Pandemic: The Contagious Crisis
[Liberty Magazine, August 2007]
If you think the free market should be blamed for our current economic woes, you are on the wrong track.
Libertarians face charges these days that capitalism has failed or at least that deregulation has invited our current economic troubles. These charges are not persuasive. A more realistic view is that a housing boom and bust happened to strike a fragile financial system whose fragility was worsened by ill-conceived government interventions. Before commenting on how to fix the system, I should outline what happened to damage it.
Government policies intended to promote home ownership, even by people otherwise not able to afford it, date back to the 1930s if not before. Today, many government agencies and government-sponsored companies guarantee or subsidize mortgage loans, either directly or by providing a secondary market. Examples are legion: they include the Federal Home Loan Banks, the Federal Housing Administration (FHA), the Government National Mortgage Association (GNMA, "Ginnie Mae"), and the Department of Agriculture's Rural Housing Service and Rural Development Guaranteed Loan Program. The staffs of these programs are enthusiastic about their missions and anxious to extend their services. Some programs aim to make housing more affordable for particular groups, including military veterans, police officers, teachers, and Native Americans.
Some programs have forged strong links with politicians. The Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac), both government sponsored, have been particularly notorious, enjoying cozy relations with members of Congress and an implicit (now explicit) government guarantee of their bonds.
Several much-discussed laws and regulations, including the Community Reinvestment Act of 1977 and its sequels, pressured financial institutions to make mortgage loans to normally unqualified borrowers, and even to make them in parts of cities where a prudent person would hesitate to walk. Lenders have also been pressured to grant relief to troubled mortgage debtors.
Now, it is not obvious that homeownership is as unequivocally desirable as contemporary Americans seem to think. Owning a house puts friction in the way of the owner's moving to a place where he could have a better job. The owner carries the burdens of maintenance, landscaping, and finding plumbers and other repairmen when emergencies arise. These burdens might be left in the first place to managers of rental properties, who would take advantage of professionalism, risk-spreading, and economies of scale. Yet government has gone to remarkable lengths in obeisance to "the American dream."
Tax laws have long privileged owner occupancy over renting. Homeowners may deduct mortgage-interest payments and real-estate taxes in figuring their federal income taxes, and they enjoy favorable tax treatment of gains on the sale of their houses. Federal tax law permits state and local government agencies to offer below-market-rate financing to homebuyers. Owners enjoy tax-free nonmonetary income (implicit rental income) from occupancy of their homes, whereas landlords pay tax on their rental income and pass it and the property tax along to their tenants.
Such policies have effects. Cheap credit during the years of the boom compounded the long-term effects of government action. Opinions differ about how much of the blame falls on Federal Reserve policy and how much on a "world savings glut," notably in China, that fed heavy flows of loanable funds into the United States. In any case, from around 2002 to 2005 the Federal Reserve's target rate of interest remained below what the "Taylor rule" would have recommended.
John Taylor originally offered his formula as a description of how the Fed appeared to be setting its target rate during years of relatively successful policy: it raised its rate to resist inflation or economic overheating and lowered it to resist deflation or unemployment. Taylor's formula has often been misinterpreted as an actual prescription for policy. Although it is not a hard and fast rule, it does provide one clue to whether current monetary policy is too loose or too tight. During the years mentioned, the target interest rate, adjusted for inflation, was sometimes even below zero, as it is again nowadays.
As one would predict, cheap credit encouraged borrowing, building construction, and bullish speculation in houses. Even financially unqualified homebuyers took advantage of dubiously attractive subprime mortgages, mortgages whose initial teaser rates could later be raised, loans requiring no payment of principal during the early years, and even negative-amortization loans.
Some borrowers and mortgage brokers connived to conceal applicants' inability to meet even the loosened financial standards. Borrowers and lenders were seduced by expectations that the collateral — houses — would keep rising in price indefinitely. Low interest rates spurred savers and institutions to look for better yields even on new or exotic and riskier kinds of investment. Financiers reached for these yields, resorting to complicated and poorly understood financial derivatives and making defective assessments and unclear explanations of risks.
Fragility and Contagion
All of this was bound to make the financial system more fragile. To identify what happened, we may speak of contagion of at least two related but distinguishable types: structural and psychological.
An advanced economy is a tissue of intricate multilateral interdependencies whose unraveling damages finance, production, employment, and consumption. Contagion particularly bedevils financial intermediation, which is the business of banks and other financial firms and the stock market. Lending institutions borrow, normally at shorter-term and lower rates of interest, to relend at higher rates. Banks, for example, owe short-term debt to their depositors and use the funds for medium- and long-term loans and securities.
