Former Fed chief Alan Greenspan has an article in Foreign Affairs explaining why he and other economists and policymakers didn’t see the financial crisis or the housing bust coming. It’s a long but fascinating piece, not least because Greenspan, unlike most former policymakers in similar positions, doesn’t try to deny he missed something or that he is blameless. Instead, he explains what he now believes was wrong with the approach he was using at the time and how economists need to change their methods to incorporate this. The short answer is that Greenspan no longer discounts irrational behavior by people and the potential for bubbles to occur. He says now that bubbles can be identified and predicted. He also says that animal spirits are important. That people can act irrationally, especially being fearful of action in times of crisis, and economists need to take note of that.
From the perspective of a forecaster, the issue is not whether behavior is rational but whether it is sufficiently repetitive and systematic to be numerically measured and predicted. The challenge is to better understand what Daniel Kahneman, a leading behavioral economist, refers to as “fast thinking”: the quick-reaction judgments on which people tend to base much, if not all, of their day-to-day decisions about financial markets. No one is immune to the emotions of fear and euphoria, which are among the predominant drivers of speculative markets. But people respond to fear and euphoria in different ways, and those responses create specific, observable patterns of thought and behavior.
Perhaps the animal spirit most crucial to forecasting is risk aversion. The process of choosing which risks to take and which to avoid determines the relative pricing structure of markets, which in turn guides the flow of savings into investment, the critical function of finance. Risk taking is essential to living, but the question is whether more risk taking is better than less. If it were, the demand for lower-quality bonds would exceed the demand for “risk-free” bonds, such as U.S. Treasury securities, and high-quality bonds would yield more than low-quality bonds. It is not, and they do not, from which one can infer the obvious: risk taking is necessary, but it is not something the vast majority of people actively seek.
Most people haven’t heard of Andrew Smithers, but he’s very well-respected, and deservedly so, among those who follow economics discussions. He’s based in London, and most of his thoughts are delivered only to clients. But periodically he pops into the public debate with a book, article, speech, or interview. Here’s a review of his latest book, which attacks some of the very foundations of modern corporate structure. I’ve long believed that there is something wrong with executive incentive plans that directly tie compensation to stock performance. Smithers explains in great detail why that’s a problem, why it was a major factor in causing the financial crisis, and why it will keep growth subpar.
Andrew Smithers annoys people. A great deal. Long one of the best-known and most respected analysts in the City of London, in my experience he provokes anger and annoyance in the Square Mile like almost no other.
This is partly because of his arguments. He has been bearish about stocks for a while, which irritates those who have been enjoying a protracted rally. But other stock market bears remain popular.
The issue is that Smithers does not hide his disdain for what he calls “stockbroker economics”. His regular weekly reports, always ineffably logical with numbered paragraph flowing from numbered paragraph, drip with contempt for arguments from the City.
There’s a summit in Europe this weekend that was intended to improve economic policy coordination among the countries. That would boost the currency and make for an easier resolution of the financial crisis there. But now it looks like the summit isn’t going to amount to much, and pessimists think this will make it difficult to preserve the euro as a continent-wide currency. A subscription might be required for this preview in The Wall Street Journal, but it is worth a read. The sources for the story say Germany put a stop to coordinating policies, fearing that the result would be Germans bailing out banks in other countries.
A failure to achieve the initial goals of the summit and to adopt a plan proposed by EU staffers doesn’t mean the pessimists are right. The euro and economic union still can survive. But countries with fiscal problems or banking problems will have to negotiate terms with countries such as Germany each time a bailout is needed instead of working with a few regulators. The failure also means crises are more likely in some of the countries.
The push to build a more stable currency union arose from a May 2012 dinner, when Europe’s leaders charged top EU officials with figuring out a plan. Herman Van Rompuy, a conservative Belgian politician who presides over EU summits and who writes haiku in his spare time, led the effort.
At the time, massive capital flight from Italy and Spain was threatening to unravel the euro. Observers on both sides of the Atlantic were saying the euro zone needed an “Alexander Hamilton moment,” akin to the 1790 move by the U.S. treasury secretary to take over states’ debts, which made the U.S. a deeper economic and political union.
During the summer of 2012, Mr. Van Rompuy and his colleagues worked on proposals that echoed the view of many economists in the U.S. and Europe: The euro zone needed to become a little more like America by replicating some of the functions of U.S. federal authorities.
The former Fed Chairman is out with a new book that purports to explain where he and the economics profession went wrong in the years before the financial crisis. In particular it addresses forecasting errors as well as other topics, such as how Washington has changed over the years. I haven’t seen the book, but read these two reviews. The reviews have very different takes on the book, and I suspect it’s because the writers have very different opinions of Greenspan. The Washington Post writer Steven Pearlstein obviously doesn’t think much of Greenspan. The Wall Street Journal review is a bit more temperate and says the crisis forced Greenspan to complete change his worldview. Pearlstein, on the other hand, says Greenspan hasn’t changed much and insists his actions had no role in the crisis. You can read the reviews and decide if you want to read the book. Here’s a take from the Journal’s review.
