part of the increase in bene- tion to normal income, the smaller the ½ts in a recession takes the form of high- fraction that goes out as immediate con- er unemployment insurance payments, sumption. All the research ½nds that the and a presumption that the unemployed context of an income receipt is an impor- have their backs to the wall ½nancially, tant determinant of the amount that is the hypothesis of a high propensity to consumed in the ½rst year. Providing as- consume bene½ts commands the high sistance to families with their backs to ground of plausibility. One factor point- the wall ½nancially raises their spending ing in the opposite direction is that peo- by more than would giving the same ple with their backs to the wall borrow amount of assistance to those with ample to the hilt. Credit cards make this kind liquid savings. Thus, raising unemploy- of borrowing very easy. A worker who ment bene½ts generates more added has avoided falling into the credit-card consumption spending than does a gen- trap while working may well start bor- eral tax reduction. rowing after losing a job. Much research The application of all this research to shows that one of the ½rst things that the question of the marginal propensity people do with bene½ts is pay off debts. to consume given an increase in bene½ts Reducing debt is a use of bene½ts that during a recession is controversial and does not result in a boost to consump- uncertain. The bulge in bene½ts is not tion spending. Rather, reducing debt is con½ned to a single year. As of the ½rst a form of saving; the effect on the econo- quarter of 2010, it was still growing, de- my of a family paying off some debt is spite the recovery that appears to have equivalent to that of another family rais- begun more than six months earlier, in ing its savings by the same amount. mid-2009. The longer duration points It has proven surprisingly dif½cult to in the direction of a higher propensity resolve the issue of new spending versus to consume. A defensible guess for the paying off debt with hard research. The marginal propensity to consume from United States lacks a body of data that a bene½ts stimulus is around 0.4, but tracks consumption spending accurately opinions range from almost zero to one.

92 Dædalus Fall 2010 Table 3 Fiscal Effects on gdp stimulus

Purchases Bene½ts Total

Q Q Average Federal Stimulus, 2009 2 to 2010 1, 58 220 Billions of 2007 Dollars

Multiplier 2.0 0.8

Effect, Billions of 2007 Dollars 115 176 291

gdp, Billions of 2007 Dollars 14,338

Percent of gdp 0.8 1.2 2.0

Average gdp Shortfall, Percent of gdp 8.2

Counterfactual gdp Shortfall, Percent of gdp 10.2

Source: U.S. National Income and Product Accounts, as adjusted by author.

Combining the two elements, I con- federal purchases resulted from a mili- clude that the bene½ts multiplier is tary buildup unrelated to the recession. around 0.4 in normal recessions, in And the bene½ts estimates apply not which the interest rate is never pinned only to the increased bene½ts resulting at zero, and around 0.8 in deep reces- from the stimulus legislation, but also to sions like the one that began at the end the increases that occurred because the of 2007, during the period starting at bene½t programs helped more people as the end of 2008 and continuing to this a result of the recession. writing, when the interest rate was The combination of increased federal pinned hard at zero. purchases and bene½ts raised output and income by 2 percent. Had the two ele- What was the overall contribution of ments not been in place, the shortfall of the increases in federal purchases and gdp from its trend path would have been bene½ts? In spite of my previous warn- 10.2 percent rather than the actual 8.2 ings about the uncertainty in the multi- percent. Stimulus worked in the sense pliers, I make estimates in Table 3. These that the recession would have been sub- calculations refer only to the federal pur- stantially worse without the stimulus chases component, as I have no way to considered here. But the stimulus moved measure the federal contribution to state the economy only a bit of the way toward and local ½nances that prevented even its normal growth path. It left an econo- greater shrinkage in their purchases. I my badly injured by the recession. reiterate that some of the increase in

Dædalus Fall 2010 93 Robert endnotes E. Hall 1 on the A computer ½le containing the data and calculations is available at http://www.stanford ½nancial .edu/~rehall. crisis & 2 For a discussion of this topic aimed at professional economists, with many references, see economic gdp policy my paper, “By How Much Does Rise If the Government Buys More Output?” Brook- ings Papers on Economic Activity 2 (2009): 183–231. For a detailed discussion of the effect of ½scal policy in a slack economy, see Lawrence Christiano, Martin Eichenbaum, and Sergio Rebelo, “When Is the Government Spending Multiplier Large?” nber working paper 15394 (National Bureau of Economic Research, October 2009).

94 Dædalus Fall 2010 Edward L. Glaeser

Housing policy in the wake of the crash

Between 2000 and 2010, the U.S. hous- household formation. In both 2005 and ing market experienced a convulsion 2006, builders completed more than 1.9 more extreme than in any previous re- million new units, at least 580,000 more corded cycle. From May 2001 to May than the rate of household formation in 2006, the Case/Shiller Standard & Poor’s each year. By a conservative estimate, twenty-city housing price index, which America erected at least 2 million extra controls for changes in housing quality units, relative to historic standards, dur- by comparing prices from repeat sales of ing the boom. By 2009, there were up- the same homes, rose 54 percent more wards of 5 million more vacant homes than consumer prices rose. In the three in the United States than there were in years that followed, housing prices, mea- 2000. That glut, in turn, explains the de- sured by the same index and corrected cline in new construction and jobs: few- for inflation, fell more than one-third. er than 800,000 units were built in 2009; Across metropolitan areas, the corre- the unemployment rate in the construc- lation between boom and bust was al- tion sector exceeded 20 percent in early most perfect. For every 10 percent that 2010. an area’s prices increased between 2001 While the extremity of the cycle is and 2006, that area’s prices fell by 7.6 clear, the causes of the great housing percent between 2006 and 2009. As convulsion are more mysterious. Some prices plummeted, ½nancial institu- economists have emphasized the role tions that had exposed themselves to of easy credit and low interest rates. sizable housing-market risk became Certainly, as real and nominal rates fell, insolvent. The entire U.S. banking buyers bene½ted from cheaper mort- system seemed at risk. gages, and credit-constrained purchas- The extreme housing-price swings ers were able to cover the costs of more were mirrored by equally oversized fluc- expensive houses. But there is little evi- tuations in the construction industry. dence to support the view that changes America typically produces about 1.5 in interest rates were large enough to ex- million housing units annually, which plain the housing market’s recent crash. is about 200,000 more than the rate of On average, as interest rates decline by one percentage point, housing prices © 2010 by the American Academy of Arts increase by roughly 6.8 percent. Even at & Sciences very low interest rate levels in markets

Dædalus Fall 2010 95 Edward L. where housing supply is limited, a one- cile with informed housing acquisition. Glaeser hundred-basis-point decrease in real These areas have few limits on new con- on the ½nancial rates does not push prices up more than struction, and builders supply new hous- crisis & 8 percent. Between 2000 and 2006, real ing for less than $100 per square foot. economic policy interest rates fell by 1.3 percent, which The power of unfettered building has suggests that falling rates can explain, at long kept prices low despite decades of most, a 10.4 percent housing price rise. enormous growth. But while these mar- Another view implicates aggressive kets did not see price growth during the mortgage approval or low loan-to-value boom of the late 1980s, buyers in Phoe- ratios. Similarly, compelling evidence to nix and Las Vegas must have assumed support this explanation is hard to ½nd. that their regions were headed for a per- My work with economist Joshua Gott- manently higher price plateau. Subse- lieb and ½nance expert Joseph Gyourko1 quent events have proven that, to the has estimated that changes in approv- contrary, unrestricted construction will, al rates explain about one-½fth to one- in the medium run, keep prices low. third of the price boom. Loan-to-value While we do not yet understand the levels appear to have an even smaller reason for the whirlwind that coursed impact, but the dif½culty of controlling through the housing markets, we can for changes in the pool of mortgage ap- draw a major policy lesson from the cy- plications limits the value of this ½nd- cle. For decades, the U.S. government ing. Moreover, the results of our research has pushed homeownership with poli- are not meant to clear the Federal Re- cies that subsidize mortgage rates and serve System, or anyone else, of error, encourage borrowing. The bust reminds but rather to emphasize that we cannot us that housing prices move down as identify with any certainty what caused well as up. Promoting homeownership the boom or why it ended. by subsidizing borrowing now seems We do know, however, that individ- as likely to create a “default nation” as ual buyers had wildly unrealistic ex- it does an “ownership nation.” Federal pectations about future price growth policies that encouraged home buyers and little understanding of the basic to leverage themselves to the hilt in or- economics of housing markets. Typical- der to bet on housing were clearly com- ly, housing prices adjust back to their plicit in the debacle. As the crash has historic norms, so that if prices rise, demonstrated, it is time to rethink relative to historic trends, by an addi- these policies. tional $10,000 over one ½ve-year period, those prices should be expected to The home mortgage interest deduc- fall (again, relative to trend) by $3,200 tion, the sacred cow of federal housing over the next ½ve-year period.2 Yet dur- guidelines, was not originally meant to ing booms, economists Karl Case and serve as a housing policy. It was intro- Robert Shiller have found, buyers typi- duced with the income tax law in 1916, cally expect growth to continue.3 Such when essentially all interest payments irrational exuberance was clearly pres- were deductible. Home mortgages were ent in Las Vegas in 2006, when home a minor form of borrowing at that time; buyers paid more than twice as much the deductibility of interest was largely as buyers had only six years earlier. used to make business expenses tax de- The price booms in Las Vegas and ductible. Although the Tax Reform Act Phoenix are particularly hard to recon- of 1986 eliminated the deductibility of

96 Dædalus Fall 2010 non-mortgage interest payments, by make more loans. When Fannie was pri- Housing then the majority of Americans were vatized in the 1960s, the Federal Home policy in the wake homeowners, and the home mortgage Loan Mortgage Corporation (Freddie of the interest deduction had become untouch- Mac) was created to generate competi- crash able. Today, the deduction is restricted tion. During the 1970s, Freddie and Fan- to mortgages of less than $1 million, or nie moved–with private-sector partners to the ½rst $1 million of mortgages above like Salomon Brothers–into the securiti- that amount, though in 2005, President zation business. They moved from hold- Bush’s tax reform panel unsuccessfully ing mortgages on their own balance proposed a substantial reduction of that sheets to becoming pass-through agen- upper limit. cies that bundled and insured mortgages In the wake of the Great Depression– for resale on the secondary market. Fan- era housing crisis, the federal government nie Mae and Freddie Mac used a varie- pursued a number of interventions to re- ty of criteria, such as debt-to-income invigorate the moribund credit market. ratios, credit rating, and mortgage size, The National Housing Act created the to determine whether a particular loan Federal Housing Administration (fha) conformed to quality standards and in 1934; it encouraged home buying by could be securitized. Like the fha, Fan- insuring mortgages against default. The nie Mae and Freddie Mac primarily im- fha has typically charged borrowers a pacted housing markets by allowing bet- signi½cant “up-front” mortgage insur- ter credit terms. A third player, the Gov- ance charge (equal to 2.25 percent of the ernment National Mortgage Association mortgage during mid-2010)4 and has ½- (Ginnie Mae), also insures mortgage- nanced itself from that fee.5 In fact, dur- backed securities and does so with the ing the early postwar period, the organi- full faith and credit of the U.S. govern- zation received criticism from the left ment. Ginnie Mae’s role is considerably for being too stingy and refusing insur- more modest, however, because it in- ance to borrowers and neighborhoods sures securities representing mortgages that the fha deemed higher risk. Dur- that already have a guarantee from the ing the same period, the Veterans’ Ad- fha, va, or another federal source. ministration (va) also became a signi½- During most of their post-privatiza- cant insurer of new mortgages at below- tion history, these enterprises steadfast- market rates; recent evidence uncovered ly claimed that their pro½ts reflected the by economist Dan Fetter suggests that bene½ts that came from the large, liquid the va had a signi½cant impact on home- market in mortgage-backed securities ownership. The fha was relatively in- created by the vast scale of their opera- active during the recent boom, as pri- tions, not implicit government guaran- vate insurers offered better terms; in tees. Those claims were never terribly 2009, however, one-third of all new plausible, and they certainly are not so mortgages were fha-insured. today, as the agencies are now kept alive In 1938, the fha was joined by the only through tax dollars. Although these Federal National Mortgage Association entities continue to be subsidized primar- (Fannie Mae), which was also intend- ily because their failure would further ed to encourage bank lending. While damage the economy, historically, Fan- the fha insured mortgages, Fannie Mae nie Mae was justi½ed as a means of solv- actually bought mortgages from banks, ing market imperfections in the second- freeing capital and allowing banks to ary mortgage market. Because banks

