Crisis Economics Part 2

Friedman and Schwartz opposed government intervention on principle-especially if it was government spending a la Keynes-but they believed that a drop in the money supply could have been avoided had the Federal Reserve aggressively cut the rates at which banks could borrow from it. More important, the monetarists blamed the Federal Reserve for not acting as a lender of last resort, making lines of credit available to faltering banks and financial inst.i.tutions. Had the Federal Reserve prevented the waves of bank failures in the early 1930s, they argued, the Great Depression would not have been so great, and the nation would have suffered through an ordinary recession before recovering.

The monetarist interpretation of the Great Depression has some merit: the collapse of the money supply in the 1930s certainly exacerbated the credit crunch, and the Federal Reserve only made matters worse. But other economic historians, most notably Peter Temin, have since argued that the collapse in aggregate demand was the primary catalyst for the disaster. Keynes, they argued, was mostly right: only increased public spending could have sustained aggregate demand, even if a more aggressive monetary policy would have contributed to the eventual recovery.

Nonetheless, it was Friedman, not Keynes, who became increasingly influential in the 1970s and 1980s. One reason was that what little remained of Keynesian economics by this time was a pale imitation of the original. Significant portions of Keynes's writings-not only The General Theory but his earlier A Treatise on Money-contained plenty of other insights that the postwar generation of economists ignored in their attempt to reconcile Keynes with earlier schools of economic thought, particularly the cla.s.sical economists. That effort, which came to be known as the neocla.s.sical synthesis, was a mixed bag. (One critic called it "b.a.s.t.a.r.d Keynesianism.") The great economist's belief in the power of government to stimulate demand was retained, but almost everything else Keynes wrote was ignored.

Not everyone discounted the other implications of Keynes's work, however. Hyman Minsky, a professor of economics at Was.h.i.+ngton University in St. Louis, dedicated his life to building a theoretical edifice on the foundation that Keynes had laid. Minsky auth.o.r.ed an intellectual biography of Keynes and an elaboration of his own distinct interpretation, pointedly t.i.tled Stabilizing an Unstable Economy.

In these works, along with numerous articles, Minsky argued that Keynes had been misunderstood. He focused on several neglected chapters of The General Theory that dealt with banks, credit, and financial inst.i.tutions, and he synthesized them with insights from A Treatise on Money. Keynes, Minsky argued, had made a powerful argument that capitalism was by its very nature unstable and p.r.o.ne to collapse. "Instability," Minsky wrote, "is an inherent and inescapable flaw of capitalism."

According to Minsky, instability originates in the very financial inst.i.tutions that make capitalism possible. "Implicit in [Keynes's] a.n.a.lysis," he wrote, "is a view that the capitalist economy is fundamentally flawed. This flaw exists because the financial system necessary for capitalist vitality and vigor-which translates entrepreneurial animal spirits into effective demand for investment-contains the potential for runaway expansion, powered by an investment boom." This runaway expansion, Minsky explained, can readily grind to a halt because "acc.u.mulated financial changes render the financial system fragile."

Minsky repeatedly came back to Keynes's observation that financial intermediaries-banks, most obviously-play a critical and growing role in modern economies, binding creditors and debtors in elaborate and complex financial webs. "The interposition of this veil of money," wrote Keynes, ". . . is an especially marked characteristic of the modern world." According to Minsky, Keynes offered a "deep a.n.a.lysis" of how financial forces interact with variables of production and consumption, on the one hand, and output, employment, and prices on the other.

All of this stood in stark contrast to the economics profession in the postwar era: the equations and models deployed by architects of the neocla.s.sical synthesis had little or no place for banks and other financial inst.i.tutions, despite the fact that their failure could wreak havoc on the larger economy. Minsky set out to change this state of affairs by showing how banks and other financial inst.i.tutions could, as they became increasingly complex and interdependent, bring the entire system cras.h.i.+ng down. The centerpiece of his a.n.a.lysis was debt: how it is acc.u.mulated, distributed, and valued. Following Keynes, he saw debt as part of a dynamic system that would necessarily evolve over time. Again, per Keynes, he recognized that this dynamism injected uncertainty into economic calculations. In good times, the promise of continuing growth and profits allayed uncertainty. But in bad times, uncertainty would prompt financial players to curtail lending, reduce risk and exposure, and h.o.a.rd capital.

In itself, this view was not entirely revolutionary. But Minsky's Financial Instability Hypothesis had another dimension. He categorized the debtors in a given economy into three groups, according to the nature of the financing they used: hedge borrowers, speculative borrowers, and Ponzi borrowers. Hedge borrowers are those who can make payments on both the interest and the princ.i.p.al of their debts from their current cash flow. Speculative borrowers are those whose income will cover interest payments but not the princ.i.p.al; they have to roll over their debts, selling new debt to pay off old. Ponzi borrowers are the most unstable: their income covers neither the princ.i.p.al nor the interest payments. Their only option is to mortgage their future finances by borrowing still further, hoping for a rise in the value of the a.s.sests they purchased with borrowed money.

