| Nicholas Bloom |
Opinion
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The subprime crisis along with its associated financial and economic problems is due, in good measure, to some failures of democracy -- financial democracy, that is. Many working-class people and first-time home buyers who took out high loan-to-value mortgages with adjustable rates did not have ready access to information about what they were doing -- the kind of information easily available to wealthier people -- and so made serious mistakes. By the same token, many people who bought securitized mortgages had little access to financial advice that might have warned them how risky these instruments really were.
Fortunately, this country has a history of financial democratizers who have made the financial system work for the people as well as it does, and who have made the U.S. financial system, despite its flaws, the envy of the world. Now, deep into a financial crisis and awash in a newfound culture of financial complexity from 401K plans through reverse mortgages, it is worth reflecting on their past achievements, and considering what lessons they carry for the resolution of the current crisis.
John Moody, along with John M. Bradstreet and Henry Varnum Poor, democratized finance by inventing credit ratings to be made available to the general public. When Moody published a statistical manual in 1900, followed by a system of rating securities with categories Aaa, Baa etc, and a series of investor-advice books, he provided reams of information to everyone, for just the price of a few books. These beginnings led to the development of Moody's Investor Services and other rating agencies. The securities rating system has now spread from the United States to the whole world, and helped make possible the capitalist explosion of growth and prosperity.
Moody left behind an autobiography, "The Long Road Home," 1933, and so we can glean some of his motivations.
Though Moody was a democratizer, he was not acting out of populist philanthropic motives when he launched Moody's. As he makes very clear in his autobiography, he did it to make money. But there were other things he cared about besides making money. People asked him around 1900, why give away all this information so cheaply? They told him he might expect to make a lot more money as an underwriter, middleman or bond salesman. But he recognized that was not his personality, and that "there was that 'literary' or writing bent of mine. To bring out a book -- even a mere compilation -- fired my imagination far more than could any dreams of becoming a successful banker."
He called it a "writing bent" but as is plain from his autobiography, it might be considered an impulse to speak perspicaciously and openly to the people. A "writing bent," connotes an impulse to consider the interests of a broad reading public, and publishing tables of statistics and ratings, as well as the various investing advice books Moody wrote for retail investors, is just that.
Moody was not selfless but he cared about people, and he cared about ethics. His autobiography was filled with admonitions about speculative bubbles that draw in unsuspecting investors (as he himself had personally experienced). He wanted to provide the careful information that would prevent financial misfortune for the average family. He was obsessed with ethical behavior and musings about his traditional Roman Catholic religion. He wrote about moral dilemmas, and his refusal to accept money under terms that would bias his ratings.
It is ironic that the rating agencies today are sometimes blamed for the subprime crisis. We have come to expect perfect behavior from them, and do not give them credit for the multitudes of other crises that never happened because they disseminated the information to prevent them.
Another great financial democratizer, and one with great resonance for today's generation, is the popular personal financial adviser Suze Orman. Her 2005 book is entitled "The Money Book for the Young, Fabulous & Broke." This is a great title. But more than that, Ms. Orman is a success because she knows how to reach many people, and shows some sympathetic understanding of their concrete problems.
Her readers know they are fabulous, as the title of her book implies. Each of them has a unique talent and genius. But they have made mistakes that have gotten them into trouble financially. They need to get the information in synch with their emotions. They do not want to be told blandly to diversify their portfolio, for they have higher aspirations and needs than that. Maybe not everything she says is on target, but on the whole she tells them what they find they really need.
She was not the first to warn of the housing crisis. In fact, in her 2005 book, published at the height of the housing boom, she says "a home is flat-out the best big-ticket purchase you will ever make" and she gives no warning of the housing debacle we have since observed. But to give credit where it is due, she did warn in that book that adjustable rate mortgages "can become a nightmare soon after" when rates reset upwards. She warned readers not to accept lenders' judgments about how much is OK to borrow. Moreover, she provided detailed advice about the total cost of owning a home with advice to "set your own budget."
Ms. Orman has spawned a legion of emulators -- popular financial advisers to the masses. None of these writers or media personalities is perfect. They can get caught up in a boom psychology just as anyone. But, these media figures represent a new hope for preventing further crises by arming the average family with the information they need to protect them from the tantalizing but ultimately dangerous elements of too-good-to-be-true bubble psychology.