Dædalus Fall 2010 97 Edward L. have an incentive to keep high-quality that helped create the crisis, not on the Glaeser mortgages on their books and sell only interventions–like the purchase of mort- on the ½nancial the worst mortgages on any secondary gage-backed securities–that tried to pre- crisis & market, the fact that Fannie Mae and vent the Great Recession from turning economic policy Freddie Mac guaranteed mortgages was into a second Great Depression. supposed to prevent a market breakdown. Today, however, a large market in private Broadly speaking, there are three pub- mortgage insurance permits securities lic objectives that underlie housing in- backed by jumbo mortgages, credit card terventions and, in theory, justify the debt, and commercial credit to trade existence of the fha, Fannie Mae, and comfortably in the secondary market Freddie Mac. The ½rst is narrowly relat- without an implicit federal guarantee. ed to imperfect information in credit The majority of federal housing poli- markets. For at least four decades, econ- cies are either less signi½cant or less prob- omists have understood that a “lemons” lematic. Section 8 housing vouchers pro- problem–whereby borrower and lend- vide housing-related aid to poorer Amer- er have asymmetric information–may icans, who typically rent. Economists hamper insurance or lending markets. generally accept this intervention as a In principle, the lending market could reasonable form of market-oriented in- break down if some borrowers face a kind redistribution. The Low-Income higher cost (psychic or otherwise) of Housing Tax Credit subsidizes the pro- default than others and if those borrow- duction of affordable housing nation- ers (but not their lenders) know the costs wide. The credit, however sensible in of default. If lenders cannot distinguish places where housing is expensive, such between high and low risk and, in turn, as along America’s coasts, is less tenable charge all borrowers the same rate, then in the case of construction-crazy Atlanta it is possible that high-risk borrowers or depressed Detroit. I am no fan of the will be more likely to borrow while low- tax credit, but I will restrict my discus- risk borrowers may choose to self-½nance sion to the even bigger interventions– or, less plausibly, rent. In this scenario, the home mortgage interest deduction, the high-risk borrowers are willing to the fha, and the Government-Spon- pay the high interest because they have sored Enterprises (gses)–that encour- a greater chance of defaulting, or exer- age people to buy homes by borrowing cising their option not to repay the loan. cheaply. If only risky borrowers go to banks, then In 2009 and 2010, the Federal Reserve interest rates will be extremely high, in bought $1.25 trillion worth of mortgage- which case the safe borrowers who will backed securities, allegedly “to provide never default may prefer to avoid the mar- support to mortgage and housing market altogether. A vicious circle results in kets and to foster improved conditions which risky borrowers cause high inter- in ½nancial markets more generally.”6 est rates, and high interest rates deter The vast size of this purchase certainly safe borrowers. The fha is tasked with suggests the large public cost of Fannie preventing this scenario by creating a Mae and Freddie Mac, but the interven- more liquid market that does not charge tion itself had far more to do with avoid- prohibitively high rates. ing a ½nancial market meltdown than A similar breakdown can occur in the with supporting housing markets. This secondary market for mortgages if mort- essay focuses on the housing policies gage issuers know more about a mort-

98 Dædalus Fall 2010 gage’s quality than any prospective buy- sense during the Great Depression but Housing er. The U.S. Securities and Exchange are less relevant today. It is particularly policy in the wake Commission case ½led against invest- hard to justify the existence of for-pro½t of the ment banking and securities ½rm Gold- entities that deal in mortgages with the crash man Sachs in April 2010 hinges squarely aid of an implicit government guarantee. on whether the ½rm had material private A second reason for public interven- information about mortgage-backed tion in the mortgage markets is the de- securities that it failed to disclose. More sire to encourage Americans, especially generally, mortgage issuers, like banks, veterans, to consume more housing. In have an incentive to keep the good mort- 1940, 45 percent of America’s housing gages on their own balance sheets and units lacked complete plumbing facili- sell only the bad mortgages to outside ties, and 20 percent housed more than investors. This lemons problem in the one person per room.7 Nostalgia for pre- secondary market can impede the devel- war housing is misguided: the attractive opment of a risk-sharing mortgage mar- older homes that remain are the homes ket and lead banks to hold housing risk that were nice enough to keep around. in their own portfolios. If bank defaults The typical prewar home was terrible carry systemic consequences, either be- by modern standards. cause of federal deposit insurance or Prewar America provided at least because a failure of the banking system three defensible reasons for the govern- threatens the entire economy, then the ment to encourage housing consump- country has an interest in developing a tion. First, tiny homes that lacked plumb- secondary market to spread mortgage ing were often unsanitary and helped risk more widely. By creating a subsidy spread disease. The externalities from so that all mortgages, at least within a contagious illness were a primary moti- given class, are resold, Fannie Mae and vation for the progressive reformers who Freddie Mac can help that lemons prob- focused on improving housing condi- lem disappear. tions in America’s cities. Second, Ameri- These asymmetric information prob- cans have often been more comfortable lems are real, but are they large enough with in-kind transfers, like food stamps, to justify the vast public subsidies that then with outright cash grants. It was now exist? Do the public subsidies actu- surely an easier political sell to support ally solve the problems? A remarkably better housing than to support higher large body of information about borrow- welfare payments. Even “Mr. Republi- ers and their credit histories is available can,” Robert Taft, was an advocate of to banks and could be provided to pur- federal housing assistance. Third, some chasers of mortgage-backed securities. have argued that better housing implicit- The fact that many lenders were sloppy ly helps children by providing a healthier in the run-up to the crash and ignored and safer environment. Recent research this information does not help the case on Section 8 housing vouchers has found for public insurance, which only mutes that voucher recipients move to neigh- the incentives for due diligence. More- borhoods with less crime and less expo- over, an abundance of lending occurs sure to environmental irritants that may without the bene½t of public insurance. trigger asthma.8 Many mortgages are securitized without It is hard to justify mortgage-related the help of Fannie Mae and Freddie Mac. interventions with this line of reasoning Arguably, the fha and Fannie Mae made today. Essentially all Americans have ad-

Dædalus Fall 2010 99 Edward L. equate plumbing, and even the poorest The case for homeownership is also Glaeser quintile of the population enjoys an av- supported by the view that it leads to as- on the ½nancial erage of 855 square feet of living space set accumulation. Certainly, homes are crisis & per capita. Indeed, the average amount the primary asset for many Americans, economic policy of housing space consumed among the and rising home values have made many poorest ½fth of Americans is nearly dou- people wealthier. Various political lead- ble the population-wide average in ers, including former President George France, Germany, and the United King- W. Bush, have thought that America dom.9 Americans are now, by either his- would be better off if more people had toric or world standards, spectacularly more capital and as a result have pro- well housed. moted homeownership as a means of The third standard justi½cation for achieving an “ownership society.” mortgage-related interventions is that Economist David Albouy has provid- they encourage homeownership and its ed a more original argument for the (alleged) attendant social bene½ts. Cer- home mortgage interest deduction. tainly, homeowners are more likely to Income taxes influence many person- vote, go to church, garden, know the al decisions, such as how many hours name of their U.S. representatives, and to work or how much money to save; say that they “work to solve local prob- economists typically consider these ar- lems.”10 Economists have struggled to ti½cial influences, called distortions, to identify whether these effects represent be unfortunate.12 Income taxes also dis- a causal effect of homeownership, where- tort decisions about where to live by dis- by owning a house creates better citizens, proportionately taxing people who live or whether the reverse is true: people in highly productive, high-wage areas who are inclined to good citizenship are like Boston and New York. Albouy ar- more likely to become homeowners. gues that the home mortgage interest One approach to this problem has deduction makes up for some of this been to look at people over time, track- distortion by providing greater bene- ing whether their citizenship-related ½ts for people living in high-cost areas, activities change with homeownership which tend to offer higher wages.13 status. Using data on homeownership and civic involvement in Germany, The real bene½ts of federal housing economist Denise DiPasquale and I policy must be stacked against the have found that a change indeed occurs costs. Perhaps the most obvious dis- when people become homeowners, but advantage of the home mortgage inter- the effect is much smaller than that esti- est deduction is its highly regressive mated by comparing homeowners and character. Economists James Poterba renters.11 We have also attempted other and Todd Sinai have estimated that the –perhaps less convincing–means of es- average homeowning household earn- timating the causal link between owner- ing between $40,000 and $75,000 per ship and citizenship. For example, we year receives an annual tax bene½t of ½nd that much of the impact of home- $523 from the deduction. An average ownership appears to come simply from homeowning household that earns length of time lived in the community. more than $250,000 per year receives When people stay in one place, they de- a bene½t of $5,459.14 These estimates velop ties and work more for commu- assume–no doubt incorrectly–that nal aims. behaviors would not change if the de-

100 Dædalus Fall 2010 duction were eliminated. However, we other forms of capital. Indeed, providing Housing have no good way of estimating how incentives for people to buy bigger homes policy in the wake many people would pay off their mort- may not make much sense in a country of the gages were the deduction eliminated. where homes are already extremely large. crash Less attention has been paid to the Larger homes typically use more energy,15 progressivity of subsidies implicit in and if carbon emissions damage the en- the fha, Fannie Mae, and Freddie Mac. vironment, then pushing people to buy The fha provides insurance only for large, energy-intensive dwellings has less expensive homes and moderate- costs. income individuals, though in the past, By pushing homeownership as a source it has been accused of bias against mi- of asset accumulation, the government norities and poorer neighborhoods. ensures that individual portfolios will be Likewise, Fannie Mae’s and Freddie highly skewed toward housing wealth. Mac’s bene½ts typically go to a mid- As we have just seen, housing wealth is dle section of the U.S. income distribu- hardly risk-free. Moreover, individual tion. These programs certainly are not wealth levels are often enormously sen- strongly progressive–the very poor sitive to changes in the housing market. are less likely to be homeowners–but Private buyers and lenders ultimately they are also far less regressive than the bear primary responsibility for the de- home mortgage interest deduction. faults and bankruptcies that have fol- The regressive nature of the deduction lowed the housing collapse, but by en- should be part of any public discussion couraging individuals to borrow to bet about reform. To an economist, howev- on housing, the government bears some er, regressivity is not intrinsically damn- auxiliary responsibility. ing. After all, the income tax as a whole Any housing subsidy would encour- is highly progressive, and the regressivi- age individuals to invest too heavily ty of a particular deduction must be con- in housing–relative to uninfluenced sidered within that larger context. Even decision-making–but mortgage subsi- more important, the tools of economics dies in particular encourage people to do not naturally allow us to consider the leverage themselves to the hilt. Even virtues of taking from one group of citi- before the recent boom, in 1998, 3.9 zens and giving to another. That discus- percent of new mortgages had loan-to- sion is the province of philosophers and value ratios above 95 percent. Enabled politicians. by subsidized mortgage interest, indi- More aptly, the tools of economics are viduals typically re½nance their homes designed to judge the impact of these to get cash out. In turn, home buyers mortgage subsidies on potential home- have debt-½nanced portfolios, the value owners’ behavior. The subsidies do more of which fluctuates wildly with the state than just encourage homeownership; of the housing market. they have signi½cant, usually negative, As Todd Sinai and Nick Souleles16 side effects–at least from the perspec- have argued, owning a home is itself tive of mainstream economics, which something of a hedge. People are born generally views unjusti½ed distortions into the world short of housing. Rent- of behavior as negative. ers bear housing-price risk associated Perhaps the most obvious distortion with changes in rental costs. At its best, is that the subsidies encourage people to homeownership provides protection invest excessively in housing relative to against these fluctuations in rental costs,

