Financial Fiasco: How America's Infatuation With Homeownership and Easy Money Created the Financial Crisis

FINANCIAL

FIASCO

JOHAN NORBERG

FINANCIAL

FIASCO

HOW AMERICA'S INFATUATION

WITH HOMEOWNERSHIP AND EASY MONEY

CREATED THE ECONOMIC CRISIS

Copyright © 2009 by Cato Institute.

All rights reserved.

First Paperback Printing: 2012

Library of Congress Cataloging-in-Publication Data

Norberg, Johan, 1973–

  Financial fiasco : how America’s infatuation with homeownership and easy money created the economic crisis / Johan Norberg.

    p. cm.

  Includes bibliographical references and index.

  ISBN 978-1-935308-13-3 (alk. paper)

   1. Home ownership—Government policy—United States. 2. Financial crisis— United States—History—21st century. 3. Keynesian economics.

I. Title.

HD7287.82.U6UN67 2009

330.973—dc22                                                         2009026629

Cover design by Jon Meyers.

Printed in the United States of America.

CATO INSTITUTE

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www.cato.org

For Alexander

—who will look back on these as the good old days.

We will not have any more crashes in our time. I find the markets very interesting, and the prices low. So where should a crisis come from?

—John Maynard Keynes, 1927

The most common beginning of disaster was a sense of security.

—Marcus Velleius Paterculus, Compendium of Roman History

Contents

PREFACE TO THE PAPERBACK EDITION

PREFACE TO THE FIRST EDITION

1. PREEMPTIVE KEYNESIANISM

2. CASTLES IN THE AIR

3. HOW TO BUILD FINANCIAL WEAPONS OF MASS DESTRUCTION

4. HURRICANE SEASON

5. MADLY IN ALL DIRECTIONS

6. TOMORROW CAPITALISM?

7. OOPS, WE DID IT AGAIN

MY DEBTS

NOTES

REFERENCES

INDEX

Preface to the Paperback Edition

In the last three years, policymakers in the United States, Europe, and China have responded forcefully to the great recession. A crisis caused by cheap money, indebtedness, and bad investments has been met with even cheaper money and more debt and by subsidizing and protecting bad investments and overproduction in the housing sector, the infrastructure, and the car industry. In short, they are trying to do what the Federal Reserve did in 2001, when it saved the economy from a bursting bubble by inflating a new one, with disastrous results.

In this new edition, I have not changed the original text, but I have added a new chapter about government action in the wake of the crisis and about how the financial fiasco resulted in the euro crisis. It is much too early to tell whether these actions will have the intended effect. It could instead result in investors fleeing governments suffering under unsustainable debts. There might be a hard landing in China, the euro could collapse, and there might be a crisis of confidence in the dollar.

But there is also the chance that these short-term measures will succeed in inspiring our animal spirits more than market opportunities and hard data could have done on their own. In that case, we will have another episode of short-term investments, new bubbles, and a reinforced belief that investors will always be saved by taxpayers and the printing presses, no matter how much they engage in reckless lending and speculation.

At times when listening to politicians and businessmen these last few years, it has felt like we are living in a 2008 article from the satirical newspaper The Onion:

A panel of top business leaders testified before Congress about the worsening recession Monday, demanding the government provide Americans with a new irresponsible and largely illusory economic bubble in which to invest.

Unfortunately, the reality we face is much less amusing.

Stockholm, Sweden, March 2012

Preface to the First Edition

I can calculate the motions of the heavenly bodies, but not the madness of people.

—Isaac Newton, after losing a fortune in the South Sea Bubble in 1720

In the fall of 1991, a high-pressure system from northern Canada collided with a powerful low-pressure system over the coast of New England. The large temperature contrast in such a small area gave rise to a cyclone. The cyclone, in turn, absorbed a nearby dying hurricane, which created an enormously powerful storm. The winds at times attained 75 miles per hour, and 35-foot waves shook unfortunate seafarers. The biggest individual wave measured was 100 feet high.

Meteorologist Bob Case at the National Weather Service in Boston explained that circumstances were perfect for the emergence of a storm. Three independent weather phenomena happened to occur at the exact times and places required for them to interact to create the most severe storm in living memory, causing great loss of human life and property. Circumstances were—unfortunately—perfect for devastation.

The world has just been struck by a perfect financial storm. A series of circumstances that individually would not have had to lead to disaster—low- and middle-income countries starting to save money; the head of a central bank’s wishing to avoid a crisis; political demands to expand homeownership; new financial instruments; and new banking regulations, credit-rating requirements, and accounting rules intended to prevent cheating—came into existence at the same time and reinforced one another into what Alan Greenspan has called a once-in-a-century event. Circumstances were perfect for a financial storm so tremendous that few people now alive have seen anything like it. The monster waves are swallowing gigantic banks and long-established industrial companies alike. The wind gusts are tearing apart entire economies.

