Economy

No Ordinary Recession, No Ordinary Fix

By Ryan McGreal
Published April 02, 2009

We're not in a garden-variety recession, which is usually caused by a shortage of liquidity and is easily fixed by the central bank relaxing interest rates to circulate more money into the economy.

The economic crisis today is the result of a major collapse in the global financial system - specifically, the 'shadow banking' system that developed in the past couple of decades outside financial regulations and grew massive, on the order of many trillions of dollars.

Because investments in these 'shadow banking' institutions were unregulated, there was very little fiduciary oversight and firms made some very risky investments, e.g. in collateralized debt obligations on securities made up of blocks of subprime mortgages.

They were also very highly leveraged, which means every dollar invested was multiplied by 20 or 30 dollars borrowed; and their so-called insurance - credit default swaps, which are essentially bets on whether a mortgage-backed security will fail - was itself an unsustainable bubble of highly leveraged risk.

The whole edifice formed because neoliberal governments refused to extend financial regulations into this new sector, and it persisted as long as it did only as long as house prices, driven by a combination of strong sales from extremely low real interest rates and a general relaxation of fiduciary responsibility in mortgage lending, continued to rise.

Perfect Financial Storm

Between the tremendous run-up in oil prices between 1999 and 2008 and the fact that by 2007/8, everyone who could remotely afford a house (and many who clearly could not) already had one, the mania was doomed to stall eventually.

Since real median incomes actually declined and nearly all the growth in the US economy during 2002-2007 was in home construction, automobile and furniture sales, and growth in private health care spending, there was no 'real' economy or savings to fall back on once the housing boom stalled.

The result was a perfect storm:

Rising foreclosure rates resulted in a glut of houses on the market, which depressed house prices further, made it harder for people whose incomes had stagnated to keep spending, and threw more people out of work. That, in turn, fed back into more foreclosures.

The turnaround was so fast and hard that the shadow banking institutions that had so much money invested in CDOs on subprime mortgages were shocked - SHOCKED - to discover that their investments were suddenly worthless, as panicked investors carried out what amounted to a bank run to extract their money before their investments became worthless.

(Again, with traditional banking regulation, banks are offered deposit insurance in exchange for regulation. With deposit insurance, people will no longer panic and rush to withdraw their money on the rumour of insolvency, thus creating a self-fulfilling prophecy. It creates a very strong measure of financial security and stability by preventing the panicked herd mentality of unregulated markets.)

Of course, since the funds were so highly leveraged, there was absolutely no way they could pay back their investors, and so they just collapsed spectacularly.

Credit Crisis Spills Over

Since so much of the real economy was now financed through these shadow banking institutions, they destroyed trillions of dollars in real money, money that was no longer available to invest elsewhere. Outside of Canada, many legitimate, otherwise solvent institutions were brought down in the panic.

Investors were suddenly afraid to put their money anywhere, and financial institutions were afraid to extend capital to each other any more. This so-called credit crunch ground the rest of the economy to a halt, reversing GDP growth and forcing losses and layoffs in unrelated industries. That, of course, only fed back into the spiral of declining property values, falling consumer spending and investor panic.

The last hurrah was investors desperately throwing their money into commodities as a supposedly safe parking spot. Of course, the high and rising commodities values - particularly oil - were due to the sustained strong demand growth of the housing bubble - a growth that abruptly reversed in summer 2008 when oil prices skyrocketed to $147/barrel and then suddenly collapsed when the economy gave up the ghost.

Because the recession is caused by a general collapse in the financial sector - a collapse, I should point out here, that was preventable if only our governments had had the fortitude and good sense to extend the successful regulation of the banking sector to these new de facto banks - we're in serious danger now of falling into a liquidity trap, a situation in which interest rates are already so low that central banks can't lower them any more, yet investors still refuse to invest and instead keep their money parked in low-risk, short-term investments and bank accounts.

The problem with liquidity traps is that banks can't reduce the nominal interest rate to less than zero, so they can't reduce rates enough to trigger new spending.

A Way Out?

Economists from Milton Friedman through John Maynard Keynes are broadly agreed that the way out of a liquidity trap is for the government to step in very aggressively and act as both the banker and builder of last resort, dumping money into infrastructure projects and giving loans directly to businesses.

Unfortunately, the lesson of Japan's liquidity trap since the early 1990s is that sometimes even this isn't enough to kickstart the economy. Paul Krugman makes an unconventional case that if banks can't reduce the nominal interest rate below zero, the answer is for the government to create an inflationary expectation to achieve a negative real interest rate. In other words, the central bank would need to abandon its normal policy of maintaining price stability (inflation in the 1-3 percent range) and deliberately try to raise the inflation rate significantly.

