Lost Decades: The Making of America’s Debt Crisis and the Long Recovery

From the preface to Lost Decades, published today (9/19) by W.W. Norton:

The United States … lost the first decade of the
twenty-first century to an ill-conceived boom and a subsequent bust.
It is in danger of losing another decade to an incomplete recovery
and economic stagnation.
In order to not lose the decade to come, the United States will
have to bring order to financial disarray, gain control of a burgeoning
burden of debt, and re-create the conditions for sound economic
growth and social progress. None of this will be easy. The tasks are
made more difficult by the fact, which we have learned to our alarm,
that all too many policymakers and observers cling to the failed
notions that got the country into such trouble in the first place. If
Americans do not learn from this painful episode, and from others
like it, they will condemn the nation to another lost decade.. (p. xvi).

lostdecades.jpg

When Jeffry Frieden and I wrote those lines in Lost Decades nearly a year ago, we were still somewhat optimistic that our leaders would rely upon the lessons from history to inform their decisionmaking. However, Republican opposition to funding consumer financial regulation and intransigence regarding revenue increases during recent debt ceiling debate have highlighted the fact that basic economic theory has been trumped by ideology and raw special interest politics.

 

The Causes of the Crisis

 

As there have been numerous excellent accounts of the global financial crisis, one might wonder why yet another is of interest. In our view, none have adequately placed the origins of the crisis in a cross-country historical perspective, while highlighting the political economy forces at play. Without a proper understanding of the origins of the financial catastrophe, we are likely to replay the crisis again — but with governments around the world facing a more precarious fiscal outlook.

The origins of the financial crisis of 2008 remains contested territory. Here is a short list of candidates:

 

 

  • Community Reinvestment Act (CRA)
  • The GSE’s: Fannie and Freddie
  • Derivatives: MBS’s, CDO’s and CDS’s
  • Lax monetary policy
  • Global saving glut
  • Financial deregulation
  • Tax cuts and fiscal profligacy
  • Tax policy

 

Some of these are favorites in conservative circles. The allegedly pernicious effects of the CRA, which required a certain proportion of lending to historically underserved neighborhoods, occupies a particularly prominent place in the fevered imagination of some. The role of the Government sponsored enterprises, Fannie Mae and Freddie Mac, in making the market for securitization of subprime mortgage backed debt is often fingered as well — despite the fact that the vintages of mortgage backed securities that went bad were predominantly private label-issued. These arguments were discussed in this post).

 

What about derivatives such as mortgage backed securities (MBS’s), collateralized debt obligations (CDOs), and credit default swaps (CDS’s)? As we discuss in our book, these financial innovations certainly exacerbated the magnitude of the crisis. MBS’s and CDO’s certainly gave a mistaken impression of reduced risk even while concentrating it in financial institutions. Credit default swaps certainly gave the mistaken impression that investments in housing related securities were insured against defaults. All of these led to an underpricing of risk, and a transference of eventual costs to the public sector. But housing booms and busts occurred in other countries without these innovations. So in our view these developments exacerbated and widened the geographic scope of the crisis, but did not cause it.

 

Of the remaining, it would be hard to rule them out completely. Monetary policy was perhaps, in retrospect, looser than it should have been, based on the Taylor rule. [1] Whether this deviation caused the crisis is unproven in our view. The crisis occurred in other countries as well, some in regions with tighter monetary policy than that in the US (the UK, eurozone).

 

For us, we find key blame in a toxic and synergistic mixture of ample foreign savings, a profligate fiscal policy (EGTRRA, JGTRRA, Iraq, Medicare Part D), a debt-biased tax code, and most importantly regulatory disarmament.

