A Brief History of Doom

by Richard Vague

  In Europe, the governance of the recovery process among so many different countries was more difficult and fragmented than in the United States. Germany, the European Union’s most influential member, was guided by fear of inflation, a wholly misplaced fear given the pervasive deflation inherent in a financial crisis, and it therefore constrained the effectiveness of Europe’s Central Bank in righting Europe’s economy. Nevertheless, Europe, too, muddled forward.

  The United States had learned its lesson from the Great Depression. It intervened to prevent contraction, a vastly better response than in 1929. Neither the Federal Reserve, nor the Office of the Comptroller of the Currency, nor the Treasury, nor the president, nor the Congress had foreseen the crisis, but when the economy began to unravel, they did enough things correctly enough and swiftly enough to avoid a deeper crisis. However, because the government intervened to stop loan contraction, the United States emerged from its 2008 crisis with still-high levels of private debt. This burden dampened growth.

  The United States focused its government largesse on banks and corporations, and it largely neglected individuals. The executives of many large institutions that had helped cause the crisis kept their jobs, with trillions in taxpayer aid quickly provided to their institutions. But the Obama administration made no broadly targeted effort to address those whose extended unemployment hurt their chances to return to the job market nor to help those with underwater mortgages. Some advisers to Donald Trump attributed his presidential victory directly to the crisis of 2008 and the lingering impact on the lives of middle-class voters.

  Most economists missed forecasting the great Global Crisis of 2008. The forecasting blunder was so widely noted that policymakers and economists, including former Federal Reserve chair Alan Greenspan and former U.S. Treasury secretary Timothy Geithner hurried to assert how impossible it was, and is, to predict crises. Some characterized 2008 as a black swan event—too rare to predict yet catastrophic.70

  Ben Bernanke exemplified this blindness. In February 2004, he gave a speech known as “The Great Moderation,” which was enthusiastically received and frequently referenced. In it, he stated that “one of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility. . . . My view is that improvements in monetary policy, though certainly not the only factor, have probably been an important source of [this] Great Moderation.”71

  At the very moment he spoke these words, the mortgage lending craze was in high gear. The past twenty years of moderation he cited had been anything but moderate. It had included the S&L crisis, the junk bond crisis, and many other crises of the 1980s (see Chapter 2), as well as the first collapse of high-flying Internet stocks in the late 1990s and early 2000s. Bernanke’s obliviousness continued over the next three years. Shortly before housing prices fell and the lending industry crumbled, in July 2005, he said, “We’ve never had a decline in house prices on a nationwide basis.”72 His statement conveniently overlooked the dramatic fall in house prices in the Great Depression. Three months later, on October 20, 2005, he conceded that “speculative activity” in houses had increased but asserted that “at a national level these price increases largely reflect strong economic fundamentals.”73 And a short time later, on February 15, 2006, he said, “Housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise.”74 This was followed by another statement on March 28, 2007: “At this juncture, however, the impact on the broader economy and financial markets of the problems in the sub-prime market seems likely to be contained.”75 On January 10, 2008, a point when we would later learn the recession had already begun, he intoned that “the Federal Reserve is not currently forecasting a recession.”76

  Whatever the case, it wasn’t true that the 2008 crisis couldn’t be foreseen or predicated—or even prevented. To do so, however, forecasters would have had to look elsewhere to data not included in prevailing models: private debt. In fact, a small coterie of heterodox economists, including Steve Keen, Wynne Godley, and Ann Pettifor, had done precisely that. But their analysis and warnings had gone unheeded.

  Conclusion

  The Crisis Next Time—and Policy Solutions

  When I talk to noneconomists about my work on financial crises, I usually get these questions: where and when are the next financial crises, and what can we do to prevent them?

  At the time of this writing, the winter of 2018, while overall U.S. private debt is still high, private debt-to-GDP growth is not occurring at a pace that indicates a pending national financial crisis. Overall household debt growth, especially mortgages, is benign, though there are segments within household debt, such as student loans, where overly rapid growth suggests problems. Corporate debt-to-GDP is growing, and high growth within certain segments does merit concern, notably the “highly leveraged” segment. But in aggregate, it remains below the level that would cause concern about a near-term system-wide financial crisis.

  Globally, however, there are a small number of countries that do have both very high private debt growth and overall private debt levels that together are above the thresholds of concern. There is, therefore, a good chance of a financial crisis in these countries, although it is beyond the scope of this book to examine this in greater detail. They are potential or pending crises because private debt there is still growing, and, as we’ve seen, continued private debt growth, however improvident, can in some cases unnaturally extend the life of the boom well past the point of overcapacity.