Dædalus Fall 2010 101 Edward L. but for people who anticipate moving or Suburban living normally entails more Glaeser trading down, homeownership also cre- energy use because of larger homes and on the 18 ½nancial ates portfolio risk. Policy that encour- longer commutes. Much of the world’s crisis & ages people to borrow as much as possi- economic and cultural innovations oc- economic policy ble to invest in just one asset class is of cur in cities, and if such urban-centered dubious value. activity generates wider social bene½ts, Subsidizing homeownership and then discouraging city living carries fur- housing consumption also impacts ther social costs. urban form. There is a tight connec- Finally, homeowners are less mobile tion between structure type and owner- and less able to respond to economic ship type. More than 85 percent of peo- shocks. Economist Andrew Oswald has ple who live in single-family detached found that, across European regions, homes own their residences. More than unemployment is highest where home- 85 percent of people who live in struc- ownership is highest. This fact does not tures with ½ve or more units rent. This hold in the United States, but his argu- pattern provides good incentives for ment has merit, especially in declining maintaining single-family homes and regions. Should public policy really be avoiding inter-owner conflict in multi- encouraging poorer Americans to buy family dwelling. Single-family detached property, tying them to cities that seem houses depreciate by an additional 1 per- locked in long-run decline? cent per year when they are occupied by renters who fail to provide the sweat eq- A housing market crash creates two uity needed for maintenance. As those opposite pressures on government pol- familiar with co-op boards can attest, icy. On one side, it exposes the folly of the costs of spreading ownership of one government policies that push people to large structure across a large number of bet on housing markets. On the other, it owners underscore the bene½ts of hav- produces a dangerous climate in which ing one owner for each roof. to attempt new policies that could de- But single-family detached houses are press the housing markets even more. typically in suburbs while apartments One force pushes toward reform, the are typically in cities. High land values other toward the status quo. in the urban core push structures up- As of May 2010, the housing market ward. Seventy-six percent of Manhattan seemed somewhat less poised on the residents rent; 64 percent of residents in brink of further disaster. Between May nearby Westchester County own.17 By 2009 and January 2010, housing prices subsidizing homeownership, the govern- remained relatively steady in much of ment implicitly encourages people to the country. In Las Vegas and Phoenix, leave cities and move into single-family prices had returned to their historic detached houses elsewhere. norms, which are closely related to con- There are good reasons to question struction costs. If recent trends provide the many government policies, includ- any guide, the housing market can be ing subsidies to agriculture and high- quite stable for many years after prices way construction, which tilt against level off. For example, between March urban areas. In many cases, suburbs 1991 and May 1997, the Case/Shiller ten- are far more homogeneous than cities, city index neither rose nor fell more than and encouraging suburbanization push- 2.5 percent in nominal terms relative to es people to live in segregated polities. its March 1991 level. It is therefore rea-

102 Dædalus Fall 2010 sonable to contemplate appropriate thus be far less tilted toward the rich. Housing housing reforms as long as those re- Inevitably, homeowners will tend to policy in the wake forms are implemented gradually and be wealthier, and a tax credit likely will of the with care. not bene½t people who do not pay taxes. crash The most promising target is the home Nevertheless, even though a flat home- mortgage interest deduction. Even if the owner’s tax credit would still encourage goal of homeownership is considered migration from cities and would still sacrosanct, there are far better ways to give more bene½ts to the rich, it would promote it. The deduction not only has be far less regressive and distortionary a number of harmful side effects, like than the current policy. encouraging borrowing and extra hous- As a somewhat more politically fea- ing consumption, but it is also poorly sible policy approach, the cap on the targeted. The biggest bene½ts of the de- home mortgage interest deduction duction accrue to the wealthy, who are might be lowered from $1 million to, likely to be homeowners regardless of say, $300,000, as suggested by the 2005 tax policy. Less prosperous Americans, Tax Reform Panel. A simple, gradual who are as equally likely to own a home method of implementing this change as they are to rent, often fail to itemize would be to reduce the deduction cap the deduction even if they are home- by $100,000 per year for the next seven owners. In fact, more than three-quar- years. To a small degree, the cap would ters of homeowners do not itemize; the limit the incentive to invest in larger poorest four-tenths of Americans take homes or borrow extreme amounts, the standard deduction.19 but this approach would be decidedly For this group, the mortgage interest second-best relative to the straight tax deduction does little, if anything. Over credit; for most Americans, it would time, the deduction greatly increases in preserve strong incentives to borrow value during expected periods of high in- and buy large homes. flation because nominal interest can be The fha, Fannie Mae, and Freddie deducted, yet there is hardly an observ- Mac present a thornier problem. It is able increase in homeownership during reasonable to argue that the fha does periods when the deduction becomes solve a genuine market failure. More- more valuable. Across states, the size of over, it provides for lower income the bene½t (or changes in the size of the Americans and is thus the least attrac- bene½t) has no apparent effect on home- tive candidate for major reform. The ownership. fha has taken on a great deal of risk, To increase homeownership without but by slightly raising fees, it can easily encouraging excessive borrowing or big- accumulate enough capital to continue ger homes, the natural tool would be a to cover its costs. flat homeowner’s tax credit. This tax The case for a major overhaul of credit could be independent of the size Freddie and Fannie is considerably of the house or mortgage, would reduce stronger. At the time of this writing, tax payments for every American who many estimates for the taxpayer losses owns his or her own home, and could paid by Fannie and Freddie were up- be included on top of the standard de- wards of $300 billion.20 Any subsidy duction. This clear, tangible tax bene½t to homeownership can be created di- would accrue to the owner regardless of rectly through the tax system; there the size or value of the home, and would is little apparent need for a second,

Dædalus Fall 2010 103 Edward L. less visible subsidy operating through of loan-to-purchase price, but also on Glaeser government-sponsored enterprises. the ratio of loan-to-expected resale val- on the ½nancial These public agencies may not need ue, which may be considerably lower. crisis & to exist at all, but if they do, they will For example, in markets that have ris- economic policy probably function best as slow-moving, en considerably, expected resale value highly regulated public utilities, with a will be lower than current prices because mandate limited to insuring, bundling, prices tend to revert to historic norms. and selling mortgage-backed securities. In markets where there is little restraint One model suggests reinstating them on building and land is abundant (which as a strong, independent public entity, is the case in much of America), expect- with a governance structure vaguely reed resale value should be tied to con- sembling that of the Federal Reserve struction costs–despite the vicissitudes Board. The gses have often been thought of current prices–with the expectation to wield much weight on Capitol Hill, that prices will eventually return to the and lawmakers have often supported costs of delivering housing. While it is an expansion of their activities, as long a mistake to put too much faith in any as this expansion was joined with other forecasting model, the evidence for mean activities that lawmakers found desir- reversion is suf½ciently strong that re- able. A better model would establish a quiring higher guarantee fees in places national mortgage insurer with a great- that have experienced signi½cant recent er degree of separation from politics price increases is a solid policy approach. and the pro½t motive. If this policy had been followed during National mortgage insurers should the boom, then guarantee fees would be required to refrain from all activities have become much higher during the other than the insuring, bundling, and booms of Phoenix and Las Vegas. The selling of mortgages. There is no reason higher fees would have both protected for these entities to hold hundreds of the gses against risk and perhaps also billions of dollars of mortgage-backed helped check the wild swings in prices. securities in their own portfolios, as It is, of course, quite possible that an they did before the crash. If the agency excessively conservative national mort- is meant to solve market failures that gage insurer will charge too much, but challenge a purely private secondary that is a fairly minor problem as long as mortgage market, then it should stick there are no barriers to free entry in the to that function. market for mortgage insurance. If pri- A revamped public mortgage insurer vate insurers offer better and cheaper would continue to charge a guarantee products, then the public entity will not fee based on borrowers’ loan-to-value have much business, which is perfectly and credit score. However, fees can be acceptable, at least as long as the private conservatively high. Moreover, the na- insurers cannot offer an implicit govern- tional mortgage insurer, like the Feder- ment guarantee of their own. The national Reserve Board, should recognize that al mortgage insurer should guarantee housing prices are not like stocks. They that the secondary mortgage market do not typically follow a random walk does not disappear; that is its primary but, rather, show considerable mean re- function. version over ½ve-year horizons. To correct this phenomenon, guarantee fees The great national housing convulsion should be based not only on the ratio bears two major lessons: housing mat-

104 Dædalus Fall 2010 ters and prices fall as well as rise. Ordi- were provided by the government- Housing nary home buyers and the global ½nan- sponsored enterprises, which insured policy in the wake cial system can suffer enormously when mortgages at a cost that now seems of the housing markets crash. It is neither pos- too low. These policies arti½cially en- crash sible nor desirable to legislate housing couraged borrowing. bubbles out of existence; the human Even if America wants to encourage capacity for over-optimism is just too homeownership, it does not need to en- strong. But it is both possible and desir- courage borrowing or buying big homes. able to limit the public role in encourag- A simple, moderate homeowner’s tax ing those bubbles and to reduce the suf- credit would encourage homeownership fering they cause. We can reduce the more fairly and with fewer distortions. public subsidies that encourage people A plodding, conservative public mort- to borrow as much as possible to make gage insurer that charges relatively high risky investments in housing. fees can ensure the existence of a sec- The tax code is currently geared to ondary mortgage market with less risk induce mortgage debt. Every buyer to taxpayers and less excessive borrow- who bought during the boom had the ing. The housing crash exposed the folly blessing of a government that encour- of subsidizing leveraged bets on hous- aged homebuying through rhetoric ing. It would be a shame if we ignore and the tax code. Additional subsidies that lesson.

endnotes 1 Edward L. Glaeser, Joshua D. Gottlieb, and Joseph Gyourko, “Can Cheap Credit Explain the Housing Boom?” nber working paper 16230 (National Bureau of Economic Re- search, 2010). 2 Edward L. Glaeser and Joseph Gyourko, “Housing Dynamics,” nber working paper 12787 (National Bureau of Economic Research, 2006). 3 Karl E. Case and Robert J. Shiller, “The Behavior of Home Buyers in Boom and Post- Boom Markets,” in Stock Market Crashes and Speculative Manias, ed. Eugene N. White, Elgar Reference Collection, International Library of Macroeconomic and Financial History, no. 13 (Cheltenham, U.K.; Brook½eld, Vt.: Elgar, 1996), 314–330 (distributed by Ashgate). 4 http://www.hud.gov/of½ces/adm/hudclips/letters/mortgagee/½les/10-02ml.pdf. 5 This fee, called the “up-front” fee, is paid at closing, but lenders often roll the fee into the loan, so that the “up-front” fee is paid off over many years. The fha also charges an annual mortgage insurance fee. 6 http://www.newyorkfed.org/markets/mbs_faq.html. 7 Edward L. Glaeser and Joseph Gyourko, “Rethinking Federal Housing Policy” (Wash- ington, D.C.: aei Press, 2009). 8 Lawrence F. Katz, Jeffrey R. Kling, and Jeffrey B. Liebman. “Moving to Opportunity in Boston: Early Results of a Randomized Mobility Experiment,” Quarterly Journal of Economics 116 (2) (May 2001): 607–654. 9 Glaeser and Gyourko, “Rethinking Federal Housing Policy.” 10 Denise DiPasquale and Edward L. Glaeser, “Incentives and Social Capital: Are Home- owners Better Citizens?” Journal of Urban Economics 45 (2) (March 1999): 354–384.

Dædalus Fall 2010 105 Edward L. 11 Ibid. Glaeser 12 on the David Albouy, “The Unequal Geographic Burden of Federal Taxation,” Journal of Political ½nancial Economy 117 (4) (August 2009): 635–667. crisis & 13 economic The correlation across metropolitan areas between median incomes and median property policy values in the 2000 U.S. Census was 67 percent. Joseph Gyourko and Todd Sinai provide a summary of the geography of the home mortgage interest deduction, demonstrating that the bene½ts accrue primarily to richer areas; Joseph Gyourko and Todd Sinai, “The Spa- tial Distribution of Housing-Related Ordinary Income Tax Bene½ts,” Real Estate Economics 31 (4) (Winter 2003): 527–575. 14 James Poterba and Todd Sinai, “Tax Expenditures for Owner-Occupied Housing: Deduc- tions for Property Taxes and Mortgage Interest and the Exclusion of Imputed Rental In- come,” American Economic Review 98 (2) (May 2008): 84–89. 15 Edward L. Glaeser and Matthew E. Kahn, “The Greenness of Cities: Carbon Dioxide Emis- sions and Urban Development,” Journal of Urban Economics 67 (3) (May 2010): 404–418. 16 Todd Sinai and Nick S. Souleles, “Owner-Occupied Housing as a Hedge Against Rent Risk,” Quarterly Journal of Economics 120 (2) (May 2005): 763–789. 17 The U.S. Census, American Fact½nder, is the source of both ½gures, which refer to the 2006–2008 period. 18 Glaeser and Kahn, “The Greenness of Cities.” 19 Edward L. Glaeser and Jesse M. Shapiro, “The Bene½ts of the Home Mortgage Interest Deduction,” Tax Policy and the Economy 17 (2003): 37–82. 20 http://www.bloomberg.com/apps/news?pid=email_en&sid=a2Z5GnTAPcuo.