During a speculative boom, Minsky believed, the number of hedge borrowers declines, while the number of speculative and Ponzi borrowers grows. Hedge borrowers, now flush with cash thanks to their conservative investments, begin lending to speculative and Ponzi borrowers. The a.s.set at the center of the boom-real estate, for example-rises in price, prompting all borrowers to take on even more debt. As the amount of unserviceable debt balloons, the system becomes ever more ripe for financial disaster. In Minsky's view, the trigger is almost irrelevant: it could be the failure of a firm (much as the failure of hedge funds and major banks marked the end of the bubble in 2007 and 2008) or the revelation of a staggering fraud (like the Bernard Madoff scheme, exposed in 2008).

When pyramids of debt start to crumble and credit dries up, Minsky realized, otherwise healthy financial inst.i.tutions, corporations, and consumers may find themselves short of cash, unable to pay their debts without selling off a.s.sets at bargain-bas.e.m.e.nt prices. As more and more people rush to sell their a.s.sets, the prices of those a.s.sets spiral downward, creating a self-perpetuating cycle of fire sales, falling prices, and more fire sales. As the level of aggregate demand falls below the supply of goods, the larger economy suffers from price deflation: with every pa.s.sing day, each dollar purchases more than it did the day before.

It sounds like a blessing, but for debtors it's a curse. Irving Fisher, a Great Depression economist who coined the term "debt deflation" (see chapter 6) to describe this process, observed that if the price of goods falls faster than debts are reduced, the real value of private debts will rise over time. For example, imagine that someone borrows a million dollars to buy a house with no money down. The house is worth a million dollars; the owner owes a million dollars. Then deflation kicks in, and prices fall across the economy; everything from the price of the house to the salary of the owner declines. Everything costs less, but everyone has less money. Unfortunately, the real size of that mortgage has increased: a million dollars' worth of debt is now a bigger burden than it was previously.

Because deflation increases people's debt burden, it also increases the probability of default and bankruptcy. As defaults and bankruptcies soar, the downward spiral continues, dragging the economy into a depression. Between October 1929 and March 1933, for example, the liquidations of a.s.sets reduced the nominal value of private debts by 20 percent. But thanks to deflation, the real burden of those debts increased by a whopping 40 percent.

In order to avoid a repeat of the Great Depression, Fisher (and for that matter, Friedman and Minsky) counseled that a central bank-the Federal Reserve, in the case of the United States-should step in to play the role of lender of last resort, providing the necessary financing for banks and even for corporations and individuals. In extreme cases, Fisher argued that the government should pursue "reflation," reviving the economy by flooding it with easy money.

That's exactly what has been done in our own time. Over the course of 2007 and 2008, as the financial crisis deepened, American policy makers looked to the lessons of the Great Depression and acted accordingly. Rather than let thousands of banks and corporations go under, as Hoover had done in the early 1930s, the Federal Reserve made available unprecedented lines of credit. That enabled investment banks, insurers, hedge funds, money market funds, and others to avoid insolvency and eventually halted the vicious cycle of fire sales, falling prices, and more fire sales. Likewise, major firms like Chrysler and General Motors were given lines of credit to prevent them from falling into Chapter 7 bankruptcy proceedings, where their a.s.sets would have been liquidated. Instead, the government steered them into Chapter 11, where they could be reorganized and reborn. It was all a far cry from the "leave-it-alone liquidationists" of the Hoover administration.

The policy response on the fiscal level also starkly contrasts with what happened during the Great Depression. As the early 1930s crisis spiraled out of control, the idea of using government spending to take up the slack in demand was still a glimmer in Keynes's eyes. Instead, governments across the world insisted on balancing the budget, which prompted cuts in government spending and tax hikes, both of which arrived at the worst possible time. But in 2009 the Obama administration pa.s.sed the biggest stimulus bill in the nation's history, which included plentiful tax breaks. Between monetary policy (the government's various levers of control over the money supply) and fiscal policy (the government's means of taxing and spending), everything that should have been done was done, however imperfectly.

So regardless of their theoretical inclinations, economists of all stripes should be happy with the handling of the recent crisis, right? Wrong. There's another way of looking at financial crises, one that points to an entirely different understanding of the Great Depression of the 1930s, the j.a.panese near depression and Lost Decade of the 1990s, and the Great Recession of our own time.

To Austria and Back.

The Austrian School originated in the late nineteenth and early twentieth centuries with a loosely affiliated group of Austrian economists: Carl Menger, Ludwig von Mises, Eugen von Bohm-Bawerk, and Friedrich Hayek. These economists and their many students, including Joseph Schumpeter, were a fractious bunch and are next to impossible to categorize. The same can be said of those twenty-first-century economists who consider themselves heirs to the Austrians.

Nonetheless, a few generalizations are possible. Being an Austrian economist today is tantamount to holding libertarian economic beliefs. Indeed, a deep skepticism of government intervention in the economy-especially in the monetary system-is a pillar of the Austrian School. For example, most Austrians make a strong distinction between sustainable economic expansion financed by private savings and unstable, ill-fated expansion financed by credit from a central bank. While they would agree with Keynes and Minsky that excessive a.s.set and credit bubbles lead to dangerous crises, they don't blame capitalism for that problem. Instead, they point to government policies, namely easy monetary policy, along with regulations and interventions that allegedly interfere with the workings of the free market.