Many politicians and businesspeople who use the perfect storm metaphor for this crisis do so to explain its catastrophic consequences. They believe they took all the necessary precautions and sailed their ships the way they should, but that they happened to find themselves in a storm beyond their control. As a result, they cannot take responsibility for the losses and problems that have arisen. However, my intention in writing this book is to show that each circumstance that led to the crisis—each low and high, and each colliding hurricane—was the result of conscious actions on the part of decisionmakers in companies, government agencies, and political institutions.

What makes today’s crisis unique is that it has taken such a short time to wash over practically every corner of the world. Other countries have been negatively affected by the backwash of national crises throughout the 20th century, but never before has a financial crisis as such happened in so many places at the same time and in such a similar form. The panic went global in a moment. Two hundred years ago, the Rothschild brothers could earn a fortune by being spread across many European cities: Nathan lived in London, Amschel in Frankfurt, James in Paris, Carl in Amsterdam, and Salomon sometimes here and sometimes there. This enabled them to obtain information from one another immediately, so that before anyone else, they could buy securities and resources where they were cheapest and sell them where they were dearest.¹

Today computers, satellites, and global media have given us a global market where each player can be a mini-Rothschild. This makes it harder for anyone to profit from being better informed, and it makes the division of labor and the use of resources more efficient, which gives us all greater opportunities. But it has also given rise to new risks, as bad news now travels so fast across the globe—especially since the media are becoming ever more likely to shout at the top of their voice. In fact, a comparison shows that they have been significantly more alarmist this time than they were after the 1929 stock market crash.² And when people are alarmed, they all simultaneously stop consuming and lending. Trouble on Wall Street soon leads to a 99.7 percent fall in the sale of trucks by Volvo in Sweden, to riots in eastern European democracies, to half of China’s toy exporters having to close up shop, and to Taiwanese animal shelters receiving lots of dogs that households can no longer afford to care for.³ The globalization that only yesterday seemed so relentless has changed into its opposite. Right now we are experiencing a fall in global trade, investment, transportation, migration, and tourism. People all over the world are losing their jobs, their businesses, and their homes—and yet what we have seen so far is just the beginning of the recession.

We are experiencing the first global financial crisis in history, and that has rapidly given rise to a widespread reaction against globalization and free markets. Faith in big and active government has made an improbably fast comeback. To someone like myself, who believes that the free-market economies and globalized markets that have evolved over the past few decades have created fantastic opportunities for rich and poor countries alike, it has felt particularly important to understand this crisis.

This is the story of what happened and why it happened. It was written during the most dramatic months, when the sky seemed to be descending on our heads. It builds on the observations of participants and onlookers during these months and on the background to the events that unfolded. It is inevitable that our field of vision is restricted at this time, since we are still so close to the events. Journalists and researchers are hard at work right now analyzing and explaining the anatomy of the crisis in a wide range of fields. Our knowledge will grow, and it will be revised on many counts. Some of the low- and high-pressure systems that I describe may turn out to have been much more important for the storm than I believe now, others perhaps less. I expect us eventually to find out that some events actually occurred in an entirely different way from what we believe today. This book is an attempt to solve a jigsaw puzzle showing a changing picture. I would like you to consider it a first historical sketch.

Why should someone whose specialty is the history of ideas write a book about a financial crisis? Like many economists, I consider it a problem today that academic training in finance provides ever more advanced knowledge in an ever-narrower field.⁴ Many of the brightest students now major in finance or business, but they leave college without having an overall idea of the function and interlink-ages of the economic system or in-depth knowledge of economic history. The typical career in the financial market lasts a quarter of a century, meaning that the average person will experience only one major crisis. Lessons are thus lost, and each generation repeats the same mistakes.

Moreover, as a historian of ideas, I have learned that the interaction of ideas, politics, and economics is what governs the fate of the world. Economic crises in particular have led to political paradigm shifts and to the transformation of entire societies. Those who do not study economics are doomed to repeat the big economic mistakes of history. Crises strike us all hard. There is something deeply unsatisfactory— bordering on undemocratic—about the fact that people may have their lives shattered because of monetary policy and financial instruments that are sometimes felt to be the preserve of a small circle of economists and market players. Seldom have so many people been so heavily struck by something of which they understand so little. War is simply too important to be left to generals, and the financial markets are too important to be left to financial analysts and economists.

For this reason, I have tried to write this book for those who have no previous knowledge of financial markets. The first three chapters deal with the prelude to the crisis—the various factors that then meet in chapter 4 and reinforce one another into an historic financial chaos whose consequences I describe in chapters 5 and 6.

Chapter 1: Monetary policy. How the U.S. central bank (the Fed) and the surpluses of fast-growing emerging economies made money cheaper than ever in the past decade, and why that money ended up in people’s homes.

