Niall Ferguson on the credit crunch
Historian Niall Ferguson has a very enlightening essay on the financial crisis, putting it in its broader and immediate historical context.
The triggering failure is straightforward: The proximate cause of the economic uncertainty of 2008 was financial: to be precise, a crunch in the credit markets triggered by mounting defaults on a hitherto obscure species of housing loan known euphemistically as “subprime mortgages.”
But the trigger sets the collapse off, it does not explain it. For that we have the failure of prudential regulation: It was not unusual for investment banks’ balance sheets to be as much as 20 or 30 times larger than their capital, thanks in large part to a 2004 rule change by the Securities and Exchange Commission that exempted the five largest of those banks from the regulation that had capped their debt-to-capital ratio at 12 to 1.
Then there are liquidity issues. First, the wider context of the general loss of value of money: Credit and money, in other words, have for decades been growing more rapidly than underlying economic activity. Is it any wonder, then, that money has ceased to hold its value the way it did in the era of the gold standard? The motto “In God we trust” was added to the dollar bill in 1957. Since then its purchasing power, relative to the consumer price index, has declined by a staggering 87 percent. Average annual inflation during that period has been more than 4 percent.
Consumer Inflation has come down since then, partly because many of the items we buy-from clothes to computers-have gotten cheaper as a result of technological innovation and the relocation of production to low-wage economies in Asia. Which is to say, goods have become easier to produce and so more plentiful. Monetary policy has also become much better at reducing consumer inflation.
Ferguson goes on to say: Just as important, some of the structural drivers of inflation, such as powerful trade unions, have also been weakened. This I am much more sceptical about. Wage pushes from unions are only inflationary if monetary authorities accommodate it.
The enduring experience of inflation led people to try and protect their wealth against it: By the 1980s, in any case, more and more people had grasped how to protect their wealth from inflation: by investing it in assets they expected to appreciate in line with, or ahead of, the cost of living. These assets could take multiple forms, from modern art to vintage wine, but the most popular proved to be stocks and real estate. The real appeal is for assets that increase in value faster than inflation: which zoning allowed houses to do, an asset that most families could aspire to.
Hence what Ferguson calls “the Age of Leverage”: Once it became clear that this formula worked, the Age of Leverage could begin. For it clearly made sense to borrow to the hilt to maximize your holdings of stocks and real estate if these promised to generate higher rates of return than the interest payments on your borrowings. Between 1990 and 2004, most American households did not see an appreciable improvement in their incomes. Adjusted for inflation, the median household income rose by about 6 percent. But people could raise their living standards by borrowing and investing in stocks and housing.
But, as Ferguson points out: The Age of Leverage was also an age of bubbles, beginning with the dot-com bubble of the irrationally exuberant 1990s and ending with the real-estate mania of the exuberantly irrational 2000s. Which brings us to specific liquidity issues: The key point is that without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission and commission of central banks.
Back to how people were seeking to protect and expand their wealth: The Age of Leverage, as we have seen, brought a growing reliance on borrowing to buy assets in the expectation of their future appreciation in value. For a majority of families, this meant a leveraged investment in a house. That strategy had one very obvious flaw. It represented a one-way, totally unhedged bet on a single asset. But with continuous inflation the backdrop and land-rationing providing house prices which increased faster than inflation it seemed simply sensible. And, for decades, it worked.
But there have been some ominous experiences - particularly in the two most heavily land-rationed economies in the developed world: In Britain between 1989 and 1995, for example, the average house price fell by 18 percent, or, in inflation-adjusted terms, by more than a third-37 percent. In London, the real decline was closer to 47 percent. In Japan between 1990 and 2000, property prices fell by more than 60 percent. Here in Oz, we took our land-use control regime from the postwar UK. With the result that some of the most expensive housing (pdf) in the Western world is in Oz cities surrounded by lots of un-built on land suitable for housing. It is also worth mentioning that housing price bubbles have collapsed in the US, Ireland, the UK and New Zealand: why should Oz be magically exempt?
In the US, it has been a persistent notion of public policy that conventional banks are too risk-averse when it comes to lending to low income folk. So, the US experienced the Savings & Loans disaster of the late 1980s and early 1990s. In the late 1970s, the savings-and-loan industry was hit first by double-digit inflation and then by sharply rising interest rates. This double punch was potentially lethal. The S&Ls were simultaneously losing money on long-term, fixed-rate mortgages, due to inflation, and hemorrhaging deposits to higher-interest money-market funds. The politicians acted to “fix” the problem, then they had to fix the fix: When the ensuing bubble burst, nearly 300 S&Ls collapsed, while another 747 were closed or reorganized under the auspices of the Resolution Trust Corporation, established by Congress in 1989 to clear up the mess. The final cost of the crisis was $153 billion (around 3 percent of the 1989 G.D.P.), of which taxpayers had to pay $124 billion.