Government policies enabled, catalyzed, and fueled America’s
crisis. The Bush administration’s tax cuts and spending splurge
drove the federal budget from surplus to deficit, beginning the
most recent cycle of foreign borrowing boom and bust. The Federal
Reserve’s excessively loose monetary policy encouraged households
to take advantage of very low real interest rates to embark on a
debt-financed consumption spree, with much of the debt borrowed
from abroad. Neither the government nor the households that did
the borrowing used enough of the borrowed funds to increase the
nation’s productive capacity and its ability to eventually service the
debt without sacrifice. Lawmakers disarmed financial regulators,
who in turn used few of the weapons left in their arsenals, allowing
financial institutions to develop new instruments that were largely
untested and wholly unsupervised. Financial institutions worked
madly to increase their profits in a low-interest-rate environment by
taking on ever riskier assets, insisting that they had mastered risks
they barely understood.
Any one of these policies might have gotten the United States
into serious trouble. Together they created a financial perfect storm,
driving the American economy to the brink of financial collapse and
dragging much of the rest of the world with it. (pp. 201-02)

Our treatment therefore departs from the Bush Administration’s overly simplistic view that the excess for foreign saving caused us to irresponsibly borrow — that is what I characterize as the “blame it on Beijing (and Seoul, and Riyadh)” view. Rather, as I wrote in Econbrowser on Christmas Day, 2008, there was a synergistic effect between these factors.
Regarding monetary policy, there seems to be a widespread consensus that it was too lax in 2002-04, this is a viewpoint made with the benefit of hindsight. As Orphanides and Wieland (2007) [pdf] have pointed out, according to the Greenbook forecasts, monetary policy was not — according to a Taylor rule framework — overly lax.

 

On the regulatory front, I think it’s important to not indict all deregulation (eliminating the Glass-Steagall barriers makes sense to me, while the Phil Gramm-sponsored Commodity Futures Modernization Act exemption of regulation of CDS’s does not). I outline some empirical research on what factors were important in this crisis in this post.

 

But clearly, regulatory disarmament/nonenforcement and “criminal activity” were important. Office of Thrift Supervision under the Bush Administration “helped out” IndyMac [2] [3], and how deregulatory zeal [4] [5] metastatized over into criminal activities on the part of regulators and the regulated.

 

Fiscal profligacy is important because it pushed the economy more into a boom exactly at a time when not needed (i.e., near full-employment), and the tax cuts made people feel like they had more discretionary income than justified, thereby adding extra fuel to the asset boom.
lastingleg1.gif

Chart C: from Irons, Edwards and Turner (2009).

Finally, tax policy clearly provided incentives to borrow and leverage. In particular, I have been thinking about the tax deductibility on second homes, a provision dating back to 1997 [6] [7] [8]. (Mortgage deductibility on a second home never made sense to me, let alone on a first home); see Capital Games and Gains, who highlighted this provision, citing a NYT article). I suspect that on its own, this provision wouldn’t had a big impact, but in combination with the other forces and distortions, it might have.

 

Typically, for ordinary phenomena, I would think of these factors adding up in a linear fashion, so that each of the impulses would sum to the total effect. But I think it’s worthwhile to think about lax monetary policy, deregulatory zeal and criminal activity/regulatory disarmament, and tax cuts and tax policy changes, all combining to lead to the “bubble” (in a nontechnical sense) or episode of Akerlof-Romer “looting”, and subsequent collapse we’ve witnessed.

 

Consider one example of a pernicious synergy: the 2001 and 2003 tax cuts were aimed at higher income households, while the second home mortgage deductibility benefited mostly higher income households [9]; with regulatory oversight absent, and low interest rates, the stage was set.

So, despite the outward trappings that seemingly differentiated the last crisis from previous ones, we can interpret the recent episode as yet another capital flow cycle: We borrowed from overseas, not only because of ample supplies of capital, but because government profligacy and the distortions in the purportedly “deep and liquid” (but actually under-regulated) financial markets.

 

Looking Forward, But Ignoring the Past?

 

Viewed through this historical lens, the hazards for policymakers are all too clear.

 

First, in our view, we are very much in danger of repeating the experience of 1937 [10], when monetary and fiscal authorities prematurely withdrew stimulus, and threw the US economy into a contraction of 3.5%.
LDepi.gif

Figure 1: Real GDP growth (y/y, log differences). Source: Johnston/Williamson, Measuring Worth and author’s calculations.

