Sunday, December 30, 2007
What caused the financial meltdown?
One theory is that a feckless Alan Greenspan cranked interest rates down too close to zero and left them there too long. The result was excessive creation of money, which inflated asset bubbles. A given asset category was inflated to the extent that it had machinery for rapidly turning over money; real estate suffered so badly because the mortgage industry had a pre-deployed infrastructure that hooked right up to the printing presses.
But the longer I think about it, the less I believe the interest rate theory. The main direct effect of the government loaning out money cheaply is to cause inflation. In standard hyperinflation, risk pricing is refined to a high art. For example, restaurants call the farmers every few hours to lock in a price for replacements for the vegetables used since the last call (to spend the money from their customers before it wastes away). growing up in that environment get the time value of money with mother's milk. Hyperinflation also causes a flight from monetary instruments to hard assets of all kinds.
What we saw preceding the present meltdown was the polar opposite: careful, systematic ignoring of the time value of money. The waitresses buying mansions, the bond insurers, and everybody in between, were all smoking crack on an epic scale. Monetary instruments were prized, the more complex the better.
As Market Ticker lucidly describes in this article, what we have is not an asset bubble, but a credit bubble. The Fed did not print a mountain of money. Rather, money already in the system was loaned out, changed hands in a purchase, was redeposited back into a financial institution, was loaned out again, and so on and so forth. For each new loan, the creditor could treat the balance due almost like real money—it could be bought, sold, traded, repackaged, even borrowed against—and that is the real source of the price inflation and supply glut that developed over the past 5 years. For a while, that sort of spiral looks virtuous. The easier it is to create debt, the richer everybody gets.
One could argue that the U.S. Federal Reserve and other central banks had primed the pump, but it's too big a leap from borrowing money merely at low rates to loaning it back out with total indifference to repayment. One could also argue that the central bankers were remiss in the securities they would accept in temporary open market operations, and perhaps that made some contribution, but it would have been little trouble for a bank to pawn only its sound collateral. In any event, temporary operations are just that—temporary—and have to be repaid with interest in a few weeks or months.
Nor does simple rapacious cheating explain the problems. A professional cheat slyly shifts the risk, so that the counterparty eats the whole loss. In many cases in this meltdown, the biggest cheaters kept the loans on their own books, and even many conservative organizations have taken painful losses.
No, the failure here was regulatory. The government regulators should have required that promised payments only be reported as an asset to the extent that they are likely to be paid. And then they should have randomly audited payment obligation contracts, from individual credit card purchases to giant corporate insurance deals, to verify that the probability of repayment was at least vaguely as promised.
This regulation would not have needed to be invasive or risky. One does not need to split legal hairs or make three-significant-figure measurements to determine that a $10/hour laborer cannot afford a $650k house. The thresholds can be set to ignore transactions that are unprofitable or even moderately risk, and still catch the stuntman transactions. The cost of appropriate regulation would have been a small fraction of a percent of each transaction, the interference with productive endeavors would have been minimal, and they would have uncovered systematic risk mispricing years before it became a civilization-threatening problem.