Mark Twain famously said that at age 60 he was surprised to find out he was right about something as he was at age 20 when he found out he was wrong about something.
This must especially be true of economists who on Oct. 24, 2009 will mark the 80th anniversary of the stock market crash that led to America’s greatest and most prolonged depression. Despite the passage of time, millions of words dissecting the crisis, comprehending the Great Depression is, in the words of its foremost scholar, Federal Reserve Chairman, Ben Bernanke, a significant and daunting challenge.
Since WWII, economists have effectively used, intermittently, the fiscal accelerator and the fiscal brakes to keep America’s economic juggernaut from veering too wildly out of control. It became an article of faith that our knowledge on managing the economy had deepened; how else does one explain why recessions and downturns have become progressively shorter and shallower.
Making sense then, after so short a time, of the gigantic forces that recently crippled the economy would be the height of conceit. But a trip of a thousand miles, including an intellectual journey, must begin with a single step.
In the realm of settled thought, it is scripture among classical, free market economists that the actions of millions of people conducting billions of transactions will, in the aggregate, prove the most rational and accurate measure of true value. Such notions were as fixed as Newtonian laws; but in the wake of the latest financial carnage some of its most cherished, creedal presumptions, have been challenged.
Pandemonium in markets, however, is nothing new and, in studying them, one gleans perspective, if not a measure of understanding. In 1907, the closing of some large New York banks triggered a panic, as frightened depositors sought to withdraw all of their cash. With only $12 of cash for every $100 of deposits, the entire U.S. banking system was on the verge of a nervous breakdown. Under the leadership of financial titan, the imperious J.P. Morgan, the banks refused to pay cash to depositors on demand stopping the panic dead in its tracks. As time passed, the hysteria subsided, confidence in banks was restored and the globe went spinning on its axis without a new series of runs.
J.P. Morgan, the hero of our little story, was immensely rich and extraordinarily powerful but, alas, he was also mortal. What was needed was institutional reform enabling banks to convert their assets into cash rapidly, not by borrowing from other banks, which is useless during a widespread panic, but to create for banks, so to speak, an emergency printing press. Hence, the “Federal Reserve Act of 1913” was created to prevent disruptions produced by restrictions of payments. The 12 regional banks established by the Act would be under the supervision of a Federal Reserve Board in Washington and were empowered to act as a lender of last resort.
In the 1920s, the Federal Reserve served as an effective regulator by increasing the rate of monetary growth when the economy weakened and reducing it when it burned too hot. The upshot was a stable monetary climate yielding low inflation and substantial economic growth. Everything was coming up roses until the market crashed and the system failed to do what it was set up to do: Stop panics. Why?
Some economic historians believe the untimely death of Benjamin Stone in 1928, the first head of the Federal Reserve Bank of New York, left the bankers feeling uncertain and irresolute in the face of an unprecedented financial collapse. Others contend that the failure was related to America’s adherence to the gold standard; a country that allows its currency to be exchanged for a fixed amount of gold on demand cannot increase its money supply without increasing its gold supply.
Whatever the source of its fecklessness, the Federal Reserve first allowed the quantity of money to decline and then, in 1931, after two years of depression, recklessly raised the rate of interest that it charged banks for loans more sharply than at any time in its history. Borrowing, as a result, became next to impossible, freezing the economy and plunging the country into a deep and precipitous deflation.
The Depression’s extreme severity, Milton Friedman and Anna Schwartz persuasively argued, happened because the Fed allowed money and credit to tighten to the point of strangulation. The Federal Reserve should have engaged, said Friedman, in large-scale open market purchases of treasury bonds that would have rescued the banks by providing the additional cash to meet the demands of their depositors. Ben Bernanke, before Friedman’s death, toasted the brilliant economist for finding an antidote to paralyzing and consuming deflation.
Yet, the financial storm of 2008 came. It began, I believe, not because Adam Smith’s invisible hand clenched into an angry fist, but because of policies engineered by the government. With the bursting of the dot-com bubble and the after-shocks of 9/11, the then-Federal Reserve chairman, Alan Greenspan, suppressed short-term interest rates to about 1 percent, a rate not seen since the early 1950s.
Lowering interest rates during economic downturns encourages more lending and borrowing to spur the economy. It’s an effective tool, providing rates aren’t too low or overstays its welcome. But this, indeed, is what transpired: Rates were too low for too long. As interest rates bottomed, money flowed like a mighty river to irrigate investments that depended heavily on debt, since interest rates make debt more affordable.
