We are in the middle of three economic crises. Although it would be preferable to handle an attack of food poisoning, a vicious cold, and the flu separately, we got all three at the same time. The patient is feverish, heaving, and has not yet seen the worst of it. The malaises are related economic diseases, but each requires different policy medicine.
We have a credit crisis. Banks won’t lend to people, they won’t lend to businesses, and they won’t lend to each other. Banks are on strike.
We have a recession. This is a classic crisis of consumer spending. When consumers don’t spend, businesses don’t grow, since consumer spending is 70% of the economy. Consumers are on strike and frozen credit markets are turning a bad recession into a depression.
We have massive and unsustainable global financial imbalances. High-saving Asian countries grow by exporting goods and savings to the US. They cannot recover from the current crisis by resuming this export-led growth and we cannot recover through borrowing more. China is not on strike – it has been laid off. This condition carries with it a very high risk of complication in the form of economic nationalism.
The Credit Crisis
The credit crisis is food poisoning. Banks consumed toxic assets and ended up sick and paralyzed. Some are actually dead but still walking around -– zombie banks.
The food looked healthy enough at the time. Banks and other financial institutions took on portfolios of loans secured by homes or insurance on bundles of loans secured by homes. Yummy. But the assets were toxic for two reasons – both made worse by government inattentiveness.
First, lending standards fell apart. There were a lot of reasons for this, but a fundamental one is that banks no longer held the loans they originated. If I loan you money and quickly sell the loan, I care a lot less about your creditworthiness. That’s now the other guy’s problem. My incentive is to loan to anybody. So-called Ninja loans (no income, no job, no assets), and loans with teaser rates that reset into unsustainable payments are the logical result. Whether this was flagrant lending abuse by mortgage originators, progressive policies that let farm workers buy $700,000 houses, or innumerate borrowers who did not read their loan documents is much debated but no longer matters. A lot of people took out loans that they cannot repay. As housing prices dropped below the value of the loans, mailing the house keys to the bank starts to make economic sense.
Thanks to easy credit, housing prices soared and many people borrowed money against their newly valuable homes. And why not? Rates were low and on paper, we were wealthy. Americans borrowed $700 billion against their homes in 2005 and 2006. (Last year the number was well under $100 billion). These borrowings sustained a much higher rate of economic growth than would otherwise have occurred – adding an astonishing 1-3% to GDP growth in 2000-2006. All good — so long as housing prices do not grow faster than incomes for a long period of time. But they did.
Banks made the problem worse by chopping the mortgages up into securities. Nothing wrong with this – it allows investors to purchase bundles of mortgages according to the underlying credit risk and lowers the cost of capital for banks and consumers. But it only works if you really understand the underlying credit risk – and nobody did. In a bond portfolios cited earlier, 15% of consumers reportedly never made even one house payment. In every portfolio, the market value of many of the homes is now less than the mortgage.
Worse, securitized loans are really hard to restructure. Normally, consumers and banks would rework these loans (banks don’t want to own the house, which in any case is not worth as much as anybody thought). But with every mortgage smashed to pieces and traded in parts, most borrowers have nobody to negotiate with.
Having eaten a plate of bad fish, banks washed the meal down with paint thinner. Financial institutions that held portfolios of collateralized mortgage obligations understood that the underlying mortgages might default. So they took out insurance in the form of credit default swaps. Organizations like AIG wrote credit default swaps to banks. A CDS is an insurance contract. For a fee I agree to reimburse you in the statistically unlikely event that your mortgage bonds turn out to be worth less than some amount we agree on.The dirty secret however, was that neither of us had any real idea what the odds of default were.
The CDS market is an unregulated insurance market. The writer of a CDS are not subject to capital sufficiency or other underwriting requirements. CDS soon became a way to insure not only a security or a portfolio against credit default, but even an entire company. It became a parallel and unregulated stock market — meaning a way to bet on the rise or fall of any company.
The market for credit default swaps went completely nuts. The value of US housing stock is about $10 trillion. The value of credit default swaps is estimated at $65 trillion — meaning that every dollar of lending has six dollars betting on whether the dollar will get repaid. Many of these are offsetting bets of course (some banks hold both the asset and the insurance against the failure of the asset. Presumably they are hedged). When you hear about “toxic assets” held by banks, think credit default swaps for mortgage bonds built on poorly underwritten loans.