In the 1990s, we had another burst of public policy deeming banks to be too risk-averse, with the expansion of the activity of Freddie Mac and Fannie Mae: For the majority of mortgages continued to enjoy an implicit guarantee from the government-sponsored trio of Fannie, Freddie, and Ginnie, meaning that bonds which used those mortgages as collateral could be represented as virtual government bonds and considered “investment grade.” Between 1980 and 2007, the volume of such G.S.E.-backed mortgage-backed securities grew from less than $200 billion to more than $4 trillion. In 1980 only 10 percent of the home-mortgage market was securitized; by 2007, 56 percent of it was.
We move into unintended consequences: Once there had been meaningful social ties between mortgage lenders and borrowers. … By contrast, in a securitized market the interest you paid on your mortgage ultimately went to someone who had no idea you existed. The full implications of this transition for ordinary homeowners would become apparent only 25 years later.
The aim was to spread the joy: Between 2000 and 2006, the share of undocumented subprime contracts rose from 17 to 44 percent. Fannie Mae and Freddie Mac also came under pressure from the Department of Housing and Urban Development to support the subprime market.
Then there was the recourse to the magic of computer models: The quants’ Value at Risk models had implied that the loss the firm suffered in August 1998 was so unlikely that it ought never to have happened in the entire life of the universe. But that was because the models were working with just five years of data. If they had gone back even 11 years, they would have captured the 1987 stock-market crash. If they had gone back 80 years they would have captured the last great Russian default, after the 1917 revolution. Meriwether himself, born in 1947, ruefully observed, “If I had lived through the Depression, I would have been in a better position to understand events.” To put it bluntly, the Nobel Prize winners knew plenty of mathematics but not enough history. (One wonders how far back the data in those much-touted clmate models go?)
Between the enduring long-term inflation of fiat money, the specific liquidity injections, the misfired prudential regulation, the creation of artificial shortages in housing from land-rationing, the regulatory interventions to encourage lending to higher-risk home-buyers, there is a lot of dubious public policy in this “crisis of capitalism”. But government actions and interventions have market manifestations, for good and ill. It may be happening in markets, but that does not mean the public policy is not a major causal factor. Which makes fixing it, and trying not to repeat mistakes, that much harder since there is no “superior realm” of politics which will “naturally” do better.
The triggering failure is straightforward: The proximate cause of the economic uncertainty of 2008 was financial: to be precise, a crunch in the credit markets triggered by mounting defaults on a hitherto obscure species of housing loan known euphemistically as “subprime mortgages.”
But the trigger sets the collapse off, it does not explain it. For that we have the failure of prudential regulation: It was not unusual for investment banks’ balance sheets to be as much as 20 or 30 times larger than their capital, thanks in large part to a 2004 rule change by the Securities and Exchange Commission that exempted the five largest of those banks from the regulation that had capped their debt-to-capital ratio at 12 to 1.
Then there are liquidity issues. First, the wider context of the general loss of value of money: Credit and money, in other words, have for decades been growing more rapidly than underlying economic activity. Is it any wonder, then, that money has ceased to hold its value the way it did in the era of the gold standard? The motto “In God we trust” was added to the dollar bill in 1957. Since then its purchasing power, relative to the consumer price index, has declined by a staggering 87 percent. Average annual inflation during that period has been more than 4 percent.
Consumer Inflation has come down since then, partly because many of the items we buy-from clothes to computers-have gotten cheaper as a result of technological innovation and the relocation of production to low-wage economies in Asia. Which is to say, goods have become easier to produce and so more plentiful. Monetary policy has also become much better at reducing consumer inflation.
Ferguson goes on to say: Just as important, some of the structural drivers of inflation, such as powerful trade unions, have also been weakened. This I am much more sceptical about. Wage pushes from unions are only inflationary if monetary authorities accommodate it.
The enduring experience of inflation led people to try and protect their wealth against it: By the 1980s, in any case, more and more people had grasped how to protect their wealth from inflation: by investing it in assets they expected to appreciate in line with, or ahead of, the cost of living. These assets could take multiple forms, from modern art to vintage wine, but the most popular proved to be stocks and real estate. The real appeal is for assets that increase in value faster than inflation: which zoning allowed houses to do, an asset that most families could aspire to.
Hence what Ferguson calls “the Age of Leverage”: Once it became clear that this formula worked, the Age of Leverage could begin. For it clearly made sense to borrow to the hilt to maximize your holdings of stocks and real estate if these promised to generate higher rates of return than the interest payments on your borrowings. Between 1990 and 2004, most American households did not see an appreciable improvement in their incomes. Adjusted for inflation, the median household income rose by about 6 percent. But people could raise their living standards by borrowing and investing in stocks and housing.
