So many forces drove the global financial meltdown that it’s all but impossible to keep track of who and what’s to blame. My partial list: Mortgage lenders, subprime borrowers, real-estate speculators, investment banks that peddled collateralized debt obligations, other banks that held the toxic assets, lax regulators, inept or compromised bond ratings agencies, the Fed, the Treasury, the Congress for encouraging too many people to buy homes, tax policies that tilt too far in the direction of real estate and, of course, greed, stupidity and keeping up with the Joneses. I’m sure I’ve left someone or something out.
Early this week, I spent a stimulating day at the Hoover Institution at Stanford University, listening to several prominent economists explain what went wrong, why and what, if anything, can be done to fix it. I wish I’d taken this seminar before writing my FORTUNE cover story on Hank Paulson last fall, because I came away from Stanford persuaded that Paulson, Ben Bernanke and other in the Bush administration (yes, including our current treasury secretary, Timothy Geithner) were too slow to grasp the depth and seriousness of the crisis. I was also persuaded that the stimulus package now awaiting action in Congress probably won’t do the job, despite its enormity. But before we get to that, I want to show you a chart that points to yet another explanation for the current mess that we’re in:
See what the chart shows? Or seems to show? We’re getting a lot smarter, or at least the people in charge of the economy are. The U.S. struggled with recessions for most of the 19th and 20th centuries until the period from 1982 to 2007, a long stretch which gave us “the best macroeconomic performance in our history,” said Michael J. Boskin, a professor of economics at Stanford, who showed this chart. (You may know his name because he was chairman of the president’s council of economic advisors during the first Bush administration,) The Dow, he reminded us, was at 770 in 1982. By the early 2000s, the conventional wisdom held that smart monetary policy, a.k.a. the genius of Alan Greenspan, and structural changes in the economy, that is, the information technology revolution, drove this remarkable economic performance. Reinforcing the view that mere mortals knew how to manage the increasingly complex and interconnected economy was the fact that each time the economy or the stock market hit a bump, including such big bumps as the 1987 stock-market crash or the 2001 terrorist attacks, the economy and the markets bounced back very quickly.
You remember how that felt, don’t you? Those were the days of “Buy on the dips” and Dow 36000. Risk? Why, the I-banks had sophisticated, proprietary models that reassured them that risk was under control, as Joe Nocera explained last month in an excellent magazine story in The Times.
Of course, the people in charge weren’t quite as smart as they thought they were. Nor, truth be told, were the rest of us, at least those of us who turned their houses into ATM machines or neglected to read the fine print in our adjustable rate mortgages.
It’s one more reminder, not that we need one, that perhaps the most underrated quality in a business or political leader is humility. Knowing what you don’t know is worth a lot. So is admitting to uncertainty. That, at least, was my big takeaway from the day-long immersion with these very smart economists. Even with 20/20 hindsight, they don’t know for sure what caused the meltdown. And they certainly can’t agree on how to dig ourselves out.
As Russsell Roberts, an economics professor at George Mason University and a Hoover research fellow put it: “If you laid all the economists in the world end to end, they still wouldn’t reach a conclusion.” Roberts organized the program and meeting him was a a highlight of my trip because I’m a regular listener to his excellent series of podcasts in which he interviews economists, called EconTalk. They’re available on iTunes.
Here are just a couple of other highlights from my day at Stanford:
Serious warning signs that something was truly awry with the U.S. economy were evident by the fall of 2007. John Taylor, another Stanford prof and one of the world’s preeminent monetary theorists, delivered an eye-popping presentation in which he argued, persuasively, that Paulson & Co. badly misdiagnosed the problem with the financial markets in late 2007 and early 2008. I wish I could reproduce his argument here, but the essence is that beginning in August 2007, after the collapse of several housing-related hedge funds, unprecedented and truly shocking interest rate spreads arose between the three-month LIBOR and the three-month overnight index swap. (Don’t ask me to explain, please.) These spreads were essentially alarm bells, signaling financial stress. “We call it a black swan in the financial markets,” Taylor said, referring to the now-famous book by Nassim Nicholas Taleb.
Paulson, Bernanke & Co. misdiagnosed the problem, according to Taylor. They thought the problem was lack of liquidity. So they made it easier for banks to borrow, cut interest rates and supported last March’s ineffective fiscal stimulus. Taylor argued that this prolonged the crisis. The real reason that the spread increased was that big lenders no longer trusted big borrowers to pay back their loans. Even today, by all accounts, the credit markets are not functioning well.
Of course, the lenders were right to be worried about risk because the big banks – Bear Stearns, Lehman, Merrill and Citigroup – were all insolvent or close to it. “One of the surprising things,” Taylor said, “is how little the CEOs and boards knew about the instruments that were on their balance sheets. That was amazing.” Hubris.
For those who want to know more, Taylor has a small book (less than 100 pages) coming out soon called Getting Off Track: How Government Actions and Interventions Caused, Prolonged and Worsened the Financial Crisis.
Alan Greenspan caused the crisis—or he didn’t. Boskin and Taylor both place much of the blame for the housing bubble and resulting crash on Greenspan. They argue that the fed kept interest rates too low for too long even as the economy grew briskly after the 2001-2002 recession. Real interest rates, that is, interest rates after inflation, were negative, setting off a frenzy of borrowing. Said Boskin: “You get to borrow $100 and you’re only going to have to pay back $98.” Aggregate U.S. credit market debt went from about 2 times GDP in 1990 to 3.5 times GDP by 2007, he said.
“People were getting mortgages of several hundred thousand dollars who couldn’t quality for an auto loan,” Boskin said.
Meanwhile, investment banks like Bear Stearns and Lehman took on so much debt that a decline in the value of their mortgage-backed assets pushed them into insolvency. Goldman Sachs and Morgan Stanley “were maybe a week from insolvency,” Taylor said. Again, this was hubris–these guys figured they were too smart be so wrong.
But Robert Hall, another Stanford prof, defended Greenspan. The low interest rates in the early part of the decade, he argued, were responsible monetary policy to head off deflation, not an irresponsible contribution to a housing bubble. Deflation is a “very, very large danger to the country,” Hall said. “With deflation, people’s debts become larger and larger relative to their incomes. That causes more and more collapse.” Hall and economist Susan Woodward have posted their own detailed analysis of the financial crisis and recession, which is well worth reading, at their website.
There was lots, lots, lots more, including Hall’s argument that the fiscal stimular before Congress, while badly needed, won’t be spent fast enough. A better approach, he said, would be for Congress to encourage people to spend more right away—by, for example, having the federal government pay all state sales taxes for the rest of the year. The three Stanford profs all forecast a very gloomy 2009, I’m sorry to report.
Then again, as Russ Roberts argued, no one really knows what’s going to happen or how we can best dig ourselves out of this hole. The problems are so complicated, the variables so many, the historical precedents are so few.
“In the debate over the stimulus, we have Nobel laureates on both sides,” Roberts says. “What does that tell you?”