Today banks have no idea what most of this stuff is worth. Worse, they don’t really want to know because as banks sells these assets, other banks have to mark down their portfolio to the new market price. Doing so will put many banks in violation of their capital requirements and force them to seek new capital or close shop. So they hold their breath, take some government money, and do nothing.
Paradoxically, the situation for regional banks is in many ways worse because they hold more “whole mortgages” — loans that were never securitized. Even though mortgage bonds are written down as their market price falls, whole mortgages are traditionally not written down so long as the loan payments are current. As a result, regional banks are much more exposed to government purchases of mortgages at deep discounts — likely to be a part of any Treasury or Fed-led restructuring or homeowner relief effort. Re-pricing mortgages and setting a market rate for mortgage bonds and CDS will drive hundreds of banks out of business.
The sooner, the better. Far better to have fewer, better capitalized banks than zombie banks. When Obama says “some banks won’t make it” he is really saying “you are dead and starting to smell funny. Mind if we bury you?”
A few years ago, economists wrote a lot about “the wealth effect”. Essentially it meant that if you felt wealthy, you spent more – often more than you earned. Wealth effects were widespread because asset values – especially homes – were at an all-time high.
Now we have a “poverty effect”. Home prices have collapsed and will decline further. Consumers who feel impoverished, stop spending. Companies cut prices to spur demand, then lay off people when that doesn’t work. When they realize that they can hire people back for 25% less than their current employees make because prices are dropping, they lay off more people. This is a classic deflationary spiral and it is as bad for debasing an economy as inflation. Homeowners default in droves, which further reduces creditor’s willingness to lend. Reduced credit and hits to household wealth further depress economic growth. Pretty soon you are hoarding cash and growing your own food.
Three-decades of family income stagnation lies at the root of the recession and the credit crisis. Starting in the seventies we financed economic growth by adding women to the workforce and by working longer hours. Combined weekly work hours for dual-earning couples with children rose 10 hours per week, from 81 hours in 1977 to 91 hours in 2002, according to the New York-based Families and Work Institute.
In the nineties, we financed growth not by earning more but by borrowing more– typically against houses, but also using credit cards and other forms of consumer debt. Today the economy has twice as much debt as our long term average and is higher than our previous peak during the Great Depression. Debt of all kinds (consumer, mortgage, business, government) is at record levels. Mortgage debt grew 60% from 1998-2008. Household income did not.
Of course income can grow only as fast as labor productivity. But the gains from labor productivity have gone overwhelmingly to top income earners. This has produced a set of economic arguments for stronger unions, including the so-called Employee Free Choice Act, about which more in a future post.
It is also true that labor productivity is unlikely to grow much faster than the share of our workforce that is college educated. In the last century, the US led the world in the share of 25 year olds who were college educated. Today we are 31st — behind Bulgaria and just ahead of Costa Rica. As Obama economic adviser Austan Goolsbee notes, “The problem for countries with skill levels between Bulgaria and Costa Rica is that 20 years from now they’ll also have income levels between those countries”.
The massive increase in home mortgages, consumer credit, business, local government, and federal debt has not come from the savings of Americans. It has come from the savings of Chinese who were selling to Americans and not spending much of their paychecks (which many would argue were too small in dollar terms to start with). High Chinese savings required Americans to spend ever larger shares of our income to support China’s export-led growth.
Americans have now stopped spending and started saving – with a vengeance. The Chinese are being forced to stimulate local spending in a big way (every family got a bonus check from the state just before New Year’s this month). But with so little social safety net, Chinese families save for medical emergencies and retirement. The global economic crisis will almost surely force the Chinese government to divert resources from capital projects to social ones in order to spur consumer spending in China.
Also as a result, China is unlikely to continue to loan the US trillions of dollars. In part this is because Chinese growth will increasingly be driven domestically, so the share of their state treasury consisting of dollars will decline. It is also true that with US savings rates rising, we may need less overseas capital (not necessarily a good thing). Also, Chinese direct investments in the US have frequently done poorly (Blackstone and Morgan Stanley come to mind).
