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LinkedInAfter the Wall Street crash of 1987, there was a period of perhaps half a dozen years in which American self-doubt was a factor in international relations. The crash was blamed on “portfolio insurance,” the bubble-fuelling financial innovation of the time, and it persuaded many commentators that the U.S. economic model, featuring hyperkinetic trading of financial securities, was inferior to the bank-dominated systems of Germany and Japan. A few weeks after the crash came the publication of Paul Kennedy’s study of imperial overstretch, “The Rise and Fall of the Great Powers.” Kennedy’s warnings about the combination of vast military commitments with limited budgetary resources captured the mood of the nation: The book became an improbable best seller, despite its formidable 600 pages.
Looking back on that period, it is remarkable that the crash and the budget deficits of the 1980s had any impact at all on U.S. behavior. Within a few years, American confidence was boosted by the Soviet implosion, a fast victory in the first Gulf War, and the economic humbling of Japan and then Germany, despite their supposedly far-seeing banking systems. But although some celebrated “The End of History,” American self-doubt remained. “The cold war is over and Japan and Germany won,” some quipped; and in the 1992 election, a foreign policy veteran was unseated by a challenger who promised to put domestic economic challenges ahead of international ones. For at least the first year or so of his administration, moreover, Bill Clinton tried to act on his mandate. He downgraded the US-Japan military alliance in favor of an aggressive push to open Japanese markets—until Joe Nye, a contributor to this Forum, helped to reverse that error. He stood aloof from the war in the Balkans, at least until 1995. He presided over a decline in foreign policy spending, ranging from the peace dividend extracted from the Pentagon to the dwindling of US foreign assistance.
The issue today is whether Wall Street turmoil will produce similar pressure for the United States to look inward—and indeed whether its capacity to sustain an international role may have been compromised. Or, to frame it in a different way, the issue is whether German Finance Minister Peer Steinbrueck is right to state that “the United States will lose its superpower status in the world financial system.” I’m not going to pretend I have the answers—the point of this Forum is to generate a collective effort to come up with some. But I would like to get the discussion going with three questions.
1] Will U.S. growth slow relative to that of its rivals? There are (at least) two channels to consider here:
– In the short to medium run, how far will deleveraging disproportionately hit the US? In a world of global banks, credit losses and deleveraging hurt all economies in which those banks operate. So far, it appears that the most global US banks have suffered the biggest losses—Citigroup and the highly international investment banks were overexposed to risk, whereas the vast majority of the second and third tier institutions, which are more narrowly US focused, are plodding along more or less stably. So deleveraging that is concentrated inside global financial institutions may have global rather than just US effects. Still, the bottom line must surely be that the US will suffer more from the credit crunch than the rest of the world economy. If less international US banks start to report large losses, as many fear, the relative hit to the United States becomes larger.
– In the medium to long run, might New York lose its edge as the dominant global financial center? Charlie Calomiris, a contributor to this Forum, once prodded me to think about the way that competitiveness in a knowledge-based economy hinges on retaining clusters of innovation—Silicon Valley for software, Hollywood for movies, New Jersey for pharmaceuticals, New York for finance. These clusters succeed in large part because they have succeeded in the past: New York is the go-to place for finance because ambitious young financiers have chosen to go there. The good news is that once a cluster has established itself as a global leader, it is hard to unseat because it has inertia on its side. But the bad news is that if it loses its leadership position, recovery will be difficult.
Will the discrediting of securitized US finance create a tipping point that costs New York’s financial center its leadership? Should we worry that US institutions such as Lehman Brothers and Morgan Stanley are selling chunks of themselves to Barclays and Mitsubishi? (Brad Setser, another Forum contributor, has quantified foreign governments’ stakes in Morgan Stanley, Citi and Merrill Lynch here.) There was a lot of concern about the resilience of New York as a financial center even before the turmoil hit, so it might seem reasonable to worry even more now. On the other hand, London is the leading rival to New York, and London may suffer as much during the current fall-out.
