kolb - lessons from the financial crisis; causes, consequences, and our economic future (2010)

Library of Congress Cataloging-in-Publication Data: Lessons from the financial crisis : causes, consequences, and our economic future /Robert W.. White 57 The Greenspan and Bernanke Feder

LESSONS FROM THE FINANCIAL

CRISIS

The Robert W Kolb Series in Finance series provides a comprehensive view of the

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ume in the Kolb Series in Finance consists of new articles especially written for the

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develops the volume outline and commissions articles by the world’s experts inthat particular field of finance Each volume includes an editor’s introduction andapproximately thirty articles to fully describe the current state of financial researchand practice in a particular area of finance

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grad-to encapsulate the current state of knowledge in a particular area of finance so thatthe reader can quickly achieve a mastery of that special area of finance

LESSONS FROM THE FINANCIAL

CRISIS

Causes, Consequences, and

Our Economic Future

Robert W Kolb

The Robert W Kolb Series in Finance

John Wiley & Sons, Inc.

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Library of Congress Cataloging-in-Publication Data:

Lessons from the financial crisis : causes, consequences, and our economic future /Robert W Kolb, editor

p cm — (The Robert W Kolb series in finance)

Includes bibliographical references and index

ISBN 978-0-470-56177-5 (cloth)

1 Financial crises 2 Global Financial Crisis, 2008-2009

3 Financial crises—United States I Kolb, Robert W., 1949–

HB3722.L476 2010

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

1 Leverage and Liberal Democracy 3

George Bragues

2 A Property Economics Explanation of the Global

Gunnar Heinsohn and Frank Decker

3 Of Subprimes and Sundry Symptoms: The Political

Economy of the Financial Crisis 17

Ashok Bardhan

4 The Political Economy of the Financial Crisis of 2008 23

Roger D Congleton

5 The Global Financial Crisis of 2008: What Went Wrong? 31

Hershey H Friedman and Linda Weiser Friedman

6 The Roots of the Crisis and How to Bring It to a Close 37

9 Four Paradoxes of the 2008–2009 Economic and

11 The Origins of the Financial Crisis 79

Martin N Baily, Robert E Litan, and Matthew S Johnson

12 Ten Myths about Subprime Mortgages 87

Yuliya Demyanyk

13 The Financial Crisis: How Did We Get Here and Where

Do We Go Next? New Evidence on How the Crisis

Spread Among Financial Institutions 95

James R Barth, Tong Li, Lu Wenling, and Glenn H Yago

14 A Decade of Living Dangerously: The Causes and

Consequences of the Mortgage, Financial, and

Jon A Garfinkel and Jarjisu Sa-Aadu

15 Making Sense of the Subprime Crisis 109

Kristopher S Gerardi, Andreas Lehnert, Shane M Sherlund, and Paul Willen

16 Miraculous Financial Engineering or Legacy Assets? 119

C ONTENTS ix

20 The Past, Present, and Future of Subprime

Shane M Sherlund

21 FHA Loans and Policy Responses to

Dr Marsha Courchane, Rajeev Darolia, and Dr Peter Zorn

22 The Single-Family Mortgage Industry in the Internet

Era: Technology Developments and Market Structure 163

Forrest Pafenberg

23 Speed Kills? Mortgage Credit Boom and the Crisis 175

Giovanni Dell’Ariccia, Deniz Igan, and Luc Laeven

24 Subprime Mortgages: What We Have Learned From a

New Class of Homeowners 181

Todd J Zywicki and Satya Thallam

25 Rating Agencies: Facilitators of Predatory Lending

in the Subprime Market 191

David J Reiss

26 A Primer on the Role of Securitization in the Credit

28 Did Securitization Lead to Lax Screening? Evidence

Benjamin J Keys, Tanmoy Mukherjee, Amit Seru, and Vikrant Vig

29 Tumbling Tower of Babel: Subprime Securitization

and the Credit Crisis 225

Bruce I Jacobs

30 The Incentives of Mortgage Servicers and Designing

Loan Modifications to Address the Mortgage Crisis 231

Larry Cordell, Karen Dynan, Andreas Lehnert, Nellie Liang,

and Eileen Mauskopf

31 The Contribution of Structured Finance to the

Financial Crisis: An Introductory Overview 239

Adrian A.R.J.M van Rixtel and Sarai Criado

32 Problematic Practices of Credit Rating Agencies:

The Neglected Risks of Mortgage-Backed Securities 247

Phil Hosp

33 Did Asset Complexity Trigger Ratings Bias? 259

Vasiliki Skreta and Laura Veldkamp

34 The Pitfalls of Originate-to-Distribute in

Antje Berndt and Anurag Gupta

35 Behavioral Basis of the Financial Crisis 277

Michael McAleer, Juan-Angel Jim´enez-Martin, and Teodosio P´erez-Amaral

40 Risk Management Lessons from the Global Financial

Crisis for Derivative Exchanges 317

Jayanth Varma

C ONTENTS xi

41 Regulation and Financial Stability in the Age

David S Bieri

42 The Financial Crisis of 2007–2009: Missing Financial

Regulation or Absentee Regulators? 337

George G Kaufman and A G Malliaris

43 The Demise of the United Kingdom’s Northern Rock

and Large U.S Financial Institutions: Public

Robert A Eisenbeis and George G Kaufman

44 Why Securities Regulation Failed to Prevent the

Richard E Mendales

45 Curbing Optimism in Managerial Estimates Through

Transparent Accounting: The Case of Securitizations 361

Stephen Bryan, Steven Lilien, and Bharat Sarath

46 Basel II Put on Trial: What Role in the Financial Crisis? 369

Francesco Cannata and Mario Quagliariello

47 Credit Rating Organizations, Their Role in the Current

Calamity, and Future Prospects for Reform 377

Thomas J Fitzpatrick IV and Chris Sagers

48 Global Regulation for Global Markets? 383

Michael W Taylor and Douglas W Arner

49 Financial Regulation, Behavioral Finance, and the

Global Financial Crisis: In Search of a New

Emilios Avgouleas

50 Why Financial Conglomerates Are at the Center of

Arthur E Wilmarth

51 Corporate Governance and the Financial Crisis:

A Case Study from the S&P 500 411

David Colander, Michael Goldberg, Armin Haas, Alan Kirman, Katarina Juselius,

Brigitte Sloth, and Thomas Lux

54 Fannie Mae and Freddie Mac: Privatizing Profit and

David Reiss

55 Disclosure’s Failure in the Subprime Mortgage Crisis 443

Steven L Schwarcz

PART VIII The Federal Reserve, Monetary Policy,

56 Federal Reserve Policy and the Housing Bubble 453

Lawrence H White

57 The Greenspan and Bernanke Federal Reserve Roles

in the Financial Crisis 461

John Ryan

58 The Risk Management Approach to Monetary Policy:

Lessons from the Financial Crisis of 2007–2009 467

Marc D Hayford and A G Malliaris

59 Reawakening the Inflationary Monster: U.S Monetary

Policy and the Federal Reserve 475

Kevin Dowd and Martin Hutchinson

60 The Transformation of the Federal Reserve System

Balance Sheet and Its Implications 483

Peter Stella

Shock Suggests the Emergence of a Range of New

Channels During the Credit Crisis 501

Nathaniel Frank, Brenda Gonz´alez-Hermosillo, and Heiko Hesse

63 Credit Contagion From Counterparty Risk 509

Philippe Jorion and Gaiyan Zhang

PART X International Dimensions of the

John R Graham and Campbell R Harvey

66 Australia’s Experience in the Global Financial Crisis 537

Christine Brown and Kevin Davis

67 Collapse of a Financial System: An Icelandic Saga 545

Tryggvi Thor Herbertsson

68 Iceland’s Banking Sector and the Political Economy

James A H S Hine and Ian Ashman

69 The Subprime Crisis: Implications for

William B Gwinner and Anthony B Sanders

PART XI Financial Solutions and Our Economic Future 569

70 The Long-Term Cost of the Financial Crisis 571

Murillo Campello, John R Graham, and Campbell R Harvey

71 Coping with the Financial Crisis: Illiquidity and

the Role of Government Intervention 579

Bastian Breitenfellner and Niklas Wagner

72 Fiscal Policy for the Crisis 587

Antonio Spilimbergo, Steven Symansky, Olivier Blanchard, and Carlo Cottarelli

73 The Future of Securitization 595

Michael R King and Philipp Maier

78 Regulating Credit Default Swaps 633

Houman B Shadab

My first appreciation extends to the authors who contributed to this volume

Their work is what makes the volume possible I would also like to thankPamela Van Giessen, Jennifer MacDonald, and Melissa Lopez at JohnWiley & Sons for their editorial expertise and their support and encouragement