Financial intermediation tailors types, maturities, and risk/reward characteristics of financial instruments to meet the desires both of ultimate savers and of borrowers and stock-issuing firms. Even innovative instruments, such as credit-default swaps and securitized loans — to which I will return in a moment — can legitimately serve healthy specialization in lending, borrowing, saving, investment, and risk-bearing. In an advanced economy, this intermediation is essential to channel savings efficiently into factories, farms, machinery, and other capital goods, so promoting economic growth.
By its very nature, intermediation requires firms performing it to operate heavily with borrowed funds. Their excess of assets over liabilities — their capital in this accounting sense (net worth) — amounts to only a very small percentage of either. Even ordinary businesses use borrowed funds to some extent; but financial firms practice this leverage, so called, to a more extreme degree. Their capital, being so small a percentage of their balance sheets, is vulnerable to being wiped out. It is hardly sound advice, though, that financial firms should employ no more leverage than other firms — for their doing so would subvert the very rationale of financial intermediation. Still, leverage, and especially undoing it (deleveraging), do intensify structural and psychological contagion.
Securitization means bundling loans into packages that provide the backing for bonds issued by the bundlers. Ideally, these "collateralized debt obligations" enable their buyers to enjoy the convenience of not making individual mortgage loans and also, normally, the relative safety of diversification. The bundlers receive their shares of these benefits from an interest-rate spread between what they earn on the loans and what they pay on their own obligations.
The process can be carried to further stages as the first-level bonds are cut into "tranches" according to the estimated riskiness of their backing. The different tranches can then serve as backing for a further level of bonds, and even further levels. The results are called CDO2s (collateralized debt obligations squared). Many of them received the highest ratings by the three government-privileged bond-rating companies, S&P, Moody's, and Fitch, so becoming approved holdings even for conservative investors such as pension funds, and building confidence among other investors also.
Yet these ratings, especially of unfamiliar debt instruments, proved overoptimistic. At the beginning of the chain, some of the underlying mortgage borrowers may not have been creditworthy — and in recent years, many of them certainly were not. While the process may achieve the apparent safety of diversification, it also makes risk assessment more difficult and obscures how participants along the chain share the risk of default on the underlying mortgages. Unforeseen defaults can spread and magnify damage along the whole ingenious chain.
When defaults on loans or bonds held by a financial firm erode their value as assets, the capital of the affected firm shrinks as a percentage of its balance-sheet totals. The firm suffers when depositors or other short-term creditors rush to cash their claims. To restore its required capital margin, it must either issue more common or preferred stock or shrink its balance sheet by selling off assets to pay its liabilities somehow. This can be painful. Meanwhile, other firms that have been holding the bonds of the troubled firm see those assets losing value and their own capital ratios impaired. Then they too must either raise more equity capital (implausibly) or reduce their size.
Attempts to raise money by selling assets depress their prices, contributing to contagious deleveraging all along the line. Not only does default on mortgages hit investors in mortgage-backed bonds, it also brings foreclosures, empty and ill-tended houses, deterioration of neighborhoods and house prices, and further loss of homeowners' equity.
Credit-default swaps are essentially insurance against default on bonds or other debt. An issuer of credit-default policies hopes to receive more in premiums paid than it loses in compensating for defaults. A borrower may buy such insurance to improve the marketability of its obligations, or a lender may buy it for protection. Even third parties not directly involved with the underlying debt may buy this insurance either as a hedge on risks in other transactions or, since the swaps are marketable, as a speculative bet.
Dealings in swaps are no more inherently scandalous than hedging or speculative dealings in futures on the commodity exchanges. But just as an occasional fire- or life-insurance company may go broke, so may a default-swap issuer — and probably with greater likelihood, because of the relative complexity and novelty of the transactions. The travails of AIG, which obtained a government rescue, provide an example. Credit-default swaps constitute another channel, then, through which structural and psychological contagion can spread widely.
"Fair value" or "mark-to-market" accounting is also widely blamed. This accounting rule came to be more widely insisted on a few years ago than it had been before, and has only recently been relaxed a bit. It requires financial firms to carry large chunks of their asset portfolios on their balance sheets at the low prices they might fetch on already depressed markets, even though the markets are temporarily inactive, though the crisis will end sooner or later, and though the companies intend to hold much of the assets until they payoff at face value upon maturity.