2] Will it become harder to sustain the pre-eminence of the dollar?
The dollar’s status as a reserve currency has allowed the United States to exercise monetary sovereignty: It has been able to cut interest rates in response to economic shocks without fearing a run on its currency. This has given the United States a privileged measure of economic stability relative to its rivals, and has allowed the United States to project power abroad, too: After the Russian default in 1998, the Fed cut rates aggressively to stabilize global markets. If the dollar had not enjoyed a safe-haven status, it might have been harder for the central bank to use its monetary tool so actively.
This prompts the question of whether the dollar’s special status is likely to survive the current episode. The dollar’s safe-haven status was predicated partly on the Fed’s commitment to protect the purchasing power of the dollar. This would seem likely to come through this episode intact: A sharp increase in the US budget deficit resulting from crisis bail-outs need not be inflationary so long as the deficit is financed by bond issuance rather than by printing money. But the dollar’s safe-haven status was also predicated on the notion that US asset markets are reliably liquid and stable. This notion has been battered.
3] Will American foreign policy be compromised by mounting indebtedness?
This question is the flip side of the previous one. If foreign appetite for US assets diminishes, the dollar will fall and the world may cease to regard it as the pre-eminent store of value. On the other hand, if foreigners continue to buy dollar assets, the pile of US bonds and other instruments in the hands of foreign governments will grow, and this brings its own problems. As Brad Setser has documented in Sovereign Wealth and Sovereign Power, foreign demand for US assets has increasingly come from central banks and other official entities, which have all made a political decision to buy dollars. In extremis, they could make another political decision to sell them, forcing a massive deleveraging in the US economy. One does not have to regard the use of this financial weapon as likely in order to take it seriously. Nuclear weapons have gone unused for six decades but have still influenced the balance of power profoundly.
Well, that’s enough from me for now. I look forward to hearing your thoughts on my three questions above. And no doubt there may be other linkages between the financial turmoil and U.S. power that I have overlooked entirely.
Participating in this discussion are:
Adam Posen
Arvind Subramanian
Benn Steil
Brad W. Setser
Brink Lindsey
Charles Calomiris
Daniel Drezner
Desmond Lachman
Heidi Crebo-Rediker
James K. Galbraith
Jeffrey Frankel
Joseph Nye
Megan McArdle
Michael Mandelbaum
Nicholas Eberstadt
Peter Gosselin
Richard Medley
Robert Litan
Roger Kubarych
The current bill is better than nothing, but it is a close call. The right approach, which the vast majority of economists who have studied such matters supported, was preferred stock investments into financial firms. This was rejected without a hearing by Congress, and the scandal in this process was the complete absence of independent testimony. The preferred stock approach would have protected taxpayers from bearing much risk (as it did in the US in the 1930s and in Finland in the 1990s), provided the capital and liquidity necessary to end the panic and avoid a severe credit crunch, and avoided the need for complex interventions into the financial sector — such as limits on executive pay, stock warrant tranfers to taxpayers, and ex post assessments on financial firms to pay for losses. Instead, we will do all these (although precisely how is unknown), and will buy assets with no reliable mechanism for price discovery, at ill-defined prices “above fire sale” values. That approach invites errors and abuse in execution, and by moving the process of asset liquidation from New York to Washington, we will add to the job loss in New York’s financial sector at a time when New York is already in trouble. There will also be substantial confusion and uncertainty about stock valuation coming from the uncertainty of ex post assessments and ill-defined warrants mandate (in amounts and at exercise prices to be determined by Secretary Paulson). No wonder stock futures are down.
