February 03, 2011
The Financial Crisis: Foreseeable and Preventable
Many things contributed to the Great Recession of 2007-2010. Massive foreign borrowing, excessively loose monetary policy, reckless lending practices, lax regulation, and other factors all fed into the crisis. The relative importance of different causes is still open to debate.
Economists of varied ideological bents warned of dangers in the housing and financial markets long before the crash..But there should be no dispute over the fact that there were major warning signals before the crisis. Nor should there be any dispute over the fact that more appropriate policies could have reduced the impact of the crisis, or avoided it altogether.
By 2003-2004, most analysts of international economic conditions were concerned by growing global macroeconomic imbalances, in particular, the fact that the United States was borrowing between a half trillion and a trillion dollars a year from the rest of the world. This huge capital inflow was fueling a financial and real estate boom, in ways typical of such borrowing experiences.
By 2005, most analysts agreed that these imbalances would cause serious problems, although the specific nature and timing of the problems were debated. All through 2005 and 2006, economists of varied ideological persuasions -- from Raghuram Rajan and Ken Rogoff to Nouriel Roubini and Robert Shiller -- warned of dangers accumulating in the housing and financial markets.
At this juncture, I think that -- going forward -- it might be useful to think about what the opponents of implementing financial regulation now were saying at that time. Actually, readers can join in and tell me what the FCIC dissenters (Hennessey, Holtz-Eakin, Thomas, and Wallison) had on record. Here are some random assessments:    
What could the government have done? The Bush administration could have reduced the outsized fiscal deficits that spurred foreign borrowing, and more generally could have acted to slow an overheated economy. The Federal Reserve could have raised lending rates to decelerate the credit boom. Regulators could have been more stringent about applying prudential principles to all of the complex financial operations in which financial institutions were engaging. But instead, none of these government agencies did anything.
Why was nothing done to heed the warnings? Electoral considerations may have mattered: no incumbent government wants to put the brakes on the economy before an election. Special-interest pressures undoubtedly mattered: real estate salesmen, homebuilders, financial institutions, and many borrowers had come to rely on a continuation of the boom. David Lereah, chief economist of the National Association of Realtors, whose 2006 book was titled "Why the Real Estate Boom Will Not Bust," explained to Business Week several years later, "I worked for an association promoting housing, and it was my job to represent their interests."
Ideology probably mattered. Larry Kudlow, economics editor of the conservative National Review, in 2005 dismissed "all the bubbleheads who expect housing-price crashes in Las Vegas or Naples, Florida, to bring down the consumer, the rest of the economy, and the entire stock market." Of course, the bubbleheads were exactly right, but the predictions did not accord with Kudlow’s partisan commitments or his ideology.
And so it is with the post-mortems. Politicians, special interests, and ideologues all have their reasons to insist on a particular interpretation of the crisis. And those connected to the Bush administration have strong incentives to deny that the administration could have done anything differently. But they are wrong.
For more on this last point, see this post.
In the exchange, Yves Smith presents her views here. Good for a laugh is the view propounded here (or, "if we just make the rules binding enough, all will be well," just like putting rules on monetary policy into the constitution -- it worked so well for Argentina!)
Posted by Menzie Chinn at February 3, 2011 02:40 PMdigg this | reddit
"The Bush administration could have reduced the outsized fiscal deficits that spurred foreign borrowingg, and more generally could have acted to slow an overheated economy."
Under what logic did the fiscal deficits contribute to the crisis? A fiscal deficit consists of the government's borrowing on behalf of its citizens. This should be expected to reduce the tendency of citizens to borrow on their own behalf. If you've got more money (because of a tax cut) than you otherwise would, why would you borrow more, or even borrow as much? Government debt had nothing to do directly with the crisis, and, if anything, it reduced borrowing by the private sector compared to what it otherwise would have been and thereby reduced the severity of the crisis compared to what it otherwise would have been.
And what evidence is there that the economy was overheated? There was no rapid employment growth, no ultra-low unemployment rates, no ultra-high rates of capacity utilization, no significant acceleration in unit labor costs or core consumer prices.