So in the short term, it’s essential that we maintain aggregate demand by not further cutting discretionary spending, especially since the fiscal problems we face are at the longer horizon involving the Bush tax-cut induced revenue shortfall and growing entitlement spending. That was the point of CBO Director Doug Elmendorf’s statement the other day before the deficit reduction supercommittee. In addition, we need to increase monetary stimulus, perhaps along the lines that Bank of England MPC member Adam Posen has argued: “…we cannot take our foot off the pedal….The outlook is grim — the right thing to do now is engage in more monetary stimulus.”

 

Second, turning to the longer horizon, we see equally daunting obstacles to preventing a replay of financial crisis. If one believes that highly leveraged and unregulated financial institutions and households were important, then one want to implement tighter standards and higher capital requirements. However, some have argued for a “just say no” approach to further bailouts. We believe that that approach will work as well in financial regulation as it did in drug policy, and really just covers for the naked self-interest. (See how finance was powerful enough to force Republicans to delete all references to Wall Street in the Financial Crisis Inquiry Commission report. [11]) As we note:

None of the changes necessary to avoid a repeat of this disaster
will be easy. At every turn there are major political obstacles. Financial
interests resist regulations that shift the burden of risky behavior
back onto them and off of taxpayers. Beneficiaries of government
programs fight against attempts to curb their benefits. Taxpayers
refuse to pay the taxes needed to pay for the programs they want.
Partisan politicians block reasoned discussion, suggesting absurd
pseudo-solutions instead of realistic alternatives. Ideologues and
political opportunists encourage Americans to cling to the childish
things that have served them so poorly in the past: a mindless
belief that markets are perfect, that tax cuts solve every ill, that borrowing
is to be encouraged. Despite the great trouble these policies
have caused, their attractions continue to be touted and spouted by
unprincipled pundits. (p. 221)

Hence, the challenge of avoiding a second lost decade is still a very real one.

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55 thoughts on “Lost Decades: The Making of America’s Debt Crisis and the Long Recovery

  1. jonathan

    If one is a believer, which seems to be increasingly common, then the crisis might also be viewed as heavenly payback for fundamental dishonesty. One example is that we engaged in two major wars and yet gave lip service to “support our troops” and said, “Thank you for your service” while not paying for the wars. Rather than share sacrifice for wars that have killed thousands of our young and wounded tens of thousands more, we cut taxes. Add those things together – the wars and the tax cuts – and we would be in a wholly different fiscal picture. And now of course the attempt is to shift the cost of the wars to the poor, the sick and the young. That can’t speak well about how heaven will treat us in the future.

  2. In Hell's Kitchen (NYC)

    Some economists saw the signs of the oncoming debt debacle as it was beginning to happen and told us but no one listened
    http://www.nber.org/papers/w2186
    Abstract: Until the 1980s the outstanding indebtedness of government and private-sector borrowers in the United States exhibited sufficient negative covariation that total outstanding debt remained steady relative to nonfinancial economic activity. Three hypotheses — one based on lenders’ behavior, one on borrowers? behavior, and one on credit market institutional arrangements — provide potential explanations for this phenomenon. Since 1980 the U.S. debt markets have departed from these previously prevailing patterns, however, as both government and private borrowing have risen sharply.

  3. Get Rid of the Fed

    Causes of the “crisis” (maybe a retirement crisis):
    1) too much debt (whether private or gov’t)
    2) an economy that goes from mostly supply constrained to mostly demand constrained and not being something unnatural
    Lastly, the solution to too much lower and middle class debt is NOT more gov’t debt.

  4. Ricardo

    Regulatory disarmament is an interesting phrase. Regulations are the politicians greatest tool for extortion and theft, but opposing them is very difficult. Proponents of regulations always reference their high moral purpose while ignoring their abuse. When the abuse is noted the proponent never blames the regulation for creating the structure that allowed the abuse of power.
    Those who support central planning big government love regulation because it grows the bureaucracy, but those who love liberty and freedom strongly oppose regulation as a violation of freedom. The question comes down to is the abuse worse than the actual benefit. But this is the debate that never happens.

