Anatomy of the financial crisis
Barry Eichengreen*
23 September 2008http://www.voxeu.org/index.php?q=node/1684
The crisis solution depends upon its causes. Here one of the world’s leading
international macroeconomists explains how the world got into this mess. This
is the ‘Director’s cut’ of his 18 September 2008column on Project Syndicate.
Getting out of our current financial mess requires understanding how we got
into it in the first place. The dominant explanation, voiced by figures as
diverse as Thomas Friedman and John McCain, is that the fundamental cause was
greed and corruption on Wall Street. Though not one to deny the existence of
base motives in the institutional investor community, I would insist that the
crisis has roots in key policy decisions stretching back over more than three
decades.
At the domestic level, the key decisions in the United States were to
deregulate commissions for stock trading in the 1970s and then to eliminate the
Glass-Steagall restrictions on mixing commercial and investment banking in the
1990s. In the days of fixed commissions, investment banks could make a
comfortable living booking stock trades for their customers. Deregulation meant
greater competition, entry by low-cost brokers like Charles Schwab, and thinner
margins. The elimination of Glass-Steagall then allowed commercial banks to
encroach on the investment banks’ other traditional preserves. (It was not only
commercial banks of course, but also insurance companies like AIG that did the
encroaching.)
In response, investment banks to survive were forced to branch into new lines
of business like originating and distributing complex derivative securities.
They were forced to use more leverage, funding themselves through the money
market, to sustain their profitability. Thereby arose the first set of causes
of the crisis: the originate-and-distribute model of securitisation and the
extensive use of leverage.
It is important to note that these were unintended consequences of basically
sensible policy decisions. It is hard to defend rules allowing price fixing in
stock trading. Deregulation allowed small investors to trade stocks more
cheaply, which made them better, off other things equal. But other things were
not equal. In particular, the fact that investment banks, which were propelled
into riskier activities by these policy changes, were entirely outside the
regulatory net was a recipe for disaster.
Similarly, eliminating Glass-Steagall was a fundamentally sensible choice.
Conglomeratisation allows financial institutions to better diversify their
business. Combining with commercial banking allows investment banks to fund
their operations using a relatively stable base of deposits rather than relying
on fickle money markets. This model has proven its viability in Germanyand
other European countries over a period of centuries. These advantages are
evident in the United States even now, with Bank of America’s purchase of
Merrill Lynch, which is one small step helping to staunch the bleeding.
Again, however, the problem was that other policies were not adapted to the new
environment. Conglomeratisation takes time. In the short run, Merrill, like the
other investment banks, was allowed to lever up its bets. It remained outside
the purview of the regulators. As a self-standing entity, it was then
vulnerable to inevitable swings in housing and securities markets. A crisis
sufficient to threaten the entire financial system was required to precipitate
the inevitable conglomeratisation.
The other key element in the crisis was the set of policies giving rise to
global imbalances. The Bush Administration cut taxes, causing government
dissaving. The Federal Reserve cut interest rates in response to the 2001
recession. All the while the financial innovations described above worked to
make credit even cheaper and more widely available to households. This of
course is just the story, in another guise, of the subprime,
negative-amortization and NINJA mortgages pushed by subsidiaries of the like of
Lehman Brothers. The result was increased U.S.consumer spending and the decline
of measured household savings into negative territory.
Of equal importance were the rise of Chinaand the decline of investment in much
of Asiafollowing the 1997-8 crisis. With Chinasaving nearly 50 per cent of its
GNP, all that money had to go somewhere. Much of it went into U.S. Treasuries
and the obligations of Fannie Mae and Freddie Mac. This propped up the dollar.
It reduced the cost of borrowing for U.S.households by, on some estimates, 100
basis points, encouraging them to live beyond their means. It created a more
buoyant market for Freddie and Fannie and other financial institutions creating
close substitutes for their agency securities, feeding the
originate-and-distribute machine.
Again, these were not outright policy mistakes. The emergence of Chinais a good
thing. Lifting a billion Chinese out of poverty is arguably the single most
important event in our lifetimes. The fact that the Fed responded quickly to
the collapse of the high-tech bubble prevented the 2001 recession from becoming
worse. But there were unintended consequences. Those adverse consequences were
aggravated by the failure of U.S.regulators to tighten capital and lending
standards when abundant capital inflows combined with loose Fed policies to
ignite a ferocious credit boom. They were aggravated by the failure of Chinato
move more quickly to encourage higher domestic spending commensurate with its
higher incomes.
Now we are all paying the price. As financial problems surface, a bloated
financial sector is being forced to retrench. Some cases, like the marriage of
BofA and Merrill, are happier than others, like Lehman. But either way there
will be downsizing and consolidation. Foreign central banks like China’s are
suffering immense capital losses for their unthinking investment. As the
People’s Bank and other foreign central banks absorb their losses on U.S.
Treasury and agency securities, capital flows toward the United Stateswill
diminish. The U.S.current account deficit and Asian surplus will shrink.
U.S.households will have to begin saving again. All this is of a piece.
The one anomaly is that the dollar has strengthened in recent weeks against
pretty much every currency out there. (The one exception is the yen, which is
being supported by Mrs. Watanabe keeping more of her money at home.) With the
U.S.no longer viewed as a supplier of high-quality financial assets and the
appetite of foreign central banks for U.S.treasury and agency securities
falling off, one would expect the dollar to weaken. The dollar’s strength
reflects the reflex action of investors rushing into U.S.treasuries as a safe
haven. It is worth recalling that the same thing happened in early August 2007,
when the Subprime Crisis first erupted. Once investors realised the extent of
U.S.financial problems, the rush into treasuries subsided, and the dollar
resumed its decline. Now, as investors recall the extent of U.S.financial
problems – and even more so as they realise the U.S. Treasury debt is going to
rise significantly as the authorities are
forced to recapitalise the banking system – we will again see the dollar
resume its ongoing decline.
Emphasising greed and corruption as causes of the crisis leads to a bleak
prognosis. We are not going to change human nature. We can’t make investors
less greedy or to prevent them from cutting corners when they see doing so as
in their self interest. But emphasising policy decisions as the mechanism
amplifying these problems into a threat to the entire financial system suggests
a more optimistic outlook. Policy mistakes may not always be avoidable.
Unintended consequences cannot always be prevented. But they at least can be
corrected. Correcting them, however, requires first looking more deeply into
the root causes of the problem.
________________________________
*Professor of Economics and Political Science at the University of California,
Berkeley; and formerly Senior Policy Advisor at the International Monetary
Fund. CEPR Research Fellow
[Non-text portions of this message have been removed]