Innovation is a tricky word. NY financial institutions have been innovative but not lately. Securitization of mortgages was innovated here in the early 1980s and by 1990 was a mature business. What we had after 2002 was a mutation. Subprime mortages were securitized but then reblended into a concoction (CDOs) misunderstood by the banks that engineered them so badly that they held huge amounts of that now-toxic paper. (If they had been more knowledgeable and ruthless, they would have sold on everything to gullible clients and would still be thriving, instead of either bankrupt or severly wounded.) In the simpler, clearer, and less abusive world of finance to come, it will take real skills, like credit evaluation skills, rather than glib salesmanship, to make money in investment banking activities. It is an open question who will do best, but certainly not the same people that are detested by buy-side investors in Asia, the Middle East, indeed the world over.
What do participants in the group believe will happen next, after the crushing defeat of the compromise rescue bill?
Sebastian raises a set of very relevant questions as to how the present financial turmoil might impact US relative power. However, a highly relevant question that he does not raise is whether there is not the very real risk that the impending prolonged and deep global economic recession might derail globalization in its present form. This question would seem all the more pertinent in the context of the failed Doha Round and of the likelihood that a new US Administration might not be committed to championing the maintenance of free trade at a time of sharply rising domestic unemployment.
In the event that there were to be a rise in global protectionism, there would be no winners among nations and the global economic recession would be all the deeper. However, it would seem that the biggest losers would be the non-Japan Asian countries, and especially China, whose whole economic growth strategy is premised on ever-increasing exports to the industrialized nations.
As to the questions that Sebastian does raise, I would offer the following comments:
1. Will US growth slow relative to its rivals?
Now that Congress has rejected the Paulson Plan, there can no longer be any doubt that the US economy will enter a deep and prolonged economic recession. It will do so as the vicious process of de-leveraging by the banks continues and as home prices continue to decline and as home foreclosures continue to rise. However, it is far from clear that the US economic recession will necessarily be deeper than those likely to be experienced by Europe and Japan. It would also seem likely that the US political system and the Federal Reserve will respond more rapidly to the US economic recession than their counterparts in Europe and Japan.
There is every indication that Europe and Japan have already entered into recession. Further, the prospects for Europe are very much clouded by the fact that Europe is being hit by a credit market shock of the same order of magnitude as is the United States, at the very same time that a strong Euro is crimping exports and major housing market busts are being experienced in the United Kingdom, Spain, and Ireland. For its part, in the context of falling international commodity prices, Japan could again have to struggle with deflation at a time that it has little room for fiscal policy or monetary policy maneuver to cope with its domestic economic recession.
2. Will it become harder to sustain the pre-eminence of the US dollar?
It is all too easy to point to the US dollar’s very weak economic fundamentals. For not only does the US still have a gaping external current account deficit and a large external debt, but it will now have a ballooning budget deficit due to the sharp economic downturn and the various financial bailout packages in which the US government will now be engaged.
However, for the dollar to lose its pre-eminent position, it must be replaced by another currency. The Japanese yen is hardly a serious contender to the US dollar given Japan’s highly compromised public finances and its outsized public debt. For its part, the Euro does not look like a serious long-term challenger to the US dollar, given the acute tensions within the Euro as exemplified by the highly precarious situations of the Italian and Spanish economies. It is highly plausible that, in the event of a prolonged global recession, the Euro could be torn asunder as the Italian and Spanish economies become mired in deep recessions that make it difficult to sustain continued Euro membership.
3. Will American foreign policy be compromised by mounting indebtedness?
There would seem to be little doubt that US foreign policy will be compromised by a markedly weakened US fiscal position. For not only is the US government going to have to bail out large swathes of the US banking system but it is also going to have to spend very large sums to stabilize the US housing market, which is importantly responsible for the US financial system’s present woes. And it is going to have to do so at a time that prospective problems with the US entitlement programs are going to further compromise the US long-term fiscal position.
The limits that a compromised fiscal position will place on US foreign policy are most vividly underlined by the fact that not only is the US now the world’s largest debtor nation. Rather, the US is primarily indebted to countries like China and Russia, which are not particularly well disposed to the United States and which could use their financial leverage in a manner not helpful to US interests.