Because it is a superior form of collateral, the investment incurring the most debt was housing. First time buyers, developers and speculators bought more and more homes for the same money. House prices, because of demand, soared. Meanwhile, low interest rates caused the stock market to escalate to artificial heights.
The seeds of this crisis, for all its complexity, was, pure and simple, an overabundance of easy money. This liquidity dovetailed very nicely with the Community Reinvestment Act of 1977 and subsequent amendments boosting and expanding mortgage loans in areas of extreme blight by easing credit requirements. In short, loose money and relaxed credit was a bankrupting combination.
Fannie and Freddie Mac, government-backed loaning institutions, exuberantly responded to the new, hip-hop music of mortgage lending. So did licensed and unlicensed mortgage brokers, homeowners who refinanced more debt to pay their initial debts and even regular banks who, to compete, assumed risky mortgages to compete.
The blind were leading the blind.
Why no one saw that a precipitous drop in housing prices becomes an existential threat to bank solvency is an interesting question. Hindsight, of course, is 20/20 and when a bubble is inflating you can only suspect, not know, whether it’s a bubble or a positive change in fundamentals until, in fact, it bursts. With the real estate market appreciating so magnificently, few wanted to rain on the parade by entertaining such dark thoughts, much less voicing them.
Meanwhile, the poor saving habits of Americans left them unprepared for the upcoming shock while, conversely, excessive savings by Asian countries looking for a place to put their money led to an avalanche of cash that made borrowing even easier for Americans. America was living on credit and to make a bad situation worse, the major financial houses repackaged mortgage debt into various and sundry bundles labeling it with all kinds of fancy names that received the approval of credit rating agencies. An astute observer referred to these instruments, which became commonplace, as “financial weapons of mass destruction.”
The pooling of mortgages reduced the risk of default by diversification, but less-protected securities did not stay with the originators but were marketed to big investors that believed risk spells reward. When home prices fell, many homeowners owed more on their homes than the homes were worth and began defaulting on their mortgages. As mortgage defaults rose, investors became fearful that securities backed by those mortgage payments would also default, undermining the value of those securities. In this perilous environment, lenders became reluctant to lend money, even to other institutions because of uncertainty about which borrowers might owe money to whom and how much. “You don’t know, Warren Buffett colorfully noted, “who’s swimming naked until the tide goes out.
Ultimately, day-to-day business activity, such as ordering inventories and paying employees, came to a screeching halt. With mortgages being sold to foreign banks and investors, the financial cataclysm became globalized. When the government finally intervened and froze assets, mark to market reevaluation revealed, with appalling clarity, the depressed value of these assets. With this revelation – the chickens came home to roost. By 2008, not only were there more foreclosures of homes than purchases, but also Fannie and Freddie were so overburdened by crushing debt the government placed them into conservatorship.
So what can we conclude? First, corporate greed and deregulation were not the primary culprits of the crisis. The underlying cause was that subprime mortgages, in just five years, tripled from 400 billion to 1.2 trillion. Nor can we scapegoat the unregulated mortgage brokers or their predatory lending. Whatever their moral compass, they responded to and did not create demand. What created demand, or most of it, was government policy.
The FDIC-insured banks, government-backed Fannie and Freddie and the FHA were all guaranteed the same bad mortgages based on the government’s own requirements. The argument that because Fannie and Freddie were shareholder-owned implicating private profit in the financial collapse is unconvincing, since almost two-thirds of all bad mortgages were bought by government agencies.
But this is not to maintain that because capitalism is a dynamo for sustained economic growth, that it’s without sin. Markets are cyclical, at times — unstable, and subject to manipulation requiring restrained, but measured counterweights. Moreover, while we should never twist or temporize facts to fit our prejudices and preconceptions, it seems to me, in light of the magnitude of this crisis, where untamed forces debilitated the American economy and world markets with cyclonic speed, that reflection and humility is not too much to ask for economists of every ideological bent.
I was reminded of this lesson in humility when I visited the stone library built by President John Adams’ grandson, Charles Francis Adams, housing 14,000 books belonging to his father, John Quincy Adams, sixth president of the United States. The library is a monument to the Adams family’s unparalleled achievements as America’s first and most distinguished family and the American people, to whose service they were totally devoted.
What I found so striking about the building’s foundation, was the white-and-blue diamond tiles whose pattern was flawlessly and exquisitely quilted together, with the exception of a single tile, which Charles Francis directed a slight blemish in the pattern be made. The blemish stood as a solemn reminder to him, as well, he hoped, to a prideful humanity, to walk humbly in life – for only God is perfect.