One may perhaps reasonably object to US fiscal policy on the grounds that the accumulation of government debt made it harder to respond to the crisis when it happened. But I see no evidence whatsoever that fiscal policy contributed to the crisis itself.
Posted by: Andy Harless at February 3, 2011 04:55 PM
I think Andy Harless is right that the fiscal deficit did not cause the private debt market collapse. However, the continuing and unsustainable international imbalances will sooner or later result in a truly disastrous result. Although strict bank regulation could have averted the crisis in private debt markets, it is doing nothing for the international imbalances. In fact, after a temporary slowdown caused by the 'financial crisis,' the international balances are quickly resuming their unhealthy trend. It appears that what is happening is that whereas before, the imbalances were supported by private and public debt accumulation, they are now supported largely by public debt accumulation.
Foreign currency interventions have got to be stopped.
Posted by: don at February 3, 2011 06:30 PM
Andy Harless is right in a riccardian equivalennce world like barro's. but is this the death knell for the fiscal deficit as a contributory factor line of reasoning, or is this the death knell for riccardian equivalence. sure seems to me like people were spending as if they never had to pay those govt. bonds back.
Posted by: Ausstin Kelly at February 6, 2011 05:19 PM
Since we know that Ricardian equivalence only holds, as far as we can tell from the empirics, about 40%, then I think we need a different framework to analyze budget deficits. Further, if we think about deficits, and fiscal policy more broadly, including the types of tax expenditures granted, etc., which bias the system toward borrowing, we can see that fiscal policy could plausibly be interpreted as helping push up the bubble in housing (don't forget deductibility on second homes...).
Greater detail in our forthcoming book, Lost Decades, by myself and Jeffry Frieden.
Posted by: Menzie Chinn at February 6, 2011 06:10 PM
Can you give me one example of a central bank being able to preempt a financial crisis in a democracy. To use the blunt instrument of monetary policy before an economy and the media has felt any pain I just don't think that is a practical answer.
The second possibility would be to target the specific sector as China is trying to do currently. I can only imagine the lobbying that would ensue here in the U.S.
A capital allocation process which includes besides banks many shadow banking factors such as the stock market and venture capital, etc. will always at some point make wrong decisions. What is necessary is once the issue is in the scope of the public mind that the Central Bank respond vigorously.
Allowing the politicians and their advisors to let Lehman fail was such a waste of resources. The Central Bank should have been a little more forceful in presenting their views. Of course, as someone who was watching the hearings in Congress I can understand their fear.
Posted by: Alan Manas at February 7, 2011 03:59 PM
"if we think about deficits, and fiscal policy more broadly, including the types of tax expenditures granted, etc., which bias the system toward borrowing, we can see that fiscal policy could plausibly be interpreted as helping push up the bubble in housing"
Cutting tax rates reduces the incentives associated with deductions that encourage borrowing, so it would tend to push down the bubble. Tax rate reductions were the primary feature of Bush's fiscal policy. Reducing borrowing incentives was even an explicit part of the rationale for the cut in the dividend tax.
Now it's certainly true that the Bush administration (if we heroically assume that Congress would have coopreated) could have reduced or eliminated the mortgage interest deduction, and this would have resulted in both a smaller deficit and a smaller housing bubble. But this isn't the way one usually analyses fiscal policy (nor is it something that was being contemplated by either party at the time). Public finance people might imagine a revenue-neutral tax reform that would reduce the mortgage interest deduction (and would clearly have reduced conditions leading to the crisis), while macro people might imagine a lump sum tax increase (which, by further reducing interest rates, would have increased conditions leading to the crisis). In the combined policy -- a reduction in the deduction without a revenue offset -- the former effect would likely have predominated, but this doesn't support the view that defcits per se were part of the problem.
Ausstin has mistaken the role of Ricardian Equivalence in my argument. My argument does not require 100%, or even 40%, Ricardian equivalence. It requires only that there be at least 0% Ricardian equivalence, rather than perversely anti-Ricardian behavior where for some bizarre reason the expectation of future taxes causes people to consume more.
Posted by: Andy Harless at February 9, 2011 02:03 PM