In the present moment, it’s easy to picture all the ways things can go badly wrong – for the U.S. and world economies, for American power and American ideals. Allow me then to make a case for constrained optimism.
We’ve endured a shock: the collapse of an asset bubble based on the delusion of perpetually rising home prices. Recognizing and recovering from the bad investments made during this bubble will impose hardships of uncertain severity and duration. But, assuming an utter cataclysm is avoided, this is a temporary setback. The long-term health of the U.S. economy (and with it, the long-term prospects for U.S. power) depends on the soundness of U.S. economic institutions. And there are good reasons for thinking that the current crisis will not do lasting damage to those institutions. Indeed, the crisis may even spur some needed improvements.
This crisis could lead to long-term institutional damage if the ensuing political reaction were to take the form of heavy-handed regulatory restrictions on financial intermediation. In other words, in a backlash against the Type II errors of financial excess, we run the risk of committing Type I errors of financial repression. I believe that the United States’ relatively market-oriented financial system – with its deep, highly developed capital markets, as opposed to more traditional, bank- and “insider”-dominated financial systems – is integral to our entrepreneurial dynamism and, thus, our long-term economic vitality. Accordingly, “reforms” that end up throttling market-based financial development would do lasting harm to our economic strength – and thus to our global power.
Perhaps I’m being Pollyannaish, but I think a serious regulatory hobbling of America’s financial system is unlikely. Don’t get me wrong: some level of regulatory overreaction is all but inevitable. But with the health of the financial sector so imperiled at present, and with the competition that New York faces from other global financial centers (and thus the risk that ham-handed regulation could chase financial activity overseas), I am hopeful that policymakers will refrain from doing too much harm.
And maybe, just maybe, they can actually do some good. As Charles Calomiris and others have pointed out, real estate finance in recent years was badly distorted by the quasi-public GSEs and a general policy bias in favor of expanding home ownership ueber alles. We badly need to remove or at least mitigate these distortions going forward, and perhaps the current crisis will make it possible.
If the crisis leaves U.S. economic institutions more or less intact, then I’m bullish on America’s long-term economic and geopolitical position. Who, after all, is going to take our place? In other words, whose economic institutions are superior to ours?
Why did the majority of Republicans in the House of Representatives reject the Paulson compromise, despite President Bush’s nationally televised defense of the program? And why did numerous Democrats also vote “no”?
It has been written in the press that Republicans voted against in order to retain their seats in the November elections. That is basically false. By far, the greatest number of “no” votes were from Republicans who face little or no competition in the election.
The fact is that, of the 133 Republicans who voted against the bill, only 22 face any serious competition from a Democrat. That means that 111 out of 133 “no” votes, or 83%, were made by Republicans who are virtually guaranteed to retain their seats. Other factors, including economic philosophy and constituent opposition to a bill that would ask ordinary taxpayers to bail out tainted Wall Street firms, were behind their votes, not fear of personal political cost. The assertion that members of Congress voted “no” to assure political survival isn’t true for Democrats either. Of the 95 Democrats who voted against the bill, fully 83, or 87%, have safe seats. Their opposition turned on other factors, including an equal revulsion against the excesses of imprudent bank executives and constituency appeals for programs that would help low and middle income families rather than big banks. Thus, representative government was at work in the defeat, not primarily selfish political interests of House members.
That the dollar is unique among world currencies is illustrated in two relationships. Most currencies most of the time show a positive relationship between depreciation and inflation, and between depreciation and interest rates. That is, depreciation drives up inflation and forces up interest rates to counteract capital outflows. Not so the dollar. At least not until recently.