This skepticism toward government intervention goes hand in hand with another hallmark of the Austrian approach: a focus on individual entrepreneurs as the unit of economic a.n.a.lysis. Though he was hardly a libertarian, Joseph Schumpeter developed a powerful theory of entrepreneurs.h.i.+p that is often distilled down to a pair of powerful words: creative destruction. In Schumpeter's worldview, capitalism consists of waves of innovation in prosperous times, followed by a brutal winnowing in times of depression. This winnowing is to be neither avoided nor minimized: it is a painful but positive adjustment, whose survivors will create a new economic order.

For those who embrace the Austrian point of view, the Great Depression is an object lesson in the perils not of doing too little in the face of a crisis but of doing too much. According to some Austrian economists, Roosevelt prolonged the Great Depression by intervening in the economy. The Austrians even criticize Herbert Hoover, arguing that by overseeing the Reconstruction Finance Corporation, a government agency that made loans to beleaguered banks and local governments, he too stood in the way of the necessary but painful process of "creative destruction."

This dispute over distant crises may seem academic, but it's not: Austrian School economists make a historical case that the policy response to the recent crisis will eventually give us the worst of all worlds. Instead of letting weak, overleveraged banks, corporations, and even households perish in a burst of creative destruction, thereby allowing the strong to survive and thrive, governments around the world have meddled, creating an economy of the living dead: zombie banks that cling to life with endless lines of credit from central banks; zombie firms like General Motors and Chrysler that depend on government owners.h.i.+p for their continued survival; and zombie households across the United States, kept alive by legislation that keeps creditors at bay and that spares them from losing homes they could not afford in the first place.

In the process, private losses are socialized: they become the burden of society at large and, by implication, of the national government, as budget deficits lead to unsustainable increases in public debt. In time, the a.s.sumption of these crus.h.i.+ng debts can strain government finances and reduce long-term economic growth. In extreme cases, this kind of burden will lead the government to default on its debt, or alternatively, to start printing money to buy back its debt, a maneuver that can swiftly trigger bouts of dangerously high inflation. In either case, the Austrians argue, the best course of action would have been to let the inevitable liquidations take place as quickly as possible. If Andrew Mellon were alive today, he would find friends in the Austrian camp.

Economists of the Austrian persuasion are also deeply skeptical of the rush to regulate that so often occurs in the wake of a crisis. In their view, too much regulation was the cause of the crisis in the first place, and adding more will only make future crises worse. This seems counterintuitive: how can regulation cause a crisis? The Austrians would respond that innovations like deposit insurance and lender-of-last-resort support, while offering security to anyone with a savings account, have nonetheless increased bankers' appet.i.te for risk. Much as someone who wears a seat belt may be tempted to drive faster, banks a.s.sumed greater risks-and the potential for accruing greater profits-secure in the knowledge that if they failed, the federal government would make things right with their depositors.

This same logic extends to any number of other government interventions in the economy. Earlier this decade, Wall Street a.n.a.lysts spoke of the "Greenspan put"-the belief that the Federal Reserve would rescue financial firms with easy money, special lines of credit, and lender-of-last-resort support. (A put is an option that an investor can purchase to hedge against a sharp market downturn.) The Greenspan put is precisely what happened when the crisis. .h.i.t: the Federal Reserve stepped into the breach, rewarding incompetent risk taking with monetary largesse-or at least, that is how the Austrians would interpret it. In the process, they argue, it only fostered a bigger and more disastrous boom-and-bust cycle down the line.

Austrians argue that many of the common cures for financial disasters are worse than the disease. On the one hand, if governments run fiscal deficits in order to keep the economy afloat, levels of public debt become unsustainable. Eventually, governments are forced to raise interest rates, killing off whatever recovery may be under way. The Austrians are equally critical of the easy solution to this problem: printing money to "monetize" deficits. Doing so, they argue, will invariably lead to inflation and anemic economic growth comparable to the stagflation that crippled the United States in the 1970s. Either way, the Austrians believe, government can only make a bad situation worse and plant the seeds of a bigger bubble down the line, as everyone comes to believe that in the event of a future financial crisis, a bailout will be forthcoming.

Much of the Austrian vision seems extreme, or at the very least heartless. It is the ant.i.thesis of Keynesian thinking, much as Joseph Schumpeter was the most significant rival of Keynes when both were alive. If Keynes advanced a vision of capitalism that might occasionally become imbalanced (but could readily be stabilized with government intervention), Schumpeter believed instability to be the necessary consequence of the kind of innovation that made capitalism possible in the first place.

From the Austrian perspective, the fear now is that the United States is heading down the road that j.a.pan paved in the 1990s, when it responded to its own slow-motion financial crisis by propping up zombie banks and corporate firms and by dropping interest rates down to zero, flooding the economy with yet more easy money. The government also ran enormous fiscal deficits to finance the kind of stimulus spending that Keynes prescribed. Instead of allowing "creative destruction," the j.a.panese built bridges to nowhere that merely put enormous amounts of debt on the shoulders of the national government. The result, the Austrians maintain, was j.a.pan's Lost Decade.