106 Dædalus Fall 2010 Barry Eichengreen

International ½nancial regulation after the crisis

What was once almost quaintly re- Herein lies the problem: to be effec- ferred to in the United States as the tive, regulation of ½nancial markets and Subprime Crisis eventually came to be institutions must be coordinated across known, in America and abroad, as the countries. Most big banks operate in Great Global Credit Crisis of 2008–2009. more than one country, affording them The change in terminology is itself indic- the opportunity to relocate their opera- ative of the international spread of the tions and employees. When the United crisis. It reflects how, in the end, no coun- Kingdom moved to tax bankers’ bonus- try was immune to the global reach of es, the bankers in question threatened ½nancial instability. to move to Geneva. When the European Now that the worst effects are past, of- Union began to contemplate strict regu- ½cials have begun drawing lessons and lation of hedge funds, fund managers formulating policy responses. The United proposed moving their operations to States has focused on strengthening mort- New York. When the eu then mooted gage underwriting standards, moving the possibility of prohibiting residents transactions in derivative ½nancial instru- from investing in hedge funds and pri- ments onto organized exchanges, and vate equity ½rms regardless of where curbing proprietary trading by depository they were located, the U.S. Treasury institutions insured by the Federal De- complained that such measures unfairly posit Insurance Corporation (fdic). The discriminated against the U.S. ½nancial United Kingdom has emphasized the per- services industry and violated interna- verse incentives created by bonus-based tional treaties like the General Agree- compensation of ½nancial executives and ment on Trade in Services. sought to reform executive pay. France Not only is disagreement among na- and Germany have singled out the risks tional regulators over priorities and strat- created by lightly regulated hedge funds egies a source of potential conflict, but it and private equity ½rms. Of½cials in other threatens to vitiate their efforts to make countries have prioritized still other is- the world a safer ½nancial place. In a ½- sues. On what should take precedence nancially integrated world, many regula- there is little agreement. tory restrictions are impossible to effectively enforce purely at the national level. © 2010 by the American Academy of Arts Whatever the regulatory response–tax- & Sciences ing bank size, bank bonuses, or speci½c

Dædalus Fall 2010 107 Barry bank activities–limiting evasion re- ing parties not to undercut one another’s Eichengreen quires a signi½cant degree of interna- regulatory efforts.1 on the ½nancial tional cooperation. A further argument for international crisis & The above examples are speci½c in- cooperation is that individual countries, economic policy stances of the general phenomenon making decisions in isolation, lack ade- known as regulatory arbitrage. When quate incentive to engage in rigorous restrictive regulation raises the cost supervision and regulation of domestic of doing business (as it is designed to ½nancial ½rms and markets. While doing do when business activities have social so is costly, the bene½ts accrue not just costs), businessmen have an incentive to the individual country but also to its to relocate to more permissive jurisdic- neighbors. The virulence of ½nancial tions, frustrating regulators’ efforts and “contagion”–the speed and extent to raising the costs to society of the busi- which instability can spread, infecting ness activity in question. In the United the ½nancial systems of other countries States, regulatory arbitrage may mean –such as that which was evident in the shifting an activity between af½liated aftermaths of the Bear Stearns, Ameri- ½rms that are subject to different regu- can International Group, and Lehman lations and overseen by different regu- Brothers crises in March and September lators–from a bank to an af½liated in- 2008, illustrates the point. In these epi- surance company or a structured invest- sodes, inadequate supervision and reg- ment vehicle (siv), for example. Regu- ulation in the United States spawned a latory arbitrage can also mean shifting crisis that engulfed the entire world. high-risk activities from a country with As Thomas Mayer, chief economist of more stringent regulation to another Deutsche Bank, put it, “In this day and where regulation is more permissive. age, a bank run spreads around the To limit this behavior, international co- world, not around the block.”2 operation in establishing a common The implications for regulation are regulatory standard is the obvious way direct. If a government invests in regu- forward. lation, some of the bene½ts may accrue While the case for cooperation is to other countries, giving the initiating straightforward in principle, the mobil- country inadequate incentive to invest. ity of ½nance creates a temptation for The problem is not unlike that of res- regulators to undercut one another in idents of a ½re zone. It is in the self- practice. Competition for business may interest of each resident to clear the create a race to the bottom. Competing underbrush around his home in order jurisdictions, seeking to attract foot- to enhance his own safety. But the indi- loose ½nancial ½rms, have an incentive vidual homeowner may not consider to offer more permissive regulation or the additional bene½ts, from a social lax enforcement. More than one coun- point of view, of his brush-clearing try has launched “Big Bang” reforms, exercise; he may not see that doing so liberalizing burdensome regulation and, also enhances the safety of his neigh- sometimes, weakening enforcement in bors. In the urban context, municipal an effort to enhance its attractions to regulation requires everyone to clear internationally mobile ½nancial ½rms. additional brush. In the context of glob- To address this problem, competing al ½nance, the solution rests on interna- countries might enter into an international standards and coordination of tional agreement that requires consent- ½nancial regulation.

108 Dædalus Fall 2010 Finally, cooperation could create a and other large nonbank intermediaries Inter- viable alternative to the uncontrolled are also beyond its jurisdiction. national ½nancial bankruptcy of troubled ½nancial insti- The Dodd-Frank ½nancial reform bill regulation tutions on the one hand and emergency adopted in Summer 2010 gives federal after the rescues on the other. Emergency rescues regulators new authority to seize and crisis are criticized on both equity and ef½cien- break up large troubled ½nancial ½rms. cy grounds. To the extent that a rescue is What it fails to recognize, unfortunately, ½nanced by taxpayer money, present or is that most large ½nancial companies future, it is rightly seen as unfair. More- –the presumed targets of these proce- over, because banks know they will re- dures–operate internationally. A case ceive assistance in the event that the bets in point is Lehman Brothers, which had they make go bad, they have an incentive consequential operations in the United to place bigger and riskier bets. Regular Kingdom as well as in the United States. recourse to rescues creates moral hazard, The conflicting claims of creditors in the which has social costs. two jurisdictions, together with differ- But the alternative–allowing a big ences in resolution regimes, created seri- bank to declare bankruptcy–is not ten- ous dif½culties for courts and regulators able if doing so threatens the stability of seeking to limit the systemic consequen- the ½nancial system. The troubled insti- ces of the institution’s failure in 2008. tution will have borrowed from other Establishing an orderly resolution ½nancial institutions. It will have other regime as an alternative to bailouts is contracts outstanding, many of which desirable. But meaningful progress will will be frozen when bankruptcy is ½led require, at a minimum, that provisions and an automatic stay is imposed. A stay adopted at the national level be coordi- may therefore cause liquidity problems nated internationally. And if coopera- –and worse–for the bank’s counterpar- tion proves inadequate, regulators will ties, forcing them to call in their own have to contemplate creating a supra- loans in order to raise funds. Asset prices national resolution authority. may collapse in a ½re sale, and the liquidity crisis may cascade through the ½nan- Not everyone is convinced, however, cial system. Lack of attention to third- by the case for international regulatory party effects in Chapter 7 and Chapter 11 coordination. Regulatory oversight, to bankruptcy proceedings coupled with be effective, must be tailored to local the slow pace of court proceedings ren- needs. National ½nancial structures and der these problems especially pervasive systems differ, requiring differences in and this approach to resolution particu- the structure and application of regula- larly problematic in the case of ½nancial tion. In some countries, ½nancial sys- ½rms.3 tems are predominantly bank-based. In In the United States, the fdic can step others, the United States and the United in, seize, and ring-fence the operations Kingdom being prominent examples, the of a bank to which it extends deposit-in- securitization of ½nancial claims is more surance coverage. It can pay off a bank’s extensive. In these countries, the growth obligations to its counterparties. But the of securities markets has led to “disinter- fdic lacks this authority with regard to mediation”–the displacement of bank the big, complex bank holding compa- borrowing and lending to securities mar- nies that pose the most serious threat to kets. Financial systems must be regulat- systemic stability. Insurance companies ed differently according to whether they

Dædalus Fall 2010 109 Barry are dominated by banks or securities ciently stringent to protect his or her Eichengreen markets. Further differences include interest. This is another reason that on the ½nancial whether the state owns a stake in the international agreements may lead crisis & country’s leading ½nancial institutions; to weak and ineffectual rules. economic policy whether Internet banking is prevalent; Finally, some argue that regulatory di- and whether the country is predomi- versity is desirable for the same reasons nantly Islamic, as Islamic banking pro- that biodiversity is desirable. Efforts at hibits the payment of interest, requir- international coordination, whereby gov- ing lending to be structured in other ernments converge on a single set of stan- ways. All these are reasons why one-size- dards, may in fact leave the global ½nan- ½ts-all regulation, which is what tends cial system more exposed. The standards to come out of international agreements, in question may turn out to be poorly is undesirable. designed and inappropriately targeted. An additional danger is that interna- If they are designed to contain one set of tional coordination may lead to lowest- risks and a different set materializes, the common-denominator regulation. Agree- fact that all jurisdictions have adapted ments on matters such as minimally ad- their regulatory policies in the same way equate capital ratios for internationally may only contribute to ½nancial insta- active banks, to be effective, must be ac- bility. From this standpoint, given the cepted by all countries with consequen- possibility of diverse shocks to global ½- tial banking systems. As a result, agree- nancial markets, the presence of diverse ments tend to be by consensus. For all regulation may enhance the stability of concerned countries to agree, any pro- the ½nancial ecosystem. vision that one country ½nds objection- There is something to these arguments able must be removed from the agree- –which is precisely why there is a debate ment or, at the least, watered down. The about the ef½cacy of internationally coor- result is a weak and ineffectual agree- dinated reform. Yet, even conceding these ment. As a case in point, critics of inter- points, the case for cooperation is over- national agreements point to the Basel whelming. For one, the implications of Accord for Capital Adequacy for Interna- differences in ½nancial structure should tionally Active Banks. The Basel Accord not be overstated. Despite variance across is designed to ensure that banks have national systems, over time there has buffers to cope with adverse circum- been a strong tendency toward conver- stances, but it has not prevented bank gence. Furthermore, countries with bank- capital from falling to near zero and based ½nancial systems and those with bank solvency from being threatened market-based systems can adopt the same in each of our recent ½nancial crises. approach to regulation of their banks and Part of the problem may be that inter- securities markets; the consequential dif- national agreements negotiated in far- ference would be to which set of regula- distant places like Basel are prone to be tions they devote the bulk of their en- captured by the regulated. Banks with forcement effort. a preference for relatively permissive Second, the fear that agreement by con- regulation have the resources and exper- sensus leads to lowest-common-denom- tise to influence the Basel Committee inator regulation should not preclude on Banking Supervision. This is not so cooperation. Rather, countries most con- for the man or woman in the street concerned with risks to ½nancial stability cerned that regulation should be suf½- should move ahead with coordinated

110 Dædalus Fall 2010 reforms and apply sanctions that dis- investment-grade ratings from commer- Inter- courage their ½nancial institutions from cial credit rating agencies. Because rat- national ½nancial doing business with the countries that ings are revised upward in good times regulation lag behind. They should similarly pro- and downward in bad times, this prac- after the hibit ½nancial ½rms chartered in less tice was strongly procyclical. It encour- crisis regulated jurisdictions from entering aged even more lending when lending their markets. was booming and more retrenchment Finally, if non½nancial interests are when ½nancial institutions were re- inadequately represented in internation- trenching. It ignored the conflicts of al negotiations, then the appropriate re- interest to which the rating agencies sponse is not to abandon those negotia- were subject. It also allowed banks to tions but to open them up to additional use their own internal models–later stakeholders. shown to be problematic–to evaluate the risk of losses and the amount of cap- Historically, the most prominent in- ital that had to be held against those ternational institution concerned with risks. It bought into the bankers’ argu- regulatory reform has been the Basel ments that they could safely reduce their Committee on Banking Supervision, own funds held in reserve (so-called which is made up of representatives of Tier 1 capital) to little more than 2 per- central banks and other banking super- cent of bank assets. visors. The Basel Committee meets on Some of these problems issue from the premises of the Bank for Internation- the Basel Committee’s origins and their al Settlements in Basel, Switzerland, a influence on its remit. The Committee minimum of four times a year. When it was created in 1974 in response to prob- was founded in 1974, only the United lems with a major cross-border bank States, Canada, Japan, and seven Euro- (Germany’s Herstatt Bank); the focus pean countries were represented. Mem- of the Basel Committee on Banking Su- bership has since expanded to twenty- pervision, therefore, is on banking super- seven countries, including the emerging vision. Once upon a time, the perimeters markets of Latin America and Asia. of the banking and ½nancial systems were While the Basel Committee has tradi- roughly coincident because banks were tionally focused on ensuring that banks the dominant providers of ½nancial ser- have enough capital to weather shocks, vices. But with the growth of securities over time it has also considered a variety markets and nonbank ½nancial ½rms, of other stability-related issues, includ- this is no longer the case. ing, most recently, liquidity risk. Its sig- As a result, the Basel Committee set nature achievement is the Basel Accord capital adequacy standards for commer- for Capital Adequacy for Internationally cial banks; meanwhile, in countries such Active Banks, as virtually all large banks as the United States, it was not just the today are internationally active. large commercial banks (and commer- Unfortunately, the Basel Accord, and cial bank holding companies) that posed especially the updated version, Basel II, potential risks. Once upon a time, invest- published in 2004 and adopted by a ment banks like Lehman Brothers in- growing list of countries subsequently, vested only their own partners’ capital, are now understood to be seriously but more recently, they began leveraging flawed. Basel II allowed banks to hold their operations with borrowed funds. less capital against assets that received Broker dealers like Bear Stearns that