For the first seven years of this decade, the dollar exhibited a negative relationship between depreciation and inflation, which may be explained by higher U.S. inflation leading to market expectations of higher U.S. interest rates, thus encouraging a shift towards dollar assets. Those expectations were entirely absent in early 2008, when the Fed, diverging from practice over the previous 25 years, made clear that it would continue to cut interest rates to ward off recession in spite of elevated inflation levels. Of course, even an economy the size of the United States is not immune from imported inflation when depreciation is so large that the opportunities for substitution are not sufficient to suppress it. And indeed, inflation and dollar depreciation began moving in tandem as the dollar fell sharply in 2007 and early 2008.
A more remarkable dimension of monetary independence that the Fed has retained has been the ability to set interest rates without regard to those of other currencies. This was easy for central banks to do when they operated in closed monetary markets, but became far more difficult as financial markets globalized. Local currency interest rates around most of the world get driven up as the currency depreciates against the dollar, irrespective of the wishes of the central bank. The Fed has not been similarly constrained in its setting of interest rates.
The fact that the United States has been able to conduct monetary policy independently of interest rates in other currencies is a reflection of the fact that investors in the United States and elsewhere, particularly central banks, have accorded a remarkable premium to dollar-denominated assets. Yet there is little basis for presuming that this premium will persist, that investors will indefinitely sacrifice yield vis-à-vis investments denominated in other credible currencies.
The signs are already there: in early 2008, American investors reacted to dollar weakness by pouring money into U.S.-managed foreign bond funds, assets in which had nearly doubled since two years prior. This is consistent with the observation of the president of the Federal Reserve Bank of Dallas, Richard Fisher, that “in today’s world, where investors can move their funds instantly from one currency to another to avoid depreciation, the price central bankers pay for high inflation is much higher than in the past.”
Suppose, for example, that in an environment of much greater U.S. investor sensitivity to foreign asset yields the Fed pursues an expansionary monetary policy by lowering interest rates. This would depreciate the dollar and reduce the relative yield of U.S. financial instruments. Up to this point, nothing would be new. The new element would be that an enormous mass of people, controlling most of the world’s dollar financial assets, would have a greater awareness of alternatives and feel impelled to take defensive action, selling dollars and driving down their value further. Market rates on dollar assets would have to rise in order to attract investment back, thus nullifying the Fed’s easing. The Fed will have lost its ability to set dollar interest rates and determine the rate of dollar creation. It will have become dependent on the decisions of the other major central banks, especially the ECB. It will, in essence, have become a mortal central bank like all the others.
The flip side of financial globalization is information asymmetry–all around the world, investors are exposed in countries they do not understand very well; industries they do not understand very well, and of course companies and financial instruments they do not necessariuly understand very well. This is a basic problem–it can be mitigated but not eliminated. I am not convinced current quantitative techniques for “pricing risk” help us all that much in this regard–in fact I think one can argue the opposite, that an unwarranted reliance on those approaches has actually made our current international financial fragility all the more acute.
Three points
One. Putting all the blame for the housing crisis on DC (the CRA, Fannie and Freddie) lets the lightly-regulated profit-maximizing (or so we thought) firms on the Street off a bit too easily. The worst excesses of the housing boom came from private mortgage originators selling mortgages that didn’t qualify for an Agency guarantee to private banks and broker dealers who packaged these mortgages into securities that were sold to private investors that wanted a bit more yield than could be obtained in the Treasury and Agency m markets. In 2005 and 2006 in particular, the net issuance of private MBS/ private ABS dwarfed net Agency issuance – in part because the Agencies were constrained by the fallout from their accounting difficulties. Moreover, the value of private institutions existing housing collateral would be far lower – and the current crisis far deeper – if the Agencies were not still providing mortgage financing to American households. Right now they are the only game in town.