  5. Get Rid of the Fed

    I suggest this article titled ‘”No One Saw This Coming”: Understanding Financial Crisis Through
    Accounting Models:’

    http://mpra.ub.uni-muenchen.de/15892/1/MPRA_paper_15892.pdf

    Here is one paragraph:

    There is an immediate link to accounting, organizations and society. Previewing the results,
    it will be found that ‘accounting’ (or flow-of-funds) models of the economy are the shared mindset of those analysts who worried about a credit-cum-debt crisis followed by recession, before the policy and academic establishment did. They are ‘accounting’ models in the sense that they represent households’, firms’ and governments’ balance sheets and their interrelations. If society’s wealth and debt levels reflected in balance sheets are among the determinants of its growth sustainability and its financial stability, such models are likely to timely signal threats of instability. Models that do not – such as the general equilibrium models widely used in academic and Central Bank analysis – are prone to ‘Type II errors’ of false negatives – rejecting the possibility of crisis
    when in reality it is just months ahead. Moreover, if balance sheets matter to the economy’s macro performance, than the development of micro-level accounting rules and practices are integral to understanding broader economic development. This view shows any clear dividing line between ‘economics’ and ‘accounting’ to be artificial, and on the contrary implies a role for an ‘accounting of economics’ research field. Thus this paper aims to encourage accountants to bring their professional expertise to what is traditionally seen as the domain of economists – the assessment of financial stability and forecasting of the business cycle.

    Next, put the amount of medium of exchange in that model along with a correct understanding of debt and see where that model goes.

  6. Ricardo

    As a prime example of regulatory over-reach consider Sarbanes-Oxley that passed both the House and Senate with a nealy unanimous vote.
    John Berlau writes:
    Despite fading from the policy spotlight in DC, Sarbox remains a significant burden keeping the U.S. economy from reaching its potential. U.S. initial public offerings dropped off dramatically after Sarbox’s passage and have never come back. According to statistics from University of Florida finance professor Jay Ritter, in no year after Sarbox’s passage has the number of IPOs reached that of the slow-growth and recession years of 1991 and 1992, let alone the late ’90s boom years.
    And the law still disproportionately burdens smaller public companies. Much has been made of prominent IPOs this year such as the one for LinkedIn and the forthcoming Groupon, and we should indeed celebrate these American success stories. Overlooked, however, is that much of the internal growth at these firms has already occurred. Most of these companies have already reached large-cap status with market valuations of more than $1 billion.
    But smaller companies, which routinely would raise money by going public in the ‘80s and 90s, are caught in a Catch-22 with the Sarbox accounting regs. According to a Securities and Exchange Commission study released this April, for small-cap and micro-cap companies with market valuations between $75 million and $250 million, the cost of first-year compliance with the “internal control” mandates equals an amazing 77 percent of their total assets. Even after four years, this cost only goes down to 41 percent the firms’ total assets.
    http://www.realclearmarkets.com/articles/2011/09/14/will_obama_and_congress_slay_the_sarbox_job-killing_monster_99253.html

  7. 2slugbaits

    Get Rid of the Fed Lastly, the solution to too much lower and middle class debt is NOT more gov’t debt.
    Then how exactly do you propose we get rid of debt? High inflation? Is that your recommendation?
    And while you’re at it, please explain how anyone EVER saves without another party accepting an exactly equal and offsetting debt obligation? I suppose there’s the old “stuff it in a mattress” possibility, but you need to think about that scenario in terms of income flows rather than in terms of stock variables with pictures of dead Presidents.
    At the macro level the economy cannot save its way out of debt.