(Austrians, of course, take the stance that a liquidity trap is punishment for central bank policy and government interference in the free market. They recommend sitting back and letting the economy flush all those bad investments out of its system, somewhat akin to the way doctors used to bleed people when they had fevers.)

In summary, people are right to worry. No one knows if this will actually turn into a Depression (and anyone who tells you otherwise is just guessing), but we are definitely back in the realm of the economic forces that produced the Great Depression of 1929-39.

If we don't carefuly apply the lessons learned after early attempts to 'bleed out' the bad investments spectacularly failed, we may once again find our economy stuck in a long, downward spiral that normal macroeconomic policy can't seem to reverse.

Ryan McGreal, the editor of Raise the Hammer, lives in Hamilton with his family and works as a programmer, writer and consultant. Ryan volunteers with Hamilton Light Rail, a citizen group dedicated to bringing light rail transit to Hamilton. Ryan writes a city affairs column in Hamilton Magazine, and several of his articles have been published in the Hamilton Spectator. He also maintains a personal website and has been known to post passing thoughts on Twitter @RyanMcGreal. Recently, he took the plunge and finally joined Facebook.

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By gullchasedship (registered) - website | Posted April 02, 2009 at 12:03:37

One factor that's making all this worse is a failure of morality. People who have promised to pay mortgages on on houses that are no longer worth the amount of the mortgage are walking away, even when they can afford to make the payments.

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By Ryan (registered) - website | Posted April 02, 2009 at 13:16:59

Gullchasedship,

Your hypothesis is tempting, and it almost certainly underlies the Austrian analysis, which is long on comeuppance.

The main problem I see is that it seems highly unlikely that people suddenly became greedy and irresponsible around 2002, when the housing bubble took off.

If we accept that this crisis was caused by the personal greed and irresponsibility of home buyers, we need to ask why it blew up when it did. Why not five years earlier, or a year later? Why is the housing industry not in permanent crisis?

To answer that, we need to look at what has changed - namely, the system of regulations that govern financial transactions. Prior to the 1990s, financial institutions weren't allowed to loan money to people who couldn't afford to pay it back. In exchange for this stricture, deposits to banks were federally insured so that an innocent bank couldn't collapse due to an unfounded rumour of insolvency.

The unmistakeable conclusion of the long period starting in the 1940s is that When banks are forbidden from giving mortgages to people who can't afford it, our financial system remains stable and reliable, our economy grows steadily, and our society prospers.

In other words, personal greed and irresponsibility may be problems, but they're not unmanageable problems. From a public policy perspective, we have the choice of 1) creating a framework that encourages and incentivizes desirable behaviour, or 2) issuing edicts ("Don't borrow more than you can pay back!") that make demands based on moral suasion.

A century of macroeconomics and economic management demonstrates clearly that the former works and the latter does not.

As a parting note, I refer you to Philip Zimbardo, the psychologist who led the notorious Stanford Prison Experiment. After three decades of research into human behaviour, he wrote a summary of his findings called _The Lucifer Effect: Understanding How Good People Turn Evil_.

It's not a bad apple that spoils the barrel, Zimbardo argues, but a bad barrel that spoils the apples.

His research demonstrates that a lot of behaviour is situational, not dispositional. Put people into situations where they're motivated to behave badly (like the student "guards" in the Stanford Prison study or the actual guards in Abu Ghraib prison), and they're a lot more likely to behave badly.

We can respond by isolating the bad apples and removing them, but the bad barrel will just go on generating more bad apples. It make more sense to me to do something about the barrel.

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By Anonymous (anonymous) | Posted April 02, 2009 at 13:18:14

gullchased ship, I have to disagree. Even when people promise to make payments, the banks always hedge their bets. For mortgages the bank can seize your home, sell it, and pay themselves out, including expenses, and leave you with the rest. For unsecured loands like credit cards or lines of credit they might make you purchase insurance, have a co-signor/guarantor, and they'll give you a high rate of interest that they expect you to pay.

There is nothing inherently "immoral" about choosing to break a contract. In fact it is legally accepted that if you can find a better deal, you are permitted to break your contract, although you'll have to pay damages. If your deal is so good that you can pay damages and be better off, then this is an "efficient breach" and you should take it and break the contract.