of the idea behind this volume I also wish to thank Sarah Schaffer for her expertediting work

xv

Taken together, the articles in this volume present a deep understanding of

the financial crisis we have all endured But it must be acknowledged thateven this volume is only an initial view The financial crisis has been aneconomic event that ranks second only to the Great Depression Like the GreatDepression, the financial crisis will be studied for decades to come, and yet greaterunderstanding of these recent events is sure to emerge with further study Much

of that understanding will come from the further researches of those represented

in this volume

xvii

Many efforts to understand the historical origins, the present meaning,

and the future trajectory of the present financial crisis rely on the GreatDepression as a touchstone For some, the Great Depression serves merely

as a metaphor, while others try to use that great historical event as a reliableguide to our future While the current financial crisis differs greatly from the GreatDepression, there is at least one important similarity—those who are enduring thecrisis struggle to understand the event even as it evolves, and many will continue

to study the crisis for decades to come

Already many popular and journalistic books on the crisis have appeared andgained considerable attention Some are quite good and make fascinating reading.Yet the broad scope of these books and their focus on drama and personalitiesimplies that they cannot provide the definitive word on the crisis Far from thelimelight of the best-seller list and television interview shows, an entirely alter-native literature continues to develop, a literature that will ultimately be of morevalue in understanding the crisis than the rapidly produced and impressionisticaccounts that already sit on bookstore shelves

Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future

aims to bring to the attention of the general public an understanding of the tual underpinnings of the issues that lie at the heart of the crisis Objective concep-tual studies of the crisis are being produced mainly by academics and economists

concep-at government agencies, and this research is directed toward policy makers andacademic economists Not surprisingly, much of this thought and study is notaccessible to a wider public because the work is often highly mathematical, usescomplex econometric techniques, and appears in academic journals The core idea

of Lessons from the Financial Crisis is to bring the broader meaning of this

contem-porary research to a wider audience, and to achieve this now, rather than at theleisurely academic pace of the usual publication outlets

This book consists of 78 articles written specifically for this volume Almost all

of them present the conclusions of more formal studies that are in preparation byprofessional economists In the writing of these articles, every care has been taken

to reduce academic jargon and superfluous technology and thus to focus on thebroader meaning of the specific discoveries of the underlying research As such,this book is really about understanding the financial crisis, why it began, how itdeveloped, its effects on people, its implication for our economy, and its broaderramifications for our society

xix

The articles are arranged into eleven broad sections:

1 Overview of the Crisis

2 Causes and Consequences of the Financial Crisis

3 Borrowers

4 The Process of Securitization

5 Risk Management and Mismanagement

6 The Problem of Regulation

7 Institutional Failures

8 The Federal Reserve, Monetary Policy, and the Financial Crisis

9 Implications of the Crisis for our Economic System

10 International Dimensions of the Financial Crisis

11 Financial Solutions and Our Economic Future

OVERVIEW OF THE CRISIS

The discussion in this first section takes the broadest overview of the crisis Forexample, most analysts believe that leverage played a pivotal role in causing thecrisis But do perhaps the roots of the crisis lie in the very nature of our society?One paper in this section considers whether the tendency toward excessive lever-age lies in the very nature of liberal democracy Another article focuses on theimportant role of subprime mortgages in the crisis, but argues that the problemsthat arose in the mortgage market are but a symptom of deeper structural andpolitico-economic problems of present-day globalized capitalism, rather than theprimary cause of the crisis Another contribution asks: “Should we have seen itcoming?” and argues that the present crisis is a rerun of previous crises from which

we have failed to learn our lessons

CAUSES AND CONSEQUENCES

OF THE FINANCIAL CRISIS

The second section moves to consider more proximate causes of the crisis and toevaluate the emerging consequences of the crisis for our economy and our lives

In retrospect, it does seem clear that housing prices in the United States rose to sustainable extremes, and one article in this section argues that this “asset bubble”interacted with financial innovation to create a disaster of a proportion beyond thatwhich could have been created by either factor alone In the rush to understandthe causes of the crisis, it is not surprising that many initial analyses were faulty.One paper debunks various “myths of the subprime crisis” and concludes: “Thesubprime crisis was building for years before showing any signs and was fed bylending, securitization, leveraging, and housing booms.”

un-To some extent, the cause of the crisis can be traced to good intentions ofgovernment policy: the urge to extend the perceived benefits of homeownership to

a portion of society for which owning a home has always been out of reach One ofthe consequences of this well-intentioned effort was the inflicting of financial harm

on exactly those families that were supposed to benefit But beyond that effect, the

of borrowers in a meaningful way without taking into account their individualdifferences Furthermore, some of the borrowers contributed to causing the crisis,while many others were simply victims Without doubt, still others of these sub-prime borrowers unwittingly contributed to causing the crisis and yet fell victim

to the crisis as well

One simple development appears to have had a profound effect on borrowersand the generation of the crisis As one article in this section shows, automatedunderwriting systems greatly accelerated the loan approval process and reducedthe cost of making loans The cost savings of this automated process made itprofitable to lend to borrowers that were previously not attractive As a result, loanorigination expanded considerably

Predation in subprime lending has garnered considerable emotional attention

As some articles in this section explain, many subprime borrowers were the victims

of predatory lending, in which mortgage brokers and lending institutions profited

by putting na¨ıve borrowers into homes and mortgages that they could not afford

Yet at the same time, other borrowers engaged in predatory borrowing, or mortgage

fraud, in which they acquired homes by misrepresenting their financial capabilitiesand their intentions for the property

THE PROCESS OF SECURITIZATION

The securitization of mortgages consists essentially in purchasing mortgages, lecting them into a pool, and then selling securities that give ownership to portions

col-of the cash flows from that pool col-of mortgage The first mortgage securities were

merely pass-through certificates that gave each holder a fractional ownership of all of

the payments from the pool of mortgages, and this simple method of securitizationworked quite well for decades

In recent years, financial innovation in mortgage securitization proceeded tocreate many more types of securities based on pools of mortgages It is not too much

to say that the payments from mortgage pools were “sliced and diced” into ever

more complicated and obscure packages called a collateralized debt obligation, or a

CDO The actual valuation of these securities quickly becomes extremely difficult asthe securities become more complex Yet this entire process of securitization played

a tremendous role in the mortgage market and in the broader financial crisis.Partially due to the obscurity of these instruments and the difficulties in as-sessing their true value, it appears in retrospect that there was a tremendousunderpricing of risk Because these convoluted securities were overpriced, giventhe true risks they have proven to embody, losses were tremendous when defaults

on the underlying mortgages started to bloom and markets eventually began torealize just how risky these securities actually were.