Dædalus Fall 2010 111 Barry booked and cleared the trades of others what is desirable, after which regulators Eichengreen increasingly engaged in proprietary trad- are free to go home and do more or less as on the ½nancial ing, using an even higher ratio of bor- they please. Like the Pope, the fsb has no crisis & rowed money to own capital than was army. It has even less sanctioning power. economic policy typical of investment banks. Insurance Its members are aware of this prob- companies like the American Interna- lem. Indeed, one need only consult the tional Group (aig) were overseen only fsb’s antiseptically titled January 2010 by state insurance commissioners–to report, “Framework for Strengthening the extent that they were overseen at all. Adherence to International Financial Markets in structured derivative secu- Standards.” This report succeeds in iden- rities were often entirely unregulated. tifying only three mechanisms for ensur- The members of the Basel Committee ing adherence to its standards: leading were aware of these gaps, but awareness by example on the part of member juris- does not equate to the capacity to act. dictions, peer review, and a vaguely speci- Early recognition of these problems ½ed “toolbox of measures” (speci½c tools led to the 1999 formation of a second presumably being too sensitive for the body, the Financial Stability Board (fsb; lid on the box to be lifted). It seems un- originally named the Financial Stability likely that the fsb entertains any illusion Forum). The fsb, which is supported by that these limp instruments will get na- a small secretariat also housed at the Bank tional regulators to sit up and listen. for International Settlements, has a man- Then there is the Group of 20 (G20), date to assess vulnerabilities affecting which, recognizing the emergence of the entire ½nancial system and to over- a more multipolar world, has assumed see action to address them. It seeks to the role of steering committee for the monitor market activity, highlight regu- world economy (a role played previous- latory developments, and identify sys- ly by the Group of 7 and Group of 10 temic risks. Some two dozen countries advanced countries). Its twenty mem- are represented. Members include not bers include advanced countries and just central banks and other regulators emerging markets alike, as well as the but also ½nancial standard-setting bod- European Union. At recent meetings, ies like the International Association of it has also included a twenty-½rst mem- Insurance Supervisors and the Interna- ber, Spain, a large country that was in- tional Organization of Securities Regu- explicably excluded when the G20 was lators. The fsb has created committees formed but whose attendance was in- concerned with a range of issues that po- sisted upon by the European Commis- tentially pose risks to ½nancial stability, sion, and a twenty-second, The Nether- including international capital flows, lands, a member of previous groupings hedge funds, and offshore ½nancial cen- that insisted on inviting itself. The G20 ters. Its deliberations, when agreement is a mechanism to ensure that not just is reached, result in a set of recommen- regulators but leaders (½nance ministers dations and a published report. and prime ministers, who presumably The fsb’s mandate to monitor the give marching orders to the regulators) global ½nancial system as an integrated buy into the process of policy reform. whole constitutes an important step for- Following its biannual meetings of heads ward. The Board’s limitation is that it of state and government, it issues com- is essentially a talk shop: a place to ex- muniqués that include commitments on change information and ponti½cate on ½nancial reform. At its June 2010 summit

112 Dædalus Fall 2010 in Toronto, for example, leaders com- of its loan to countries it judges to have Inter- mitted to phasing in higher capital stan- made inadequate progress in ½xing eco- national ½nancial dards for banks. Similar to the fsb, the nomic and ½nancial problems. regulation G20 forms working groups to investigate But the imf possesses no such power after the ½nancial problems and offer recommen- over other countries. Illustrative of this crisis dations. limitation is the fact that countries must But the G20 has a legitimacy problem: agree before a potentially embarrassing it was formed in response to an earlier assessment of their ½nancial sectors can crisis in the late 1990s, essentially in ad be conducted. Shortly before the Sub- hoc fashion. (The equally ad hoc partic- prime Crisis, the imf and World Bank ipation of Spain and The Netherlands, reportedly approached the U.S. govern- whether desirable or not, is indicative ment to request an assessment and were of this fact.) No one appointed this par- refused. ticular set of countries to make decisions for the world. Nothing ensures that their Evidently, there is no dearth of studies recommendations will be respectfully and no shortage of committees, boards, received and acted upon by countries and organizations concerned with inter- represented in their deliberations. national aspects of regulatory reform. A ½nal institution concerned with There is, however, a shortage of conse- ½nancial stability is the International quences for countries whose regulatory Monetary Fund (imf). The imf has a policies are not adequate. The question written constitution, the Articles of is how to address this problem. Agreement, to which its members are One option would be to create a new bound. It organizes countries into con- body, a World Financial Organization stituencies, each of which is represent- (wfo), membership in which would cre- ed by a member of its Executive Board, ate concrete obligations whose violation ensuring that all 180-plus national mem- would have signi½cant consequences. bers have voice; it therefore does not In the same way that the World Trade suffer from the same kind of legitimacy Organization (wto) establishes prin- de½cit as the G20. It publishes a Global ciples for trade policy (such as nondis- Financial Stability Report designed to crimination, reciprocity, transparency, provide a synthetic assessment of risks binding and enforceable commitments) to the international system. In conjunc- without prescribing outcomes, the wfo tion with the fsb, it conducts early- would establish principles for prudential warning exercises designed to antici- supervision and regulation (capital and pate ½nancial problems. Together with liquidity requirements, limits on portfo- the World Bank, its sister organization, lio concentrations, adequacy of risk mea- it conducts regular ½nancial-sector as- surement systems and internal controls) sessments intended to provide outside without attempting to prescribe the reviews of the ½nancial strength and structure of regulation in detail. regulatory practices of its members. In But once the wfo de½ned obligations the course of this review, it recommends for its members, the latter would be adherence to international best-practice obliged to meet them. Membership could standards. Countries that borrow from be made mandatory for all countries seek- the Fund are subject to an enforcement ing freedom of access to foreign markets mechanism; the imf can deny disburse- for their investors and domestically char- ment of the next quarterly installment tered ½nancial institutions. The wfo

Dædalus Fall 2010 113 Barry could appoint independent panels of obligations. The wto has the power to Eichengreen experts to determine whether countries establish dispute settlement panels and on the ½nancial were in compliance with their obliga- determine whether national law com- crisis & tions. In cases of noncompliance, other plies with a country’s wto obligations. economic policy members would be within their rights Violators have the choice of changing to restrict the ability of ½nancial institu- that legal provision or facing trade sanctions chartered in the offending country tions. If the United States and other to do business in their markets. Not only countries accept this authority in the case would this measure protect members of trade, one might ask, why shouldn’t from the negative consequences of inad- they accept it in the case of ½nance? equate regulation abroad, but doing so There is no reason why the Basel Com- would provide a real incentive to comply. mittee, the fsb, the imf, and the others Critics will undoubtedly object that should not continue their useful work governments, not least the U.S. govern- studying regulatory problems, encourag- ment itself, will never allow an interna- ing their correction, and promoting the tional organization to dictate their na- international coordination and harmo- tional ½nancial policies. However, the nization of regulatory initiatives. It has wfo would not dictate; the speci½cs of become clear, however, that more com- implementation could be left to the indi- prehensive, binding, and coordinated vidual country. Furthermore, the equiva- international regulation will be crucial lent already exists for trade. The United to ½nancial stability worldwide, now States is among the countries that have and in the future. signed wto agreements with speci½c

endnotes 1 To be sure, some would assert that restrictions on ½nancial ½rms and markets are excessive and that regulatory competition is desirable as a countervailing force. But their position is less tenable in the wake of the crisis. 2 Quoted in Mark Landler, “Europe Catches What’s Ailing U.S. Financial Sector,” The New York Times, October 1, 2008. 3 Chapter 7 and Chapter 13 are the provisions of the bankruptcy code under which the operations of an insolvent entity are liquidated and reorganized, respectively.

114 Dædalus Fall 2010 Peter Temin

The Great Recession & the Great Depression

In the depths of the Great Depression, a paroxysm of violence that brought John Maynard Keynes wrote that “[p]rac- the long economic expansion of the tical men, who believe themselves to be nineteenth century to a sudden end, quite exempt from any intellectual influ- produced the imbalance that led to the ence, are usually the slaves of some de- Depression. Britain, the workshop of funct economist.”1 This acute observa- the prewar world, was exhausted by the tion is applicable to our current Great struggle. America, the rising economic Recession as well. In fact, the newly dis- behemoth, was unprepared to take re- credited ideas are not all that different sponsibility for its new role in the inter- from the old, suggesting that Keynes may national economy. Germany, having have overestimated people’s ability to unsuccessfully challenged the Allied learn from their mistakes. Powers, refused to acknowledge its I pursue the parallels between these defeat. two watersheds in recent economic Patterns in the international move- history along three paths: the causes of ment of capital reveal this imbalance. the crises and their relation to econom- During the postwar decade, one of the ic theory; the spread of the crises on a most important reasons for approving global scale; and, ½nally, recovery–at resumed capital flows was the ruling least as far as we can see it at this point. economic theory of the gold standard. As Karl Marx famously said, history In the eighteenth century, philosopher, repeats itself “the ½rst time as tragedy, historian, and economist David Hume the second as farce,”2 a criticism that explained how currencies valued in gold also ½ts our current condition. remain stable relative to each other. If, for instance, a shock to one country de- Both of these dramatic and costly eco- creased its exports, the result would be nomic crises emerged from the interac- an outflow of gold, which would lower tion of economic imbalances in the prices in the exporting country. Lower world economy and the ruling ideolo- prices would encourage exports and de- gy of ½nancial decision-makers who con- crease imports, leading to an inflow of fronted these imbalances. World War I, gold. Prices would rise again, re-creating the previous equilibrium. This argument © 2010 by the American Academy of Arts is known among economists as the price- & Sciences specie-flow mechanism.