Does the Austrian view have any merit? Economists who swear fealty to Keynes argue that j.a.pan failed to implement the appropriate fiscal stimulus and monetary policy in time. They point out that the government waited two years after the collapse of the bubble to start its stimulus spending. Even worse, the Bank of j.a.pan took eight years to cut interest rates from 8 percent to 0 percent. Then it moved away from this zero-interest-rate policy (better known as ZIRP) too soon. Just as FDR curtailed fiscal and monetary policies in 1937, ushering in a severe recession, j.a.pan triggered a recession that lasted from 1998 to 2000. By the same logic, the United States, should it curtail stimulus spending or tighten the monetary reins while the recovery has barely started, risks repeating this mistake today.

In short, the Austrian approach is misguided when it comes to short-term policies. As Keynes and Minsky recognized, in the absence of government intervention, a crisis caused by financial excesses can become an outright depression, and what begins as a reasonable retreat from risk can turn into a rout. When the "animal spirits" of capitalism vanish, the "creative destruction" hailed by the Austrians can swiftly turn into a self-fulfilling collapse of private aggregate demand. As a consequence, distressed but still-solvent firms, banks, and households can no longer gain access to the credit necessary for their continued survival. It's one thing if truly insolvent banks, firms, and individual households go under; it's another altogether when innocent bystanders to an economic crisis are forced into bankruptcy because credit dries up.

In order to prevent this kind of collateral damage, it makes sense to follow the playbook devised by Keynes in the short term, even when the underlying fundamentals suggest that significant portions of the economy are not only illiquid but insolvent. In the short term, it's best to prevent a disorderly collapse of the entire financial system via monetary easing and the creation of bulwarks: via lender-of-last-resort support, for example, or capital injections into ailing banks. It's also best to prop up aggregate demand through stimulus spending and tax cuts. Doing so will prevent a financial crisis from turning into something comparable to j.a.pan's Lost Decade or, worse, the Great Depression.

But when it comes to the medium term and long term, the Austrians have something to teach us. Even Minsky correctly pointed out that resolving a financial crisis over the medium and long term requires that everyone from households to corporations to banks reduce their level of debt. Putting this off is always a serious mistake. By failing to reduce private leverage, banks, firms, and households drown in debt, unable to lend, spend, consume, or invest. Likewise, socializing these losses-via unending government bailouts-is untenable. So too is the impulse to get rid of these debts by trying to inflate the currency. These actions merely move the problem from one part of the economy to another. In the long term, it is absolutely necessary for insolvent banks, firms, and households to go bankrupt and emerge anew; keeping them alive indefinitely only prolongs the problem.

In general, the followers of Keynes and the followers of Schumpeter don't talk to each other. That's unfortunate, because both thinkers-and the larger schools of economic thinking they represent-have something to say about what should be done. The insights of both schools can be synthesized and brought to bear on the problems we face now; indeed, the successful resolution of the recent crisis depends on a pragmatic approach that takes the best of both camps, recognizing that while stimulus spending, bailouts, lender-of-last-resort support, and monetary policy may help in the short term, a necessary reckoning must take place over the longer term in order to achieve a return to prosperity.

What we counsel is a kind of controlled "creative destruction." Financial crises are a bit like nuclear energy: they are enormously destructive if all the energy is released at once, but much less so if channeled and controlled. The ma.s.sive interventions by the Federal Reserve and governments around the globe brought the financial crisis under control. But much remains to be done: radioactive a.s.sets the world over must be acknowledged, contained, and disposed of. Regulations must be written, and international financial inst.i.tutions reborn.

How to manage that task is the pressing question of our time. Keynes once observed that "economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again." The waters will eventually stop churning, but how long it takes them to subside depends on how economists approach the problem, craft solutions, and make difficult decisions.

In facing these challenges, it's worth adding one more arrow to the quiver of crisis economics. The study of crises cannot be confined to economic theories alone. A final perspective is necessary, one that is not easily distilled to a school of thought, a model, or an equation: the study of the past.

The Uses of History.

In June 2009 the legendary economist Paul Samuelson sat down with an interviewer. Samuelson, who remained as productive as ever into his nineties, is widely considered the greatest economist of the last half century. A founder and codifier of the neocla.s.sical school, he oversaw his profession's embrace of esoteric mathematical models as a way of describing timeless economic phenomena. But when the interviewer innocently asked, "What would you say to someone starting graduate study in economics?" Samuelson gave an unexpected answer. "Well," he said, "this is probably a change from what I would have said when I was younger. Have a very healthy respect for the study of economic history, because that's the raw material out of which any of your conjectures or testings will come."

