TheMarketForIdeas

Almost ten years have passed since the first symptoms of America’s subprime crisis emerged, yet the lessons of the “age of turbulence” remained unabsorbed by the great public. People devoured semi-explanations imputing the crisis to epidemics of greed and/or stupidity, ignoring the white elephant in the room: the flawed design of the modern finance & banking system.

I wrote at that time a “pop economics” article, one of the first from the Romanian mass media on this subject, a year before the epic fail of Lehman Brothers (mechanically considered the starting point of the crisis), using the framework of the highly ignored Austrian Business Cycle Theory. I took the liberty to republish it below in English, hoping that it will not become topical again too soon.

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America’s Subprime-acy

(September 2007)

John Subprime Smith, unemployed worker from Zzyzx, California (real city), assesses at a quick glance that he fits the requirements of his local bank’s exclusive mortgage terms. Five years later, in the summer of 2007, John realizes he can no longer pay his mortgage rates, the bank runs out of liquidity, and the Fed realizes that it is its moral duty to provide liquidity… Ten years earlier, Joe “the Overoptimistic” Doe has also taken out a loan from the same bank and placed it in Mirage.dot.com.Inc. stock. Highly over-valued, the stock was to go bust, shaking the bank and bringing in the Fed with liquidity. The bank was saved and was generously waiting for… Mr. Smith.

“Markets are very good in finding their own ways of solving problems” was the statement of Ed Lazear, the Head Economic Councillor of GW Bush, in a totally unexpected surge of laissez-faire for an economist on the government’s payroll. The claim was made in the context of the subprime debt crisis surging from the US banking system towards the world’s capital markets. The high-level official suggested that more than three quarters of the 2.5 million affected house owners were NOT exposed to default and repossession risks, because either they would find the resources to continue the payments, they would manage to refinance, or they would renegotiate their contract with the bank. The Administration declared that it would marginally interfere to minimize the number of unemployed bankrupt debtors, but that it did not see any reason for a general bailout.

The tough road from theory to practice

If the US administration was at least 75% certain that an intervention was not necessary, this certainty level drops significantly when we correct for the liquidity inputs that the independent Fed felt bound to provide. In fact, how much, or, in other words, which way is better? For almost a century, economists didn’t manage to reach a consensus on the final cause and perfect answer to such economic troubles. Mainstreamers say there exist no bubbles or boom-bust cycles, just complex states of the economy, due to atypical evolutions in factor structure, such as technology, that the government cannot systematically control. Keynes’ supporters claim that, on the contrary, everything resides in “the psychology of the market”, but we have anti-cyclic policies that can calm down the boom and revive the bust. Finally, a third category blames all these problems on the fundamental model on which modern banking systems work, with a fractional reserve and backed up by the central banks. (And the diagnosis is 50% of the cure…)

The grammar of intervention: to feed, fed, Fed

It is rather hard to find a technology shift that could have started the subprime bubble. People take shelter in houses for ages, and American habitats have the same four walls made of the same materials. The thesis of banks and creditors’ collective irrationality doesn’t hold either, as modern psychology is silent on irrationality epidemics or generalized human error.

A proven fact though is that an economic crisis is also a moment of intellectual crisis in the economists’ tribe. Three characteristics interest us when it comes to such phenomena: they come from somewhere (are recurrent), they appear in the industry of financial assets (for example, real estate) and they sit on clusters of errors (it is not just a bank or developer that fails, but clusters of them).

A non-mystical explanation though exists. Mises and Hayek, the two great heretic economists (for central bankers at least) found it a long time ago – the expansion of credit. The reasoning is simple enough: the credit expansion (money multiplication by the banking system and borrowing – (1) at the artificially low interest rate compared to the natural rate that would result from the actual real consumption-savings ratio and / or (2) to borrowers with sub-marginal credibility) distorts the pattern of spending and investment in the economy. Capital is lost in unsound and unprofitable investments, and the realization of the loss leads to a sanitary contraction of credit. Resource-wasting projects are stopped. What can the central bank do under the circumstances? Nothing… that would repeat the story.

Subprime boom, a relative of dot.com bust

The subprime crisis of 2007 was the daughter of the one exploding in 2000 that marked the ending of the dot.com economy on the US stock exchanges. And that one was related to the one in the mid-90s, and so on.

In order to avoid the deflationary consequences of the 2000 bust plus 9.11, the Fed decided to sponsor a suite of interest rate reductions, to less than 1% (in the summer of 2003). The M.O. was a classical one: by crediting the mandatory reserve accounts kept by commercials banks in the Federal Reserve System. On these new reserves, banks created new deposits, on which more borrowing could be made to the mathematical limit of the credit multiplier. The increase in credit availability reduced both the interest rate and banks’ prudence. And the banks, naturally looking to maximize profits by using all available resources, opened their gates to clients with a credit history and rating that would have made a credit officer smile… out loud. In 2004, the Fed started to fear the inflationary effects of its cheap money policy and slowly raised the interest rate, in order to reduce the propensity for credit expansion. The volume of credit entering the real estate was drastically reduced, house prices fell, and multiple underperforming mortgages started to put pressure on banks’ liquidity. Banks, in turn, not only stopped lending, but also went looking on the inter-bank market for money to plug their balance sheets.