Dædalus Fall 2010 115 Peter Hume’s contribution is still useful Nevertheless, after World War I, policy- Temin today, although we are now aware of makers could think of no better way to on the ½nancial the many assumptions that underlie the reorganize the international economy crisis & mechanism’s proper functioning. In than to restore the gold standard–that economic policy particular, the theory presupposes that is, to ½x one price (the exchange rate) prices are fully flexible and determined while assuming all others were flexible. in competitive markets. These assump- Freezing exchange rates in this fashion tions express a view of the economy– reduced countries’ ability to adapt to often attributed to Adam Smith–that new conditions; this defect, however, has become characteristic of economic was deemed preferable to the anticipat- models in the years since Hume’s writ- ed chaos of alternative arrangements. ing. This view is taught in introductory When England attempted to reduce economics classes; it is the starting prices to sustain the value of sterling, a point for many journal articles; and it general strike resulted, revealing both is referred to as a perfectly competitive the inaccuracy of the gold standard’s economy. When conditions cross the underlying assumptions and the strength line between descriptive and normative, of the economic policies based on those however, they are transformed from assumptions. description–which may or may not In this context, the United States took be accurate–to prescription–which over the position of leading internation- in turn affects public policy. al lender and exported massive amounts These conditions may have been ful- of capital to Germany in the 1920s. The ½lled in the eighteenth century, but they loans were meant to help Germany main- were not accurate in the 1920s postwar tain the gold value of its currency, and world. In contrast to Hume’s assumption they enabled Weimar Germany to pay of a ½xed link between gold flows and reparations owed to the victors in World prices, central bankers thought them- War I and enjoy a consumption boom. selves responsible for inflation and Higher prices after the war also put strain deflation. Business ½rms had become on gold currencies, and while England larger, and many product markets were and Germany struggled as a result, econ- no longer fully competitive. As the size omists in the more prosperous United of production units, whether mines or States proclaimed the advent of a new factories, became larger, the ability of economy in which stability and prosper- labor markets to be fully competitive ity would continue inde½nitely. Hind- also diminished. Large employers yield- sight suggests that these conditions were ed little bargaining power to workers not sustainable; rather than celebrating to negotiate wages and working condi- the promised strength and vitality of a tions. If a factory, for example, was the new economy, countries should have only large employer in town, the options been concentrating on how to avoid a for workers were even more limited and rough landing from the high-flying re- the market power of the employer more sults of the previous shocks. obvious. Workers formed unions to Economic troubles appeared in Ger- countervail the market power of employ- many and the United States in the late ers, and wage bargaining and strikes 1920s. The former’s consumption growth supplanted the individual wage nego- produced a boom in municipal expendi- tiations implicit in Hume’s and Smith’s tures that began to ½zzle; in the latter, analyses. both housing and stock market booms

116 Dædalus Fall 2010 eventually crashed. As recession spread stable exchange rates and responsible The Great to other countries, international trade ½scal policies to deregulation and priva- Recession & 4 the Great decreased, but prices did not fall rapidly tization. It was an adaptation of the gold Depression enough to equilibrate markets in the standard to current conditions, stipulat- fashion Hume described. Prices were ing stable–instead of ½xed–exchange sticky, and rather than deflation, a lack rates to avoid the rigidities of the gold of foreign reserves led to unemployment. standard that proved to be harmful in When all countries found their exports the 1930s. Other requirements marked a falling, the processes of deflation and departure from the era of large govern- depression chased a moving target.3 ment that followed the Great Depression A similar international imbalance and World War II. The terms of the Con- developed after the end of the Cold War. sensus favored diminished government The new world lender, the United States, influence, so as not to impede the prog- traded roles and became the world’s larg- ress of private ½nance and industry; com- est borrower. China, a “loser” in the Cold petition would ensure continued growth War, became the United States’ primary and prosperity. Like the gold standard, lender. Just as the inflow of capital to the Washington Consensus was based Weimar Germany had fueled expansion, on the Enlightenment ideas of David the inflow of capital from China ½nanced Hume and Adam Smith and promulgated a consumption boom in the United States as a way to organize the postwar world. that developed into a housing boom. It was the economic component of the This global imbalance was apparent, new world order that the ½rst President and economists feared that a crisis Bush was looking for. would ensue. Because the United States More explicitly than the gold standard no longer adhered to the gold standard, mentality, the Washington Consensus the value of the dollar could change free- spelled out the conditions needed to ly from day to day. The question was maintain stable exchange rates. It ac- whether there would be a smooth decline knowledged that most economies in the in the value of the dollar, in the fashion later twentieth century did not resemble of the price-specie-flow mechanism, or the eighteenth-century conditions ana- an abrupt fall. These concerns were mis- lyzed by Hume and Smith and argued placed; even though the international that policies designed to re-create these imbalance created crisis conditions, earlier conditions would lead to econom- short-run booms and busts precipitated ic growth and prosperity. Using familiar economic calamity in the interwar and theories of competition and flexible recent years. One such boom was surg- prices, the underlying theory showed ing housing expenditures in the 1920s. how the competitive process of allocat- The housing market was only a minor ing resources in individual markets player in the drama of the Great Depres- would generate stable conditions for sion, but it had a starring role in our cur- society as a whole. rent crisis. Banks and associated businesses in the The housing boom flourished in recent United States extended the underlying years, nourished by the availability of reasoning to the creation of new assets Chinese capital and the ruling economic known collectively as structured ½nance. theory of the Washington Consensus. The Washington Consensus was designed This term, coined in 1989, referred to a to reduce risks, and innovative securities set of economic policies that ranged from provided a means of allocating risk to

Dædalus Fall 2010 117 Peter those investors who wanted to take it from the eighteenth century, hard-headed Temin on. Just as banks can hold fractional policy-makers either assumed or tried on the ½nancial reserves on the assumption that people to re-create the idealized conditions crisis & draw on their deposits randomly and described by Hume and Smith. These economic policy independently, the creators of new se- policy-makers ignored both the growth curities reasoned that homeowners of economies of scale in modern econo- default on mortgages randomly and mies and the work of behavioral econo- independently. Collateralized debt obli- mists that has shown that people do not gations (cdos) allowed ½nancial insti- behave as homo economicus. Their efforts tutions to bene½t from the fact that only produced the new economy of the 1920s a few homeowners default in any given and the Goldilocks economy of recent de- time, so that most mortgages are safe. cades that turned into booms and busts. Combining mortgages into “tranches,” Was it inevitable that these economic banks could separate the safe part of expansions would end badly? According mortgages from the risky parts without to the late economist Hyman Minsky, knowing which mortgages would be people become more complacent with defaulted–just as banks do not know prosperity and more willing to take on which deposits will be withdrawn but risks they often know are highly suspect.6 can safely assume that only a fraction More recently, economists Carmen Rein- will be withdrawn at any given time. hart and Kenneth Rogoff analyzed histor- Based on the ability to sell mortgages ical evidence and reached a similar con- to be securitized, mortgage brokers exclusion: booms typically precede ½nan- panded, encouraged homeownership, cial crises, just as pride goes before a fall.7 and promoted the ownership society More formally, people in both expan- championed by the second President sions miscalculated the risks they faced. Bush. Banks and other ½nancial inter- Their models were based on shocks to mediaries holding securitized assets individual countries or homeowners and took on more and more leverage, which did not allow for collective actions. The was justi½ed by their calculations that gold standard model explained how to the risks of many of these assets were deal with a shock to an individual coun- vanishingly small. But when the result- try, implicitly assuming that other coun- ing housing boom burst and many tries would be immune to whatever dis- mortgages failed, the assumption that turbance affected the distressed country. defaults occurred randomly and inde- The interaction between the country in pendently turned out to be false. cdos crisis and other countries would lead were much more risky than they had back to stability; a collective shock to appeared to be, and the separation of many economies was not considered. risky and safe assets proved to be invalid.5 Similarly, the model behind the Wash- Investors refused to buy the cdos, and ington Consensus considered individual credit markets seized up. Countries that risks. Structured ½nancial obligations had adopted the policies of the Washing- were valued as if the underlying risk of ton Consensus found themselves mired mortgage foreclosure was the result of in a worldwide ½nancial crisis. random and independent shocks to in- The Great Depression and the Great dividual homeowners. As with the gold Recession were both caused by policies standard, no consideration was given to derived from nostalgia for the world of collective shocks; housing prices were the Enlightenment. Drawing on theories expected to rise continually. It was

118 Dædalus Fall 2010 assumed that homeowners experienced for expansive policies, which were neither The Great ½nancial dif½culty and defaulted on their large nor expansive enough to stimulate Recession & the Great mortgages randomly. The randomness recovery in countries that remained in Depression of defaults enabled ½nancial designers to thrall to gold. It has become common to reduce the risk to any security by diver- attribute the continued economic decline si½cation, that is, combining many mort- to banking crises, but banks failed only gages the same way a bank combines in countries that adhered to the gold many bank deposits. When the housing standard.9 As long as countries set pol- boom ended and housing prices fell, icies to maintain the value of their cur- however, many homeowners began to rency, their banks were at risk; bank fail- default, and the risk that was supposed ures were a damaging outcome of the to be protected for through diversi½ca- depression, not its cause. Governments tion was now present in securities pre- and central bankers–not commercial viously thought to be risk free. Investors banks–led the way into depression in could not discern safer assets from those country after country. more at risk, and the prices of all struc- This process is illustrated clearly in the tured ½nance fell. Prices of some securi- United States’ experience. Banks contin- ties fell rapidly because there were no ued to fail as the government clung to buyers for them. Financial markets froze the gold standard. For instance, in early in September 2008. 1933, the Reconstruction Finance Corpo- ration refused to help a prominent Michi- The second step of this comparative gan bank holding company for reasons analysis is to evaluate the spread of each that are not clear (anticipating the fail- crisis. In the early 1930s, countries pur- ure of Lehman Brothers in 2008). States sued a moving target as their economies declared bank holidays, and the New contracted to deal with what appeared to York Federal Reserve Bank lost gold as be budget and current-account de½cits. investors speculated against the dollar. Consequently, a series of currency crises Franklin Delano Roosevelt took of½ce in Summer and Fall 1931 turned a bad in early March 1933; he immediately recession into the Great Depression. The instituted what he called a federal bank German mark collapsed when the chan- holiday to protect the banking system cellor put domestic politics ahead of from complete collapse.10 sensible ½nance.8 The Bank of England At the center of the ½nancial panic abandoned the gold standard after a sub- that initiated the Great Recession were sequent speculative attack. And the U.S. the banks and other private ½nancial Federal Reserve raised its discount rate institutions that had accumulated large dramatically in October 1931 to preserve portfolios of mortgage-backed assets, the value of the dollar; the Fed kicked the in which mortgages were combined and American economy when it was down then separated–at least in theory–into and drove it further into depression. securities of differing risks. When the Many countries continued to maintain housing boom ended in 2006 and 2007, deflationary policies in the early 1930s homeowners began to default on mort- as they tried to hold on to the gold stan- gages at an increasing rate. These defaults dard or, in the case of Germany, follow were not the random defaults assumed its prescriptions even after abandoning in the construction of mortgage-based the gold standard. Some countries fol- securities, and investors could no longer lowed England off gold and created room distinguish between the various assets.

Dædalus Fall 2010 119 Peter Ef½ciency-promoting securities were absent evidence that a crisis is indeed Temin transformed into toxic assets as it became about to emerge. Certainly, if palliative on the ½nancial progressively harder to sell them. High action forestalls the putative crisis, peo- crisis & leverage, initially a way to multiply earn- ple will ask what all the pressure was economic policy ings, became a company hazard as the about. Congress is a large and unwieldy price of assets fell. body; all these complexities precluded Apparent in American and European preventive action in Summer 2008. ½nancial markets by Summer 2007 were In September, another investment the deleterious effects of the inability to house, Lehman Brothers, found itself sell these toxic assets. Pressure contin- unable to borrow. It tried selling assets ued during the fall, and the Fed lowered to pay its obligations but could not sell its discount rate by more than a percent- its toxic assets and fell short of its needs. age point between September 2007 and Creditors wanted to be paid and investors January 2008. (The National Bureau of wanted to sell Lehman Brothers stock. Economic Research later concluded that Though an investment rather than a com- a recession had started in December mercial bank, Lehman was in a process 2007.) Fed Chairman Ben Bernanke, that resembled nothing so much as an Treasury Secretary Henry Paulson, and old-fashioned banking panic. Bernanke, President of the New York Fed Timothy Paulson, and Geithner did not wish to Geithner rescued the New York invest- repeat their rescue of Bear Stearns and ment house Bear Stearns at the point of therefore allowed the ½rm to fail on Sep- collapse with Fed funds and purchase by tember 15, 2008. After the fact, none of another investment house in March 2008. these articulate policy-makers was able They took over the two quasi-governmen- to tell a coherent story about why they tal mortgage brokers, Fannie Mae and had not avoided bankruptcy for the ½rm. Freddie Mac, in August. Even at this late The event reprised the government con- date, the Fed and other public ½gures fusion that led Michigan banks to fail in argued that the pressure was largely lim- early 1933, precipitating the bank holiday. ited to the housing sector and that the The ½nancial triumvirate had tried to measures taken up to that point were ½nd a buyer for Lehman Brothers, as they suf½cient to maintain ½nancial health. had done for Bear Stearns, but was unable Bernanke and Paulson asserted after to do so. They apparently reverted to the the fact that they tried in Summer 2008 gold standard mentality as expressed in to get Congress to take action to forestall the free-market ideology of the Washing- a crisis. This effort proved futile for sev- ton Consensus: Lehman Brothers had eral reasons. For one, the ½nancial lead- taken large risks and now had to pay the ers were making reassuring statements penalty for losing too many bets. But hard to the public at the same time they were on the heels of Lehman Brothers’ failure appealing to Congress, a mixed message came American International Group that did not lend persuasiveness to the (aig). Although it was not an investment arguments they presented. In addition, bank, this multinational insurance com- Congress was not convinced that the ½- pany also had taken too many bets on nancial system was on the verge of a what were now toxic assets and was about meltdown and was reluctant to act out- to collapse. The epidemic had escaped side of an emergency. This reluctance the mortgage market and infected the may illustrate a general problem: it is whole ½nancial system. Nearly a year hard to prepare for a hypothetical crisis earlier, the global ½nancial system had