Two. It seems pretty clear now that governments are not will to subject financial institutions to the full force of market discipline and thus there is a need for additional regulation of the financial sector’s capital and aggregate leverage – particularly among the set of institutions that are almost certainly too big and systematically important to fail. The fact that the Fed has had to provide over a trillion dollars in liquidity to the financial sector over the past year; regulation needs to adapt to this reality. One of the lessons of this crisis is that in extreme situations, the government ends up either assuming the liabilities of the financial sector (see Ireland) or the financial sector’s bad assets (see the United States). Under-capitalized and over-leveraged financial institutions could even be considered a potential strategic vulnerability. This crisis originated in a breakdown in credit intermediation in the US – not a withdrawal of external financing. But I suspect that if some global shock had led China to scale back its purchases of Treasuries and Agencies, the result would have been much the same. Higher rates would have pushed down home prices, and falling home prices would have caused problems for an under-capitalized financial system that had bet heavily (with borrowed money) that homes prices never fall. The US financial system as a whole bet that macroeconomic and financial volatility had fallen permanently, allowing more leverage — a rather risky bet for a country whose financial stability rested heavily on ongoing financial inflows. Moreover, a country whose regulated banks end up turning to another country’s government for emergency equity infusions reduces in some small way its strategic options. Democratic change in some countries that hold non-trivial stakes in core US financial institutions might now prove to be financially destabilizing.
Three. The current angst about the dollar’s status as a global reserve currency seems hard to square with the IMF’s data on global reserve growth. While most of that growth now comes from countries that do not report data on the currency composition of their reserves to the IMF, it is almost certainly the case that the world’s central banks added record sums to their dollar, euro and pound reserves over the past year – just because they added record sums to their total reserves. Counting China’s hidden reserves and the Saudi central banks’ non-reserve foreign assets, I would estimate that total reserve growth over the last four quarters of data (q23 07 to q2 08) was around $1350b – and dollar reserve growth was at least $900 billion. Rather than debating the dollar’s status as a global reserve currency, we should be debating whether it ever made sense to rely so heavily on central bank dollar reserve growth to sustain a large external deficit.
Global reserve growth likely slowed significantly in the third quarter – but a somewhat reduced pace of dollar reserve growth doesn’t imply the end of the dollar as a reserve currency. Indeed, I would argue that a world with somewhat slower global reserve growth – and even a world where the dollar is the reserve currency for the Americas, the euro is the reserve currency for Europe (as is increasingly the case now) and the yuan or a mix of the yuan, the rupee and the yen were the reserve currencies of Asia and each of the major regions floated against each other – would be in the United States strategic interest. The US would get a bit less cheap financing from excessive reserve growth from countries targeting an undervalued exchange rate v the dollar – but the US also would run a smaller trade deficit, have a more balanced economy and have less exposure to the risk that a government might suddenly reduce its desire to add to ever-more dollars to already bloated reserves.
A Brazilian journalist asked me to comment on the recent charge by German Finance Minister Steinbrück that the US is no longer a “financial superpower”. Here’s how I answered:
The US has continuing advantages over other financial centers in nine dimensions: 1. derivatives 2. cheap, efficient trade execution, clearing, settlement and funds transfer. 3. Anonymity. 4. Venture capital firms that spot and finance the next generation of exciting companies. 5. Mutual fund industry. 6. Private equity boutiques. 7. Reliable court system. 8. English language. 9. Ability to work with counterparts, firms and individuals from different cultures.
Minister Steinbrueck may not be well-briefed on these important advantages and would do well to look around Europe to see where there is work to be done in order to boost competitiveness in several segments of the financial services industry.
Brad Setser’s comments about Fannie and Freddie miss the mark. None of us who have written in depth about the sources of the current crisis have argued that Fannie, Freddie, the Federal Home Loan Banks, the FHA, CRA, and the other government policy distortions that imprudently promote leverage as the means of subsidizing housing are the ONLY problem. In my Jackson Hole paper (available here) I point out that there were three main causes to the crisis, which operated multiplicatively: loose monetary policy, government policies that subsidized subprime mortgage risk on the buy-side (especially the massive subprime purchases in 2005-2007 of Fannie and Freddie), and buy-side agency problems of private fund managers and banks that purchased or retained this junk.