Beyond the complexity of the securities, the movement from the old simple

originate-to-hold model of mortgage production to the originate-to-distribute model

had a tremendous effect In the originate-to-hold model, a lender, typically a localbank or savings and loan, would lend to a home buyer and hold the mortgagefor the life of the loan By contrast, in the originate-to-distribute model, the lendermakes the loan with no intention of holding the mortgage, but rather with the plan

of selling the mortgage into the securitization process As articles in this sectionexplain, this new way of originating mortgages involved a change in incentivesfor various participants in the mortgage origination process that has proven to beextremely perverse For example, a lender planning to hold a mortgage among itsown assets will ensure that the borrower can pay as promised, but if the mortgage

is to be originated and sold immediately, the borrower’s capacity to pay becomes

a matter of limited importance if not indifference

RISK MANAGEMENT AND MISMANAGEMENT

Before its humbling in the subprime and broader financial crisis, contemporaryfinance prided itself on its sophistication in evaluating and managing risk Thefailures of those methods of risk analysis and management are now painfullyapparent The articles in this section appraise the errors in risk management andlook to ways to improve the process

In recent years, financial analysis has become increasingly sophisticated andmuch more mathematical These complicated techniques, it now seems, failed

to capture the true risk of mortgage-backed securities There is now a painfulreassessment of those techniques, and the immediate future is sure to witness lessreliance on these more sophisticated techniques In spite of stunning failure, it alsoseems clear that these mathematical techniques can be very useful, so the questionbecomes how to harness the benefits of greater analytical power without becomingthe mere captive of these sophisticated models

One risk management flaw that is now apparent can be characterized as an

outsourcing of risk management to credit rating agencies, such as Standard & Poor’s,

Moody’s, and Fitch Due to analytical errors and perverse incentives, it now seemsclear that these agencies wildly overstated the safety of many mortgage-backedsecurities Yet while these credit agencies deserve much criticism, so do thoseinvestors who failed to take responsibility for their own risk assessment Again inretrospect, it now seems clear that many investors were foolish and irresponsible

in taking a triple-A rating from the credit agencies as a green light for investingwithout any further inquiry

THE PROBLEM OF REGULATION

Perhaps the most frequently hailed cause of and presumed remedy for the financialcrisis turns on regulation According to one facile analysis, deregulation causedthe entire problem, and what is needed is more regulation The truth is morecomplicated, of course The articles in this section consider the role of regulation,its absence, and the failure of regulators to enforce existing regulations

I NTRODUCTION xxiii

Some analysts regard the structure of housing regulation as a prime cause

of the crisis, as the United States has had a policy that goes back to the GreatDepression of encouraging ever more widespread home ownership Furthermore,

if one looks at the institutions that took the largest and most foolish risks, many

of them are the most particular creatures of government, such as large commercialbanks and government-sponsored entities such as Fannie Mae and Freddie Mac.But it must also be acknowledged that beyond poorly designed regulation,relaxation of regulation and weak regulatory enforcement also played a role Forexample, the SEC loosened its capital requirements for investment banking firms

in 2004, and the firms responded by increasing their leverage and risk Similarly,

in 2000 the government abjured the regulation of credit default swaps, a locus ofenormous losses in the crisis that threatened profound systemic risk

INSTITUTIONAL FAILURES

Beyond the debacle in regulation, other social and economic institutions failed

to perform and thereby contributed to the economic crisis In a disaster of theproportions that we are experiencing, there is plenty of blame to share, and thearticles in this section analyze some of the particular institutional problems thatwere revealed in the crisis

For example, the last 20 years have seen the rise of financial firms of enormouspower and scope We might call them financial conglomerates Citicorp, for ex-ample, gave a signal of its size on November 18, 2008, when it announced that itwould lay off 50,000 employees worldwide (A firm that can suddenly discover ithas 50,000 extra people on the payroll must be a very large firm indeed!) As onearticle in this section indicates, a very large proportion of the losses in the crisiswere concentrated in these financial conglomerates

Economists and finance academics come in for a share of the blame as wellfor emphasizing elegant models divorced from real-world markets In addition,the financial crisis has revealed serious problems in corporate governance, includ-ing management conflicts within firms that arise between senior and mid-levelmanagers Also, government-sponsored entities, a peculiar kind of firm that is pri-vate, yet government-created and government-controlled, have failed their socialfunction as well

THE FEDERAL RESERVE, MONETARY POLICY,

AND THE FINANCIAL CRISIS

By mid-2009, the financial crisis seemed to be waning, and there was talk of “greenshoots” in an economy on the mend Virtually every day the Federal ReserveSystem was in the news taking action in one way or another to help end the crisis.But the Federal Reserve, according to many analysts, helped to foment the crisis,then played a critical role during the crisis in limiting its effect, and presently may

be laying the foundation for more financial problems in the future by the veryactions that it has taken to avert disaster

Some charge that a Federal Reserve policy of easy money and artificially lowinterest rates before the crisis helped to fuel a mortgage borrowing binge that led

directly to the housing crisis and its subsequent systemic effects On that analysis,the Fed receives a share of the blame for actually causing the crisis.

While the Fed may have played a role in starting the crisis, it has been a majoractor in efforts to preserve the financial system from ruin as well Ben Bernanke,chairman of the Federal Reserve Board, has, in effect, been training his wholeprofessional life for this crisis, as he made his academic reputation by his work onthe Great Depression Now as things seem to be more stable and it looks like a totalfinancial collapse has been averted, the Fed has received considerable credit for itsdecisive action in response to the crisis as it deepened Yet new worries arise fromthe Fed’s apparently successful actions in saving the financial system The veryactions that helped avert disaster during the crisis may be laying the foundationfor serious inflation in the months and years to come

IMPLICATIONS OF THE CRISIS FOR OUR

ECONOMIC SYSTEM

The financial crisis has certainly revealed that our financial and economic system

is not as robust as we may have thought previously Externally imposed stressesoften reveal the weaknesses in all kinds of structures, from bridges to marriages,and that has certainly been the case as the financial crisis has tested our entireeconomic system

The articles in this section consider some of the specific weaknesses revealed byour financial crisis Perhaps foremost among these is the exposure of our complexand worldwide financial system to systemic weaknesses in which a challenge toone part of the structure is transmitted quickly to other parts that were previouslythought to be well-insulated from the original source of trouble The Asian financialcrisis and the collapse of Long-Term Capital Management in the 1990s providedearly signals of the systemic linkages in our era of financial globalization, but thatpoint has been driven home with tremendous force by our present crisis

New linkages have been revealed as well, perhaps most strongly in two eas: credit contagion and counterparty risk For example, the rumors that swirledaround Bear Stearns brought the creditworthiness of its obligations into doubt, butthe uncertainty attached to Bear quickly brought suspicion upon the other firmswith which it dealt, for if Bear failed to honor its obligations, what would be theeffect on the financial soundness of its creditors? Closely related to this issue ofcredit contagion is the idea of counterparty risk, a problem that emerged as par-ticularly acute with credit default swaps When AIG was revealed to have writteninsurance against the failure of many firms that were suddenly defaulting, whatwas the implication for the counterparties to those swaps, and what was the likelyeffect on them if AIG defaulted on its own promises? As the financial crisis revealedwith amazing suddenness, fear of insolvency traveled as fast as rumor itself

ar-INTERNATIONAL DIMENSIONS

OF THE FINANCIAL CRISIS

According to some, the navel of the world lies somewhere between New York Cityand Washington, D.C While such an idea may be false in general, it does seem

I NTRODUCTION xxv

that the United States played a special role in the crisis with its huge subprimemortgage market and its insatiable demand for investment from abroad Even if

the financial crisis illustrates the idea of American exceptionalism, the crisis spread

far beyond its shores, as the articles in this section demonstrate

While the subprime crisis and mortgage problems may have been most acute

in the United States, other countries clearly experience similar problems more, the flight from risk experienced in the United States was a phenomenonshared around the world

Further-Perhaps the experience of Iceland was the most acute among all nations probably, the financial crisis that may have been centered in the United Stateseventually spread to overwhelm the entire banking system of Iceland and to lead

Im-to a virtually complete, if temporary, economic collapse

FINANCIAL SOLUTIONS AND OUR

ECONOMIC FUTURE

The articles in this section provide a summing up along with some signpoststoward an improved future After any disaster, one of the first tasks is a damageassessment, and articles in this section analyze the long-term economic implications

of the crisis But beyond that evaluation, other articles point the way forward toresponses and possible solutions

So often, efforts to respond to one problem lay the foundations for the next, sothere is a great incentive to respond to the present crisis in a way that will not createfuture harm The process of securitization of home mortgages has been revealed

to contain disastrous flaws Yet, securitization offers the promise of a financialsystem that can stimulate the flow of credit in a socially beneficial manner Thisraises the question of how the process of securitization might be restructured toavoid the pitfalls of the previous system while preserving the benefits of heightenedcredit availability