But, as Ferguson points out: The Age of Leverage was also an age of bubbles, beginning with the dot-com bubble of the irrationally exuberant 1990s and ending with the real-estate mania of the exuberantly irrational 2000s. Which brings us to specific liquidity issues: The key point is that without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission and commission of central banks.
Back to how people were seeking to protect and expand their wealth: The Age of Leverage, as we have seen, brought a growing reliance on borrowing to buy assets in the expectation of their future appreciation in value. For a majority of families, this meant a leveraged investment in a house. That strategy had one very obvious flaw. It represented a one-way, totally unhedged bet on a single asset. But with continuous inflation the backdrop and land-rationing providing house prices which increased faster than inflation it seemed simply sensible. And, for decades, it worked.
But there have been some ominous experiences - particularly in the two most heavily land-rationed economies in the developed world: In Britain between 1989 and 1995, for example, the average house price fell by 18 percent, or, in inflation-adjusted terms, by more than a third-37 percent. In London, the real decline was closer to 47 percent. In Japan between 1990 and 2000, property prices fell by more than 60 percent. Here in Oz, we took our land-use control regime from the postwar UK. With the result that some of the most expensive housing (pdf) in the Western world is in Oz cities surrounded by lots of un-built on land suitable for housing. It is also worth mentioning that housing price bubbles have collapsed in the US, Ireland, the UK and New Zealand: why should Oz be magically exempt?
In the US, it has been a persistent notion of public policy that conventional banks are too risk-averse when it comes to lending to low income folk. So, the US experienced the Savings & Loans disaster of the late 1980s and early 1990s. In the late 1970s, the savings-and-loan industry was hit first by double-digit inflation and then by sharply rising interest rates. This double punch was potentially lethal. The S&Ls were simultaneously losing money on long-term, fixed-rate mortgages, due to inflation, and hemorrhaging deposits to higher-interest money-market funds. The politicians acted to “fix” the problem, then they had to fix the fix: When the ensuing bubble burst, nearly 300 S&Ls collapsed, while another 747 were closed or reorganized under the auspices of the Resolution Trust Corporation, established by Congress in 1989 to clear up the mess. The final cost of the crisis was $153 billion (around 3 percent of the 1989 G.D.P.), of which taxpayers had to pay $124 billion.
In the 1990s, we had another burst of public policy deeming banks to be too risk-averse, with the expansion of the activity of Freddie Mac and Fannie Mae: For the majority of mortgages continued to enjoy an implicit guarantee from the government-sponsored trio of Fannie, Freddie, and Ginnie, meaning that bonds which used those mortgages as collateral could be represented as virtual government bonds and considered “investment grade.” Between 1980 and 2007, the volume of such G.S.E.-backed mortgage-backed securities grew from less than $200 billion to more than $4 trillion. In 1980 only 10 percent of the home-mortgage market was securitized; by 2007, 56 percent of it was.
We move into unintended consequences: Once there had been meaningful social ties between mortgage lenders and borrowers. … By contrast, in a securitized market the interest you paid on your mortgage ultimately went to someone who had no idea you existed. The full implications of this transition for ordinary homeowners would become apparent only 25 years later.
The aim was to spread the joy: Between 2000 and 2006, the share of undocumented subprime contracts rose from 17 to 44 percent. Fannie Mae and Freddie Mac also came under pressure from the Department of Housing and Urban Development to support the subprime market.
Then there was the recourse to the magic of computer models: The quants’ Value at Risk models had implied that the loss the firm suffered in August 1998 was so unlikely that it ought never to have happened in the entire life of the universe. But that was because the models were working with just five years of data. If they had gone back even 11 years, they would have captured the 1987 stock-market crash. If they had gone back 80 years they would have captured the last great Russian default, after the 1917 revolution. Meriwether himself, born in 1947, ruefully observed, “If I had lived through the Depression, I would have been in a better position to understand events.” To put it bluntly, the Nobel Prize winners knew plenty of mathematics but not enough history. (One wonders how far back the data in those much-touted clmate models go?)
Between the enduring long-term inflation of fiat money, the specific liquidity injections, the misfired prudential regulation, the creation of artificial shortages in housing from land-rationing, the regulatory interventions to encourage lending to higher-risk home-buyers, there is a lot of dubious public policy in this “crisis of capitalism”. But government actions and interventions have market manifestations, for good and ill. It may be happening in markets, but that does not mean the public policy is not a major causal factor. Which makes fixing it, and trying not to repeat mistakes, that much harder since there is no “superior realm” of politics which will “naturally” do better.