Like actually realized portfolio losses, these markdowns shrink the holders' reported capital. Capital deficiencies make the affected firms more hesitant to grant loans, worsen their own and perhaps the whole financial system's perceived unsoundness, and can trigger further deleveraging all along the chain. Marking to market probably does enhance the transparency, honesty, and trustworthiness of firms in normal times and for that reason should perhaps not be suspended even in times of crisis. Perhaps regulators should openly relax capital requirements instead. Yet however desirable the rule may be on balance, it does intensify the structural contagion.
I turn now to psychological contagion, which hit me as well as other people. Until the late summer of 2008 the structural aspect of the crisis had fascinated me. Then I realized that the situation had become downright scary.
The whole tissue of economic interrelations rests on trust. Confidence can be justified, excessive, or abnormally weak. Confidence can rise or fall in waves of herding: understandably, people without enough information to make judgments on their own regard others' behavior as guided by information that they possess. A boom reinforces confidence. People are inclined to fall for dishonest schemes. A bust saps confidence. People and institutions, including banks, become more cautious in doing business with one another.
The stock market, swinging widely, both registers and magnifies the state of confidence or fear. Loss of stock and house values makes consumers hesitant to spend money, depriving businesses of sales in a further fall of dominos.
U.C. Berkeley economist J. Bradford DeLong, writing around the end of 2008, estimated that global financial assets had sunk in value over the preceding 18 months from about $80 trillion to $60 trillion, with only about $1–$2 trillion of the decline coming from losses on mortgages and mortgage-backed securities. ("The Financial Crisis of 2007–2009: Understanding Its Causes, Consequences — and Its Possible Cures"). That estimate, although necessarily imprecise, raises the question of what the lost $20 trillion consisted of and where it went.
Goodwill sometimes appears on balance sheets as an asset. This accounting concept recognizes that a firm may be worth more than its physical and financial assets minus its liabilities; it has additional value as a going concern and profit-making entity. Managers' and employees' skills and experience, the firm's traditions, technology, business connections, attunement to conditions in the industry and the whole economy — in short, internal and external coordination and ongoing or potentially profitable activities — have value beyond that of cut-and-dried assets.
But even those assets lose value when discoordination of the firm or of the entire economy diminishes their profitability. The appraisal of good will in the sense just described shows up notably on the stock market — where, as on other asset markets, prices often swing between too high and too low. This is psychological contagion.
Theories — and Remedies?
The apparatus of mainstream macroeconomic theory is of little use for understanding such troubles. DeLong recognizes that that is true even of his own textbook. Economists of the Austrian School, on the other hand, recognize that an economic system cannot be analyzed with typical models of aggregate demand confronting aggregate supply, nor with models possessing stable parameters. They emphasize the subjective element in economic life.
People's economic decisions and actions respond to experiences, doctrines, and emotions. Change, unpredictability, and uncertainty abound. Relevant though imperfect information is scattered among millions, even billions, of minds around the world.
Yet a smooth course of economic life presupposes a reasonably good meshing of their many different plans. The title of Gerald P. O'Driscoll's book aptly describes Economics as a Coordination Problem (1977). The price system works toward the meshing of plans. Coordination has been impaired at times of unsustainable boom and, more obviously, of recession. Willingness and capacity to produce remain essentially unimpaired (although a long period of unemployment would erode them). Unemployed workers are eager for jobs and for the consumer goods they would buy with their wages, while employers would eagerly hire or retain more employees if only they had customers for their products.
What has disrupted coordination in such episodes? Both Austrian and monetarist economists, although with analyses differing in details, often put the blame on bad central-bank policy. While the financial distress sketched above surely plays a big role in the current recession, a monetarist interpretation (by Robert L. Hetzel, manuscript, Federal Reserve Bank of Richmond, Feb. 2009) adds that the Federal Reserve kept its belatedly tightened monetary policy tight too long in 2008.
Contagious panic arguably called for early intervention, before the severe deterioration of September 2008. Government action would have violated libertarian principles, but the situation was exceptional. Arguably, the government had a moral responsibility to help check the damage to which its earlier interventions had contributed — if, indeed, government can be personalized in that way. Anything plausible, even if mostly symbolic, could have helped, such as a clear offer to buy or guarantee the temporarily troubled assets of financial firms at suitably reduced prices.