If people are walking away from mortgages that they can afford, first I would question why, since it will end up costing them more in expenses for the bank to seize the home. But assuming you're right, the bank should not be out money. There should be enough value in the house for the bank to recover all that they're owed. If there isn't then the banks shouldn't have lent you that much money, or they should request additional security and/or raise your interest rate. Banks dealing with existing customers are likely to do raise interest rates, this way they can make money off of their paying customers, even if others are walking away.

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By The Real Blame (anonymous) | Posted April 02, 2009 at 13:45:27

Who's more responsible/guilty for these bad morgages, some poor shmo just trying to provide a house for his family (''I'm approved? you really think I can make these payments? well all right!!'') or the bank manager who signed the lease and ought to know better?

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By UrbanRenaissance (registered) | Posted April 02, 2009 at 16:26:03

Ryan said: "If we accept that this crisis was caused by the personal greed and irresponsibility of home buyers, we need to ask why it blew up when it did. Why not five years earlier, or a year later? Why is the housing industry not in permanent crisis?"

Personally I think it blew up when it did for one simple reason. In Hamilton, according to HamiltonGasPrices.com, gas prices peaked in mid September 2008 (shortly before things collapsed) at $1.37/L which means a 50L tank of gas cost $68.50 compare that to September of 2007 where that same tank would only cost $47, an increase of nearly 46%! To the people who were just barely meeting their financial obligations as it was, this huge cost increase was the straw that broke the camel's back.

I wonder if the speculators and oil cartels who drove up prices knew what they were leading us all to? Probably not any more than Gavrilo Princip knew that he'd indirectly start 2 world wars...

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By JonC (registered) | Posted April 02, 2009 at 17:29:32

The problems started being noticeable on a large scale back in 2007 (particularly in the southern US), but the media was too busy ignoring them for most people to notice. http://www.imf.org/external/pubs/ft/gfsr... or this http://www.boston.com/business/globe/art... The investment industry managed to keep a lid on it for a while and the mainstream media is lazy, which prolonged the magic.
Speculators dumped money into commodities (such as gas) as a safe holding spot as the realized the market was on it's death bed (but didn't tell you that). So while there is some correlation between the events, the run up in commodities prices didn't cause the housing bubble to pop so much as it was the other way around.

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By Dundasguy (anonymous) | Posted April 02, 2009 at 18:57:36

Bleed Baby, Bleed!

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By A Smith (anonymous) | Posted April 02, 2009 at 19:16:57

Ryan >> we need to ask why it blew up when it did. Why not five years earlier, or a year later?

Click the second link "1991 to current"...
www.nahb.org/page.aspx/category/sectionID=135

>> Prior to the 1990s, financial institutions weren't allowed to loan money to people who couldn't afford to pay it back.

Why would lenders want to loan money to those unable to pay it back?

>> From a public policy perspective, we have the choice of 1) creating a framework that encourages and incentivizes desirable behaviour,

So if we want to encourage investment, we should cut the capital gains rate and corporate tax rate, if we want to increase employment, we should cut payroll taxes, if we want to increase consumer and business spending, we should abolish the HST.


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By beancounter (registered) | Posted April 02, 2009 at 21:37:45

Ryan said "...letting the economy flush all those bad investments out of its system, (is) somewhat akin to the way doctors used to bleed people when they had fevers."

Although that's an interesting analogy, which coincidentally seems to equate Austrian economic theory somewhat to dangerous quackery, I think a more apt comparison would be the draining of an abscess. Blood is generally a good thing to have in your body; what you want to do is get rid of the bad stuff.

There are economists who believe, as you suggested,Ryan, that the bad stuff in the dangerously bloated economic body resulted from the manipulation of the Federal Rererve System. Artificially low rates of interest resulted in sending the wrong signals to players in the economic system and caused a great deal of malinvestment. Thus the current economic problems resulted from overstimulation of the economy. And the cure, according to "economists from Milton Friedman through John Maynard Keynes" is ... more stimulation. Would this be like pumping more pus into the abscess?

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By Ryan (registered) - website | Posted April 02, 2009 at 23:09:41

Hi beancounter,

Doctors used to believe that fevers and other ailments were caused by an oversupply of blood, and that the solution was to drain the excess and restore balance to the humours. As a model of human health it was as internally consistent as it was empirically unsound - much like Austrian economics.

The Austrian School explicitly disdains empirical evidence for its conclusions, preferring to argue from what its adherents regard as a priori premises. Their defence is that human behaviour is irreduceably complex; and their backup defence is that the Pythagorean Theorem is also derived from a priori premises (as if ancient Greek geometry has any bearing on how modern economies operate).