  The largest potential concern is China, but, as we saw in Chapter 3, China has remarkable and demonstrated expertise in finding ways to remediate its lending institutions when they have excessive bad debt. In fact, China’s massive, innovative intervention to rescue its major banks in the 1999 crisis would suggest an almost boundless willingness and ability to prevent their failure—uniquely feasible since China’s government owns or controls almost all the entities involved in any rescue equation—banks, major companies, regulators, and more. Still, private debt growth (or, more accurately, nongovernment debt growth) in China is the largest such growth in history. In the United States, when a major lender gets in trouble, depositors, funders, and investors have no ultimate certainty that the government will step in to rescue that lender. In China, the opposite assumption holds.

  But preventing institutional failure does not mean that the accumulation of overcapacity will stop, and China’s continued growth relentlessly adds to its already massive overcapacity. There are fifty million empty homes in China, most owned as largely unused second homes by its citizens. How many millions more can be added? Can this go on indefinitely if China keeps using money creation that comes from lending to fuel it and accounting legerdemain to prop up its institutions? If not, it means that China’s GDP growth will slow markedly in the next several years.

  This is a multitrillion-dollar question and in my view the greatest global economic question of the moment. A major portion of the world’s economic growth over the last decade has come from China, and therefore much hinges on the answer. The timeline of Japan’s 1900s crisis is instructive when considering China. Japan reached a point of significant overcapacity in the late 1980s but did not truly begin to intervene on behalf of troubled banks until 1998, a process that continued until the mid-2000s. And even though Japan already had excess capacity by the end of the 1980s, loan growth continued to create still more overcapacity until the late 1990s. Japan then struggled with that overcapacity for a generation.

  Some of the other countries that risk crisis are well within China’s economic orbit and tend to follow trends there. They have concerning private debt growth and are particularly vulnerable to a slowdown in China, but they don’t have the same broad government control as China to deal with a crisis and therefore have greater risk for a widespread calamity.

  As for the United States, do we now have t
he regulations necessary to prevent the next crisis?

  The answer is no. As this book has shown, lending markets have repeatedly succumbed to financial crisis and in fact are prone to those crises. They have occurred in every environment: under different types of governments, different tax and regulatory regimes, in the presence and absence of a central bank, and with and without a gold standard.

  Regulations often do not adequately address the problems they target. A case in point is the Sarbanes-Oxley Act, passed in 2002 in the wake of the WorldCom and Enron financial scandals. It was enacted to help prevent corporate misbehavior and was massive in scope and highly expensive to implement and maintain. However, it did nothing to mitigate the misbehavior just two to three short years later of any number of subprime lenders, conventional lenders, mortgage banks, and investment banks—misbehavior that led to the crisis of 2008.

  Dodd-Frank, the 2010 law passed in hopes of preventing the next crisis, is in many respects helpful. Dodd-Frank did a number of things designed to increase the safety of the banks and the financial system, including increasing capital and leverage ratio requirements, increasing liquidity requirements, adding rules to curb abusive lending practices, increasing scrutiny of financial institutions deemed “too big to fail” (including a plan for more orderly shutdown of troubled institutions), extending oversight to certain nonbank financial firms, limiting banks’ proprietary trading operations, regulating certain derivatives, and regulating credit ratings agencies.

  But it will not prevent the next crisis.

  To speak to just one aspect of Dodd-Frank, the increases in capital and liquidity levels it requires at banks are not enough to be truly effective. Banks are inherently very highly leveraged and therefore highly fragile institutions, and Dodd-Frank’s modest changes in capital and liquidity requirements will do little to change that. Truly meaningful capital level changes would be so large as to completely change the profitability and pricing requirements of the industry. As regards liquidity, it always disappears in a crisis, even if it has been plentiful, unless it is locked in a quantity and for a period that extends beyond the crisis, which is more than the new requirements mandate.

  Furthermore, banks are expert in designing ways to sidestep such requirements, not as a matter of bad faith but simply to maximize returns. To top it off, increasing these requirements simply pushes more lending to nonbank institutions outside the banking system, where these requirements don’t apply.

  It’s like the old saying that accuses military generals of always fighting the last war. With Dodd-Frank, we have probably prevented any crisis that would take the form of the 2008 crisis but not a crisis that would take a different form. Next time, the lending industry may very well overlend using a different form or structure, through different types of institutions, or in different sectors than in the 2008 crisis.

  Given enough time, the lending industry has shown that it is capable of innovating its way around legislative barriers or mounting the necessary lobbying efforts to remove those barriers, as with the 2018 Economic Growth, Regulatory Relief, and Consumer Protection Act, which took many steps in that direction. The industry makes those efforts not because of any malicious intent but instead as a function of its responsibility and desire to increase the earnings performance at its firms or in an effort to meet a need of its customers, even if sometimes ill advisedly.