I thought so at the time on the basis of amateur psychology, not of economics or political science. It was unrealistic, however, to expect such focused decisiveness from the government. Calls arose to "do something for Main Street as well as for Wall Street." Favoritism is indeed unattractive; yet financial firms are different from nonfinancial ones. Their financial intermediation is inherently leveraged — they borrow to relend or invest — and the credit they supply or allocate is essential to ordinary business. Sparing millions of people the pains of recession almost unavoidably benefits a culpable minority also.
Moral hazard is a danger: past rescues breed expectations of more in the future. So soothed, firms run greater risks than would otherwise be prudent (just as fire insurance soothes homeowners to be less obsessively cautious than they would be without it). Against a long background of bank and hedge-fund rescues, the rescue of Bear Stearns in March 2008 further bolstered expectations. These were disappointed when Lehman Brothers was allowed to fail in mid-September. The crisis deepened, arousing hopes that the authorities had learned a lesson and would not allow a similar major collapse. The economy faces a catch-22: damned by immediate damage if a rescue goes unattempted, and damned by the longer-run moral hazard if a rescue is undertaken.
Treasury Secretary Henry Paulson muffed the opportunity for a psychological counterstroke. He and his successor Timothy Geithner offered a series of ill-considered, vague, changing, unconvincing, and even alarming approaches. Some verged on browbeating of financial firms, as in Merrill Lynch's acquisition by Bank of America. The "stimulus" bill of early 2009 ignored economic studies comparing the potencies of fiscal and monetary policy. The bill turned into a preposterous hodgepodge of porky spending projects that multiply the national debt, presumably heightening uncertainty and the hesitancy of business investors — yet another example of a spreading contagion.
Monetary policy can probably do more for early economic recovery than fiscal stimulus can. Indeed, between the end of August 2008 and late April 2009 the Federal Reserve more than doubled the size of its balance sheet. Between August 2008 and March 2009, largely by extending credit in innovative ways, it multiplied the volume of bank reserves more than seventeenfold. That great potential for money creation threatens inflation. Current worries about deflation, which would prove temporary at worst, are preposterous. If need be, deflation is much easier to check than inflation; and anyway, not all downward drifts of prices are harmful.
The Fed's expansion of reserve money threatens to overshoot the mark, especially when translated into increased lending and deposit-money creation as banks activate their newly immense excess reserves and as individuals and businesses become more willing to spend money than just hold onto it. The danger of severe price inflation and dollar-exchange depreciation looms unless the Federal Reserve somehow proves clever enough to reverse its money creation in time, patient enough to see bond prices fall and interest rates zoom and risk another recession, and sheltered enough from political pressures.
The possibility of the dollar's destruction within a few years adds relevance to academic ideas about a new "monetary constitution." Commodity-linked money issued in a privatized system of free banking is one attractive possibility. Even if the Federal Reserve should avoid early severe inflation, rethinking its role will eventually be necessary; because it operates (through interest-rate targeting) on a stock of bank-reserve money that is becoming almost vanishingly small in normal times, not in dollar amount but as a percentage of the economy's total means of payment and total liquidity.
Calls for more financial regulation have become routine. Only a libertarian more hardcore than I am would reject them outright. Regulations have indeed disappointed the intentions behind them. Yet because of the intricate ways in which some regulations may have been compensating for the regrettable side effects of others, abolishing or relaxing them must be done in an orderly way (if orderliness is practically and politically possible), not by a sudden stroke.
As for new regulations, just what should they be? A consensus in favor of suitable regulation is spurious if its advocates have contradictory ideas of what "suitable regulation" means. Merely specifying desired results is no sufficient design of how to get them. Design of new regulations should recognize which past ones have proven ineffective or pointlessly burdensome or have been gamed and wriggled around. "Gaming the system" means exploiting the rules for unintended purposes, as by resort to exotic practices and instruments such as "structured investment vehicles" to circumvent capital requirements.
Resources are scarce, so enforcement should focus on trying to suppress actual fraud, as well as deceptive obscurity and complexity in documents, practices, and sales pitches. Reform should avoid giving regulators and prosecutors abusable discretion with tempting opportunities for triumph in cases of petty technical violations and little social importance. Regulation should conform to the rule of law. Civil suits for alleged dishonesty or unfairness could be made easier by unclogging the courts, as by decriminalizing drugs.
The greater the need for financial regulation, the stronger the case for abolishing or simplifying regulations in other fields, both to avoid multiplying infringements of personal freedoms and to conserve scarce regulatory resources. Where, for example, are all the new regulators to come from, ones well versed in the complexities of Wall Street yet willing to work for civil-service salaries? The failure of regulators to catch even some of the worst financial frauds of the last several years underlines this question.