The subprime crisis is evidence that, despite significant progress, we still have a long way to go in developing financial democracy. This nation needs to consider how it can help the great mass of investors better handle financial affairs -- not only their homes, but credit, loans, medical, and retirement planning. We need to think more about how investment professionals with a bent to communicate good and honest information can make a decent living serving the broad public doing absolutely what feels right to them, not just in book publishing or in business television, but in all aspects of the financial system.
Mr. Shiller, a professor at Yale and chief economist at MacroMarkets LLC, is the author of "The Subprime Solution: How Today's Global Financial Crisis Happened and What to Do about It" (Princeton, 2008). He is also a member of the committee that oversees the monthly Standard & Poor's/Case-Shiller home-price indices.
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Last week, I suggested the need for a coordinated monetary policy rate cut. That cut arrived yesterday, with the Fed, the European Central Bank and other central banks cutting their policy rates by 50 basis points (bps).
This action is necessary, but only cosmetic, and it is too little too late. European central banks should have cut rates many months ago, before the recession and financial crisis became so virulent. Now, 50bps for the Eurozone is peanuts at a time when a minimum of 150bps is necessary to restart the economy and unclog frozen financial markets; 50bps is also too little in the U.S., given the damage to the real economy of the financial shocks of the last month. During the last recession, the Fed cut the Fed Funds down to 1%; we are still 50bps away from that level. But at the end of this cycle--as I have argued before--the Fed Funds will be closer to 0% than to 1%.
Policy rate cuts will have a limited effect as they don't resolve the fundamental problem in markets--massive counter-party risk--that is keeping money-market spreads relative to safe rates so high. Yesterday's plan to support the commercial paper market is a step in the right direction, but other, more radical policy actions are also needed now. Here are four suggestions for such additional policy action.
--To reduce the counter-party risk in the money markets, a triage between insolvent banks that need to be shut down and a recapitalization of solvent banks is necessary, together with massive injections of liquidity in non-banks and the corporate sector. Direct lending by the government to small businesses--via the Small Business Administration--is also necessary to avoid the implosion of smaller businesses.
--A generalized temporary blanket guarantee of all deposits is now necessary, both in the U.S. and in Europe, followed by a triage between insolvent banks to be closed rapidly and illiquid-but-solvent banks that deserve to be rescued to avoid the moral hazard of such blanket guarantee.
--The flawed $700 billion Troubled Asset Relief Program (TARP) legislation will have to be modified in three ways to: a) allow for direct government injection of public capital in banks in the form of preferred shares, matched by private capital contributions by current shareholders (via suspension of all dividend payments and matching Tier 1 capital provided by private shareholders); b) implement a clear plan to reduce the face value of mortgages for distressed homeowners and avoid a tsunami of foreclosures; c) do a rapid and radical triage between solvent banks and insolvent banks that need to be rapidly closed.
--Given the collapse of private aggregate demand--consumption, residential investment and non-residential investment in structures are falling, and capital expenditure by the corporate sector was falling already before the latest financial and confidence shock and will now be plunging at an even faster rate. You need to give a boost to aggregate demand to ensure that an unavoidable two-year recession does not become a decade-long stagnation.
Since the private sector is not spending, and since the first fiscal stimulus plan (tax rebates for households and tax incentives to firms) failed miserably as households and firms are saving rather than spending and investing, it is necessary now to boost public consumption of goods and services via a massive spending program (a $300 billion fiscal stimulus).
The federal government should have a plan to immediately spend on infrastructure and new green technologies; also unemployment benefits should be sharply increased, together with targeted tax rebates only for lower income households at risk; and federal block grants should be given to state and local government to boost their infrastructure spending (roads, sewer systems, etc.).
If the private sector does not spend and/or cannot spend, old-fashioned traditional Keynesian spending by the government is necessary. It is true that we already have large and growing budget deficits; but $300 billion of public works is more effective and productive than spending $700 billion to buy toxic assets.
So we are now very close to the systemic financial meltdown that I outlined in a paper I wrote in February. But radical action can--and should--be taken to control the damage and prevent this meltdown from occurring.
At this point, the U.S., the advanced economies (and now most likely even some emerging market economies) will experience an ugly recession and an ugly financial and banking crisis--regardless of what we do from now on. We are already now in a global recession that is getting worse by the day. What radical policy action can only do is to prevent what will now be an ugly and nasty two-year recession and financial crisis from turning into a decade-long economic depression.
The financial and economic conditions are extreme; thus extreme policy action is needed now to save the global economy from that very ugly prospect.
Nouriel Roubini, a professor at the Stern Business School at NYU and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.