  In any event, neither Dodd-Frank nor any regulatory policies took the one step I consider most effective and necessary to prevent financial crises: measuring growth in the ratio of private debt–to–GDP as an early warning sign. The surest strategy for early detection of a financial crisis is this: monitor the aggregates. More specifically, monitor the growth in aggregate lending totals. And in a world where derivative use has grown so markedly, monitoring should include the aggregate derivative growth. As these chapters have shown, widespread overlending leads to widespread overcapacity that leads to widespread bank (and other lender) failures. That is the essence of most financial crises.

  The policy implications of this are clear and straightforward.

  Policymakers and regulators should also monitor credit growth in individual lending sectors, including real estate, energy, student loans, and more. They should establish thresholds that, based on historical analysis, signal concern. This implies that a central authority is keeping careful, ongoing records of all lending activity, including aggregate and sector-level information on instruments that are derivatives of loans. Even today, there are emerging forms of loans that may not be included in government-reported national loan totals, as well as incomplete sector information and incomplete information about derivatives. One of the highest priorities of regulators should be to ensure that lending and derivative information is comprehensive and complete.

  In my historical review, I have yet to find a financial crisis where the unsound lending practices that led to it were difficult to see. They were major, obvious, and egregiously imprudent, never minor and subtle.

  The mortgage loan policies in 2003 to 2005 that led to the U.S. crisis of 2008 were not a modest reduction in the required down-payment amount and a minor reduction in borrowers’ income verification. Instead, it was the wholesale elimination of down payments and income verification for billions upon billions of dollars of loans. The purchase of savings institutions in the 1920s and 1980s by real estate developers to make loans for their own real estate projects was a conflict of interest of the worst sort. The list goes on.

  The surest method to detect these dangers has not been to dissect the minutiae of a lender’s credit policy or the exact structure of securitization and collateral, as these are always mutating beyond the ability of laws and regulations to contain them. Instead, the surest method is to measure aggregate lending totals in the whole and by sector. Where loan growth is extraordinary in relation to GDP, it is almost certain that lending standards have been relaxed. It should then be a straightforward matter for regulators to intervene as needed.

  Surely, regulators with broader powers with respect to the type, amount, and form of loan and debt growth can identify and intervene to curb risky practices before they threaten an entire economy. The biggest problem, of course, is that both banks and borrowers chafe at more attention and intervention. But this does not mean that regulations can or should be avoided. There is always a powerful tension between the benefits and dangers of lending, between wealth and prudence.

  This book has also shown that highly risky lending practices at the outset of a lending boom usually emanate from secondary and tertiary types of financial institutions that are less regulated and where regulators with the most resources are often legally constrained or precluded from intervening. Therefore, one of the most important antidotes to financial crisis is a central, robust, and independent regulator that has a broad enough mandate both to monitor and intervene as necessary in all material lending sectors in the economy, including instruments that are derivatives of loans. Some of this authority has come with Dodd-Frank, but it is an area that requires ongoing vigilance.

  Central bankers often say that their job is to “take away the punch bowl” by raising interest rates to curb a boom. But time has shown that when they do raise rates for this purpose, it is usually long after too much reckless lending has already occurred, and the action of raising rates only hastens or compounds the damage. Raising rates is a blunt and clumsy instrument, indiscriminate in its effects and not especially effective as a remedy for large numbers of ill-advised loans.

  Private-sector growth is an important and beneficial thing. Private-sector growth built on unsound lending practices is not. Politicians should take special care to avoid being coopted by fast-growing sectors of the financial institution industry and refrain from intervening on behalf of those very institutions whose practices are bringing the concern.

  When an overly risky loan is made, surely both the lender and the borrower are to blame. Surely the individuals who took the no-down-payment loan with
the artificially low interest rate could have and should have performed the analysis and concluded that when the rate adjusted upward, they would no longer be able to afford the payment, or if housing values declined, they would no longer be able to pay off the loan by selling the house. (I would note, however, that some lenders acted to exploit the trust of borrowers in those situations, reassuring them that even though payments exceeded their capacity to pay, prices always rose, and they would be able to sell for a profit.) In any event, while laws, regulations, and policies should be in place to protect both the lender and the borrower, from my perspective, the more important priority of government is to protect the individual, and the balance of the law should reflect that.

  Finally, if a crisis has not been prevented, and there is risk of widespread damage, a government should face up to the full cost of a crisis earlier rather than later. Regulators have sometimes been precluded from acting to address the full problem because of limited funds and resources. Ignoring or minimizing the estimate of the full cost of the problem as a political expedient has only increased the ultimate cost and damage of the crisis.