Samuelson is right-economic history is important, far more than theories of efficient markets and rational investors would lead one to believe. That's not because history repeats itself in some simplistic, cyclical way, though parallels between past and present are plentiful. Rather, history is useful precisely because its raw material can inform and inflect economic theories. It injects gritty, real-life detail into elegant mathematical models, like those devised by Samuelson and his peers. That's a good thing: an almost religious faith in models helped create the conditions for the crisis in the first place, blinding traders and market players to the very real risks that had been acc.u.mulating for years. History promotes humility, a quality that comes in handy when a.s.sessing crises, which so often come on the heels of arrogant proclamations that ordinary economic rules no longer apply.

We are hardly alone in our desire to harness history. As long as there have been crises, there have been attempts to put them in historical context. Amateurs like the Scottish journalist Charles Mackay, whose Extraordinary Popular Delusions and the Madness of Crowds was published in 1841, began the effort. Though only partially concerned with economic crises (and chock-full of inaccuracies), Mackay's book may have been the first attempt to draw lessons from the history of economic crises. His main conclusion-that human beings are an irrational lot, p.r.o.ne to fits of economic exuberance and euphoria-antic.i.p.ated both behavioral economics and the thrust of much historical writing on crises.

Several professional historians and economists followed in Mackay's footsteps, but not until the economist Charles P. Kindleberger wrote Manias, Panics, and Crashes in 1978 did someone try to articulate an overarching historical theory of crises. It became a cult cla.s.sic, and though its conclusions were evidently ignored in the years leading up to the recent disaster, its spirit of inquiry animates much of our thinking. So too does it animate the systematic and rigorous work of Carmen Reinhart and Kenneth Rogoff. In This Time Is Different: Eight Centuries of Financial Folly (2009), these two economists a.s.sembled a ma.s.sive collection of historical data on crises, showing that while the details of currency crashes, banking panics, and debt defaults change, the broader trajectory of crises varies little from decade to decade, century to century.

This work, along with the work of numerous other historians and economists of a historical bent, helps us understand the deep origins of crises as well as their lingering aftereffects. Clearly the best way to understand crises is to see them as part of a broader continuum of causes and effects, extending long before and long after the acute phase of the crisis. In this spirit, we turn next to tracking some of those deeper structural forces that over many years set the stage for a crisis.

Chapter 3.

Plate Tectonics.

A familiar account of the current economic crisis goes something like this: A housing bubble in the United States got out of control sometime around 2005 or 2006. People took out mortgages they couldn't afford and eventually defaulted on them. Having been securitized, however, those mortgages went on to infect and topple the global financial system.

This account blames a few bad apples, subprime borrowers, for the catastrophe. It's rea.s.suring but wrong: while the housing bubble rested in part on subprime mortgages, the problems were more pervasive and widespread. Nor were these problems of recent origin; they were rooted in deep structural changes in the economy that date back many years.

In other words, the securitization of bad loans was but the beginning; long-standing changes in corporate governance and compensation schemes played a role too. Government also shoulders some share of the blame, most obviously the monetary policies pursued by Alan Greenspan. So too do decades of government policies favoring home owners.h.i.+p.

In the end, however, the significance of government intervention was dwarfed by the significance of government inaction. For years federal regulators turned a blind eye to the rise of a new shadow banking system that made the entire financial system dangerously fragile and p.r.o.ne to collapse. These new financial inst.i.tutions battened on the easy money and easy credit made available not only by the Federal Reserve but by emerging economies like China.

These changes may have been invisible to most market watchers, or at the very least, their importance was not fully recognized. Subprime mortgages were but the most obvious sign of a deep and systemic rot. This fact underscores a cardinal principle of crisis economics: the biggest and most destructive financial disasters are not produced by something so inconsequential as subprime mortgages or a few reckless risk takers. Nor are they merely produced by the euphoria of a speculative bubble.

Rather, much as with earthquakes, the pressures build for many years, and when the shock finally comes, it can be staggering. In 2006-8 it was not simply the subprime securities that collapsed in value; the entire edifice of the world's financial system was shaken. The collapse revealed a frightening if familiar truth: the homes of subprime borrowers were not the only structures standing on the proverbial fault line; countless towers of leverage and debt had been built there too.

Financial Innovation.

Many bubbles begin when a burst of innovation or technological progress heralds the dawn of a new economy. In the 1840s Great Britain endured a mania driven by a new technology: the railroad. In 1830 the first commercially successful railroad began carrying pa.s.sengers between Manchester and Liverpool; thereafter investors bought shares in companies that would build even more profitable lines. During the height of the boom in 1845-46, share prices of railroad stocks soared, and corporations built thousands of miles of track, much of it redundant and unnecessary. While that boom ended with a brutal bust, it was justified in part by fundamentals: a new technology begat new business opportunities. Even though most of the railway companies of the 1840s went bankrupt, they left behind a new transportation infrastructure that was essential to the nation's economic expansion throughout the nineteenth century.

The same argument could be made for the dot-com boom of the 1990s. Though it swiftly became a speculative bubble, it was at least partly justified by a new technology-the Internet-and its many promising applications. When this bubble collapsed, plenty of new companies survived, as did a new communications infrastructure of coaxial cable lines, cell phone towers, and other tangible technological improvements.