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WASHINGTON
Thirty billion dollars to keep Bear Stearns from collapsing. Another $85 billion for A.I.G. Hundreds of billions, here and there, lent to banks.
All told, the Federal Reserve has pumped $800 billion into the financial system, Ben Bernanke, its chairman, estimated on Tuesday. That figure doesn't include the untold sum that the Fed now plans to spend buying short-term debt so that companies can continue to pay for their daily operations. And it doesn't include any of the money the Treasury Department is laying out, like the $700 billion bailout fund or the $200 billion that could be spent propping up Fannie Mae and Freddie Mac.
After 14 months of crisis, the federal government — meaning you and me — has put serious money on the line. As a point of comparison, the entire annual federal budget is about $3 trillion.
Just how are we going to pay for all this?
The short answer is that the budget problems the country seemed to have a year ago are now even worse. Next year's deficit (relative to the economy's size) will probably be the biggest since 1992, and maybe since 1983. Taxes will have to rise or government spending will have to fall, if not both. Trying to contain the mess created by a bubble no doubt costs serious money.
Yet this is also a case in which the short answer isn't the full answer, or even the best answer.
As expensive as the damage control may be, it isn't likely to cost near as much as the headline numbers suggest. More to the point, the alternative — not spending some serious money to deal with the crisis — would probably end up costing a lot more. As it is, the various bailouts are not the main reason next year's deficit is growing. The deteriorating state of the economy is.
So if you want to conjure up some doomsday stories about the federal budget, I'm happy to play along (and will do so momentarily). But those stories aren't mainly about the credit crisis. They're about the dangers of ignoring economic realities — which, when you think about it, is how we ended up in this credit crisis in the first place.
•
The most newsworthy part of Mr. Bernanke's lunchtime speech on Tuesday was his sober overview of the economy. He called the financial crisis "a problem of historic dimensions" and indicated that the Fed would soon cut its benchmark interest rate once again.
But the bulk of the speech was a catalog of the extraordinary steps that the Fed and Treasury had taken since August and the delicate line they had tried to walk along the way. They have lent enormous amounts of money to banks and trumpeted those efforts to try to restore some confidence to the credit markets. Fed officials have pointed out that they are nowhere close to being out of bullets either. They work for the central bank, after all. They can always print money.
But Mr. Bernanke and the Treasury secretary, Henry Paulson, have also emphasized that they're not being too generous. They are mainly making loans and investments, and they expect to recoup much of the money they're spreading around.
Outside the government, economists differ about whether Mr. Bernanke and Mr. Paulson have been too aggressive or not aggressive enough and whether they have been aggressive in the right ways. But there is not much concern that they are taking on additional debt — or even about the amount of it.
"The policy actions are not likely to have a large effect on the budget over the next five or 10 years," Douglas Elmendorf, who has become a go-to Democratic economist during the crisis, told me. John Makin, of the conservative American Enterprise Institute, added: "The last thing I'm worried about right now is additional government indebtedness. There really isn't an alternative."
Mr. Makin pointed out that during Japan's long malaise, the government passed a stimulus package almost every year that was equal to more than 2 percent of the country's gross domestic product (equivalent to about $400 billion in this country today). But interest rates in Japan remained low, a sign that economic weakness, not deficits, was still the problem.
That being said, today's ever-expanding bailouts do create some dangers. You've probably heard the term moral hazard, which is shorthand for the idea that government rescues may lead investors to take new, unwise risks — and ultimately require yet more rescues.
The Fed is also setting itself up for tough decisions about when to end its various emergency programs. If it waits too long, it could leave so much money sloshing around the economy that inflation will take off. Fed officials have suggested they understand that they made precisely this mistake after the 2001 recession, when they kept interest rates low and added to the mania in the housing market.
Finally, there is the net cost of the bailouts, which may well be bigger than Mr. Bernanke has acknowledged. Under the new program announced Tuesday, the Fed will own the commercial paper that serves as short-term loans for companies. If some of those companies go bankrupt, the Fed could suffer some losses.
The Treasury's $700 billion bailout fund, meanwhile, is based on the premise that investors are collectively undervaluing assets and that the government can pay above current market prices without losing much money. "One has to be at least a bit skeptical," the economist Greg Mankiw says, "about the idea that government policy makers gambling with other people's money are better at judging the value of complex financial instruments than are private investors gambling with their own."
After talking with budget analysts, I think it's reasonable to assume that the bailouts will end up costing several hundred billion dollars, spread over several years. Perhaps $100 billion of that cost may come next year. Add in another $100 billion or so for the weakening economy — specifically the fall in tax revenue, increases in spending on social programs and the possibility of another stimulus package.