“Credit crunch” is not a diet snack

The subprime crisis did not appear because the reference interest rate rose with almost 4 PPs in the four years before the crisis. That’s why it emerged earlier. On the free market, the deposit interest rate is determined only by the time preferences (savings vs. consumption) of all market actors. If it decreases rather artificially (and not due to an increase in savings), the investors, who cannot see the trick behind the numbers, enter large investment projects, which are time-consuming as well, that beforehand seemed downright unprofitable. Investors should know some economics too, and figure out what the central bank is doing, to be able to separate the good from the bad in the interest rate. Banks should also refrain from speculating on a large scale this lack of precaution (and form the above mentioned clusters of failure). The central bank should also not let commercial banks err in the way they do it, though without sapping the purpose of the banking system with excess regulation.

Difficult indeed. Problems appear when the extra money that reaches employees’ pockets is spent just like before. Thus, once the expansion-driven inflation is absorbed, the old ratios between consumption and savings are slowly re-established, penalizing the disproportion between capital and consumption goods. Companies realize they overinvested in capital goods (e.g., real-estate) and underinvested in consumption goods. The increase in the reference rate only hurries the inevitable disclosure of errors. The guilty party was thus Greenspan the Expansionist of 2001 rather than Greenspan the Anti-Inflationist of 2004.

Affirmative Action also kicks in

Fear of deflation and associated recession invariably started creeping up an economy that, at a certain point, was just in crisis. But deflation phobia is as damaging as the fear of medication. Deflation is the cure of the inflationary increase in credit that preceded it. It re-establishes the value of money and prevents the refinancing of investment errors. Only when it is confiscating in nature, such as during Argentina’s crisis, when the government suggested the appropriation of bank deposits in order to mask the massive money creation operation in the economy and save the banking system from utter bankruptcy, only then is deflation truly bad. At end of the 90s, in Japan, a country instinctively associated with the dangers of deflation, the most interesting phenomenon happened: commercial banks rejected the central bank’s game and chose to preserve the liquidity that the former has pumped in the system. The gesture, typical of a national culture of saving, meant minimizing the exposure of the already damaged individual savings. The government was forced to take the path of direct credits and fiscal and budgetary measures. Thanks to them, the economy is recovering… so slowly.

But let’s return to the subprime crisis. This one had, from the very beginning, an involuntary patron in federal law – the Community Reinvestment Act, fighting discrimination and supporting social inclusion by means of easy credit to members of poorer suburban communities. As a funny coincidence, a CRA rating is required for the approval of mergers and acquisitions in the banking system. Really interesting.

Liquidity tools or interest rate tools?

Fed’s peculiarity, as opposed to other central banks, including ours, is that its scope exceeds the classic objective of “price stability”. The Fed aims for stable prices, but also for increased employment, economic growth and balances in equilibrium. Its historical largesse is also tied to its privileged status of international dollar reserve. Inflation in the US could have easily been exported, through currency rates, in countries with dollar reserves, without any significant accountability pressures from an internationally competing currency. The introduction of the Euro along with the subsequent restructuring of currency reserves (China) and dollar usage in international transactions (Iran, OPEC) could mend Fed’s objectives towards a more disciplined and responsible fight with inflation at its root.

The OECD, as an external political factor, and voices in the US market, as a domestic factor, insistently demanded the Fed to reduce the interest rate so that liquidity inputs get both more generous and effective in countering the credit crunch – the imbalance in credit offer and demand –, and the following liquidity thirst. The Fed resorted, in August-September 2007, to more liquidity tools, different from interest rate tools. The first operate on very short term, while the latter can bring substantial changes in the economy and thus require more wisdom in use. The Fed’s meeting on September 18, 2007 answered the problem of the reference rate and the crucial choice: “shall we stay put or bail them out?”. The Fed took the “chance”, lowering the reference rate from 5.25% to 4.75% (nota bene: in mid 2008, it has already reached a glorious 2%)!

Poor banking or poor central banking?

The subprime crisis has predictably expanded across a world where both responsibility and moral hazard are globalized, mostly through innovative financial instruments such as derivatives on mortgage bundles and other. The massive securitization of illiquid assets jarred world finances, which turned for help to the closest central bank. Central banks’ behaviours differed according to national contexts and interests, but all initially chose to react with liquidity tools. The great central banks were caught on the trend of rising interest rates. Fed stated that it won’t support careless investors, but it would do anything for the health of the economy. And it did. The ECB was surprisingly the most energetic. An explanation would be that ECB offers a 3% interest rate for bank reserves above the mandatory amount, while the Fed gives nothing, so European banks had greater liquidity needs and more money tied up with the ECB. Regarding inflationary pressures, the ECB forecasted they would be smaller, as operations requiring liquidity would unload outside the euroland. The Bank of England abandoned its “business as usual” policy rather late, by throwing in temporary liquidity after the crisis has already started to unfold. The Bank of Japan also paid up, but in smaller amounts. The fear is that whoever chooses the heavy artillery of interest rate tools might also fuel recurrence, something that good bankers are able to feel. In crises, be they technological or subprime, the management of the original sin is everything, as opposed to belated refraining or hazardous forgiveness of those that only take the risk of receiving their “performance” bonuses an entire day later.

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This article was published in a slightly different Romanian version, under the title “Subprime-ația Americii”, as cover story, in Piața Financiară magazine no. 9, September 2007.