“I’ve always considered myself more of a mathematician than a psychologist,” says Mr. Greenspan. But after the Fed’s model failed to predict the financial crisis, he realized that there is more to forecasting than numbers. “It all fell apart, in the sense that not a single major forecaster of note or institution caught it,” he says. “The Federal Reserve has got the most elaborate econometric model, which incorporates all the newfangled models of how the world works—and it missed it completely.” He says JP Morgan had put out a forecast three days before the crisis saying the economy was on the rise. And as late as 2007, the International Monetary Fund also said that global risk was declining. “A few days [after the crisis hit], I run into an article, and it is titled, ‘Do we economists know anything?’ ” he says.
Mr. Greenspan set out to find his blind spot step by step. First he drew the conclusion that the nonfinancial sector of the economy had been healthy. The problem lay in finance, because of its vulnerability to spells of euphoria and irrational fear. Studying the results of herd behavior provided him with some surprises. “I was actually flabbergasted,” he says. “It upended my view of how the world works.”
He concluded that fear has at least three times the effect of euphoria in producing market gyrations. “I wouldn’t have dared write anything like that before,” he says.
I’ve read a lot of perspectives on the fifth-year anniversary of the bankruptcy filing of Lehman Brothers, which is generally considered the point that the economic downturn became a financial crisis. I’ve linked to very few of them, because they didn’t say much that was interesting or original. An exception is this piece by Martin Wolf. Wolf makes several important points. He says people overstate the importance of Lehman. The global system was fragile, and any of a number of events could have triggered the crisis. It just happened that Lehman was first. Once it happened, central banks acted rapidly to limit the damage. He makes an interesting comment that people woke up to realize that bankers were just overpaid and out of control civil servants. Importantly, Wolf says that not much has been done to resolve the problems, and the financial system remains poisonous.
Governments and central banks dealt with the global financial panic relatively quickly and effectively, though a devastating aftershock emerged in the eurozone in 2010. Yet eliminating panic and even restoring the banks to health relatively quickly, as the US did, was not enough to generate a vigorous recovery. Even in the US, which has recovered faster than the other large crisis-hit economies, gross domestic product has fallen consistently relative to the pre-crisis trend (see chart). In the second quarter of 2013, it was 14 per cent below that trend. In the UK, it was 18 per cent below trend. Since much of the income generated in the recovery has accrued to the very top of the income distribution (partly because of the policies employed), it is little wonder discontent is rife.
Lehman was not the only possible cause of a panic. Any one of a host of institutions might have failed, with similarly devastating effects. The big impact of Lehman was to make transparent the losses. That had to happen. The reason for the subsequent economic weakness is also clear: economies had become dependent on the debt-fuelled spending promoted by rising property prices. The panic was itself a result of the cessation of this demand engine. The intermediaries that had bet their prosperity on ever-rising asset prices were in trouble. So, too, were economies that had made exactly the same bet. So, too, were economies that had bet on selling to these debt-fuelled economies. Should we have been surprised by this aftermath? No. Several well-informed economists had warned of just this dire possibility.
There aren’t too many businesses or business lobbying groups that support a free economy or anything resembling it. Neither political party really supports reduced government interference in the economy. Instead, we have crony capitalism in which the government favors certain businesses and industries, discourages others, and rewards businesses for taking certain actions the politicians like. The financial crisis was the culmination of crony capitalism. of politicians and regulators being influenced by companies who were willing to throw around money to get laws and regulations they liked.
Here’s one version of how crony capitalism led to the financial crisis. There are other angles to take on this, because a lot of things went wrong to bring the economy to the brink.
Regulatory ideas have to hatch somewhere, of course; but Eakes’s statement was unsettling. First, he and Self-Help were key players in subprime lending and cheerleaders for the government’s “affordable housing” goals. Indeed, Eakes played a seminal role in mediating risky loans from unwilling private banks to an initially squeamish Fannie Mae. Second, he claimed in the same speech that Self Help’s national lobbying arm, the Center for Responsible Lending (CRL), had “hired fifty lawyers, PhDs, and MBAs to basically terrorize the financial services industry for any of their abusive practices nationwide.”
CRL was inspired and funded primarily by progressive California S & L owner Herbert Sandler, who wanted Eakes’s work to have a national impact. (Self-Help now owns a ten-story building in Washington, DC, a few blocks north of the White House.) Sandler and his wife, Marion Sandler, made news in 2008 at the height of the financial crisis, because their bank had pioneered the “option ARM loan,” which the New York Times called the “Typhoid Mary” of the housing crisis. Time magazine listed the couple among the twenty-five people to blame for the financial crisis, and even Saturday Night Live initially parodied them for their role in the meltdown.