Even before the crisis, the Bush administration was set to bequeath a $550 billion deficit to its successor. Now, a better estimate appears to be $750 billion — or 5 percent of gross domestic product. The only years since the 1960s that the deficit has been nearly so large were the early 1990s (almost 4.5 percent of G.D.P.) and the mid-1980s (with a peak of 6 percent in 1983).
Obviously, next year's deficit is a problem. And if you assume the credit crisis isn't about to lift — which seems smart at this point — the ultimate cost of the bailouts could conceivably go higher. Whatever the final figure, it should still be put in some context.
Despite everything, the biggest fiscal problem remains, far and away, health care. Based on the rate that medical spending has been rising, the Congressional Budget Office forecasts that Medicare and Medicaid will take up 10 percent of G.D.P. within two decades, up from about 4 percent now. In today's terms, that would be the equivalent of adding at least $900 billion to the deficit every single year, in perpetuity. It makes the cost of the bailouts look like a rounding error.
When it comes to health care, we have a situation that is blatantly unsustainable. With the right choices, we can prevent that. But so far, we instead seem to be hoping that the situation will magically resolve itself, which is a recipe for big problems and perhaps even a crisis.
Let's see. That doesn't sound familiar, does it?
E-mail: leonhardt@nytimes.com
Opinion
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See a sample reprint in PDF format. Order a reprint of this article now Since 2006 the U.S. economy has exhibited the features of a crash following a classic bubble.
But the bulge was not precipitated by general stock-market excesses nor by an economy-wide bubble-crash. The excesses were focused in the housing and related financial markets -- banks, mortgage, and insurance companies -- starting in 1998 and accelerating to 2006. This created the mother of all housing bubbles.
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True, the crash has been exacerbated by the increase in oil prices, up from a mere $12 a barrel in 1998, to $90 in January 2008, then a spike to $147 in July. But the economy has rolled tolerably well under that punch, and it does not pose the systemic risk of the housing debacle.
Housing is one-third of all U.S. wealth, totaling $19.4 trillion in the second quarter of 2008, according to the Federal Reserve. Almost all of the mortgage debt on those assets will be paid. Only a subset of homes funded recently with low down payments at unsustainable prices are at risk. All of you who rent -- a respectable American tradition -- can look forward to buying more cheaply in the future. Take your time.
The housing disaster-in-motion was widely reported, complete with warnings, before the crash. But every word fell on deaf ears, because bubbles are never about reason, cool calculation and courageous politicians willing to risk defeat.
By 2005 Alan Greenspan and others were warning that Fannie Mae and Freddie Mac had become seriously undercapitalized and had persistently over-accumulated high risk mortgage paper. That paper was created by an industry reluctant to hold its own brainchild, but which responded to home buyers chasing an appreciating capital asset driven by their own ebullient expectations.
Moreover all parties have long believed that the obligations of Fan and Fred were backed by the Treasury's deep pockets -- that's you and me who pay taxes.
We need to minimize systemic and taxpayer risk. Fortunately the two are entwined. Serve the needs of the former and you protect the taxpayer.
Why is this crash a classic?
- A "liquidity crisis." In every market, there is ultimately only one source of liquidity: buyers. And this is what central bankers hope to see return when they speak euphemistically of "restoring confidence."
All other sources of liquidity are stop gaps, bridges, band aids, and now a duct-tape bailout. Every seller in dire need of a buyer is in a liquidity crisis, even if he is a gainfully employed homeowner whose job security requires a move, or a fundamentally solvent bank, holding secured mortgage paper, but in need of immediate cash. Both now find that yesterday's buyers are in hiding.
A sale is always an "expectations equilibrium" -- a buyer only accepts a seller's instrument (agrees to a sale) if she believes that others will also accept it. Disequilibrium bubble-crash principles have been intensively studied in laboratory environments for over two decades (see Jerry Bishop's article in The Wall Street Journal on my work in this field "Stock Market Experiment Suggests Inevitability of Booms and Busts," Nov. 17, 1987).
- During a bubble buyers are everywhere. Then, suddenly, they disappear, waiting, watching, delaying, reluctant to buy assets that others might not. That buyers will disappear in a bubble is predictable, what is never predictable is the timing. In his 1933 inaugural address, President Franklin Roosevelt said "the only thing we have to fear is fear itself." Yes, but the return of fearful buyers is just as unpredictable as the timing of their disappearance. And only the most arrogant will pretend to know what public policies will restore buyer "confidence."