There can be no doubt that more financial regulation is on the way, but howshould that be structured? Credit default swaps have been virtually unregulated

to date, but potential default on these agreements was shown to have very serioussystemic implications It is now virtually certain that those instruments will be reg-ulated Some have called for the banning of naked credit default swaps—a nakedswap being one in which one of the contracting parties has no underlying financialrisk or exposure But such a proposal may merely reveal a lack of understanding

of how such derivatives markets operate and the valuable role that market makersperform in bearing risk for those who wish to transfer it away

Fannie Mae and Freddie Mac are government creatures in at least two tant senses First, before the crisis, they were regulated by the federal government,and the president appointed a plurality of their board members Second, duringthe crisis, they were taken into conservatorship, and their obligations were guar-anteed by the federal government The government presumably does not want tooperate these firms forever As a consequence, it will need to create a new reg-ulatory structure for these firms that will be more successful than the previousfailed system

impor-LESSONS FROM THE FINANCIAL

CRISIS

PART I

Overview of the Crisis

Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future

by Robert W KolbCopyright © 2010 John Wiley & Sons, Inc

CHAPTER 1

Leverage and Liberal

Democracy

GEORGE BRAGUES

University of Guelph-Humber, Toronto, Canada

Whenever something out of the ordinary happens that is destructive and

menacing, the search for causes is almost always intense and prolific.That has certainly been the case with respect to the financial crisis of

2007–2009 Whether on CNBC, the pages of the Wall Street Journal and the Financial Times, the economic blogs, or even explanatory videos on YouTube, plenty of

culprits have been put forward

One reads and hears about greedy mortgage brokers and bankers whose paystructure encouraged them to cut ethical corners and undertake huge risks Somepoint the finger at conflicted rating agencies that assigned Triple-A ratings tofinancially engineered junk Free market skeptics cite an ideologically driven policy

of laissez faire on the part of regulatory bodies Defenders of free markets counterwith the government’s push to increase home ownership among the middle classesand the poor through Fannie Mae, Freddie Mac, and the Community ReinvestmentAct Economists speak of informational asymmetries arising from the enhancedopportunities for mortgage originators to unload credit risk onto the investingcommunity as a result of securitization Others note the dramatic expansion ofcomplex securities like credit default swaps Many have singled out the excessivelylow interest rates maintained by the U.S Federal Reserve (Fed) between 2002 and

2005 But those who think the American central bank has been made a scapegoatrefer instead to the Asian savings glut that kept long-term interest rates low even

as the Fed subsequently endeavored to tighten monetary policy

No doubt, whenever the definitive account of the crisis is written by future torians, it will have to integrate several of these factors Yet it will need to go beyondthese, if only because the story would otherwise be restricted to proximate causes

his-We would overlook the ultimate source of our difficulties, the larger historicalforces that laid the foundation for the proximate causes that mainstream com-mentators have emphasized Interestingly enough, it is the heterodox traditions ofeconomics that have most acutely sensed the need to probe deeper Marxists, forexample, interpret the crisis as the culmination of the financialization of capitalism,

a phenomenon manifest in the growth of debt that has been gathering force sincethe 1970s in response to the systemic dearth of investment opportunities.1Austrianeconomists, by contrast, blame that financialization, with all of its attendant ills,

3

Copyright © 2010 John Wiley & Sons, Inc

4 Overview of the Crisis

on the political monopolization of money and credit creation rendered possible bythe institution of central banking.2

Though these explanations rightly focus on the prevalence of debt—and moreprecisely the leverage that it reflects—they still do not get to the root of the matter Toreach that, we have to go back and familiarize ourselves with the original principles

of the liberal democratic order within which our financial markets operate Thatregime was founded on the recognition of leverage as a morally legitimate tool

of economic life Precisely because of tendencies inherent in liberal democracy,however, leverage was progressively freed from virtually all traditional morallimits This has left present-day capitalist economies all too prone to financialcalamities of the sort in which we now find ourselves

By liberal democracy, what is meant here is not simply a particular form of

gov-ernment in which the ultimate authority for public decisions rests with a majority ofthe populace Liberal democracy is more comprehensively understood as a mode

of social organization that first arose in the seventeenth and eighteenth centuries

in northern Europe—the very place and time, not uncoincidentally, when rians typically date the first great financial crises Over the succeeding centuries,

histo-it spread globally such that histo-its principal representatives now include the Unhisto-itedStates, Canada, much of Europe, Japan, Israel, Australia, and New Zealand, though

it has also made significant inroads into Asia, Africa, and Latin America The ing feature of the regime is its neutral stance about the meaning and purpose ofhuman life Accordingly, the state’s role in a liberal democracy is limited to en-abling individuals to pursue their fulfillment as they each see fit in an environment

defin-of freedom and equality, subject to the proviso that no harm is done to others inthe process

The early philosophic exponents of liberal democracy, such as John Lockeand Adam Smith, well understood that this political vision implied freedom ofcommerce They also realized that most people, once given the liberty to pursuewhatever their hearts desired, would end up defining their happiness in terms

of material affluence Consequently, they saw that the chief occupation of ernments in liberal democracies would become, as indeed it has, the promotion ofeconomic growth, best accomplished through the establishment of a market society.Among the biggest obstacles to this, however, was the long-standing moral in-hibition against the lending of money with interest—originally known as usury Ifthe financial crisis has taught us anything, it has reminded us of the overwhelmingimportance of credit in market societies Without loans—which few would obvi-ously make without the provision of interest—individuals could not readily makelarge purchases to obtain appliances, cars, and houses Firms would find it hard tomanage the operational challenges posed by the level of receipts and outlays notbeing perfectly synchronized at each and every point in time When those outlayshappen to be for capital goods, firms must wait for a substantial period beforegenerating a return on their investment Of course, equity finance would still be anoption, but it would be cumbersome to acquire shares in a person’s future incomestream Though companies do issue stock to fund their activities, the rate of returnthat must be offered to investors has to be higher, given the risks entailed in beingplaced last in line to claim the firm’s cash flows Many with savings to deploy willshy away from such risks, while numerous capital projects with lower prospectiverates of return, yet still above what a debt financing would cost, will go unfunded

gov-While denounced in biblical texts, the moral case against lending had its thoritative philosophic articulation in the writings of Aristotle and St ThomasAquinas Aristotle, the Greek philosopher of the fourth centuryB.C whose opin-ions on a wide variety of subjects were considered truth well into the seventeenthcenturyA.D., insisted that money is naturally intended to be used in exchange forgoods But earning interest on loans is against nature precisely because it involvesproducing money from money.3In the thirteenth century, Aquinas elaborated andrefined this argument by distinguishing between goods whose use consists in theirown consumption and those in which the employment does not destroy the thing.Food is an example of the first, a house of the second No moral problem is entailed

au-in sellau-ing the use of the house for a period of time, as opposed to the house itself,

as there would be a distinct item of value being exchanged It would be unjust,though, to charge for both a hamburger and the use of the hamburger These notbeing separable; one would be selling a good that literally does not exist Aquinasheld that money is more analogous to food than a house, in that its defining feature

is for it to be used up in purchases of goods Consequently, a lender that tradesmoney now in return for anything more than that same amount of money later isessentially fleecing the borrower.4

By the time the architects of liberal democracy addressed the issue of usury, theAristotelian-Thomist picture of money as a consumption item essentially incapable

of reproducing itself had already been ruptured In the sixteenth and seventeenthcenturies, a few of the late scholastic thinkers noticed that money could be deployed

so as to become productive of more money.5 The budding of commerce in theRenaissance, with merchants and bankers adopting various strategems to evadethe usury laws, gave practical confirmation of money’s generative aspects Thus,

in 1691, John Locke could almost take it as a given that money, by furnishing themeans to engage in profitable trade, has productive uses and that interest is theprice for securing this benefit.6 Adam Smith would subsequently reiterate this

point in The Wealth of Nations (1776), as well as observing that legal prohibitions

on loaning at interest merely force borrowers to pay higher rates to compensatethe additional risks to the lender of being prosecuted and not having the courtsavailable to enforce their debt contracts It was left to Smith’s admirer, JeremyBentham, to give the coup de grˆace to the traditional teaching on interest in his