The recent crisis, by contrast, has left behind few tangible benefits: abandoned housing subdivisions in Las Vegas are next to useless. Worse, no technological revolution underpinned the housing boom: houses built in 2006 were no different and no more efficient than houses built a decade or two earlier. The most recent boom was that rare creature, a boom without any change in fundamentals. It was a speculative bubble and nothing more.

But if technological innovation wasn't driving the housing boom, what was? In fact, there was plenty of innovation-that's the good news. The bad news is that most of it percolated in one sector of the economy, the financial services industry. In itself, this was not a problem. After all, plenty of financial innovations in centuries past-insurance, for example, and commodity options-have proved their value again and again, enabling market partic.i.p.ants to manage and contain risk.

At first that same spirit animated the current crop of financial innovations. Indeed, they were attempts to improve on the older model of making loans. Several decades ago banks that made home loans followed the "originate and hold" model. A prospective homeowner would apply for a mortgage, and the bank would lend the money, then sit back and collect payments on the princ.i.p.al and interest. The bank that originated the mortgage held the mortgage; it was strictly a transaction between the homeowner and the bank.

Financial innovation changed that. In the 1970s the Government National Mortgage a.s.sociation (better known as Ginnie Mae) put together the first mortgage-backed securities. That is, it pooled mortgages it had originated, then issued bonds on the basis of that pool. Consequently, rather than waiting thirty years to recoup the proceeds from a mortgage, Ginnie Mae could receive a lump sum up front from the purchasers of the bond. In turn, the investors buying these new bonds would receive a certain portion of the revenue stream from the thousands of homeowners paying off their mortgages.

This scheme was revolutionary. Thanks to what was quickly dubbed securitization, illiquid a.s.sets like mortgages could now be pooled and transformed into liquid a.s.sets that were tradable on the open market. These new instruments had a name: mortgage-backed securities. In time other government agencies like Freddie Mac and Fannie Mae joined the securitization business. So too did investment banks, brokerages, and even home builders, all of whom brought together growing numbers of home mortgages into new and ever more profitable pools. Investors around the world snapped them up. After all, according to conventional wisdom, home prices never went down.

Investment banks typically guided the creation of pools of mortgage-backed securities. Working with whoever had originated the pool of mortgages-a bank, a nonbank lender, or a government-sponsored ent.i.ty-an investment bank would help set up a "special purpose vehicle" (SPV). The SPV would then issue bonds, or mortgage-backed securities, selling them to investors. In theory, everyone got what he wanted with this system. The homeowner got a loan, and the mortgage broker and the appraiser earned their fees. The mortgage lender made a tidy profit without having to wait thirty years. The investment bank earned a fat fee for its a.s.sistance even as it unloaded the risk of the mortgage onto someone else. And last but not least, the investors who purchased the securities looked forward to receiving a steady revenue stream as homeowners paid off their loans.

Though mortgage-backed securities became increasingly popular in the 1980s, it was not until the 1990s that they really took off. In an ironic twist, the savings and loan (S&L) crisis cemented the popularity of securitization. In that debacle more than sixteen hundred thrifts went bust because they'd made a bunch of bad residential and commercial real estate loans that they'd kept on their books (as "originate and hold" transactions). That would not have happened had the loans been securitized-or at least that's the lesson that many bankers drew from the S&Ls' collapse. The new thinking was simple enough: far better to sell off the loans and pocket a tidy profit up front than hold the loans and risk having them go bad later. Distributing the loans to those better able to shoulder the risk-pension funds, insurance companies, and other inst.i.tutional investors-could lessen the risk of a systemic banking crisis. "Originate and distribute" replaced "originate and hold."

It's a sound principle as long as the buyers of the securities can accurately a.s.sess the risk inherent in them. But if you're a bank selling off newly minted mortgages via the securitization pipeline, your primary objective is to unload as many mortgages as quickly as possible. Each sale gives you more money with which to make more loans. Unfortunately, because the bank no longer faces the consequences of making bad loans, it has much less incentive to properly monitor the underlying risk of the mortgages it originates. When originate and hold becomes originate and distribute, a bad mortgage is pa.s.sed down the line like a hot potato.

As securitization became increasingly commonplace in the 1990s and 2000s, mortgage brokers, mortgage appraisers, ordinary banks, investment banks, and even quasi-public inst.i.tutions like Fannie Mae and Freddie Mac no longer subjected would-be borrowers to careful scrutiny. So-called liar loans became increasingly common, as borrowers fibbed about their income and failed to provide written confirmation of their salary. Most infamous of all were the "NINJA loans," in which the borrower had No Income, No Job, (and no) a.s.sets.

Securitization did not stop there. Financial firms oversaw the securitization of commercial real estate mortgages along with many kinds of consumer loans: credit card loans, student loans, and auto loans. Corporate loans were securitized as well, such as leveraged loans and industrial and commercial loans. The resulting bonds-a.s.set-backed securities-proved popular, and securitization soon spread elsewhere. As one textbook on risk management concluded in 2001, "Sometimes it seems as though almost anything can be securitized." That was no exaggeration: by the time the crisis. .h.i.t, securitization had been applied to airplane leases, revenues from forests and mines, delinquent tax liens, radio tower revenues, boat loans, state and local government revenues, and even the royalties of rock bands.