- Cash is not scarce. Cash is just justifiably hard to loosen, and this makes it king. There are only three kinds of buyers in a downside housing/mortgage or equities market: those who buy too soon; the few who roll an 11 at the bottom; and those who are too spooked to buy until well after the crisis is over, if ever. Warren Buffet may be either too soon or about right. If he is too soon, it won't be his first time. The point is that no one can know.
Starting in 2007, the Fed under Ben Bernanke, did all the right things expected of a central banker facing liquidity problems in the finance/housing sector. He even risked inflation by making it easy for banks to borrow from each other and the Fed. (The dollar did temporarily fall as commodities spiked upward.) But the action failed to solve the problem.
The early evidence came when Countrywide crashed and burned last year. But as English economist Sir Dennis Robertson would have put it over 60 years ago, the Fed was "pushing on a string" that only buyers can pull. Further deterioration set in, and nothing terrorizes a central banker more.
Enter a bipartisan Keynesian-inspired Congress and administration, who authorized Treasury to write large numbers of small checks as part of a "stimulus" package to many people who do not pay taxes. People spent the money at Wal-Mart. Much of it went to China (which recycled it into U.S. bonds). And we saw a blip in retail sales that just delayed the inevitable.
So Mr. Bernanke took the only action left: He got Treasury Secretary Henry Paulson into the action. Better two scared leaders at the top than one. They went to Congress.
And the result was the House's "Emergency Economic Stabilization Act of 2008," a bureaucratic nightmare that fails to use auction markets in a way that will minimize both taxpayer and systemic risk. The key flawed provision states "The [Treasury] Secretary is authorized to purchase, and make and fund commitments to purchase, troubled assets from any financial institution as are determined by the Secretary."
Excuse me, did I read "any?"
The Senate spelled it out more clearly: "troubled assets are not limited to mortgage related assets but could include auto loans, credit card debt, student loans or any other paper related to commercial loans."
"Any other paper?" Heaven help us! Fortunately, Mr. Paulson still has some good sense. But no wonder the bailout bill is authorized at $700 billion. For a little perspective, consider that in August, MarketWatch reported that there are 4.67 million existing homes for sale, at a median price of $212,400 for a total of just under a trillion dollars. With a 30% loan, Treasury could buy them all.
Auction designers should immediately note that we are talking about a market with one buyer and many sellers of a hodge-podge of items. The mechanism that will be used is a "reverse auction" -- with sellers competitively submitting asking prices to sell Treasury a heterogeneous mix of good, some sour, apples and oranges whose content is better known to sellers than the Treasury.
Treasury expertise is in auctioning Treasury securities of a given maturity to multiple competing buyers: say $10 billion worth of six-month bills, or two-year notes. In either case every bill (or note) is identical to every other one. The only uncertainty is the final clearing price and Treasury is assured that it will get the best price.
Treasury has no expertise in this ridiculous new venture. (Auction houses such as Christie's and Sotheby's have no problem with heterogeneous items. They auction them singly or in small assemblies to multiple buyers, who assess the items and make bids that reflect best estimates of true value.)
Treasury action should focus on providing capital to individual banks and mortgage companies in return for debt, convertible bonds and equity and warrants to be negotiated. This is dangerous enough for the taxpayer, but here Mr. Paulson has previous experience. (The model was demonstrated recently when Treasury and the FDIC assisted J.P. Morgan's takeover of Washington Mutual.) Then let companies do any necessary piecemeal paper asset auctions, while Treasury holds managers accountable. This is feasible at least, if hardly risk-free for taxpayers.
This procedure will confront financial systemic risk, and allow prices to emerge competitively that will encourage the all important return of bargain hunting buyers.
Would the procedure work? I don't know. But it does focus on the knowledge that markets are capable of bringing to the table. The bailout does not.
To the extent that the bailout shores up existing home prices and its paper, it delays the inevitable. It does not assure the early return of buyers. Look at the course of home prices since 1987 in the nearby chart. Do you think the price decline has run its course since it turned the corner in 2006, then plummeted in 2007-2008?
Shoring up prices to prevent a further debasement of overly generous loans is not designed to bring back buyers of homes and mortgage paper. But there is good news: homes, stocks, crude oil, copper, corn, soy beans, wheat, lumber and even ethanol are now cheaper.
Mr. Smith, a professor of economics and law at Chapman University, received the Nobel Prize in economics in 2002.
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