It is ludicrous to argue, as Mr. Setser does, that one should not blame buyers of subprime assets for making bad purchases. Just blame the originators he tells us. But Fannie, Freddie, and institutional investors that bought or retained these risks made the markets in these instruments that encouraged the reckless underwriting. Institutional investors, including the banks that retained much of their own securitization risks, and portfolio investors who bought them (including Fannie and Freddie) severely harmed their clients, shareholders, and in Fannie and Freddie’s case, the taxpayers. They have legal and moral responsibilities to have behaved differently. Does Mr. Setser really want to argue with a straight face that fiduciaries who buy securities should not be held responsible for imprudent risk management in their asset purchases because they were not the ones who originated the assets? I hope he is kidding. It is especially ludicrous to make this argument in the case of subprime, where one can show pretty convincingly that the buyers purposely ignored obvious ex-ante information about the junk they were overpaying for.
In fact, we must blame the buyers much MORE than the sellers. The sellers don’t represent us (us being portfolio holders, stockholders, and taxpayers). Sellers should be held to account for fraud, but not for selling assets at inflated prices. It is not the sellers’ job to prevent buyers from overpaying. Snake oil is always available for purchase if someone is willing to make a market for it as a buyer.
The most remarkable scandal about subprime assets is that ex ante these were obviously not good investments, and yet the most sophisticated buyers in the world (including the management of Fannie and Freddie) bought them massively, wasting the resources of the principals who these agents were supposed to protect. I do not say this lightly or on the basis of ex post performance. I refer readers to my paper for the details. It is true that there are lots of lessons from this crisis. The depth of private sector buy-side agency problems is one of the main ones. Fannie and Freddie’s politically motivated buy-side recklessness, driven by their affordable housing mandate and their Faustian bargain with the Congress, as well as managerial greed, is another main one. I fully recognize that Fannie and Freddie were not alone in their recklessness, but they were the largest offenders. Of the roughly $3 trillion in outstanding junk, they had more than a third of it.
In a housing and credit market crisis of the proportions that we are presently experiencing, there is plenty of blame to go around. Brad Setser and Charles Calomiris seem to want to apportion the blame between the issuers and the purchasers of the sub-prime mortgages. In so doing, they seem to let off the hook too lightly Alan Greenspan’s Federal Reserve, which was fast asleep at the wheel while this lending orgy was occurring and while a housing bubble of unprecedented size was being created.
While the motives of buyers and sellers in this fiasco can be understood, what is more difficult to fathom is the complete dereliction of duty by the Federal Reserve in its role as supervisor and regulator of the US financial system. Surely the Fed should have exercised its regulatory authority to rein in the creation of around US$2 ½ trillion of sub-prime and Alt-A mortgages that has poisoned the global financial system, rather than act as a cheerleader for financial innovations, like ARMs and negative amortization loans, of highly dubious value. Surely the Fed should also be held accountable for feeding the myth that housing prices do not decline in the long run and that spreading risk in highly opaque instruments was good for the financial system.
I want to go back to Sebastian’s original post and ask whether this financial crisis is an indicator of the decline of American power. When I wrote Bound to Lead in 1989, the conventional wisdom was that the United States (and its economy) were in decline. I did not believe it then, and do not believe it now. I was in Paris last week, and spoke with a prominent French economist. He urged that we pass the legislative package quickly because, in his words, “you have a financial crisis, but the real American economy is fundamentally sound.” And even in the financial world, Roger Kubarych lists considerable strengths in his comment. There has certainly been a lot of schadenfreude on the part of Putin, Chavez, and even Lula da Silva. But as noted in the NYTimes after the failure of Congress to act last Monday, “In only a few days, Latin American leaders have gone from schadenfreude to fear.” Assuming that we accept the pain of recovering from the bubble promptly (avoiding the Japanese trap), and remain open to the rest of the world, the American economy still has impressive strengths that are reflected in our productivity. But we may pay a price for the recent debacle in our soft power. The seeming effectiveness of our capital market institutions provided an important source of attraction to the United States. Will we recover that or will it be a case of “once burned, twice shy?”