120 Dædalus Fall 2010 entered into what Frederic Mishkin, a between now and then is that it took a The Great member of the Fed’s Board of Governors, new group of leaders to change policy. Recession & 11 the Great had called an “adverse feedback loop.” The Obama administration has many Depression One failure induced another; a world- holdovers–for example, Obama reap- wide ½nancial panic ensued. pointed Bernanke as Fed Chairman –but Paulson, Bernanke, and Geithner threw there is no doubt that the theories under- in the towel and nationalized aig. Their lying policy have changed since the last commitment to the free market had last- administration. An important difference ed one day; Congressman Barney Frank between the past and current economic (D-Mass.) suggested we call it Free Mar- calamities is that because the present ket Day!12 But while the sale of Bear crisis is only a recession–not a depres- Stearns had calmed the ½nancial markets, sion–Obama does not have the oppor- the nationalization of aig–arriving on tunity for reform that Roosevelt did. the heels of Lehman Brothers’ bankrupt- Roosevelt opened most banks quickly cy–only confused the market. The gov- after their holiday; he took the United ernment had restated its ideals and then States off gold a month later. He intro- abandoned them in the twinkling of an duced the National Industrial Recovery eye. Investors could not predict what Act (nira) and the Agricultural Adjust- would come next.13 ment Act (aaa), pillars of the New Deal, Barely functioning credit markets shortly thereafter. These actions signaled seized up completely. No one knew what a clear new direction in government pol- the government policy was or if anyone icy, or what economists call a new policy was insured; no one wanted to purchase regime. Investment rose and consump- toxic assets. Economic activity and inter- tion began to recover; the long econom- national trade came to a sudden halt. The ic decline had ended.15 brief reassertion of faith in the free mar- The continuation of high unemploy- ket in 2008 was as counterproductive as ment in the 1930s is commonly blamed ½delity to the gold standard had been on the high wages created by the nira in 1931. In both cases, the United States and the subsequent growth of unions. dragged the world down with it–doing This argument is inaccurate for several so faster the second time than it had ½fty reasons. Economic growth progressed years earlier.14 rapidly during Roosevelt’s ½rst term and may not have been able to occur any fast- Fortunately, we are now in a Great Re- er because of bottlenecks in the supply cession, not a repeat of the Great Depres- of raw materials and production. Faster sion. Ten percent unemployment and growth, even if possible, likely would unemployment insurance compares fa- have led to inflation despite high unem- vorably to 20 percent unemployment ployment.16 In fact, the recovery was so without a safety net. The primary reason fast that both the Fed and the government for this divergence is the vagary of the decided to reverse policy and rein in de- American political cycle. Voters had to mand through both monetary and ½scal wait three years after the Great Depres- policies. The result was the recession of sion began and a full year after the Fed 1937, which increased unemployment turned a recession into a depression to and delayed the return to full employ- vote on public policy; voters in 2008 ment for several more years. It was poli- had this opportunity just months after cy, not gains by labor, that extended the the ½nancial crisis began. The similarity Depression’s length.

Dædalus Fall 2010 121 Peter The growth of unions was only one re- This foreshadowing of our current Temin sult of the New Deal reforms. Not all of problems was not seen as such at the on the ½nancial these reforms were consistent with each time; even the failures of Long-Term crisis & other, and not all of them lasted more than Capital Management (ltcm) in 1998 economic policy a few years. However, the enduring parts and Enron in 2001 did not raise con- of the New Deal changed the economy in cerns. Most of the crises, like the Asian many ways. Labor and tax reforms pre- crises of 1997 (which spread to Russia, served a stable income distribution in the bringing down ltcm), were seen as economic expansion that followed World problems of less developed countries, War II. Creation of the Food and Drug not mature economies like the United Administration helped expand the phar- States. Economists and politicians alike maceutical industry that extended life for pushed for less regulation at home and many people. Social Security improved deregulation abroad. In particular, they the quality of life for many older people. sought to deregulate the international Reforms to the ½nancial system pro- flow of capital and hailed the Washing- duced a half-century free from ½nancial ton Consensus as the way forward for crises.17 The Federal Deposit Insurance all countries, developing and developed. Corporation (fdic) gave most people Like Irving Fisher, a great economist of faith in the safety of their bank accounts. the early twentieth century who predict- Deposit insurance was complemented ed continued prosperity just before the by bank regulation to substitute for crit- Great Depression, they too readily be- ical investors and depositors. The Glass- lieved in the reigning economic model.18 Steagall Act separated commercial and Even Bernanke, chairman of the Fed- investment banks. The Federal Reserve eral Reserve and student of the Great System was restructured to empower Depression, did not see chaos ahead its central of½ce; the Securities and Ex- during most of 2008. Bernanke, to his change Commission (sec) was created to credit, realized what was happening by regulate ½nancial investments. Banking the start of 2009. He resolved not to let became a boring industry, and more peo- the Fed duplicate its mistakes of the ear- ple invested safely in the stock market. ly 1930s, standing by as banks failed and There was little excitement in the ½nan- supporting the gold standard instead of cial markets, and the economy grew rap- the domestic economy. He pulled all the idly and consistently after the war. strings–some of them on the outer edge Nothing lasts forever, and prosperity of his authority–to loosen monetary generated a desire for more independent policy and encourage economic activity. ½nancial dealings. Economic turmoil in It was a bravura performance, but mone- the 1970s hastened the transition, and the tary policy lost its effectiveness as banks Washington Consensus arose in the 1980s. ran for cover even after the ½nancial The Glass-Steagall Act was repealed, and panic subsided. The banks used the Fed’s the sec’s regulation relaxed. Americans services to rebuild their depleted reserves urged the rest of the world to follow suit as the value of toxic assets went to zero, and deregulate both domestic and foreign and they loaned only to the safest of capital movements. The distribution of customers.19 income widened, the size of the ½nancial Obama, even before he took of½ce, sector rose, and a string of small-scale urged Congress to pass a stimulus bill– (at least to the United States) ½nancial to create a ½scal expansion in addition crises ensued. to the hobbled monetary expansion.

122 Dædalus Fall 2010 Republican congressmen insisted he or so, but American exuberance appears The Great divert part of the stimulus to tax cuts, to chafe under these conditions. As the Recession & the Great which went into savings as individuals memory of past economic dif½culties Depression –like banks–tried to build up their de- fades, economic and political pressure pleted reserves, limiting the size of the for change rises to the fore. Internation- stimulus. This ½delity to the Washing- al economic imbalances are condoned ton Consensus reduced Obama’s ability until they have to be corrected, often to moderate the recession’s effects on painfully. ordinary people. The second lesson is that there are Expansive monetary and ½scal policies strong pressures for unregulated capital- were effective enough to preclude a repe- ism that only abate in the face of sharp tition of the Great Depression, and sup- economic downturns like the Great port for reforms on the order of the New Depression. We avoided another Great Deal ebbed. Obama had campaigned on Depression by luck–the election cycle– a program of bipartisan cooperation, and and skill. Marx was correct when he ar- although he tried to bring Republicans gued that tragic history repeats itself along with his policies, they had not as farce: we now have the oxymoronic abandoned their belief in the Washing- Great Recession after all the fears of ton Consensus. Banks, moreover–newly Great Depression II. Keynes was right, prosperous from the government bailouts too; discredited economic theories– –resisted increased regulation. When and the gold standard mentality–con- Obama put extending health care to all tinue to dominate the actions of even Americans before reforming the ½nan- “practical” men and women.20 Recent cial system, resurgent banks blunted the policy initiatives have done little to re- impact of ½nancial reforms. duce the underlying risk of another ½- nancial crisis. As of this writing, Jean- There are two lessons to be drawn from Claude Trichet, president of the Euro- this comparison. The ½rst is that the open pean Central Bank, gave a striking illus- American economy is prone to collapse tration of the continuing gold standard every once in a while. Favorable condi- mentality, calling for worldwide ½scal tions–the New Deal and a vigorous post- austerity in the early stages of a tenta- war expansion–can eliminate “great” tive recovery from our recent crisis.21 economic contractions for a generation

endnotes 1 John Maynard Keynes, The General Theory of Employment, Income and Money (New York: Harcourt, Brace, 1936), chap. 24, “Concluding Notes.” 2 Karl Marx, The Eighteenth Brumaire of Louis Bonaparte (New York: International Pub- lishers, 1964), 1. 3 Peter Temin, Lessons from the Great Depression (Cambridge, Mass.: mit Press, 1989); Barry Eichengreen, Golden Fetters: The Gold Standard and the Great Depression, 1919–1939 (New York: Oxford University Press, 1992). 4 John Williamson, “What Washington Means by Policy Reform,” in Latin American Adjustment: How Much Has Happened? ed. John Williamson (Washington, D.C.: Institute for International Economics, 1990).

Dædalus Fall 2010 123 Peter 5 Peter Temin, “Real Business Cycle Views of the Great Depression and Recent Events: A Temin Review of Timothy J. Kehoe and Edward C. Prescott’s Great Depressions of the Twentieth on the Century,” Journal of Economic Literature 46 (September 2008): 669–684; Peter Temin, ½nancial “Corrigendum,” Journal of Economic Literature 47 (March 2009): 3. crisis & economic 6 Hyman P. Minsky, Can “It” Happen Again? Essays on Instability and Finance (Armonk, N.Y.: policy M. E. Sharpe, 1982). 7 Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Finan- cial Folly (Princeton, N.J.: Princeton University Press, 2009). 8 Thomas Ferguson and Peter Temin, “Made in Germany: The German Currency Crisis of 1931,” Research in Economic History 21 (2003): 1–53; Peter Temin, “The German Crisis of 1931: Evidence and Tradition,” Cliometrica 2 (April 2008): 5–17. 9 Richard S. Grossman, “The Shoe That Didn’t Drop: Explaining Banking Stability During the Great Depression,” Journal of Economic History 54 (September 1994): 654–682. 10 Barrie A. Wigmore, The Crash and Its Aftermath: A History of Securities Markets in the United States, 1929–33 (Westport, Conn.: Greenwood Press, 1985), 433–447. 11 Frederic S. Mishkin, speech at the Risk usa Conference, New York, November 5, 2007, http://www.federalreserve.gov/newsevents/speech/mishkin20071105a.htm. 12 David Wessel, In Fed We Trust: Ben Bernanke’s War on the Great Panic (New York: Crown Business, 2009), 26. 13 Thomas Ferguson and Robert Johnson, “Too Big to Bail: The ‘Paulson Put,’ Presidential Politics, and the Global Financial Meltdown,” parts 1 and 2, International Journal of Political Economy 38 (Spring 2009): 3–34 and 38 (Summer 2009): 5–45. 14 Christina D. Romer, “Back from the Brink,” speech to the Federal Reserve Bank of Chica- go, September 24, 2009, http://www.whitehouse.gov/assets/documents/Back_from_the _Brink2.pdf. 15 Peter Temin and Barrie A. Wigmore, “The End of One Big Deflation,” Explorations in Eco- nomic History (October 1990): 483–502. 16 Christina D. Romer, “Why Did Prices Rise in the 1930s?” Journal of Economic History 59 (March 1999): 167–199. 17 Reinhart and Rogoff, This Time Is Different. 18 Irving Fisher, “Fisher Sees Stocks Permanently High,” The New York Times, October 16, 1929. 19 Richard C. Koo, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession (Singapore: John Wiley, 2008). 20 Paul Krugman, “How Did Economists Get It So Wrong?” The New York Times, September 6, 2009; Paul Krugman, “Misguided Monetary Mentalities,” The New York Times, October 12, 2009. 21 Jean-Claude Trichet, “Stimulate No More–It is Now Time for All to Tighten,” Financial Times, July 23, 2010.

124 Dædalus Fall 2010 From the writings of Alexander Hamilton

Editors’ Note: Alexander Hamilton (1757–1804) was appointed the ½rst Secretary of the Trea- sury of the United States in 1789. A major ½gure in the shaping of the new Republic, Hamilton fought in the Revolutionary War, eventually becoming Lieutenant Colonel in General Washing- ton’s Continental Army; served as a member of the Continental Congress; helped found the Bank of New York; and, with James Madison and John Jay, authored the Federalist Papers. He was elected a Fellow of the American Academy of Arts and Sciences in 1791.