Many of these newfangled products suffered from the same problems and temptations a.s.sociated with the first generation of mortgage-backed securities: the bank or firm originating the securities had little incentive to conduct the oversight and due diligence necessary to confirm that the underlying loans would be paid off. The investment banks that had midwifed the birth of these pools of securities did not perform this duty either: they intended to sell the bundled loans and thereby move them off their balance sheets.

In theory, the ratings agencies-Moody's, Fitch, Standard & Poor's-should have sounded the alarm. But relying on the ratings agencies was much like relying on the fox to guard the henhouse: they had every possible incentive to give a high rating to the securities under review (see chapter 8). Doing so earned them a nice fee from the very ent.i.ties they were evaluating and the promise of future business; giving a realistic a.s.sessment, by contrast, could mean losing the commission, along with any future commissions. Far better to award a bank the financial equivalent of a Good Housekeeping Seal of Approval and hope for the best. On the eve of the crisis, the ratings firms made upwards of half their profits from handing out AAA ratings, many of which were undeserved, to exotic structured finance products.

But there is more to the story than corrupt ratings agencies. In fact, the ratings agencies may have had a genuinely difficult time figuring out the likelihood of defaults on the loans pooled into these securities, as very little historical data about the new subprime mortgages and their default rates were available. This was particularly the case with the new, exotic, and complicated mortgage-backed and a.s.set-backed securities first crafted by investment banks in the 1980s. These securities go by different names and different acronyms: collateralized mortgage obligations (CMOs), collateralized debt obligations (CDOs), and collateralized loan obligations (CLOs).

All of them worked according to the same principle. Anyone holding a plain-vanilla mortgage-backed security necessarily took on a certain amount of risk: the homeowner might default, for example, or simply prepay the loan, thereby depriving the lender of the additional interest payments it would earn if the loan was paid off on schedule. Financial "engineers" on Wall Street came up with an elegant solution: the CDO. The CDO would be divided into slices, or tranches. The simplest CDOs had only three tranches: equity, mezzanine, and senior. The purchasers of an equity tranche got the highest return but took on the greatest risk: if any homeowners in the underlying pool defaulted, the holders of the equity tranche would see losses before anyone else. The mezzanine tranche was less risky, but its purchasers would still suffer losses if a larger percentage of homeowners in the underlying pool defaulted. At the top was the senior tranche. While it paid the lowest rate of return, it was supposed to be risk free or pretty close to it. The holders of the senior tranche got paid first and sustained losses last.

This impressive edifice of structured finance rested on shaky foundations. It depended on a sleight of hand: a bunch of dodgy and risky BBBRATED subprime mortgages would be bundled into a BBB mortgage-backed security and then sliced into tranches in which the senior tranche-approximately 80 percent of the total underlying a.s.sets-would be given an AAA rating. The process transformed toxic waste into a gold-plated security, even though the underlying pool of mortgages was just as risky as it was before.

Securitization achieved even more bizarre levels of complexity. It became fas.h.i.+onable, for instance, to combine CDOs with other CDOs, then split them up into tranches. These CDOs of CDOs (sometimes called a CDO2) paled next to the more baroque products coming out of the labs on Wall Street: CDOs of CDOs of CDOs, better known as CDO3; and synthetic CDOs, which a.s.sembled a bunch of credit default swaps to mimic an underlying CDO. Some of these more esoteric products had far more than three tranches: they might have fifty or even one hundred, each of which represented a certain level of risk tolerance.

In hindsight, the peril of this kind of financial innovation is easy to understand. Slicing and dicing credit risk and transferring it around the world suffused the system with financial instruments that were exotic, complex, and illiquid. These creations became so fiendishly complex and unique that it became difficult to value them by conventional means. Instead of market prices, financial firms resorted to mathematical models to value them. Unfortunately, these models relied on optimistic a.s.sumptions that minimized measured risk. The net result was an utterly opaque, impenetrable financial system ripe for a panic.

This state of affairs may seem unique and unprecedented, and it was, but only in the particulars. Lack of transparency, underestimation of risk, and cluelessness about how new financial products might behave when subjected to significant stress are recurrent problems in many crises, past and present.

Moral Hazard.

While the financial engineers who gave us monstrosities like the CDO3 deserve plenty of blame, many other problems were acc.u.mulating that went far beyond the obvious flaws in the securitization food chain. The faulty ways in which financial firms governed themselves helped lay the groundwork for the recent crisis as well.

The key to understanding this situation is the concept of "moral hazard." Simply put, moral hazard is someone's willingness to take risks-particularly excessive risks-that he would normally avoid, simply because he knows someone else will shoulder whatever negative consequences follow if not bail out those who took those risks. For example, someone who has auto theft insurance may be more willing to park his car in a place where it might be stolen, or neglect to buy an anti-theft device, than someone who lacks that insurance. The car owner knows that the insurance company will cover the loss; the problem will fall on someone else's shoulders. Likewise, someone who leases an automobile with a service contract is more likely to drive in ways that subject the car to wear and tear than someone without such a contract. Again, the lessee knows any damage will be someone else's problem.