  8. Munchin

    Maybe we should abolish liberal Democrats and the Federal Reserve Bank of Boston since the Dems used a bogus housing study by the FBR of Boston (Alicia Munnell in particular) to lower loan standards and then pressure banks to make mortgage loans they (the banks) knew could be be repaid. And then the Dems got Freddie and Fannie to buy sub-prime junk so banks could lend even more. It was, as always, BAD government policy that created this debt mess. And now liberal like Menzie, who likely approved the shenanigans of the government, wants to tells us how to avoid another crisis. What a hoot!
    As an aside, I also see U Wisconsin was ranked as one of the top 5 least (yes, LEAST) academically rigorous schools in the country by Newsweek. What’s going on Menzie? You not teaching or, when you do, you just giving out high grades to everyone so they won’t bother you. What a racket! Talk about freeloaders.

  9. Orange14

    Just published today? I got my copy from Amazon two weeks ago and just finished reading it. Kudos to you and Professor Frieden for a succinct portrayal of where we are, how we got here, and a possible way out. It’s going right on the bookcase next to Hy Minsky’s “Stabilizing and Unstable Economy.”

  10. Hondo

    Global savings is a myth…the result of unsupportable debt for consumption on the other side of the equation. It is in fact insane to hold to a “theory” that stomping on the gas pedal will cure the ill…it will not. Reducing the leverage for private and public will in fact reduce aggregate demand (demand that is fake and would not exist in the first place if not for policy error after policy error). You don’t not correct policy error with additional policy errors. This will be a long drawn out process and will only be made longer and more severe if we keep making such insane mistakes. Put the FED and the Treasury in a locked closet until we get through this and then let the Treasury out and kill the FED.

  11. djt

    I don’t know what the answer is going forward, but I think one problem is we don’t really know what economic equilibrium looks like for the US given the world economy, the skills of workers in the US, the wages people are willing to accept, etc. Without knowing the equilibrium, how can you make any rational policy choices? I would assert that the economy has been in fantasy land for between 10 and 20 years. What would the economy have looked like over the last 10 years without massive borrowing both by the government and homeowners? Wasn’t that an injection of 1 trillion per year, without the work to create the 1 trillion in value? What would the economy have looked like if that 1 trillion in value per year had not existed? Or if Americans had worked to generate that extra 1 trillion per year? What would our economic potential be if the 500 billion in mortgage equity withdrawals had gone to productive infrastructure, instead of houses?
    Making more policy mistakes because we think we can return to 2007 is a mistake. But I don’t think we know what isn’t a mistake since we don’t know where the base level actually is anymore.

  12. ab

    Congrats on the new book!

    I agree with Prof Chin that the confluence of loose monetary policies, unsupportable tax cuts, globalization and other factors played a large part in the US collapse, but give more weight to impact of fraudulent derivatives unleashed by deregulations in 12/99. While other nations have also experienced credit and housing burst bubbles, those that steered clear of derivatives have suffered far less. While they may not have bought into risky derivatives, traditional banking institutions were nevertheless forced to move away from traditional capital requirements and lending standards in order to stay competitive with the deregulated financial houses.

    I urge Prof Chin to examine the real effect of dismantling the Glass-Steagall Act. I contend this unleashed unfettered institutional speculators who not only manipulated stock prices here and abroad, but far more dangerously wreaked havoc by raising funds via securitisation activities on the wholesale debt markets and plundered central banks’ foreign exchange reserves across the globe. Over the last decade we have witnessed the effect of their outreach in the undermining of sovereign governments and resultant destabilization of entire national economies, whilst obscenely concentrating absolute grip on the transfer of wealth. One such case is Goldman Sachs selling the fraudulent credit default swaps concept to Greece in ’02 for a $300 million commission. While you can point to structural problems within as factors in Greece’s predicament, many in Europe hold GS culpable for structuring $1 billion in unworthy credit.

    We can all see that Greece is threatening the EU; however, few admit that its default, should it happen, will become yet another US taxpayer liability through our approximate 19% in this case share of whatever funds the IMF doles out to offset the EU effort. IMF policies routinely negatively impact the average worker in countries that received their “assistance”, but it is worth noting the IMF is now calling for greater scrutiny of advanced economies holding more than 60% debt to GDP. Those same policies which extracted from the working poor elsewhere are already now well in play in the US, and it’s foreseeable the IMF may formally set them in motion.