Defense of Usury (1787) His chief argument was that individuals, being the best

judges of their interest, should be free to contract for loans at any rate they deemappropriate Finance had finally found a home in liberal democracy

With this, the use of leverage gained a decisive encouragement, insofar asindividuals and firms could now take on higher debt-equity ratios without moralqualms Initially, though, this acceptance of leverage was qualified In coming tothe moral defense of interest lending, Smith set the condition that rates not bepermitted to go much above the market level for low-risk debt Were it to goabove that, Smith feared, a sizable portion of the credit available would end up inthe hands of profligate consumers and Pollyannaish entrepreneurs Much of thecapital stock built up by society over generations would go to waste Not only that,Smith promoted the virtues of prudence and frugality in his moral and economicwritings, as did Benjamin Franklin, the eighteenth-century American statesmanand inventor, whose counsel remained an influential part of the self-help literaturewell into the nineteenth century

6 Overview of the Crisis

But the individual freedom that liberal democracy extols would ultimately act

as an acid on these caveats To a people attached to the ideals of personal autonomyand self-expression, deferred gratification will inevitably be felt as a harsh restraint.Plato presciently set down this feature of democracy two and a half millennia ago.7

Time preferences thus changed, with present goods becoming more preferred tofuture ones People saved less and willingly assumed more debt in pursuit of theirlife goals

This additional debt had to come from somewhere Critical in enabling thiswas the consolidation of fractional reserve banking in the nineteenth century Thisinstitution arose out of the money warehouses run by goldsmiths, where peoplecould deposit their gold and silver in return for warehouse receipts, which in turnfunctioned as currency in the marketplace Within these depository establishments,

it was soon noticed that there was no need to continually have every ounce of goldand silver available for potential redemption, since relatively few receipt holdersdemanded their metal on any given day Even when they did, there were oftenothers making new deposits to balance the outflow Profits could be increased, itwas figured out, by issuing more warehouse receipts than the stockpile of metalswould cover.8The excess receipts could be lent and interest charged To this day,this same operation continues, except that banks now extend loans on the basis ofdeposits of government-issued notes rather than precious metals But the essence

of fractional reserve banking remains in that deposits are only a proportion, and aslight one at that, of the loans outstanding

That the morality of this practice elicits so little discussion is arguably the mostastounding fact of modern finance With the bulk of the money lent out havingvirtually no underpinning except for the creative powers of the banking system, thepeople exchanging actual goods and services for this currency are, for all intentsand purposes, receiving nothing intrinsic in return A profound injustice seems

to be at work here Then again, this would be to assume Aquinas’s premise thatmoney is to be understood in terms of its substance

Bentham’s critique of Aquinas’ usury teaching provides the foundation uponwhich liberal democracy is built and tells us, instead, that money is to be viewedsolely as a utility If the economic success of liberal democratic economies sincethe nineteenth century is any indication, this utility must be acknowledged Whatthe currency manufactured out of the fractional reserve system effectively does isallow society to raise the level of investment beyond what its members, throughthe sacrifice of present consumption, have managed to save For the borrower, it

is less a matter of being entrusted with the stewardship of some portion of thecapital stock and more about receiving some paper and electronic tokens Theborrower is then ordered to perform the following command: go out and harnessthe natural and human resources at your disposal so as to produce goods andservices for which other people will be willing to trade at least enough paper andelectronic tokens to pay off your loan Finance has evolved to the point that it doesnot merely grease the wheels of trade and bring savers and investors together;

it actually drives those wheels, its chief business having become to create a vastchain of obligations to generate more value out of the world

The problem with this arrangement, of course, is that it places a lot more stress

on getting the allocation of credit right With all the leverage involved, all it takes is

a slice of the loan portfolio to go bad for depositors to lose confidence and threaten

runs on the banks When that prospect beckons, banks are forced to call in loansand restrict credit even to borrowers in good standing, wreaking havoc on theeconomy As everyone knows, this is pretty much what has just happened as aresult of the bad bet the financial system made on subprime mortgages.

Despite this risk, no growth-addicted liberal democracy could have ever beenexpected to morally question the extra economic torque that fractional reservebanking provides through its pyramiding of savings As demonstrated time andtime again, whenever the viability of the system was threatened in crises past, a

fix has always been preferred, whether in the form of government-backed depositinsurance, the extensive regulation of financial institutions, or the formation of

a central bank to serve as a lender of last resort to troubled banks Needless tosay, these are far from perfect solutions, since they encourage banks to be moreaudacious, secure in the knowledge that the government will extend them a lifelineshould they run into difficulties

What also explains the maintenance of fractional reserve banking is the power

it confers on governing classes to manage the money supply, particularly when all

of the commercial banks are overseen by a central bank By changing the term rate of interest, adding or subtracting from commercial bank reserves, ormodifying the required ratio of loans to deposits, governments can try to smooththe vicissitudes of the economy and hinder recessions There was a time whenthis was not expected of governments, when the franchise was limited to a male,property-owning elite that could withstand downturns in the economic cycle Thatchanged in the twentieth century when the franchise was extended to every adultperson The upshot of all this is that a significant part of the responsibility ofensuring the optimal allocation of credit is shifted to the central bank And nomatter how much independence the latter might theoretically have, democraticpolitical pressures will influence the central bank to err on the side of preventingrecessions and, in the process, potentially setting up the next leverage-inducedboom—precisely what the Fed did in keeping interest rates low for so long afterthe bust of the dot-com bubble

short-None of this is to say that liberal democracy is fatally flawed The politicalalternatives are surely worse on balance What the financial crisis does help clarify,though, are the full terms of the bargain that liberal democracy made in originallyaccording its moral stamp of approval to leverage

NOTES

1 John Bellamy Foster and Fred Magdoff, The Great Financial Crisis: Causes and Consequences

(New York: Monthly Review Press, 2009)

2 Thomas E Woods, Jr., Meltdown (Washington: Regnery Publishing, 2009).

3 Aristotle, The Politics, trans T A Sinclair (New York: Penguin, 1981), Bk I x.

4 Thomas Aquinas, On Law, Morality, and Politics, 2nd ed., trans Richard J Regan

(Indi-anapolis: Hackett Publishing, 2002), 148–151

5 Alejandro A Chafuen, Faith and Liberty: The Economic Thought of the Late Scholastics

(Lanham, MD: Lexington Books, 2003), 122–125

6 John Locke, Some Considerations on the Consequences of the Lowering of Interest and Raising

the Value of Money, http://socserv.mcmaster.ca/econ/ugcm/3ll3/locke/consid.txt.

8 Overview of the Crisis

7 Plato, The Republic, trans Allan Bloom (New York: Basic Books, 1968), 561c–561e.

8 See Murray Rothbard, The Mystery of Banking 2nd ed (Auburn, AL: Ludwig Von Mises Institute, 2008), 85–94, and George Cooper, The Origin of Financial Crises (New York:

Random House, 2008), 47–50

ABOUT THE AUTHOR

George Braguesis program head of business at the University of Guelph-Humber

in Toronto, where he teaches economics, philosophy, and politics His researchinterests include business ethics as well as the sociopolitical aspects of finance He

is an occasional contributor to the op-ed pages of the Financial Post in Canada His articles have been published in such venues as the Journal of Business Ethics, The Independent Review, History of Philosophy Quarterly, Episteme, and Business Ethics Quarterly.