The bankruptcy of Lehman Brothers in 2008 triggered the worst of the financial crisis and almost caused a collapse of the financial system. I wrote a few months later that it was a major turning point, and the economy and markets were frozen until sometime after the Fed started quantitative easing in May 2009.
People often ask why the government allowed Lehman to fail. I’ve heard several people who were involved in the decisions made at the time give their explanations. The explanations are consistent, and here’s a good review of the details. The bottom line is that the Fed and Treasury couldn’t simply give money to or invest in businesses. They could make loan under certain circumstances, but the loans had to be backed by adequate collateral. The Fed was able to help save Bear Stearns earlier in the year and other firms in the past, because those firms had valuable assets that weren’t already pledged against loans. Lehman Brothers, according to those who looked at it at the time was leveraged to the limits. Some say it was leveraged beyond the limits.
Another reason, that I rarely see stated, is that after the Bear Stearns bailout members of Congress told top economic officials that there was no more appetite in either party for any more bailouts. The statements were made both publicly and privately. The anti-bailout attitude in Congress was so strong that the Treasury Department didn’t put forward proposals for emergency powers until after the Lehman failure caused the market collapse.
In the case of A.I.G., the Fed’s loans were collateralized by the entire assets of the firm, based on the observation that A.I.G. had potentially huge losses at its unit that sold credit default swaps but the rest of the firm was a successful insurer. The latter parts — the rest of the company — provided the collateral for the Fed’s initial loans, and eventually TARP funds were substituted for the Fed resources to provide the company with a better capital base rather than Fed loans. To be sure, it was hard to know in September 2008 that the value of the company would offset the potential losses in A.I.G.’s financial products division, but this turned out to be the case, with both the Treasury and the Fed turning considerable profits on their investments in A.I.G.
Such a successful outcome was simply less imaginable with Lehman than with either Bear Stearns or A.I.G. To all eyes, the problem at Lehman was one of solvency while the issue in the other two cases was liquidity. The Fed’s actions on Bear and A.I.G. were thus appropriate in its role as a lender of last resort and the same with its caution at Lehman. Indeed, after Lehman had filed for bankruptcy, the Fed did extend loans to allow the firm’s broker-deal subsidiary to function, but in bankruptcy these loans could be fully collateralized by assets within the brokerage subsidiary and not encumbered by obligations in other parts of the larger firm.
It was five years ago Sept. 15 that Lehman Brothers filed for bankruptcy and turned an economic downturn into a global financial crisis. There already has been some commentary on the coming anniversary, and there’s likely to be more. Much of it won’t be worth reading. I think this one is. It’s by Allan Sloan or Fortune. Sloan actually explains well and simply exactly the problems that emanated from the Lehman collapse. Most importantly, he takes a look at some problems that haven’t been solved since then and why we aren’t immune from similar events again. He also points out some actions taken since then that have the potential to make things worse. The major point is that regulators and legislators often don’t realize the potential for unanticipated consequences from their actions and inactions. But the rest of us have to pay for them.
These two Lehman side effects, which too many people have forgotten, typify the problems of dealing with financial crises. You don’t know where the problem will come from, so you need to have all sorts of resources available.
We’ve forced giant, too-big-to-be-allowed-to-fail financial institutions to beef up their capital relative to their assets, which is a good thing. However, we’ve gravely weakened the ability of the Federal Reserve by taking away key powers that it had used to stabilize things. That’s bad. Really bad. This problem, combined with the unhappy fact that much of the rest of the federal government is dysfunctional, will cost us dearly when the next financial crisis hits. And there always is a next one.
Hank Paulson was Secretary of the Treasury when the financial crisis hit and had the task of coming up with solutions and trying to cajole Congress into enacting them. He wrote a book about the experience and this week has an interview in Fortune giving a followup and some perspective. He also identifies the mortgage guarantee entities, Fannie Mae and Freddie Mac, as the likely sources of the next financial crisis. Naturally, he talks about the disfunctional Congress and how hard it is to get Congress to take action.
Is partisan gridlock stymying the economic recovery and harming growth?
You bet. Economic growth is still too slow and unemployment too high, and this is in part because we’re dealing with a disturbing, longer-term trend of declining economic competitiveness. Even in the ten-year bubble from 1997 to 2007, median family income was flat, when Americans were borrowing at historically high levels and taking on unsustainable levels of debt to maintain an unaffordable standard of living.
What it takes to restore economic competitiveness and get growth above 3% a year is to have bipartisan reform in areas like entitlement systems, immigration policy, and the tax code so that we can get the revenues we need and create jobs.
John Taylor of Stanford is one of the economists who emphasizes how slow the current recovery is and recommends policy changes to increase the growth rate. Periodically he publishes a series of charts that summarize how the economy is doing relative to history. He’s taken to calling this the Long Slump or Great Slump.
The EKG chart showing real GDP growth quarter-by-quarter over the decades remains as tragic and worrisome as ever. You can see the stability of the Great Moderation fading into the past, followed by the Great Recession and now by the Not-So-Great-Recovery.