    Before we go the path of Ireland, Portugal, Greece and soon Italy, perhaps we might consider that the biggest factor to US debt is oil import. Biggest user of imported oil is US Dept of Defense. Ike’s MIC dire prediction is fulfilled. Unfortunately, Washington continues to squander resources with excursions in Iraq and Afghanistan. Few are looking yet at its very real threat to our sovereignty. We need to make giant leaps to decouple from oil dependency, but so far several other nations are well ahead of us as we continue our suicide march.

    While some erroneously think austerity will be sufficient to revive the demand economy, it’s pretty clear that consumption won’t magically appear with austerity measures clamping harder on the US consumer. The short term answer is stimulus. Stimulus will put some to work and shore up needed infrastructure, but we need structural changes for long term economic health. Perhaps it’s time for economists to shift away from traditional growth models which cannot solve our problems in the long run to trying to develop revamped models based on sustainable steady state growth principles. That’s a challenge I hope Prof Chin and others will take.

  13. Rob

    2slugsbait: “At the macro level the economy cannot save its way out of debt.”
    Just when I think I’m beginning to think understand… I read your statement and think: If the Treasury collected more than congress ordered spent, wouldn’t we eventually pay off our debt, or in non-economist parlance “save” our way out of debt?
    I’ve read this blog for years now and appreciate that I have nothing to offer, only to digest. Professors, my thanks. And, given the luck that I have to still maintain a job, and not the wherewithal to click through every link provided I have the following question: Is there a layman’s version of a non-partisan, salt-/fresh-water version of Economics on the macro level available? Can such a thing exist?
    I ask because, at lunch today, when I proffered what I thought were sensible “Keynesian” type programs to kick-start the economy, e.g., putting road-/ bridge-workers and school teachers back to work via debt issuance programs I was labeled as “Keynesian.” It was used pejoratively. The people I was having lunch with are neither economists, nor stupid (in the field of their expertise at least, i.e. neurophysiology & business). But they are acutely aware of tax policies on the table. They are “middle class.” They want the best for their kids. They are tapped out from what I’m hearing. They don’t want more “debt,” for themselves or country.
    Is there one good book? I’ve read Krugman’s freshwater/saltwater stuff. I’ve followed his blog, the WSJ and this blog since the meltdown to see who has the better arguments. Keynesian seems more predictive. But there’s no counterfactual, or is there?
    I have learned that persuading people is not helped by ad hominem attacks–from either side. (Though when people just know they know and aren’t convinced by math, English, or pictures I too would give up)
    The more I try to understand economics the less I know, or so it seems…

  14. Menzie Chinn

    Thanks to Phil Rothman, Orange14, Steven Kopits, and ab for the congratulations.

    Ricardo: Oh, yes I do recall lots of hand-wringing about so much financial activity migrating to London, with its “light-touch” regulation, in the wake of Sarbanes-Oxley. That sure worked out well for the UK…

    djt: We’re not arguing for a return to 2007; hopefully you’ll read the book, and realize we’re asking for a return to the days before finance dominated the economy, when we produced a lot of tradable goods and services, and consumption was a lower share of total aggregate spending.

  15. ab

    I look forward to reading your book if that’s your premise. Do you envision a way to enact policies that promote the return to a manufacturing base?

  16. colonelmoore

    Monetary policy was perhaps, in retrospect, looser than it should have been, based on the Taylor rule. Whether this deviation caused the crisis is unproven in our view. The crisis occurred in other countries as well, some in regions with tighter monetary policy than that in the US (the UK, eurozone).
    So what did all of these countries share in common?
    http://www.realclearpolitics.com/articles/2011/09/16/europes_banking_crisis_111352.html
    Europe’s Banking Crisis
    By Robert Samuelson
    Under Basel I, banks were required to hold 8 percent capital against most assets. Ordinary loans to companies required 8 percent: That’s $80,000 on a $1 million loan. By contrast, home mortgages required only 4 percent; they were considered safer. Later, “securitizations” of “prudentially” made mortgages required only 1.6 percent; they were judged even safer. And most government bonds required no capital; that’s how safe they were rated.
    Not surprisingly, banks favored investments with low capital requirements. American banks liked mortgage-backed securities; European banks gorged on sovereign bonds. The perverse result: The very securities — mortgage debt, government debt — considered safest became the vortex of the crisis.
    Later, Basel II gave banks discretion — with regulators’ approval — to rate the risks in their portfolios by their own computer models.