Sydney, and University of Bremen∗

THE BREACH OF BAGEHOT’S FIRST PRINCIPLE OF CENTRAL BANKING SPARKED THE CRISIS

Neither bare greed nor market failure are at the bottom of the global financial crisis,but the altruistic belief by the world’s two largest central banks that interest ratesclose to zero would benefit businesses and workers struggling after a crisis In

1994, the Bank of Japan cut its discount rate below 2 percent It reached 0.1 percent

in September 2001, and it has remained at under 1 percent ever since In November

2002, the Federal Reserve Bank (Fed) dropped its target rate to 0.75 percent and inDecember 2008 operated near 0.25 percent Those who malign bankers as predatorsmay as well punish their dog for eating the prime steak left outside on the BBQplate Who would pass up such a bargain?

But what is interest, and why must the interest rate not equal zero? This can best

be illustrated using the nineteenth-century example of a private and note-issuingcommercial bank Here, the bank issues money in the form of promissory noteswhen it advances credit, often in secured loan contracts The borrower receivesthe bank notes, which represent claims over the property of the bank The bankreceives a loan asset secured by the borrower’s property and an interest payment.Property is involved on both sides The bank has to reserve a certain amount ofproperty, the bank capital, to serve as a buffer for unforeseen losses and to ensurethe redeemability of its notes on demand This capital is now burdened because itmust not be activated a second time, sold, or encumbered Similarly, the borrower’s

∗The authors would like to thank Ulf Heinsohn for his support on an earlier version of thiswork

9

Copyright © 2010 John Wiley & Sons, Inc

10 Overview of the Crisis

property is now encumbered as security for the loan Both bank capital and loancollateral back the note issue

Property economics1 argues that interest arises because the bank must becompensated for the burdening of its capital in this process In other words, interest

is demanded for losing property premium, an immaterial yield that accrues from an

asset that is unencumbered and free This is so because unencumbered propertyallows owners to raise funds against it when needed to protect their solvency.Both the property of the bank and the property of the borrower remain inthe possession and use of the parties during the loan contract Only the imma-terial property side, represented by legal rights over the bank property and theborrower’s collateral, are relevant for this transaction If the bank property wasfarmland, the bank would continue to till the soil and to harvest the crop Thebank money is derived from the fence around the field and not the soil There is

no sacrifice from the postponement of consumption involved

As long as private banks issue their own money, of course, nobody mustremind them to demand interest, because as proprietors liable for their note issue,they need to protect their capital and solvency The proprietor’s property premiumand associated interest rates represent market rates

The underlying principles are the same for a modern central banking system.They include:

r Central banks create money in repurchase agreements and loans with

com-mercial banks secured by eligible collateral or by purchasing assets outright.Like commercial banks, they have balance sheets with assets, liabilities, andequity, and require capital (equity) to back the note issue against unforeseenlosses

r Commercial banks provide bank funds to businesses2 through loans andneed bank capital to protect their solvency

r Businesses provide property as collateral for loans or to ensure that their

property remains unencumbered through loan covenants Even fiat money,

if sound, is always backed by valuable property titles Any departure fromthis principle, for example, by simply monetizing government debt, willdestroy a currency

The central bank, like the private note-issuing bank, must be compensated forthe burdening of its capital by interest This holds even in a crisis, when a centralbank acts as the lender of last resort providing funds to illiquid but otherwisesolvent borrowers, which was first shown by the originator of central bankingtheory, Walter Bagehot He formulated the first principle of central banking: “First:That these loans [by the central bank] should only be made at a very high rate ofinterest This [ .] will prevent the greatest number of applications by persons who

do not require it.”3

Unlike private note-issuing banks driven by market forces, modern centralbanks have the power to violate Bagehot’s principle As a government organizationseemingly protected from insolvency risks, and as the monopoly provider of fundsfor interbank settlement, a central bank can force interest rates below marketrates or even waive interest payments altogether That this power creates a moral

dilemma was most clearly demonstrated in the 2008 global financial crisis Whilenear-zero rates were a short-term reprieve for many, they not only deprived thebank owners (taxpayers) of the compensation due to them, but also produced asevere financial crisis.

FROM CHEAP MONEY TO THE SUBPRIME FIASCO

A normal bank transaction begins with an innovative business well endowedwith collateral Businesses are compelled to borrow so they can invest and stay

in competition They don’t borrow a second time for the mere reason that theinterest rate suddenly dropped In this respect, variations in the interest level canlargely be neglected as determinants of investments If, however, the starting point

is central bank money offered at ultra-low rates, commercial banks have to trackdown alternative investment opportunities to remain competitive

Banks invest the unexpected plum credits by buying every title yielding ahigher profit than the mini-interest charged by the central bank The resultingcredit boom creates extra demand, and the price of all investment classes willsuddenly rise This was reflected in the strong growth of outstanding U.S pri-vate sector debt, which between 2002 and 2007 increased by 59 percent, reaching

294 percent of GDP.4

But what are these appreciations, really? If breakfast eggs were an asset class,

a farmer would thank the Lord for the doubling of the price of his hens, but hiswife would understand that only their price has been inflated After all, she isn’tcollecting a single egg more than before from the coop

The U.S financial system created a special masterpiece so it could profit fromcheap central bank money It discovered asset classes that never existed before Sub-prime and “Alt-A” borrowers, customers with impaired credit or limited income

or asset verification, could now take out mortgages By 2006, subprime and Alt-Amortgages, largely originated by nonbanking institutions like mortgage brokers,made up 40 percent of all U.S.-issued mortgage-backed securities.5

Using the tried-and-tested techniques of securitization, high-risk subprimemortgages were turned into low-risk AAA-rated debt Structuring a pool of mort-gages into tranches allows typically 90 percent of the underlying total debt to berated AAA/AA (by rating agencies who receive their fees from this service), withother tranches exposed to the initial losses Subprime assets rated AAA/AA be-came, in turn, attractive assets for pension funds, commercial banks, and specialvehicles like conduits and structured investment vehicles (SIVs) all over the world.The latter engage in credit arbitrage by issuing short-term asset-backed commercialpaper (ABCP) to fund high-yielding long-term assets.6

The rest is now known The Fed let its interest rate move up to 6 percent(May 2006), and mortgage interest rates had to follow suit The new asset-freeclass of debtors defaulted on their nonrecourse loans, and the growing number

of foreclosures depressed house prices In 2008, senior tranches of securitizedsubprime claims had lost most of their value, and global markets for these securitiescollapsed Credit enhancement through securitization proved to be illusory asdefaults in the underlying subprime mortgages were highly correlated

12 Overview of the Crisis

When money market funds became concerned about the underlying quality ofthe assets, the market for ABCP collapsed, and conduits and SIVs could no longerroll over their paper Some sponsoring banks were forced to provide liquidity tothese vehicles by taking subprime assets back on their balance sheets Other bankswere caught warehousing out mortgages as part of the securitization process orhad made direct investments in mortgage and asset-backed securities.7Banks, inturn, were forced to write down their assets and were teetering toward insolvency,with liabilities at risk of exceeding assets because their equity capital, their property,could not balance asset writedowns any further Banks hoarded liquidity to main-tain their ongoing business Funds in the interbank market other than overnightmaturities became very difficult to obtain

THE BREACH OF BAGEHOT’S SECOND PRINCIPLE

OF CENTRAL BANKING THROUGH LOWERING

COLLATERAL STANDARDS AND AGGRESSIVE

BALANCE SHEET EXPANSION

Bagehot’s second principle states that central banks must accept all good bankingcollateral in a crisis This seeks to distinguish illiquid but solvent from insolventborrowers and has become central bank doctrine ever since Bagehot was drawing

on the lessons from the English crisis of 1825–1826 when the Bank of England hadsuccessfully stayed the panic by widening eligible collateral from commercial bills

to first Exchequer bills and later to goods

However, more than good collateral is required Bagehot also noted that the

“amount of the advance” was the “the main consideration” for a central bank.