Chapter 2: Housing policy. The story of how U.S. politicians—both Democrats and Republicans—worked systematically to increase the share of families who owned their homes, even when that undermined traditional requirements of creditworthiness.

Chapter 3: Financial innovations. How to transform big risks into smaller risks by repackaging them, labeling them, and selling them. How regulations and bonuses caused everybody to flock into the market for mortgage-backed securities, and why even cows could have made a fortune from such securities.

Chapter 4: The crisis. The story of how the fall of an investment bank gave the global economy cardiac arrest, a CEO was knocked to the floor by a subordinate, and a country went belly-up.

Chapter 5: Crisis management. About the largest government bailouts in history, the constant comparisons with the Great Depression of the 1930s, and ways to make a crisis worse than it already is.

Chapter 6: Conclusion. But also the beginning of something new— and worse.

I will give you a single piece of advice on how to read this book. If you approach it as a whodunit, you will not be disappointed. You will encounter a great many Wall Street tycoons, politicians, heads of central banks, and credit-rating agencies that are perfect for the role as perps.

But if we are to search for scapegoats, we might as well take a look in the mirror, too. Who was it that did not care how our pension funds were invested? Who is it that wants mortgages to be as cheap as possible? Who is it that plans home purchases that will influence our lives for decades on the basis of this week’s interest rate? Who is the first to call for regulations and bailouts whenever there is a crisis, without giving a moment’s thought to the fact that those very regulations and bailouts may cause the next crisis? The answer is ordinary people, ordinary voters, ordinary savers. The answer is you and I.

As you read in this book about all those who acted in a completely thoughtless and sometimes reckless way, please also try to think a little about your own role in the perfect storm.

By the way, there are lots of figures and large numbers in this book. It is easy to lose contact with reality, as did many of the senior executives and politicians who juggled such numbers daily. So just let me give you this one thought for the road before you start reading:

One billion is a one followed by nine zeros, or 1,000 million.

One billion seconds ago, Leonid Brezhnev became leader of the Soviet Union, which was then at the height of its power.

One billion minutes ago, the Gospel of John was written.

One billion hours ago, language started evolving.

One billion days ago, the ancestors of humans began to walk upright.

One billion years ago, multicellular life began to develop on earth.

One billion dollars is what the stock markets of the world lost every 17 minutes in 2008 and what the federal government was spending on half an hour’s worth of crisis fighting as Barack Obama assumed the presidency.

Stockholm, Sweden, February 2009

1. Preemptive Keynesianism

The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise.

—Alan Greenspan, Gold and Economic Freedom

Like so many other stories about our time, this one begins on the morning of September 11, 2001, with 19 terrorists and four passenger planes. Their attack, which cost almost 3,000 people their lives, shook our known universe. All U.S. aircraft were ordered to land immediately, and North American airspace was closed down. Routes of trade and communication were blocked as fear of additional attacks paralyzed the entire world, and speculation arose about long wars. The U.S. stock exchanges were closed; when they reopened, the New York Stock Exchange fell by more than 14 percent in one week. The United States was in a crisis, and the global economy was therefore under threat.

But there was one man on whom the world could pin its hopes. A New York economist of Hungarian-Jewish extraction with a bad back, who prefers to read and write lying down in his bathtub. A former jazz-band saxophone player who used to move in the laissez faire circles around writer Ayn Rand. A man whose dark clothes and reserved demeanor had caused his friends to nickname him the undertaker. After a career in the financial sector and a few stints as a presidential adviser, however, Alan Greenspan had become a pillar of the U.S. establishment.

Even so, few had predicted the next step in the career of this man, who had advocated both in speech and in writing that the Federal Reserve, or Fed, the U.S. central bank, should be closed down and that the market should instead determine the price of money, which should preferably be backed up by gold. In 1987, Greenspan was appointed chairman of the Fed at the age of 61. He soon acquired a reputation for expressing himself unintelligibly. This is probably a personality trait, but many believe he consciously adopted it to avoid scaring market players by using excessively strong words. In fact, this belief is symbolic of how commentators would always read into Greenspan’s behavior an element of careful thinking and cleverness. Indeed, he was soon declared a genius in his new role.

Less than two months after starting his new job, Greenspan had his baptism of fire. There is still disagreement on exactly what triggered it all, but an international dispute about exchange rates and an unexpectedly weak figure for the U.S. balance of trade gave rise to concern, and computer models with preset sell prices for stocks caused the decline in prices to spread quickly. In a single day— October 19, 1987—the New York Stock Exchange fell by almost 23 percent. It was Greenspan’s reaction to this Black Monday that laid the foundation of his fame. His response was to make an historically large cut in the benchmark interest rate and to offer freer credit. The market stabilized very quickly, and the ink of the magazines warning of a repeat of the Great Depression had hardly dried before the economy had shaken off the stock market crash and was back on track. A hero had been born.