Government action should not preempt the scope, as it often does, of alternative solutions to problems. Experts working for industry associations could devise and administer standards, with additional monitoring by journalists eager for sensational stories. Underwriters Laboratories, American National Standards Institute (ANSI), the Nationally Recognized Testing Laboratory (NTL), Consumers Union, and online product reviews illustrate the possibilities. Instruction and certification by private organizations could give competitive advantages to qualifying brokers and other financial operators.
If we can salvage nothing else from this crisis, we should at least learn lessons. Financiers must have learned something about the use of exotic financial instruments. They must have learned something about incentives for themselves and their associates. Employees should not be rewarded for merely making mortgage loans, leaving concern for their soundness to the buyers of mortgage-backed securities.
Several lessons involve contrasts between what is true or desirable in the short run and the opposite in the longer run. An expansionary monetary policy reduces interest rates in the short run but, if continued, raises nominal rates later because of the inflation allowance in them.
Relatedly, a cheap-money-fed boom is likely to collapse into recession. Mark to market, the accounting practice mentioned above, arguably should be relaxed in times of crisis but be retained otherwise. The law of unintended consequences warns us of long-run disillusionment from bright ideas for short-run benefits, as from prods to cheap housing credit. Consequences often appear, unrecognized, as the delayed cumulative results of earlier interventions.
Moral hazard presents a major short-run versus long-run contrast. Rescue of a troubled bank may seem the best thing to do immediately, but it reinforces expectations of further rescues, inviting repeated trouble later. I emphasize, not minimize, this dilemma; yet I can think of no solution. Further academic research might find one. Still, enjoying the long run does presuppose getting through the short run.
Over the long run, and fundamentally, prosperity depends on production. People specialize in producing particular goods and services to exchange them away, sooner or later, for the specialized outputs of other people. But occasionally money and credit go awry as lubricants of exchange and production. Especially in a deep depression, the economic law of scarcity seems to have been repealed. Demand for products and labor, not capacity to supply them, shrivels.
A form of Keynesianism crude enough to embarrass Keynes himself then appears relevant, especially in political circles. Measures to stimulate spending seem to promise relief, even though a crisis like our current one originated in overborrowing and overspending, and even though more of the same would risk long-run disaster.
A case might be made for a short-run stimulus that would be reversed in good time — if only we could count on that reversal. Theory and experience warrant expecting more stimulus from monetary policy than from fiscal policy and increased government debt. This debt, which includes implicit debts in the form of long-run commitments under entitlement programs, has been growing so large relative to tax capacity that meeting it seems unlikely other than by its eventual repudiation through inflation.
Examples abound of legislators and bureaucrats blithely implementing their bright ideas without due regard to the burdens imposed. Ideas about what additional regulations should accomplish often give scant attention to just how they are to work.
Hubris appears in the countless legislative proposals for improving the economy: mandates or tax credits for water-saving toilets and energy-saving light bulbs, for early purchases of new cars to relieve the industry's distress, for cars getting more miles per gallon, for promoting ethanol and exotic energy sources, for promoting or discouraging particular activities by tax complications, for subsidizing scientific or not-so-scientific research, for tighter responsibility in issuing financial reports, for broadband access, for sports stadiums, and even for investigating irregularities in professional sports.
Funds are appropriated for attractive causes with no consideration of how the money and the corresponding real resources might better have been used for other purposes, private and public. Furthermore, politicians are more concerned with the good intentions motivating their laws than with possible long-run adverse consequences.
Congressmen do not hatch all the bright ideas out of their own brains, of course, nor does narrow self-interest usually drive their votes. Rather, they routinely hear from persons and groups requiring money for attractive programs. Since they rarely hear informed testimony against specific programs even from witnesses who may abstractly desire spending restraint, they drift into thinking that denying the requested appropriations would be hard-hearted. (James L. Payne has explored this issue in The Culture of Spending: Why Congress Lives Beyond Our Means, 1991.)
Uncoordinated bright ideas — ideas for promoting all sorts of good and suppressing all sorts of bad things through regulation, granting or guaranteeing loans, and financing special-interest projects — figure prominently among the causes of our current crisis. Yet as Frederic Bastiat and more recently Henry Hazlitt have argued, sound economic policy presupposes considering the further-ranging and longer-run effects of specific events and interventions. That is not typical of politics. Thomas Sowell was right:
the first law of economics is scarcity, and the first law of politics is to disregard the first law of economics.