Moral hazard played a significant role in the recent economic crisis. In the securitization food chain, a mortgage broker who knowingly brought a liar loan to a bank got compensated for his efforts but bore no responsibility for what would happen as the mortgage moved down the line. Likewise, the trader who placed enormous bets on a CDO would be rewarded handsomely if he succeeded but was rarely punished if he failed. Even if he was terminated, he would get to keep whatever compensation he'd accrued over the years. The fallout of his decisions became someone else's problem-namely, the company that employed him.

This observation is pretty familiar. Less well known is the fact that moral hazard was especially rife in the financial services industry because of the way these firms provided compensation. Rather than simply paying employees a salary, the traders and bankers who worked at investment banks, hedge funds, and other financial services firms were rewarded for their performance via a system of annual bonuses. While bonuses have long played a role in compensation at these firms, they soared in recent years, and all the major investment banks-Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns-paid ever more staggering sums. In 2005 the big five firms paid $25 billion in bonuses; in 2006 they paid $36 billion; and a year later, $38 billion.

More to the point, the ratio of bonuses to base pay skyrocketed. In 2006 the average bonus accounted for 60 percent of total compensation at the five biggest investment banks. In some cases, the figure was much higher: bonuses ten or even twelve times the size of base salaries became commonplace in many firms at the center of the meltdown. Even after these firms ended up on life support, they continued to pay bonuses.

The bonus system, which focused on short-term profits made over the course of a year, encouraged risk taking and excessive leverage on a ma.s.sive scale. Nowhere was this more evident than at AIG, which specialized in selling insurance on events-the bankruptcy of Lehman Brothers, for example-that were unlikely to materialize in any given year. In the short term, this willingness to wager huge amounts of money insuring against catastrophes yielded large revenues, profits, and bonuses for traders and banks. In the long term, the inevitable happened, and when it did, companies like AIG nearly collapsed. The consequences of these gamblers' decisions ended up being shouldered by someone else-namely, American taxpayers.

In theory, this outbreak of moral hazard should have been prevented, but it was not. Why? The answer lies with what economists call the princ.i.p.al-agent problem. In large-scale capitalist enterprises, the princ.i.p.als (the shareholders and board of directors) must hire other people such as managers (the "agents") to carry out their wishes and mind the store. Unfortunately, the agents invariably know more about what's going on than the princ.i.p.als and can pursue their own self-interest to destructive effect.

Think, for example, of the problem of a store owner who has employees minding the cash registers. This is a very basic example of the princ.i.p.al-agent problem. It's obviously in the interest of the store owner to have employees behave honestly and not line their own pockets. But the store owner is not omniscient; he can't see everything that's going on beneath him. He suffers from what economists call the asymmetric information problem, in which the princ.i.p.al (the store owner) knows less than the agent (the cas.h.i.+er). The store owner needs to make his employees serve his interests, and that's no easy task.

Now imagine this problem multiplied many times, with many layers of employees or agents, all of whom have the ability to pursue their own interests at the expense of the "princ.i.p.als" who oversee them. Moreover, many employees are both princ.i.p.als (responsible for overseeing people below them) and agents (responsible for answering to someone above them). Worse, the problem here is no longer that employees will steal, but that they will use the firm's resources to place outsize, risky bets in order to collect the maximum bonus, even if that means putting the firm in jeopardy.

This, more or less, is the structure of a typical financial firm, and the dangers of this arrangement became increasingly evident over the course of the recent financial crisis. The collapse of AIG may be the most extreme example of the dangers of moral hazard, princ.i.p.al-agent problems, and asymmetric information. There, the actions of a small group of employees based in London brought the entire company to its knees, along with the global financial system.

In theory, shareholders should be able to prevent such disasters: they are the last link in the chain, the ultimate owners of the financial firm. But in fact, shareholders generally don't have much incentive to rein in reckless bankers, traders, and managers. Why? Financial firms rely far more heavily on borrowed money to finance their operations than do ordinary corporations, so when it comes to the firm's day-to-day operations, shareholders don't have much skin in the game. They have little incentive to steer traders away from taking big risks; in fact, they have plenty of incentive to do the opposite. If those risks pay off, shareholders win big. If they don't, shareholders may end up losing their small stake in the company. That's bad news, for sure, but when compared to the potential gains realized by playing with other people's money, it's a risk worth taking. Thus, shareholders with little skin in the game were "gambling for redemption."

In theory, one final firewall exists to keep moral hazard in check: the people who lend money to banks and other financial firms. If any party has a strong incentive to monitor banks, they do. After all, they stand to lose their s.h.i.+rts if the bank does something stupid. Unfortunately, this is another example of the law of unintended consequences. Funds lent to most ordinary banks come in the form of deposits. However, most deposits are subject to deposit insurance. So even if a bank recklessly gambles with depositors' money, the depositors can sleep well at night knowing that deposit insurance will make them whole. That removes any incentive for them to take actions that might punish the bank for its bad decisions.