    I don’t know what Prof. Chinn’s book says about the above, but it would seem to be the thing that all of the banking systems currently in trouble share in common.
    If every loan originated by banks had to be backed with 8% of capital while keeping monetary policy prudently tight, wouldn’t that automatically limit the amount of lending? Wouldn’t banks vie for the most creditworthy borrowers in a tight lending environment?
    My analogy is to an exclusive university like Harvard:
    Only 7 percent (of applicants) will get in, school officials said today, the most selective year yet at one of the world’s most selective universities.
    The applicant pool reached an unprecedented level of achievement, university officials said. More than 2,900 scored a perfect 800 on their SAT critical reading test, and 3,500 scored perfectly on the SAT math test. Nearly 3,700 were ranked first in their senior class.

    Compare with the University of Wisconsin Madison:
    Admission Success rate 63%
    SAT 75%ile scores 1380

    There is no Federal University Entrance Exam authority inspecting Harvard to see if its standards for handing out admissions are too loose. The only control Harvard has is the limited number of slots available for an overwhelming number of applications. If Harvard were to go on a massive liquidity operation to provide more slots for its incoming freshmen then it would have to take in more “Alt-A” students. This would increase the default rate for graduation or else it would have to renegotiate graduation terms to cure graduation defaults.
    If central banks had controlled the availability of loans then banks wouldn’t have gone so far down the ladder of borrower credit quality. This is the most obvious and yet the least discussed of the roots of the crisis.

  17. Get Rid of the Fed

    2slugbaits said: “Then how exactly do you propose we get rid of debt? High inflation? Is that your recommendation?”

    No. Reverse what has happened since about 1980. Instead of negative real earnings growth on the lower and middle class and debt to make up the difference, make it enough positive real earnings growth so that the lower and middle class can spend some and pay down debt.

    And, “At the macro level the economy cannot save its way out of debt.”

    Then have an entity that dissaves with currency and no bond/loan attached.

  18. colonelmoore

    2slugs, I am having a hard time understanding you on the matter of paying down household debt versus savings. You say, “please explain how anyone EVER saves without another party accepting an exactly equal and offsetting debt obligation?”
    If a bank lends Joe $10,000 through the agency of his credit card, the bank has created $10,000 in currency. If Joe pays off his balance, he does not put that $10,000 into a savings account. He destroys $10,000 in currency. So there is no money that government or private entities are required to re-lend. How can you say that repaying debts is the same as putting money in a savings account?

  19. Get Rid of the Fed

    Rob’s post said: “2slugsbait: “At the macro level the economy cannot save its way out of debt.”
    Just when I think I’m beginning to think understand… I read your statement and think: If the Treasury collected more than congress ordered spent, wouldn’t we eventually pay off our debt, or in non-economist parlance “save” our way out of debt?”

    Rob, not necessarily. You might want to check out Premium Question 5 and its explanation here:

    http://bilbo.economicoutlook.net/blog/?p=16151

    And, “I ask because, at lunch today, when I proffered what I thought were sensible “Keynesian” type programs to kick-start the economy, e.g., putting road-/ bridge-workers and school teachers back to work via debt issuance programs I was labeled as “Keynesian.” It was used pejoratively. The people I was having lunch with are neither economists, nor stupid (in the field of their expertise at least, i.e. neurophysiology & business). But they are acutely aware of tax policies on the table. They are “middle class.” They want the best for their kids. They are tapped out from what I’m hearing. They don’t want more “debt,” for themselves or country.”

