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Phil-osophically Speaking

In The Shadows

The Great Depression was a pivotal event whose causes have generated much heated debate. The consensus was that the stock market crash, fueled by reckless speculation, triggered an unprecedented bank crisis. This explanation became one of those unquestioning verities, an established fact, and a datum of certainty. It also happened to be dead wrong.  


Conceit is the queen of human presumptions. What we know is often overlevereged by what we don’t know. Proximity gropes in a fog of uncertainty.  Evidence, accumulative and accumulating, needs the luxury of time to purchase perspective and understanding. 


It was not until Milton Friedman and Anna Schwartz’s A Monetary History of the United States established that monetary contraction was the true catalyst for economic calamity. It was not the loosening but the tightening of the money supply that was the real culprit.


Friedman and Schwartz’s stunning revelations, which are essentially incontestable, were published in 1963.  Well, 1963 seems rather late to discover the DNA of America’s greatest economic crisis. Still, on reflection, if Rome wasn’t built in a day why can’t we accept that great insights, like great empires, take time to evolve. Five years ago, a bursting housing bubble caused an economic trauma that still hovers over us. The upshot was borrowers could no longer afford their monthly mortgages based on inflated home prices causing these mortgages to be written down by the financial institutions that issued them.


These basic facts are undisputed. What created this bubble and the nature of its ensuing consequences has swirled in a cauldron of controversy. Liberals believe it was caused by rapacious Wall Street bankers, luring unsuspecting borrowers into buying subprime mortgages at low introductory rates, which eventually spiked to unaffordable levels. 


I’m highly skeptical, since lending money to people who can’t pay you back is no way to get rich. Nor is it convincing that mortgage originators convinced another set of greedy, gullible bankers into buying these mortgages based on the same preposterous premise. Subprime mortgages are not easily disposable, since they are securitized with other mortgages. This is why Citibank lost $50 billion; if a deal sours, the mortgage originator suffers. To believe in such a scenario is to believe the banking industry is populated by fools. The conservative explanation seemed more satisfying and believable. It was Fannie Mae and Freddie Mac subsidizing mortgages for people with poor credit who could not finance these mortgages, especially if real estate values went south. Moreover, interest rates which had averaged over the Fed’s 100 year history at 5.2 percent now hovered at 1 percent. The Bank of England, created in 1694, never had interest rates below 2 percent. The Fed would halve even that creating an enormous pool of money from which to borrow. 


Most of this borrowed money went into real estate because government subsidies drew them there. Mortgage interest rates are deductible whereas other types of personal interest such as car loans, student loans and credit cards are not.

Moreover, unlike the stock market, your primary residence gets preferential capital gains treatment. Still, we’ve subsidized the housing market for decades without igniting a massive financial meltdown. So this can’t be the whole story.


Only recently has it become clear that the crisis was not the result of Fannie or Freddie (despite needed reforms) or even the housing collapse. The timeline doesn’t fit: The housing market, after a spectacular ascent, peaked sometime in 2006, at which point construction of new houses declined. By 2007, prices also began to decline in subprime markets. The housing market was slumping badly. Nevertheless, from 2006 to September of 2008 there was no recession; in fact GDP continued to grow. All the indications are that the housing bust did not cause the recession but was only a sign of trouble ahead.


The economic wrecking ball was institutional cash pools --- money held by corporations, asset managers and mutual fund managers that dramatically accelerated. In 1990, these cash pools totaled around $200 billion; by 2008 it grew to $4 trillion, a factor of 20 in less than 20 years. That’s incredible. Putting this cash into banks, when FDIC insurance was only $100,000 doesn’t really work. There are simply not enough FDIC insured banks to sock $4 trillion away, not to mention its appalling impracticality; purchasing treasury bills was also unfeasible since you can’t get long-term rates from the government.


In order to have something liquid, short term, with little credit risk, Wall Street created the shadow banking system that indirectly made its way to people who want to buy houses. The shadow banking system is a collection of non-bank financial intermediaries between investors and borrowers that act similar to commercial banks and which grew tremendously after 2000. Like ordinary banks, shadow banks provide credit and liquidity for the financial sector. Unlike ordinary banks, however, they are under-regulated, lack access to central bank funding and are devoid of safety nets such as deposit insurance and reserve funds. The absence of deposit insurance makes it more vulnerable than mainstream banks in terms of loss of confidence and runs, which creates serious systemic risks such as fueling real estate bubbles.


It’s more complicated than this because investor inability to provide funds via short-term markets was the primary cause of the collapse of Bear Stearns and Lehman Brothers in 2008. But the fundamentals remain the same; the housing bust and bank failures were a symptom not a cause of the economic cataclysm. As was true of the 1930s, the Fed made what should have been an ordinary recession into an Armageddon. The dynamite was again monetary contraction that stealthily crept into the economic bloodstream.  By September of 2008 the Fed had been tightening the money supply for months in anticipation of inflation, which made mortgage debts even more onerous.


Words have consequences and the Fed’s statements continually cited risks of inflation, which increased the expectation of tightening the money supply to combat it. Lending was consequently thwarted and made worse by the Fed’s decision to pay bank interest on excess reserves, which was but another disincentive for banks to lend. The exact opposite of what was needed. Yet, five years later, signs of inflation are invisible, but the falling spending levels that were a consequence of the fear of it led to an historic recession. The irony is that both during the Great Depression and the great recession of 2008, most economists didn’t see the money supply as being tight at all despite the fact that it seized up credit market and sent unemployment into orbit.


What’s clear is that sound monetary policy is a great leveler; mismanaging the money supply is a sparkplug for first creating mischief and then during a crisis it can frighteningly turn into a weapon of mass destruction. There is also a personal lesson, a humbling one. The world is hard to figure out; complexities multiply and sometimes a crisis is most misunderstood when people are actually living through it. I must remember that the next time I feel so sure and self-righteous.