What caused the Great Recession, anyway? Two years after it began, we don’t know. (Heck, 80 years after the Great Depression, we haven’t decided why it started, or lasted so long, or ended.) So Slate’s Jacob Weisberg went digging for answers. Just about everybody agrees that Alan Greenspan is at fault, somehow. After that, everything is up for debate.
Conservative economists–ever worried about inflation–tend to fault
Greenspan for keeping interest rates too low between 2003 and 2005 as
the real estate and credit bubbles inflated. This is the view, for
instance, of Stanford economist and former Reagan adviser John Taylor,
who argues that the Fed’s easy money policies spurred a frenzy of
irresponsible borrowing on the part of banks and consumers alike.
Liberal
analysts, by contrast, are more likely to focus on the way Greenspan’s
aversion to regulation transformed pell-mell innovation in financial
products and excessive bank leverage into lethal phenomena. The pithiest explanation I’ve seen comes from New York Times
columnist and Nobel Laureate Paul Krugman, who noted in one interview:
“Regulation didn’t keep up with the system.” In this view, the
emergence of an unsupervised market in more and more exotic
derivatives–credit-default swaps (CDSs), collateralized debt
obligations (CDOs), CDSs on CDOs (the esoteric instruments
that wrecked AIG)–allowed heedless financial institutions to put the
whole financial system at risk. “Financial innovation + inadequate
regulation = recipe for disaster is also the favored explanation of
Greenspan’s successor, Ben Bernanke, who downplays low interest rates
as a cause (perhaps because he supported them at the time) and attributes the crisis to regulatory failure.
A
bit farther down on the list are various contributing factors, which
didn’t fundamentally cause the crisis but either enabled it or made it
worse than it otherwise might have been. These include: global savings imbalances,
which put upward pressure on U.S. asset prices and downward pressure on
interest rates during the bubble years; conflicts of interest and
massive misjudgments on the part of credit rating agencies
Moody’s and Standard and Poor’s about the risks of mortgage-backed
securities; the lack of transparency about the risks borne by banks,
which used off-balance-sheet entities known as SIVs to hide what they
were doing; excessive reliance on mathematical models like the VAR and the dread Gaussian copula function,
which led to the underpricing of unpredictable forms of risk; a flawed
model of executive compensation and implicit too-big-to-fail guarantees
that encouraged traders and executives at financial firms to take on
excessive risk; and the non-confidence-inspiring quality of former
Treasury Secretary Hank Paulson’s initial responses to the crisis.
Last year, National Journal’s Jonathan Rauch wrote a killer essay on
this very topic that came to an exotic, and fascinating, conclusion.
Here‘s the quick summary: Financial innovation produced a vast network
of
complicated asset-backed securities traded among what insiders call
“shadow banks,”
or unregulated banks. Shadow banks looking to park cash where it would
hold value and earn interest created a
short-term securities market — much like a checking account. But
unlike a regular FDIC-insured checking accounts, these deposits would
not be guaranteed by the
government. So investors borrowing from
this shadow depository system had to put up collateral. And they chose
…
their asset backed securities.
Why is that dangerous? Because in the shadow banking industry, these
deposits, backed by sub-prime mortgages instead of the FDIC, acted as
money. Banks relied on it for transactions. “Subprime morgage debt had
entered the money supply.” But then the
housing bubble burst. Depositors dumped their assets to raise cash and
tried to withdraw their money, raiding the shadow depository market,
and the
money supply crashed.
And here’s Rauch in his own words:
In the so-called Quiet Period, 1934 through 2007, systemic bank runs
seemed to become relics of an unmourned past. Why? Because for about
four decades, banks’ activities were restricted to heavily regulated
ventures that were more or less guaranteed a profit — and, even more
important, because federal deposit insurance, which began in 1934,
assured depositors that their savings were safe.
Financial innovation, however, could be delayed but not denied.
Around the walled garden grew a forest of new competitors and products.
Money-market funds and other investment vehicles took deposits without
offering federal guarantees. In a process known as securitization,
investment banks converted predictable streams of income, everything
from mortgage payments to health club dues, into securities that
investors bought eagerly. Derivatives — securities based on other
securities–arose to spread risk and hedge against volatility. In time,
shadow banking, as the new institutions and instruments were
collectively called, rivaled and even eclipsed old-fashioned commercial
banks.
The firms and major financial players making all these trades needed
to park cash where it would hold its value and earn some interest, yet
be accessible on demand. In other words, they needed the equivalent of
checking and savings accounts, the “demand deposits” that banks
traditionally provide and that form the backbone of the money supply.
But no insured depository could begin to cope with the trillions of
dollars involved. And so shadow banking developed what amounted to its
own depository system, a short-term securities market called the “sale
and repurchase,” or “repo,” market. It is immense. Gorton figures its
size at perhaps $12 trillion, but he says no one knows for sure.
“It’s important to see that this is a banking system,” Gorton says. But it is like a 19th-century
banking system, because repo “deposits” are uninsured. Unable to rely
on a federal guarantee, depositors who park their holdings there
require that the borrower put up something of value as collateral.
Treasury bonds, because they are safe and liquid, are the ideal form
of collateral, but there were nowhere near enough of them to meet the
demand. So asset-backed securities — those packages of safe-looking
income from mortgages, auto loans, and all the rest — were pressed
into service as collateral. In time, the better grades of subprime
mortgage-backed securities were mixed into the blend, and they, too,
won acceptance as collateral.
All of these asset-backed securities were sorted and re-sorted,
combined and recombined, sold and resold, until, as Gorton writes,
“looking through to the underlying mortgages and modeling the different
levels of structure was not possible.” Users could not independently
assess the value of mortgage-backed collateral any more than your
grocer can independently assess the solvency of your bank before
accepting your check.
You can see, perhaps, where this leads. Repo is a form of money
because it acts as a store of value and financial actors rely on it to
conduct transactions. But instead of being backed by a federal
guarantee, it was backed by, among other things, subprime mortgages. In
this way, without anyone paying much notice, subprime mortgage debt entered the money supply. As
in the 19th century, the economy had become dependent upon a form of
bank-issued money that was not federally guaranteed and that was not as
stable as it appeared. Unlike in the 19th century, however, no one
understood how vulnerable the system was to a panic.
Calamity then struck, as it had before. First, the unexpected
decline in housing prices tanked the subprime market. Repo depositors
knew that most collateral was sound, but they had no way to know if
their own holdings were safe; so in 2007 they began what amounted to a
run on the repo system, effectively withdrawing their money. To raise
cash, repo depositories dumped assets, further depressing collateral
values and starting a tailspin.
In September of last year, when the failure of Lehman Brothers, the
mighty investment bank, convinced investors that no one was safe, the
crisis turned into a meltdown. As the repo market “virtually
disappeared” (in Gorton’s phrase), the money supply crashed and the
economy began to suffocate.
