Friday, December 07, 2007
1. It's caused by problems in real estate markets: fundamentally, a speculative bubble fed by "irrational exuberance," as it was once called.
2. This is a liquidity problem, a problem of "not enough money."
3. It's an example of the dangers of free markets and unbridled capitalism, and highlights the need for a stronger hand of government, especially in credit markets.
These are myths, and unfortunate ones, since the remedies they imply are very different from what's really needed. Let's dispel a bit of the confusion.
Myth 1 contains elements of truth. There’s certainly been a housing bubble with plenty of animal spirits (so much for the inane "wisdom" that real estate "can only go up in value.") But this entirely misses the deeper problem with the world's largest economy: we Americans depend on foreign credit, and unsustainably so. For quite some time, it's been pointed out here (e.g. my popular 24 Feb. 2006 "A-Rabs in our Ports!") and elsewhere that foreigners, and especially East Asian central banks, have been financing our federal deficits, and thus keeping our interest rates low by preventing the crowding out that would have occurred otherwise. There's no mystery here, and it's uncontroversial. Anyone who pays attention has known this for quite some time.
The controversy that arose concerned the sustainability. Supply side Pollyannas proclaimed a global savings glut that practically necessitates the U.S. running perpetual budget deficits. After all, the U.S is the safe haven, isn't it? True enough... in the same sense that it's true that real estate can never go down. It's impossible for me to understand how anyone ever really believed this, but some did.
In fact, the rest of the world has been getting increasingly uneasy about the American financial position for some time. The budget "surpluses" of the 1990s didn't take into account longer term issues with America’s welfare state: Social Security, Medicaid, and Medicare. Not that these are unsolvable problems, but the possible solutions didn't include a Republican President and Congress embarking on a growing orgy of deficits and long term spending commitments. China, our number one creditor of late, kindly played along for a while. In doing so they helped keep the renminbi low: in essence, America received inexpensive goods in exchange for U.S. government debt and dollars. This was a great deal for us... too bad we squandered it on the invasion of Iraq and similarly performing federal "investments."
Well, it turns out that America isn't the only place to invest excess funds; and certainly endless amounts of low return U.S. government debt isn't a reasonable investment, as the Chinese are now admitting. The result, as predicted, is a reduced willingness of foreigners to lend to the U.S. on the cheap, and hence upward pressure on interest rates and a falling dollar.
The poisonous mix of adjustable rate mortgages, subprime borrowers, and irrational exuberance wouldn't matter so much for a country with a sound financial balance sheet. But both the government and the private sectors depend on cheap foreign credit, which is going to be increasingly expensive. So Myth 1 is a myth simply because it misses this larger point. At heart, the problem is American insistence on living on borrowed funds.
Myth 2, "this is a liquidity problem" is easily dismissed. This isn't a liquidity problem. A liquidity problem is one in which a lender has long term (illiquid) assets and short term debits. The balance sheet balances, but the payments and receipts are out of sync. This is quite different, a credit crisis. The subprime mess involves genuine losses, as the "froth" is revealed. And there are enormous amounts of froth, i.e. bad debt. The financial engineering that packaged and repackaged and rerepackaged these bad loans has made it impossible to reasonably guess how big the problem is, but it is very big. This being a credit problem, rather than liquidity problem, means that there is no way to avoid someone taking big losses. (What we're seeing now is a fight over who that will be. Superconduit, anyone?)
Myth 3, "it's the fault of the free market:" here’s the real danger. The primary cause of all this is out-of-control federal spending, and the looney insistence by supply siders that incessant cutting of taxes without cutting spending is a recipe for something other than catastrophe, along with the insistence of America's socialist left (i.e. our two political parties, led by the GOP) on expanding the welfare state.
Secondary causes: Fed easy-money policies further encouraged the irrational exuberance. Also, the highly regulated, highly protected banking sector is regulated by the feds for the benefit of the banks. The SIVs and similar stuff that constitutes the subprime toxic waste was entirely enabled by the very unfree market and the moral hazard that arises when government stands ready to bail out the system at the taxpayer's expense. Additionally, to some unknown extent, subprime mortgages involved fraud: there’s substantial evidence that in some cases it wasn't matter of people "not reading the fine print," but rather simply fraudulent practices. Blaming the free market for fraud is akin to blaming the free market for armed robbery.
Government malfeasance caused the financial imbalance. Government malfeasance enabled the credit bubble in multiple ways. But since Myth 3 persists, the solution we'll get is more government.
The bottom line: The subprime mess isn't really a subprime mess, it's fiscal mess. The solution is fiscal responsibility, smaller government, getting government out of money and banking, and prohibiting fraud. A big part of this solution is dropping the crazy notion that Republicans are friends of free markets, and that their policies are pro-market and pro-freedom.
This mess brings back a buried memory, and it's very unsettling. When I first arrived in Moscow, Russia, one of my non-economist colleagues told me how she'd met a tipsy young Russian at a nightclub. He claimed to be an international currency trader, and was gloating that his ilk had made big on wrecking first the Asian currencies, and then the ruble. "And next," he told her, "the American dollar." Leigh asked me, the economist, if that made any sense. "I wouldn’t worry about it. Those crises were caused by financial imbalances and an enormous amount of bad investments and nonperforming debt. The U.S. has problems, but none of that third-world stuff."
Of course, that was February 1999, way back in the bad old days of Bill Clinton. Since then, we’ve had seven years of George W. Bush, enabled by a Republican Congress. I never imagined we'd have a President worse than Clinton, but... Well, thanks for the third world stuff, GOP. That you are free-marketers, that's the biggest subprime myth of all.
Professionally I have to be concerned with the details of the sub-prime market. There is an interesting anecdotal story that sheds light on institutional behavior. In the fall of 2006 I attended a research conference at UBS on MBS/ABS markets. The focus of the conference was on the coming defaults in the subprime market. Laurie Goodman and Tom Zimmerman, who head research, were unreservedly negative. At one point the fellow sitting next to me said “I’ve never seen an investment bank completely trash a sector in which they are underwriters and market makers.”
I must confess we checked there numbers, agreed, and avoided the pain. Oddly, enough, UBS didn’t take their own advice as we see from today’s article. Of course, UBS has many divisions and they act independently. Let it go on record that there are people of integrity in the research departments of major investment banks. I’m sure we’ll hear about the snake-oil salesmen as people seek scapegoats. I doubt we’ll hear about the heroes.
PS, there were other institutions talking about the problem, too. Some people think that “sell side” research is merely an aid to salesmanship. Of course, it is “fyi” and should be confirmed. While everyone is kicking the rating-agencies for not providing investment advice, one wonders why so many didn't do their homework. Others did and came out ahead.
It doesn't surprise me that some UBS analysts were warning against subprime while UBS itself was heavily involved. I saw these sorts of disconnects occur regularly in a small consulting firm where we had regular face-to-face meetings. Large organizations with many divisions -- we tend to think of them as a single entity, but they nearly never are.
Thanks again for the post.