Perhaps the most important consequence of trade and national income account imbalances however, is the common side effect. Major recessions always produce economic nationalism – which can quickly turn a recession into a depression. Whether in trade union rhetoric or the “Buy American” features of the stimulus package, economic nationalism is clearly on the rise. The urge to keep jobs and capital at home is politically powerful but economically misguided. Trade is the least of it. Trade enriches countries by enabling them to specialize, but it is global capital markets that are real engines of prosperity. Global financial institutions do a better job of allocating money than local ones and they promote economic integration and co-operation.
Even without a political backlash, globalization is suffering a huge reverse. According to The Economist, world trade will probably decline this year for the first time since 1982 with net private-sector capital flows to emerging markets dropping to $165 billion, from a peak of $929 billion in 2007.
– Print Money. The standard remedy for recessions starts with the central bank reducing interest rates and increasing the money supply. Normally this is a recipe for a debauched currency and all manner of economic havoc, but any government will lower interest rates and fire up the printing presses to prevent an awful recession.
Monetary policy hasn’t worked. The Fed has lowered interest rates to zero and the government is printing money overtime (actually buying back bonds with cash to get banks to lend). It has had at best a modest effect. Banks and investors are freaked and frozen. Free money is not an incentive to lend if you are not sure about your own balance sheet or that of your borrower.
– Spend borrowed money policy. A lot of attention this week to the massive government stimulus package that is (sort of) designed to create jobs. The package is a dog’s breakfast – short term mixed with long term, permanent mixed with temporary, capital investment mixed with spending, and the entire thing at the small end of what would stimulate a $13 trillion economy. Unless our plan is to shrink the economy to fit the stimulus, this is unlikely to make a massive difference. As a political matter, I wish Obama had written the bill and let Congress amend it. As an economic matter, I’m less sure that it matters.
As the chair of Obama’s own Council of Economic Advisors has documented, it is hard for government stimulus to make a decisive difference in a recession. But the political case against doing nothing always compels governments to try. It is not that public spending doesn’t matter, but it is very hard for a Congress to target spending to the right people at the right time. Infrastructure takes too long, favorite programs like Head Start target the wrong folks (however worthy the program may be in its own right), and all of it is hard to stop 18 months later and thus tends to become permanent — offsetting much of the stimulative effect. Sending the bottom third of all households by income a check for $200-$1,000/month for 18 months would work a lot better, but that approach annoys Congress and all the folks who don’t get checks, so politically is a nonstarter.
– Restart Lending. Next come efforts to restart bank lending. This is critical work and is likely to be a mix things short of outright nationalization. We will see direct investment in banks, the creation of so called “bad banks” to buy toxic assets like the Resolution Trust Corporation did during the Savings and Loan crisis, loan guarantees, and programs to help consumers refinance mortgages. As with the stimulus, the devil is in the details. For example: how will TARP price toxic assets (best answer: a reverse auction where banks bid to sell a portfolio of assets the only buyer in town – the government. Would probably require an accounting change however). We already have seen evidence that the Bush Treasury knowingly paid too much for bank stocks in Q4 of last year.
– Regulatory reform. This will take longer, but a mix of reporting requirements, capital requirements, registration requirements, and a clearing house for derivatives like credit default swaps makes a lot of sense. Some derivatives (basically the ones too difficult for investors and regulators to understand) should be banned because they meet the Warren Buffett definition of “financial WMD”. Mortgages need to be standardized and abusive practices prohibited. I’d be in favor of forcing banks to retain a share of the loans they originate, although there are sensible arguments against this. All of this amounts to closing the barn door after the horse got out, but some of it will help value current securities and in any case future horses ought to be properly restrained. And an SEC that is once again muscular and competent (as it was not so long ago) would also be a very good thing.
– Coordinate Globally. In his spare time, Geithner needs to coordinate US efforts with every other large economy and build in the multilateral arrangements to ensure philosophically consistent approaches with our trading partners. Stimulus plans should share principles, including a commitment to trade. Cross-border banking rules need to be reviewed and measures taken to address the crushing impact of the crisis on emerging markets. If he does nothing else, avoiding trade wars is an exceedingly good idea. It is tough to be an economic pacifist when other countries start talking trade war – but the US and Britain have done it in the past and need to do it again.
Will all of this work? In the long run it is likely to work. If we are lucky it will help in the short run. Because as the great economist pictured at the top of this post used to say, “In the long run, we are all dead.”