In this ½rst selection, from April 30, 1781, have proved to be the happiest engines Hamilton writes to Robert Morris, a wealthy that ever were invented for advancing Pennsylvania merchant and an influential trade. Venice, Genoa, Hamburg, Hol- statesman who developed a plan for the ½rst land and England are examples of their incorporated national bank, the Bank of utility. They owe their riches, commerce North America. Hamilton, only twenty- and the ½gure they have made at dif- four at the time, makes one of the earliest ferent periods in a great degree to this statements by anyone that banks and credit source. Great Britain is indebted for the can strengthen a state and foster economic immense efforts she has been able to growth. These goals would become two of make in so many illustrious and suc- Hamilton’s main objectives as a statesman. cessful wars essentially to that vast fab- ric of credit raised on this foundation. The tendency of a national bank is to ’Tis by this alone she now menaces our increase public and private credit. The independence. former gives power to the state for the She has indeed abused the advantage protection of its rights and interests, and now stands on a precipice. Her ex- and the latter facilitates and extends ample should both persuade and warn the operations of commerce among in- us. ’Tis in republics where banks are dividuals. Industry is increased, com- most easily established and supported modities are multiplied, agriculture and where they are least liable to abuse. and manufactures flourish, and herein Our situation will not expose us to fre- consist the true wealth and prosperity quent wars, and the public will have no of a state. temptation to overstrain its credit. Most commercial nations have found it necessary to institute banks and they

Dædalus Fall 2010 125 Alexander The second selection is from Hamilton’s every case, the evil is to be compared Hamilton December 1790 “Report on a National with the good; and in the present case on the ½nancial Bank.” Now Treasury Secretary, Hamil- such a comparison will issue in this, crisis & ton acknowledges that banks and borrow- that the new and increased energies economic policy ers can make mistakes, but that they are, derived to commercial enterprise from on balance, bene½cial. the aid of banks are a source of general pro½t and advantage, which greatly That Banks furnish temptations to outweigh the partial ills of the over- overtrading . . . must mean that by af- trading of a few individuals at partic- fording additional aids to mercantile ular times, or of numbers in particu- enterprise, they induce the merchant lar conjunctures. sometimes to adventure beyond the prudent and salutary point. But the very statement of the thing shows that Selections excerpted from “The Papers the subject of the charge is an occasion- of Alexander Hamilton,” vol. I–XXVII, al ill, incident to a general good. ed. Harold C. Syrett (New York: Colum- bia University Press, 1961–1988), vol. II, [. . . ] 618 and vol. VII, 314–315, respectively. If the abuses of a bene½cial thing are Special thanks to Richard Sylla, of New to determine its condemnation, there is York University, for his assistance in choos- scarcely a source of public prosperity ing these selections and preparing the notes which will not be speedily closed. In to accompany them.

126 Dædalus Fall 2010 Poem by Alice Notley

The dogs tell me it could be worse: I could be eaten by oversubtlety rather than bold red or blue letters howling,

HOWLING! That word again. The dogs open their mouths to word me. Have you ever dreamed you didn’t have a master. We dreamed we ran down the gully to the river, but not without you; we couldn’t leave you. I entered this desert long past the middle

of my life, knowing that I could only have what I wanted on paper. Everything’s covered with dog hairs; shake them off the illuminated pages, no they’re painted on, ocher, gold, and black ½laments. I stepped outside the city of Paris, and there was sun on water in clear air–surely a dream. The past loved you, though it didn’t know you, but

it projected itself towards my melancholy. Have I betrayed the past? Electricity and laughter, taunting, are inscribed on this page. The old house full of creepy scholars, walking all over colorful decades, squashing them with large, ignorant feet. Can’t you paint over their faces? Here is another

D for dog–a dog undermines anyone, whether it’s the dog of death, or the dog of dreams: more oscillating hairs, white, shaded with grey and purple; or thinly gilded. D persecutes you with its sweet disposition. Yet I dreamed that a mean man announced, in veiled irritation–for the dog had been part of his power–The dog is dead. A new dog will arise. Who volunteers to take charge of it? A healer raised her hand; but so did others. Who will be assigned

to this of½ce? Who can call Death to order, now that the planet has lost its blessing? No one.

Dædalus Fall 2010 127 Contributors

Lucian A. Bebchuk, a Fellow of the American Academy since 2000, is the William J. Friedman and Alicia Townsend Friedman Professor of Law, Economics, and Finance and Director of the Program on Corporate Governance at Harvard Law School. He is a Research Associate of the National Bureau of Economic Research and an Inaugu- ral Fellow of the European Corporate Governance Institute. His publications include Pay without Performance: The Unful½lled Promise of Executive Compensation (with Jesse Fried, 2004). Although Bebchuk served as a consultant to the Treasury Department Special Master for tarp Executive Compensation, the views expressed in his article should not be attributed to the Of½ce of the Special Master.

Barry Eichengreen, a Fellow of the American Academy since 1997, is George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley; Research Associate of the National Bureau of Economic Research; and Research Fellow of the Centre for Economic Policy Re- search. His book, Exorbitant Privilege: The Decline of the Dollar and the Future of the International Monetary System, will be published by Oxford University Press in January 2011.

Benjamin M. Friedman, a Fellow of the American Academy since 2009, is the William Joseph Maier Professor of Political Economy at Harvard University. He is author or editor of eleven books, including The Moral Consequences of Economic Growth (2005) and Day of Reckoning: The Consequences of American Economic Policy Under Reagan and After (1988), which received Columbia University’s George S. Eccles Prize. He is a Director of the Council for Economic Education and the En- cyclopedia Britannica.

Edward L. Glaeser, a Fellow of the American Academy since 2010, is the Fred and Eleanor Glimp Professor of Economics at Harvard University, where he also serves as Director of the Taubman Center for State and Local Government and the Rappa- port Institute for Greater Boston. His recent publications include Agglomeration Eco- nomics (2010), Housing Markets and the Economy: Risk, Regulation, and Policy (with John M. Quigley, 2009), and Rethinking Federal Housing Policy: How to Make Housing Plenti- ful and Affordable (with Joseph Gyourko, 2008).

C.A.E. Goodhart is Professor Emeritus of Banking and Finance at the London School of Economics (lse) and Program Director of Regulation & Financial Sta- bility at the Financial Markets Group Research Centre at lse. He served as an external member on the Bank of England’s Monetary Policy Committee from 1997 to 2000 and was Chief Adviser at the Bank of England prior to coming to lse. His publications include Monetary Theory and Practice (1984), The Central Bank and The Financial System (1995), and The Evolution of Central Banks (revised edition, 1988).

128 Dædalus Fall 2010 Robert E. Hall, a Fellow of the American Academy since 1985, is the Robert and Contrib- Carole McNeil Joint Professor of Economics at Stanford University and Senior Fel- utors low at the Hoover Institution. For 2010, he is President of the American Economic Association. He is the author of Economics: Principles and Applications (with Mark Lieberman; 5th edition, 2009). Other recent publications include Forward-Looking Decision Making (2010) and “The Burden of the Nondiversi½able Risk of Entrepre- neurship” (with Susan Woodward), American Economic Review (2010).

Nolan McCarty, a Fellow of the American Academy since 2010, is the Susan Dod Brown Professor of Politics and Public Affairs and Associate Dean at the Woodrow Wilson School of Public and International Affairs at Princeton University. His publications include Political Game Theory (with Adam Meirowitz, 2006), Polarized Ameri- ca: The Dance of Ideology and Unequal Riches (with Keith T. Poole and Howard Rosen- thal, 2006), and The Realignment of National Politics and the Income Distribution (with Keith T. Poole and Howard Rosenthal, 1997).

Alice Notley is a poet who has published more than twenty collections of verse. Her recent works include Reason and Other Women (2010), In the Pines (2007), Grave of Light: New and Selected Poems, 1970–2005 (2006), Disobedience (2001), and Myster- ies of Small Houses (1998). She is the recipient of the Lenore Marshall Poetry Prize from the Academy of American Poets, the International Grif½n Poetry Prize, the Los Angeles Times Book Award for Poetry, the Academy Award in Literature from the American Academy of Arts and Letters, and the Poetry Society of America’s Shelley Memorial Award. “The Codex Eats Me” is from the forthcoming collection Culture of One (Penguin, March 2011).

Keith T. Poole, a Fellow of the American Academy since 2006, is the Philip H. Alston, Jr. Distinguished Chair in the Department of Political Science, School of Public and International Affairs, at the University of Georgia. His publications include Ideology & Congress (with Howard Rosenthal; second revised edition, 2007), Polarized America: The Dance of Ideology and Unequal Riches (with Nolan McCarty and Howard Rosenthal, 2006), and Spatial Models of Parliamentary Voting (2005).

Thomas Romer is Professor of Politics and Public Affairs and Director of the Research Program in Political Economy at the Woodrow Wilson School of Pub- lic and International Affairs at Princeton University. His publications include “An Empirical Investigation of the Dynamics of pac Contributions” (with James Snyder), American Journal of Political Science (1994); “Interjurisdictional Sorting and Majority Rule: An Empirical Analysis” (with Dennis Epple and Holger Sieg), Econometrica (2001); and “Parties in Elections, Parties in Government, and Parti- san Bias” (with K. Krehbiel and A. Meirowitz), Political Analysis (2005).

Howard Rosenthal, a Fellow of the American Academy since 1992, is Professor of Politics at New York University. He edited What Do We Owe Each Other?: Rights and Obligations in Contemporary American Society (with David J. Rothman, 2008) and is the author, most recently, of Ideology & Congress (with Keith T. Poole; second re-

Dædalus Fall 2010 129 Contrib- vised edition, 2007) and Polarized America: The Dance of Ideology and Unequal Riches utors (with Nolan McCarty and Keith T. Poole, 2006).

Robert M. Solow, a Fellow of the American Academy since 1956, is Institute Pro- fessor Emeritus at the Massachusetts Institute of Technology. In 1987, he was awarded the Nobel Prize in Economics in recognition of his contributions to the theory of economic growth; in 1999 he received the National Medal of Science for his creation of the modern framework for analyzing the effects of investment and technological progress on economic growth. His publications include Capital Theory and the Rate of Return (1963); The Nature and Sources of Unemployment in the United States (1964); Growth Theory (1970); and Inflation, Unemployment and Monetary Policy (with John B. Taylor, 1998).

Jeremy C. Stein, a Fellow of the American Academy since 2008, is the Moise Y. Safra Professor of Economics at Harvard University. His recent publications include “Rethinking Capital Regulation” (with Anil Kashyap and Raghuram Rajan) in Maintaining Stability in a Changing Financial System (2008) and “A Gap-Filling Theory of Corporate Debt Maturity Choice” (with Robin Greenwood and Samuel Hanson), Journal of Finance (2010).

Peter Temin, a Fellow of the American Academy since 1986, is Elisha Gray II Pro- fessor Emeritus of Economics at the Massachusetts Institute of Technology. His books include Did Monetary Forces Cause the Great Depression? (1976), Lessons from the Great Depression (1989), Elites, Minorities, and Economic Growth (edited with Elise S. Brezis, 1999), and The World Economy Between the Wars (with Charles Feinstein and Gianni Toniolo, 2008). He served as President of the Eastern Economic Association (2001–2002) and the Economic History Association (1995–1996).

Luigi Zingales is the Robert C. McCormack Professor of Entrepreneurship and Finance and the David G. Booth Faculty Fellow at the Booth School of Business at the University of Chicago. He is the author of Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity (with Raghuram G. Rajan, 2003). He codeveloped the Financial Trust Index, designed to monitor the level of trust Americans have in the ½nancial system.

130 Dædalus Fall 2010 Chair of the Board Louis W. Cabot President & CEO, William T. Golden Chair Leslie Berlowitz Treasurer John S. Reed Secretary Jerrold Meinwald Editor Steven Marcus Vice Chair, Midwest John Katzenellenbogen Vice Chair, West Jesse H. Choper

Inside back cover: Unemployed men wait in long lines for bread and handouts in New York during the Great Depression. Photo- graph © Bettmann/Corbis.

Job-seekers wait in line for a job fair at a hotel in New York’s Times Square, March 5, 2009. The job fair was sponsored by employment website Monster.com as part of its “Keep America Working” tour. Thousands attended the event featuring more than ninety employers. Photograph © reuters/Mike Segar.

Dædalus coming up in Dædalus:

poetry Alice Notley The Codex Eats Me 127

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