12 March 2011

The Crisis of 2008

Finally, I return to the task of filling out my book. You'll remember that my January 27 blog entry consisted of a brief passage from what may become the third chapter of my proposed book as represented in the table of contents I provided on December 10, 2010. Now I move to the fourth chapter, about the financial crisis that precipitated these reflections. Instead of any passage, I'll just offer the following reflections on it.

The mechanisms behind the real estate bubble of 2003-07 were much less novel or mysterious than they are sometimes made out to be.

There has been a good deal of talk about how the doomsday machinery involved a 'shadow banking' system on one hand, and new-fangled off-balance-sheet entities on the other. Michael Lewis' book, by focusing on entities like Harding Advisory (which has since filed a defamation lawsuit against him) contributes to this to some degree.

But the fact is that the key failures were at the old-fashioned broker-dealers, and for that matter their failures were to a very great degree hidden in plain sight -- on the balance sheets.

The focus on the supposed shadows is an error, or at any rate an imbalance in perceptions, because in outline that crisis was created by very familiar mechanisms. The following ingredients were key:

1) Absurd easy-money policies at the Fed
2) Rest of the world (notably China) continues to treat U.S. dollar as the pseudo-gold standard, enabling those absurd easy money policy, and
3) Easy money makes the big investment banks sloppy about the risks they take — risk managers get re-assigned to closets, etc.
4) Complicity of bond raters, bond insurers, accounting standard boards, and all the usual suspects.

The truth about ingredient (3) was right there on the balance sheets. Nor did Bear Stearns, Merrill Lynch, and the others need fronting by Chau and Harding Advisory to dig themselves (and Main Street) into this hole. If you believe that the price of a certain type of asset can only go up, you too are likely to dig yourself a hole.

Although some marginal operators may have helped bring a shovel or two to the construction site.

Some dates. On January 3-4, 2001, Greenspan's Fed cut both the federal funds rate and the discount rate. One important point about this, it did NOT happen at a regularly scheduled meeting of the Fed Open Market Committee (FOMC). Greenspan thought this important enough to arrange it between regular meetings.

Why? Because the dot-com boom, fueled in part by the rescue of LTCM's counterparties arranged under Fed auspices and its "Greenspan put," had burst in early 2000, creating a (mild) recession, and like an alcoholic in the pangs of a hangover AG reached for the dog with which he had bit us.

On the last day of that month, the FOMC did meet, and cut both rates again.

It again lowered both the discount and the fed funds rate in March 2001, and then again in April, and then again in May....

When the year began, the federal funds rate was 6.5%. In early September of that year, BEFORE the US was attacked, that rate was down to 3.5%. Down nearly to the half-way mark. In reaction to the attacks, they cut some more. At the end of the year, the funds rate was 1.25%.

Given this environment of easy credit, tjhere was going to be a bubble in some assets, real estate or commodities or CDOs or tulip bulbs or something, and concomitantly it was going to find its way to people who didn't know what they were doing with it. That is what easy credit does. This would have happened had there been no GSEs. Though of course there were, and the shape the crisis took had something to do with the pro-housing ideology of many on Capitol Hill, which Greenspan did his own little bit to encourage -- but we might as well give him a bye on that one. His part in the pro-housing ideology was probably fairly small.

Quote in this context the words of a Jacksonian Democrat in 1837. Newspaper editor William Leggett, denouncing Nicholas Biddle and the bankers who had followed his lead, writing: “[They] have used every art of cajolery and allurement to entice men to accept their proffered aid” which in turn led their borrowers to rush “upon all sorts of desperate adventures. They dug canals, where no commerce asked for the means of transportation; they opened roads, where no travelers desired to penetrate; and they built cities where there were none to inhabit.”

The result was that, inevitably, the bubble burst. The panic of 1837 that occasioned Leggett’s analysis led to a depression that continued until 1843. Leggett would not have been surprised by the opening years of the 21st century. He might have been surprised, though, that in the long period between his time and our own an ideology of home-ownership-for-all had developed that compounded the extent of such artificial booms and the damage that the inevitable bust then works.


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