The Blame Game

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Washington, Wall Street, and – most importantly – Hollywood agree that the 2007-09 Great Recession was caused by excessive lending to unreliable low-income home buyers. It was an open secret that subprime applications frequently inflated borrower incomes, causing financial seers to conclude that these loans would experience widespread default. Moreover, the expected damage was greatly leveraged once the suspect mortgages were packaged with home loans to higher-income households, and the low-transparency securities were aggressively marketed to financial institutions around the world. The Big Short dramatically explained the doomed process to millions of movie-goers: subprime borrowers would begin their mass default, investors would panic and sell-off the infected securities, and big banks (having gorged themselves on the relatively high interest-rate instruments) would be bankrupted. Voilà! The Great Recession.

After viewing the tell-it-like-it-is Big Short, a number of acquaintances wanted to tell me that they finally understood what 2007-09 was all about. And they were outraged. How could their tax money be used to bail out greedy, stupid banks? Was anything being done to stop subprime lending or were we at grave risk of future Great Recessions?

The most concise answer to their questions, to which I occasionally gave in, is that their beloved Big Short is a pile of crap. It got one part of the three-part story correct. Investors did panic and sell-off subprime securities. On the more important parts, the movie badly misleads. First, its central premise is dead wrong.  There was no mass default by subprime borrowers. The actual default rate was much lower than the mortgage interest implied. Second, the taxpayer “bailout” of big banks was sound stabilization policy that was never intended, or needed, to make up for subprime mortgage losses. The purpose of the capital injections was much more fundamental: to help prevent huge multi-trillion-dollar losses to taxpayers and everybody else if the gathering late-2008 collapse of total spending was allowed to spiral into a 1930s-class depression.

Absent Subprime Default

Here is a fact that the self-described Big Short geniuses probably still don’t know. From The Financial Crisis Inquiry Report (2011), pp. 228-9: “Overall, for 2005 to 2007 vintage tranches of mortgage-backed securities originally rated triple-A, despite the mass downgrades, only about 10% of Alt-A and 4% of subprime securities had been ‘materially impaired’ – meaning that losses were imminent or had already been suffered – by the end of 2009.” As noted above, a 4% default rate given the relatively high interest charged is remarkably low, not in the ballpark of the disastrous levels predicted by the Big Short’s smartest guys in the room. Moreover, it is interesting that Alt-A mortgages, characterized by unusual terms (e.g., the deferral of interest payments), were almost always obtained by high-income borrowers.

The major theme, never questioned, running through the self-aggrandizing Big Short script is that the lending to low-income borrowers in the run-up to the Great Recession was obviously foolish. In fact, one of the few feel-good outcomes of the 2008-09 financial debacle is the upstanding behavior of “subprime” households, a fact that bankers experienced in this market already know. The stars of the movie, the short-selling investors, were the true engine of the crisis, not because of bad character as much as simple bad analysis. That they made, not lost, money was dumb luck.

Proper Role of Capital Injections

The GEM Blog recently presented a four-week analysis of post-crisis policy innovations that have been adopted to prevent future Great Recessions. It demonstrated both the criticality of aggregate-demand management in effective stabilization policymaking and, less generally, the role of bank capital injections in halting the collapse of total spending.

The central destabilizing feedback between mounting damage to the financial system’s capacity to recycle saving into investment/consumption and collapsing aggregate demand was outlined. The 2008-09 collapse in asset prices and the damage to business and household creditworthiness quickly ate up (mark-to-market) bank capital. Facing industry-wide drops in capital-asset ratios, bank managements rationally sought to reduce assets, cutting back on lending and greatly aggravating the on-going contraction in total spending. Moreover, as spooked investors cut back on short-term funding to banks (and nonbanks), even more financial-institution asset sales were needed to balance their books. Inactive investor/lenders had set off a phenomenon that economists have named “contagion”. The term describes an indiscriminate reluctance to provide short-term funding to financial institutions, forcing the sale of assets at depressed prices. It belongs to the general class of macro externalities, i.e., phenomena induced by rational individual behavior that produces significant collective welfare loss. Such externalities mandate government action.

In acute-instability crises, the effective policy response to adverse feedback dynamics has been long understood to include temporary injections of public funds to help mitigate the effects of the endogenous deterioration of bank capital on total spending. The dramatic impetus of The Big Short, however, probably would have stalled if its story had been rooted in what actually happened.

Properly Preventing Future Great Recessions

No movie has accurately described the real heroes of 2008-09. Tough-minded stabilization authorities, especially at the Fed, aggressively worked to halt and reverse contracting total nominal spending. Their success was rooted in accurate analysis of the perilous extreme instability. (Note the contrast to the shoddy analysis of the short-selling stars of The Big Short.) It follows that effective policy to prevent future Great Recessions should focus on strengthening the Fed’s demand-management tools.

Along those lines, this post closes with some toolkit-relevant observations from Stanley Fischer, the insightful macro theorist who recently retired as Vice-Chairman of the Federal Reserve. Fischer (2013, p.2) first draws attention to “… the policy of quantitative easing – the continuation of purchases of assets by the central bank even when the central bank interest rate is zero. Although these purchases do not reduce the short-term interest rate, they do increase liquidity. Further, by operating in longer term assets, as in QE2, the central bank can affect longer term interest rates, which may have an additional impact on the private sector’s demand for longer term assets, including mortgages and corporate investment.

“Second, there is the approach that the Fed unsuccessfully tried to name ‘credit easing’ – actions directed at reviving particular markets whose difficulties were creating serious problems in the financial system. For instance, when the commercial paper market in the United States was collapsing, the Fed entered on a major scale as a purchaser, and succeeded in reviving the market. Similarly, it played a significant role in keeping the mortgage market alive. In this regard, the Fed became the market maker of last resort.” The various 2008-09 market breakdowns critically aggravated collapsing total nominal spending that, in combination with meaningful wage rigidity, generated involuntary lost jobs, output, and income that were propagated by associated multipliers.

Fischer continues, illustratively identifying with cautious approval another intervention channel (considered in Chapter 6) that has never been used by the Fed. “In a well-known article, James Tobin in 1963 asked in which assets the central bank should conduct open market operations. His answer was the market for capital – namely the stock market…. Although central banks have occasionally operated in the stock market – notably the Hong Kong Monetary Authority in 1997 – this has not yet become an accepted way of conducting monetary policy.” (pp.2-3) While the GEM Project’s emphasis, in circumstances of extreme instability, on confidence and uncertainty refocuses Tobin’s argument, an important question remains. Would Fed invention as a buyer-of-last-resort in equity markets have prevented much of the welfare loss of the Great Recession?

However that question is answered, the larger message remains intact. The search for, and codification of, effective total-spending interventions is far from complete.

Blog Type: Policy/Topical San Miguel de Allende, Mexico

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