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The cause of the crisis (and how to prevent the next one)

One standard narrative of the cause of the financial crisis coming from people generally on the left is that a free-market ideology blinded policy-makers. They foolishly followed a policy of deregulation that allowed banks to run amok. And calls for regulation, such as attempts to regulate the derivative market, were ignored.

This theory is partly correct. There was some deregulation–various policy changes that let banks expand their activities. What this narrative ignores are other government policies that raised the likelihood of irresponsible investing but that were not based on a free-market ideology. In the particular, there were the relentless bailouts of large creditors that took place in the run-up to the crisis–interventions that were inconsistent with free-market ideology and that destroyed the feedback loops that might have prevented the crisis from occurring. The question remains as to whether these rescues did indeed encourage recklessness and imprudence. Maybe the mess would have happened anyway. Many argue that financial crises happen without such encouragement–every once in a while markets go haywire. According to this argument, investors get overconfident, ignore the possibility of loss, throw caution to the winds and so on. In this story, the financial crisis we’re still in is just another example of human frailty–greedy investors suffering from hubris and overconfidence.

In my essay on the crisis, Gambling with Other People’s Money, I provide some evidence that investors in large financial institutions were aware of the potential for bailout and acted accordingly. They invested their own money much more prudently than the money of the firms they ran, for example. And in one story recounted by Andrew Haldane, bankers confessed that they anticipated being rescued which is why their stress tests were so mild. Haldane, in a recent speech, provides other evidence that market outcomes in advance of the crisis anticipated rescue. I am currently revising my essay–the plan is to issue it as an e-book and I will try to provide more examples, still of past rescues that I missed in the first version.

Expectations are hard to measure. So inevitably it is difficult to “prove” in any scientific sense that past rescues were decisive in creating the current mess.

But now we have a new test. Have the rescues of the creditors of Bear Stearns and AIG and Citigroup and Bank of America had any effect on the probability of a future crisis? In the free-market narrative, the answer is yes. I suppose those who blame deregulation and ignore other types of intervention could say that past rescues had no effect but recent ones do matter. But either way, it’s interesting to think about whether recent bailouts induce future recklessness.

I’ve been thinking about this after reading this remarkable observation from Scott Sumner:

Consider the following:

Banks pour huge amounts of money into one particular asset class.  They are encouraged to do this by public policymakers, although there is some dispute about whether that was the main reason for their decisions.  These assets have a long tradition of doing well, although a close look at the evidence would have raised red flags.  The asset market in question suddenly takes a big dive as default risk increases sharply.  This drags down many large banks, forcing policymakers to provide assistance.

What have I just described?  The sub-prime fiasco or the PIGS sovereign debt fiasco?  I’d say both.  I’d say these two crises are essentially identical.  (I should clarify that by “essentially identical” I mean in essence, not in every detail.)

Of course the sub-prime crisis came first, so let’s consider the dominant (progressive) narrative of the sub-prime crisis.  If you read the mainstream media you will see it described as a sort of morality play; the evils of deregulation, which allowed the greedy big banks to take highly leveraged gambles with other people’s money, and then off-load the risk on to both taxpayers and unsuspecting buyers of MBSs.  Or something like that.

Obviously it would be impossible to tell a similar story for the sovereign debt crisis.  No regulator in his right mind would ever contemplate telling big banks not to buy European sovereign debt because it’s too risky.  Indeed the previous attempt atregulation (Basel II) encouraged banks to put funds into those “safe investments.”  Blaming the euro crisis on deregulation doesn’t even pass the laugh test.  The criminals were the regulators themselves.  Is the term ‘criminal’ hyperbole on my part?  Not at all.  Suppose Enron executives had used the same accounting techniques as the Greek government.  They’d all be in jail.  And as for Berlusconi, what can one say about a leader who continually passes laws exempting the Prime Minister from the very crimes he was accused of having committed?  As Keynes said:

“Words ought to be a little wild, for they are the assaults of thoughts on the unthinking.”

So here’s what I wonder.  Assume the eurozone crisis was obviously not caused by deregulation and greedy bankers.  Then if the sub-prime crisis was basically identical, at least in its essence, how can deregulation be the root cause of the former crisis?  I’m not saying it’s logically impossible, but doesn’t it seem much more likely that there’s a deeper systemic problem, which transcends this glib cliche?

That deeper systemic problem is that the government protects large banks. Sometimes they try to use large banks to accomplish various social policies. If it doesn’t work out (or if banks just get in trouble on their own) the largest ones who have lent money recklessly often (almost always) get all their money back anyway. What Scott Sumner is pointing out is that it’s hard to argue that imprudence occurs naturally when the effects of rewarding imprudence are so dramatic and obvious. Banks invest in AAA-rated stuff that really isn’t AAA. whether it’s subprime MBS or sovereign debt. Because regulation let’s them use ridiculous leverage for “safe” assets that are rated AAA, that’s where they head and they use as much leverage as they can even though such leverage puts them at tremendous risk where a small drop is asset values makes them insolvent. But they don’t really have to worry about that risk because the government has their back.

Government protects large banks in two ways. When large banks want freedom to take more risk, policymakers say that’s a good idea because markets will restrain risk-taking. When large banks get in trouble, the government makes sure that they get their money back plus interest, anyway. The policymakers can’t justify this policy on free-market grounds. That would be ludicrous. So they explain that it is necessary that banks that lent money recklessly get all their money back plus interest because any other alternative would harm the economy. It’s heads they win, tails we lose. It’s private gains and social losses.

There are only two solutions, broadly defined, to this problem. One is to return to a world where institutions that make bad decisions pay a price. No more creditor rescue is the first choice. Let the natural feedback loops of profit and loss restrain recklessness. When that fails, investors lose all their money so even when it fails, lessons get learned. Regulate more wise is the alternative to this policy.

The standard argument against no more rescues is that the price is just too high–there would be catastrophic consequences. But we’ve got those consequences anyway and while transferring money from taxpayers to really rich bankers. The second problem is that policymakers will simply be unable to keep the promise of not bailing out creditors. But if the political will came from the people, politicians could stand strong.

As for the idea of regulating more wisely, where is the evidence that such a policy could possibly work?

So if and when Greece and Italy can’t honor their promises, promises mainly made to large financial institutions, are we really going to allow them to keep those promises anyway with German money or ECB money or Fed money? Yes, the effects of letting those banks fail may indeed be horrific. But if we bail them out again, we may as well just give up. What kind of world is it where banks live recklessly off the rest of us? What kind of world is it where the so-called capitalists operate outside the rules of capitalism?