I'm thankful that scientists don't take this approach, or we would still be certain that the things we see around us are simply imperfect manifestations of their ideal forms on a higher plane.

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By grassroots are the way forward (registered) | Posted April 03, 2009 at 08:57:11

Who is really to blame? This is the same question another person asked, so I will try to expand on this.

Not long ago, I read a book whose title escapes me for the moment but the focus was on the corporate entity of payday loan and other similar vehicles.

What was disturbing to me in reading this book was how companies and Countrywise was mentioned as to how they preyed on the people. An example given was that they would call a person day after day pushing access to a loan, and the person would say no but after repeated phone calls, some lasting months on end, the person would succomb to the pressure and take the loan, yet in many cases the people were denied real access to the contract, nor did they really understand the terms.

The shadow banking industry that Ryan refers to, took advantage of the situation in many cases and were very predatory. De-regulation, a lack of morals within the industry has caused much of problems we are seeing today. But who pushed for de-regulation, it was the bankers themselves, so I will end my case.

While some people before who were denied access to loans, should have been able to access a micro loan, say to start up a small business. I am talking small amounts not more than say 1000 dollars.

I think people need to look further into the situation, if there is a shadow banking system, it is not a long stretch to assume that there is a shadow government as well.

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By Economista (anonymous) | Posted April 03, 2009 at 10:35:52

"if there is a shadow banking system, it is not a long stretch to assume that there is a shadow government as well"

Careful not to mix your metaphors. It's called a "shadow" banking system because it's an industry that does banking (take deposits and invest them -- sounds like a bank to me) but works outside the scope of banking rules.

Not because their existence is some kind of secret.

The issue here is derivatives. Most everyone assumed that hedge funds were failure-proof, since they used such a complex mix of long and short positions tracked by sophisticated algorithms written by Math Ph.D. Brainiacs and tweaked in realtime to maximize returns and mitigate risk across a variety of markets. And man did they maximize returns, the hedge funds outperformed nearly everyone else.

At least until Long Term Capital Management blew up, it was just assumed that hedge funds didn't have to be regulated because they hedged their own bets so efficiently (hence the name). Even after LTCM, lots of real smart people convinced themselves that it was a freaky one-off, no way it could happen again.

So they were unregulated, they paid crazy returns and seemed failsafe. As a result they grew super-massive, eventually growing even bigger than the banks.

They took aggressive long and short positions across global markets, playing havoc with currencies and flicking two-bit central banks away like unwanted boogies. They also got hot and heavy into subprime CDOs, which amazingly had AAA ratings from credit agencies because they were first on the creditor list in the event of default.

Banks were all chuckled to give mortgages to bad credit risks because they knew they could bundle them into securities and sell them off so that the hedge funds assumed the risk. The funds were happy to buy them because they thought they had an ace in the hole.

What they didn't count on was that the subprime industry would come down so fast and so hard. So many people defaulted that even the front-line creditors weren't getting paid. Because they were so leveraged (invest a little of your own, borrow the rest and pay the interest on the loan from the ROI) and they were way over their heads in hock.

The market panicked and people started trying to pull out their money -- just EXACTLY like an old-fahioned bank run. Yippe kaiay mofos, it's the wild west again. Hedge funds with half a trillion dollars in assets suddenly had crowds of investor banging on the door demanding their money (so to speak, since hedge funds don't have branches) and they had NO money to pay anyone.

They also had no money to invest anywhere. Turns out a big ole chunk of the economy was running on money invested from these funds, so when they imploded companies couldn't get their hands on capital (that's the "credit crunch" you keep hearing about).

A lot of banks were still solvent and lending money (especially in Canada, where banks weren't allowed to go to the party, boo hoo for them), but they're old-fashioned and conservative about who they give their money to, and a lot of the economy was running on loosey-goosey unregulated fund money.

Now we have a global economy with half the financial system killed off, terrified investors who won't lend, terrified consumers who won't spend, and rock bottom interest rates that you can't cut any more.

In other words, we're so screwed.

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By nobrainer (registered) | Posted April 03, 2009 at 11:06:49

Just found this great 1999 quote from Larry H. Summers, President Clinton's Teasury Secretary back when the US deregulated the financial industry and now the director of Obama's National Economic Council....

"Today Congress voted to update the rules that have governed financial services since the Great Depression and replace them with a system for the 21st century. This historic legislation will better enable American companies to compete in the new economy."

http://www.nytimes.com/1999/11/05/busine...

Pure awesome.

Hows that system working for you, there Larry?

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