Bagehot’s objective was the “efficient use” of the bank reserve against all goodsecurities consistent with the safety of the bank.8A central bank should not makeadvances “by which the Bank will ultimately lose.”9His second principle thereforeimplies that neither a commercial bank nor a public institution should supply cash

to insolvent borrowers or take risks out of proportion to its capital

While initially following central bank doctrine and providing easier access toloans secured by a wider range of eligible collateral, the Fed during 2008 relaxedits collateral standards in ways not followed by other major central banks Eligiblecollateral could now include problem assets like nonagency securities backed bysubprime mortgages,10investment grade securities,11 and shares and debt belowinvestment grade (junk).12Since October 2008, the Fed has suspended the need forcollateral altogether by purchasing unsecured commercial paper outright.13

In parallel with relaxing its collateral standards, the Fed expanded its balancesheet in ways not seen before Federal Reserve System assets14 increased from

$906 billion on July 2, 2008, to $2,250 billion on November 12, 2008, now including

a large amount of riskier nongovernment assets, while the holding of Treasurybills decreased dramatically This balance sheet expansion coincided with the Fedfinding it increasingly difficult to influence the federal funds rate For the period

of November 2008, the effective rate averaged around 0.25 percent, a whopping0.75 percent below the 1 percent target rate Monetary policy through interest ratetargeting had come to an end

The ballooning balance sheet also resulted in a decline of the total FederalReserve System capital, which dropped from 3.8 percent of total assets (August

8, 2007) to 1.9 percent (November 12, 2008) In comparison, a commercial bankunder the old Basel I accord would have required a capital of about 8 percent ofits nongovernment guaranteed asset holdings This means that a mere 1.9 percentloss on the Fed’s assets would wipe out all capital In such a situation, losses willhave to be balanced with proceeds from selling portions of the Fed’s equity capital.Once this property is exhausted, the central bank is technically bankrupt and has

to be recapitalized by the taxpayer

The popular belief that the Fed has the unlimited ability to print money andcannot go bankrupt, reinforced by the Fed chairman Ben Bernanke, who noted that

“the balance sheet of the central bank should be of marginal relevance,”15overlooksthe often-hidden capital requirements of the recently created Fed facilities At leastfor the Term Asset-Backed Securities Loan Facility (TALF),16the need for additionalbank capital is now officially acknowledged The $200 billion facility will receive a

$20 billion investment from the U.S Treasury.17

One could argue that while quick in their response, the Fed’s strategy has alsoincreased the risk of providing insolvent institutions with credit without requiringthem to fix the structural problems that created the need for liquidity in the firstplace Thus, central bank action is at the risk of prolonging a crisis and wastingpublic funds that would have been better used to wind up, nationalize, or recapi-talize troubled institutions at the outset This is precisely the moral hazard Bagehotsought to avoid

But the missing capital is only one dimension of the problem A central bankexpanding its balance sheet by accepting risky collateral or engaging in unsecuredlending also puts the country’s currency at risk An excess supply of money notbacked by sound central bank assets cannot be withdrawn by asset sales, com-petes to buy supplies, and bids up prices Inflation is the inevitable long-termconsequence

THE STATE AS PROPRIETOR OF LAST RESORT

A central bank can provide illiquid but solvent commercial banks, still in the position of unencumbered property, with liquid funds But the central bank cannothelp insolvent banks because it cannot provide them with new property to serve asbank capital or compensate losses Neither can the central bank provide the miss-ing collateral for bank loans to near-insolvent businesses.18This limits the ability of

dis-a centrdis-al bdis-ank to influence the durdis-ation dis-and severity of dis-a crisis Jdis-apdis-an’s experienceshowed that even a massive increase in the money supply does not necessarilyreach companies because banks will foremost seek to refinance themselves in acrisis, reducing capital requirements by replacing private sector loan assets withrisk-free central bank balances and government securities This makes clear thatthere is no real economy operating in its own right that only needs money to facil-itate its barter operations, even if all the Nobel prize–winning economists say so

There are only businesses tied to credit contracts Real economy just means

fulfill-ing countless credit contracts between bank and business proprietors If one side ismissing, the system collapses This network of millions of creditor-debtor contracts

14 Overview of the Crisis

forms the hand outlined by Adam Smith, but which he could only conceptualize

as being something enigmatic and invisible

Once there are too many property-denuded banks, an institution is requiredthat does not provide money but fresh property, against which bank funds can

be created This institution is the State It has to step in as the proprietor orco-proprietor of last resort so that it can at least re-enable banks to lend to companiesthat are still capable of pledging collateral After the fall of Lehman Brothers,the panic was stayed only after European countries announced programs torecapitalize or part-nationalize their banks, and many governments guaranteedbank liabilities The United States has eventually had to follow this agenda

A functioning system thus requires sufficient property in the form of bankcapital to absorb losses (banks and central banks), collateral to secure loans (com-panies), and adequate levels of interest rates to compensate for the burdening ofproperty in this process The 2008 crisis has always been beyond the reach of alender of last resort

NOTES

1 See Gunnar Heinsohn, Privateigentum, Patriarchat, Geldwirtschaft (1984); Gunnar Heinsohn and Otto Steiger, Eigentum, Zins und Geld (1996); Gunnar Heinsohn and Otto Steiger, Eigentums¨okonomik (2006); Gunnar Heinsohn and Otto Steiger, “Interest and Money: The Property Explanation,” in Handbook of Alternative Monetary Theory, eds.

Philip Arestis and Malcolm C Sawyer (2006); and Otto Steiger, “Property Economics

versus New Institutional Economics,” Journal of Economic Issues 40(1): 183–208 (2006).

2 Nonfinancial

3 Walter Bagehot, Lombard Street ([1873], 1962) 97.

4 Federal Reserve statistical releases

5 Office of Federal Housing Enterprise Oversight, Mortgage Market Note 07-1, September

6, 2007

6 See, for example, Susan Black and Chay Fisher, “The Asset-backed Commercial Paper

Market,” Reserve Bank of Australia Bulletin, January 2008.

7 See, for example, Adrian Blundell-Wignall and Paul Atkinson, “The Subprime Crisis:

Causal Distortions and Regulatory Reform,” Reserve Bank of Australia, Conference 2008.

8 Bagehot, preceding n 3, 101

9 Ibid., 97

10 For example, in the Term Action Facility (TAF), see Federal Reserve Discount Window,Frequently Asked Question No 5 www.frbdiscountwindow.org/ (accessed June 7,2009)

11 Through the Term Securities Lending Facility (TSLF)

12 A certain proportion is permitted in triparty repo system collateral See Edmund L

Andrews, “Fed Loosens Standards on Emergency Loans,” New York Times, September

15, 2008

13 Through the Commercial Paper Funding Facility (CPFF)

14 See Federal Reserve statistical releases

15 Remarks by Governor Ben S Bernanke before the Japan Society of Monetary Economics,Tokyo, Japan, May 31, 2003

16 Providing loans secured by auto loans, student loans, credit card loans, small businessloans, and commercial mortgage-backed securities.

17 See Federal Reserve Bank, TALF White Paper, March 3, 2009

18 Heinsohn and Steiger, Interest and Money, preceding n 1, 505 The severe New South

Wales 1843 depression provides an interesting example in which the missing collateralwas created by legal enactment This resolved the crisis See Frank Decker, “The Legal

and Economic History of the Lien on Wool and Stock Mortgage Act 1843 (NSW),” Legal

History 12(2): 151–175 (2008).