I did not intend to suggest that private mortgage originators bear exclusive responsibility for the mortgage crisis, only that Brink Lindsey’s argument that “real estate finance in recent years was badly distorted by the quasi-public GSEs” ignored the explosive growth in demand for “private-label” MBS at the peak of the housing boom. I was perhaps too glib in an effort to win style points, but I do not think I ever suggested that “one should not blame buyers of subprime assets for making bad purchases.” The word “excesses” in my comment was intended to apply to the entire chain that created private label securities, not just to the mortgage originators. I strongly believe that demand from the buyers of securities stuffed with risky mortgages drove the entire process. China (through its heavy purchases of GSE debt and the GSE guaranteed mortgage pools bonds), the large investment banks (some of who seem to have tried to juice their trading returns through a leveraged bet on private label MBS) and the investors who provided the leverage these banks used to gear up all bear some responsibility for the crisis .
I agree with several points Dr. Calomiris makes in his Jackson Hole paper, including:
– Investors incorrectly assumed that the low loss rate on subprime mortgages in the 2000-02 slowdown could be projected forward, and thus inappropriately discounted the risks associated with subprime lending;
– The US government subsidized borrowing to buy a home rather than home ownership per se. While end these subsidies is impossible right now, they certainly aren’t something that the US should try to encourage other countries to emulate;
– The GSEs hybrid public/private status and the associated implicit guarantee of their debt generated a host of incentive problems;
– Agency problems in the private asset management industry contributed to excess demand for certain types of risky securities (though I am not sure charging 2% for assets under management rather than 1% necessarily reduces the incentive to garner assets).
I also thought we would agree that the “subprime boom and bust occurred largely outside the realm of government-sponsored programmes.” The Federal Reserves’ flow of funds data suggests – at least to me — that the GSEs were not the main source of demand for the private-label MBS and CMOs that absorbed many of the most risky kinds of mortgages at the peak of the housing boom. From the end of 2003 to the end of q2 2007, the GSE’s holdings of “corporate and foreign debt” (a line item that I think captures their holdings of MBS) increased from $277b to $501b – and increase of roughly $225b (See table L124, line 10). Over that time frame the stock of private label MBS – proxied by the mortgage holdings of ABS issuers — increased from $1024b to $3007b, an increase of nearly $2 trillion (See table L126, line 5). As Desmond notes, the Fed could and should have used its regulatory authority to slow this process – and also could and should have drawn more attention to the risks associated with increased financial opacity.
I would argue that the Agencies greatest contribution to the recent crisis may well have been indirect. The Agencies’ implicit guarantee transformed US mortgages into an acceptable reserve asset for a host of central banks. Part of me wonders if some Asian countries would have reconsidered their policies of targeting the exchange rate and accumulating so many reserves if the Agencies had not been around. From 2004 on, the increase in the outstanding stock of Treasuries significantly lagged the growth in central bank dollar reserves; if all the growth had been directed into Treasuries central banks would have rather quickly bought up most of the outstanding stock. Instead, several major central banks increased their Agency purchases, freeing up private funds to be redeployed into riskier assets.
I’d like to clarify something in response to Brad Setser’s recent post. By pointing out the market distortions caused by the GSEs and a general policy bias in favor of expanding home ownership, I didn’t mean to imply that these distortions were the sole cause of the mess we’re in. On the contrary, many, many private actors share in the blame as well, as they succumbed to a herd mentality and blithely assumed that real estate prices would go up indefinitely. But I was talking about the prospects for policy reform in the wake of the crisis. And it seems clear enough that Fannie and Freddie, and the broader policy environment, encouraged and exacerbated private errors and excesses rather than pushing back against them. And it seems equally clear that this is something we need to fix. If we succeed in doing so, we will have found the silver lining of a very dark cloud.