With Greenspan at the helm, the Fed used the same modus operandi whenever crisis loomed: quickly cut the benchmark rate and pump liquidity into the economy. That is what it did at the time of the Gulf War, the Mexican peso crisis, the Asian crisis, the collapse of the Long-Term Capital Management hedge fund, the worries about the millennium bug, and the dot-com crash—and on each occasion, commentators were surprised by the mildness of the subsequent downturn. In someone with Greenspan’s clear-cut opinions about the importance of free markets, this readiness to throw money at all problems was surprising. However, to a direct question in Congress about his old laissez-faire views of monetary policy, Greenspan replied, That’s a long time ago, and I no longer subscribe to those views.¹ And even though he hung onto most of his other market-friendly views, he no longer felt bound by ideological principles. As an economist told the New York Times when Greenspan was appointed Fed chairman:

He isn’t a Keynesian. He isn’t a monetarist. He isn’t a supply-sider. If he’s anything, he’s a pragmatist, and as such, he is somewhat unpredictable.²

But regardless of what theory Greenspan’s actions built on, they caused him to be declared a genius in some circles, where he was viewed as a magician who had lifted growth and tamed the business cycle. Journalist Bob Woodward, of Watergate fame, chose the title Maestro for his book about Greenspan, who is there credited with orchestrating the 1990s boom in the United States. During the 2000 presidential election, the Republican primary candidate John McCain joked that he would reappoint the then 76-year-old Fed chairman—even if he were to die: I’d prop him up and put a pair of dark glasses on him and keep him as long as we could.³

An Inflationary Boom of Some Sort

After September 11, 2001, the world once more looked to Alan Greenspan, the Fed chairman who, like Archimedes, got his best ideas in his bath. And he did not hold his fire. The Fed started to increase the amount of money in the economy. All of a sudden, the annual rate of increase of M2—one of the most common measures of the money supply—soared to 10 percent. In mid-2003, it remained as high as 8 percent. In other words, the metaphorical printing press in the Fed’s basement was running red-hot. This was part of an effort to force down the Fed funds rate—the benchmark interest rate at which banks can borrow money in the short term, which is one of the Fed’s tools to control the economy. In fact, Greenspan had already been lowering this rate rapidly throughout 2001 to prepare for a looming economic downturn, and after 9/11 he pushed it down aggressively. At the beginning of 2001, banks had to pay 6.25 percent interest on the money they borrowed; at the end of the year, they could get away with 1.75 percent—and they would not have to pay more until almost three years later. But this was not enough for the Fed, and the market players were clamoring for more to cope with the downturn.

Basically, this desire to help the economy squares well with the task that the Fed has been given by Congress. Unlike most other central banks in the world, the Fed has a duty not only to maintain price stability but also to ensure that the unemployment rate is as low as possible and that long-term interest rates are low. This has made many European politicians view the Fed as a model. What’s more, there was concern at the Fed that prices would start falling. One Fed governor who was an expert on the Great Depression, Ben Bernanke, convinced Greenspan and their colleagues that the country was at risk of entering a deflationary spiral as it had in the 1930s and as Japan had done in the 1990s.

But there was in fact no collapsing economy in need of being propped up. Only two months after 9/11, the stock exchange was back at a higher level; in 2002, the United States saw economic growth of 1.6 percent. Even so, the Fed worried that higher interest rates could halt the rise and thus continued making cuts. Alan Greenspan himself has admitted that at least the last rate cut, down to 1 percent in June 2003, was not necessary:

We agreed on the reduction despite our consensus that the economy probably did not need yet another rate cut. The stock market had finally begun to revive, and our forecasts called for much stronger GDP [gross domestic product] growth in the year’s second half. Yet we went ahead on the basis of a balancing of risk. We wanted to shut down the possibility of corrosive deflation; we were willing to chance that by cutting rates we might foster a bubble, an inflationary boom of some sort, which we would subsequently have to address.⁴

One percent was the lowest the rate had been in half a century, and in August the Fed promised it would remain at that level for a considerable period. In December, promises were again made about very low interest rates for a long time to come.⁵ The most ardent defender of the record-low rates was Bernanke. The Fed ended up keeping its benchmark rate as low as 1 percent for a full year; once it finally began edging it upward, it did so in tiny, cautious steps even though the wheels of the economy were by then turning very fast. Only in June 2004 did the Fed funds rate reach 1.25 percent, and it took almost two more years to attain 5 percent. The overall effect of this for borrowers was that, over a period of two and a half years, inflation reduced the value of their loans by more than the total cost of interest. In other words, borrowing was not just free— you were actually paid to borrow.⁶ And while short-term rates