ABOUT THE AUTHORS

Gunnar Heinsohn is professor emeritus of social sciences at the University ofBremen (Germany) E-mail: gheins@uni-bremen.de He holds summa cum laudedoctorates in sociology (1974) and economics (1982) The second dissertation tried

to replace the barter paradigm of economics by the property paradigm In the

Encyclopedia of Economic Works, covering the most inspiring 650 economic treatises

of altogether 460 authors worldwide from antiquity to the twentieth century, theauthor is the only living scholar of the German-language area represented with

four different studies (cf D Herz and V Weinberger, eds., Lexikon ¨okonomischer Werke, D ¨usseldorf, 2006, 186–190) The money explanation of Eigentum, Zins und Geld [Property, Interest, and Money, Reinbek, 1996, 4th ed., 2006; with Otto Steiger

(1938–2008)] is, since 2000, represented by the Geldmuseum der Deutschen desbank (Money Museum of the Bundesbank, Frankfurt am Main) in juxtapositionwith the money views of Aristotle, Adam Smith, Bernard Laum, and John MaynardKeynes

Bun-Frank Deckerholds a Ph.D in physics from the Free University of Berlin, a master’s

of applied finance from Macquarie University, Sydney, and is currently completing

a Ph.D in economics from the University of Bremen He continues to work nationally as a management consultant Decker’s academic work has focused onmonetary theory and the interaction between property law and economics Spe-

inter-cific work includes the 2008 Global Financial Crisis, the study of Australia’s early

monetary history, the New South Wales 1843 depression, the legal history of theLien on Wool and Stock Mortgage Act of 1843 (NSW), and the role of security rightsfor economic development

CHAPTER 3

Of Subprimes and Sundry

Symptoms: The Political

Economy of the Financial Crisis

ASHOK BARDHAN

Haas School of Business, UC Berkeley

The U.S economy is in the grip of what looks to be the worst financial and

economic crisis since the Great Depression Starting with the downturn inthe housing market and rising foreclosures, the crisis spread to Fannie Maeand Freddie Mac, the government-sponsored enterprises, and to investment banksand other financial entities holding dodgy assets backed by collapsing real estate.Once the entire financial system was infected with the subprime virus, the health

of the real economy took a turn for the worse At present, unemployment is higherthan at any time in a quarter century, and there is no silver lining on the economichorizon A number of other, related issues of concern, while in abeyance right now,also keep surfacing They include the ever-present disruptive impact of globaliza-tion, in the more recent avatar of sustained global imbalances, and the ongoingchurning in the labor market brought about by offshoring Is it a coincidence that somany concerns and issues have erupted simultaneously, and is there a connection,however tenuous, between them?

A key contention of this short piece is that subprimes are a symptom of deeperstructural and politico-economic problems of present-day globalized capitalism,rather than the primary cause of the crisis These problems include the incentive-institutional structure of the financial system, the nature of distributed globaliza-tion (finance centers and entrepots in the West, production centers in the East;savings generation in the East and debt accumulation in the West), the ideologi-cal environment of not just laissez faire but laissez financier, and the governancecontradictions facing the political management of global economic development

THE EVOLUTION OF THE CURRENT CRISIS

The genesis of the current crisis lies, as is so often the case, in developments related

to the real estate sector, more specifically the housing segment In any country,the health of the housing sector is a critical indicator of the health of the economy

17

Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future

by Robert W KolbCopyright © 2010 John Wiley & Sons, Inc

at large This is due to a number of factors, including the size of the sector, itslinkages to other sectors in the economy, and the social and political implications

of an industry that is interwoven into the fabric of the family, the community,and the economy Housing and home ownership have long constituted one of thebedrocks of the U.S social and economic system Starting with the Depression era,the housing finance system has evolved into a host of agencies designed ultimately

to keep the cost of home ownership low, stable, and secure From a sociologicalpoint of view, home ownership is believed to promote community-based values,nurture respect for law and order, and provide a stake in the stability and prosperity

of the system; from an economic point of view, the hopefully steady appreciation

of home values, the main asset held by a household, would provide the basisfor a continuous increase in consumption, the driving force, or engine, of theU.S economy

The past decade saw an unprecedented run-up in house prices Historicallylow interest rates created a conducive financial environment for borrowing, whilelax lending standards set up an accommodating institutional setting for subprimeand dodgy loans In 2006, the last year of the housing boom, the share of sub-prime mortgages in total mortgage originations reached 20 percent, compared toonly 6 percent in 2002 Over 80 percent of these loans were promptly pooled andsecuritized by private financial institutions, a higher proportion than the relativelymore creditworthy mortgages securitized and backed by Fannie and Freddie Thisprocess of securitization, while doing an admirable job of generating liquidity forlumpy, nonliquid assets, did not just disperse risk but also succeeded in distancingmortgage originators from the ultimate investors in mortgage securities The risk-attenuating benefits of securitization failed to offset the new informational costsgenerated Ultimately, it led to risk doubly compounded—the most inexperiencedand risky borrowers were sought out and offered mortgages on sometimes disin-genuous and deceptively easy terms; these mortgages were precisely the onesthat were securitized, leaving investors in far-off lands holding securities theyknew little about, and whose funds now generated more mortgages and higherhouse prices

By the second half of 2006, prices had peaked in most U.S urban housingmarkets Over 14 million new mortgage loans were originated, and the total amount

of home mortgages outstanding crossed $10 trillion by the end of 2006, havingdoubled in a little over five years By the end of 2006, prices started declining,and sales weakened Early 2007 witnessed significant increases in defaults andforeclosures, and a number of financial companies started filing for bankruptcy Bysummer, the crisis had spread to the larger financial system with the emergence of ageneral credit and liquidity crunch, widening spreads of interest rates in the privatemarkets above U.S government bond yields, collapsing transactions in derivatives,and a disappearing market for loans of all kinds Mounting losses in the financialsector continued in 2008, with Bear Stearns an early victim The first apogee of thecrisis was reached with the stocks of Fannie Mae and Freddie Mac plummeting overseveral days in July and ultimately losing over 80 percent of their value The months

of September and October saw hectic activity in financial markets and in corridors

of power, with the failure of Lehman Brothers turning out to be a rude wake-upcall Ever since then, the policy establishment has lurched from one initiative to

O F S UBPRIMES AND S UNDRY S YMPTOMS 19

another, with monetary easing, a fiscal stimulus, and financial bailout being thelinchpins The economy has not budged much At the same time, through all thismaelstrom of activity, the plight of homeowners and the burgeoning problem offoreclosures has yet to receive the same level of policy intensity directed at it

SUBPRIMING THE FINANCIAL PUMP

The collapse of the subprime mortgage market heralded the unraveling of theseamy aspects of the entire financial system While subprime loans have been thefocus of attention and denunciation, we should be clear that not the entire universe

of subprime loans is necessarily socially harmful Leniency in the strict rationing

of bank credit, as well as institutional arrangements that lower mortgage costs givepeople who would otherwise find it difficult to get a mortgage the opportunity toown a home Neither is a bump up in home ownership rates necessarily an adverseeconomic or social event Indeed, U.S housing policy shows that subsidies work;wealth inequality in the United States would be even higher were it not for thesignificant level of home ownership The point, however, is that the recent uptick

in ownership rates was not a result of a deliberate, constructive social policy but aphenomenon born of other structural motivations embedded in the system.Among economic and financial causes one can also cite the savings glut inemerging economies channeled to the United States through the medium of inter-national capital flows, and leading to excessive liquidity and low interest rates Thephenomenon of global imbalances is partly due to a global shortage of creditwor-thy debt instruments, in contrast to the abundance of U.S Treasuries Intricatelyintertwined with all this is the role of the United States as the guarantor of lastresort and as a financial entrepot, and of the dollar as the numeraire par excellence.The cheap money environment fostered a frantic search for higher returns,leading to higher risk taking and high leverage (huge debts on the buying side),

as well as corner cutting (on the selling side) Securitization, the influx of newinvestors, and an incentive structure that rewarded new deals meant that deal-making, debt dispersal through sequential transfers of investments, and deriva-tives of derivatives proliferated The velocity of turnover of these instruments andtheir opaqueness were exemplified by the attitude: “Let someone else be left hold-ing this toxic stuff when the ceiling comes crashing down.” The bandwagon effectled to a swift and prolonged bubble in housing, as well as in other asset classes.The sustaining fuel for this towering house of cards was the steady and robustgrowth in house prices, and at the first sign of weakness in the housing market,the entire structure began to unravel

The complex character of some of the financial instruments served to hide thefeeling that a subtle subversion of the financial system was under way The fun-damental objectives of finance—allocation of savings to investors, risk mitigation,and hedging and insurance activity—were being undermined not just by routinespeculation but by naked gambling For example, trades in credit default swapsbetween parties with no insurable interest is tantamount to a gamble; any separa-tion of the economically relevant party—the one with an insurable interest—fromthe transaction deprives the act of larger economic purpose and value