    It seems to me your “kick-start” comment means you are assuming an aggregate demand shock. IMO, that is not what is happening here although it might look like it. These people seem to be picking up that if real GDP does not “grow fast enough” (which seems likely to me), then higher taxes and benefit cuts are coming in the future to satisfy the rich and rich entities who own the gov’t bonds.

    And, “Is there one good book? I’ve read Krugman’s freshwater/saltwater stuff. I’ve followed his blog, the WSJ and this blog since the meltdown to see who has the better arguments. Keynesian seems more predictive. But there’s no counterfactual, or is there?”

    IMO, you need to find some accounting and/or banking people who understand medium of exchange correctly (currency, central bank reserves, and demand deposits). Try interfluidity.com and look for the author of the blog, Steve Waldman (SRW), JKH, and rsj. Take a look at Billy Blog (see Premium Question 5 above) too although don’t get too far into the idea that more gov’t debt is the solution.

  20. Get Rid of the Fed

    colonelmoore said: “If every loan originated by banks had to be backed with 8% of capital while keeping monetary policy prudently tight, wouldn’t that automatically limit the amount of lending? Wouldn’t banks vie for the most creditworthy borrowers in a tight lending environment?”

    And, “If central banks had controlled the availability of loans then banks wouldn’t have gone so far down the ladder of borrower credit quality. This is the most obvious and yet the least discussed of the roots of the crisis.”

    What if the fed needed to increase the amount of private debt (and maybe gov’t debt too) to prevent price deflation from cheap labor and positive productivity growth in the early 2000′s and needed low interest rates to do it (meaning they didn’t want a shortage of capital to cause interest rates to go up because then the lower and middle class would not borrow)? The other thing to consider is that the most creditworthy may not want/need to borrow because they are rich enough to be able to spend on what they want without any debt.

  21. Charles

    I recommended the book on our blog, Menzie, with its gigantic following of perhaps 17 readers.
    Congratulations. It’s a very big deal to publish a book, especially given the frustration over how few people seem to read anymore.

  22. ppcm

    No more white pages torturing the writer,the graphics will not need updates,the logs are in place,the exponentials will be in the sales.
    Congratulations,you still have many pages to fill in Econbrowser.

  23. Tyler Durden

    Agree with colonelmoore—the banks gave out too many loans to people who had no business borrowing the money in the first place. The lending standards collapsed and the Fed as a key banking regulator stood by and did nothing about it. Correction, Greenspan actually was cheerleading how “new information technology” allowed banks to price risk more efficiently. He’d say anything to justify an upward move in stock prices (the Fed’s third mandate).
    Too bad academics mostly captured by the Fed’s visiting scholar money can’t bring themselves to bite the hand that feeds them.

  24. Jeffrey J. Brown

    A reminder about net oil exports . . .
    Following are Chindia Net Imports/GNE for 2005 & 2010 (mbpd, GNE = Global Net Exports*):
    2005: 5.1/45.5 (11.2%)
    2010: 7.5/42.6 (17.6%)
    At the 2005 to 2010 rate of increase in this ratio, Chindia would approach 100% of GNE in about 20 years.
    Chindia’s total petroleum liquids consumption rose from 9.5 mbpd in 2005 to 12.4 mbpd in 2010, a 5.3%/year rate of increase. Note that their combined net oil imports rose at 7.7%/year, from 2005 to 2010.
    Incidentally, Chindia’s recent rate of increase in net oil imports is far below what the US showed during our rapid post-war expansion period, when we showed almost a 12%/year rate of increase in net oil imports from 1949 to 1977.
    *Top 33 net oil exporters in 2005, primarily BP data, total petroleum liquids

  25. colonelmoore

    Tyler Durden said:
    Agree with colonelmoore—the banks gave out too many loans to people who had no business borrowing the money in the first place.
    I am always glad when someone agrees with me. However I would be ever more grateful if someone agreed with me on my key point. Is there anyone who agrees with Paul Samuelson on the genesis of the crisis?
    Under Basel I, banks were required to hold 8 percent capital against most assets. Ordinary loans to companies required 8 percent: That’s $80,000 on a $1 million loan. By contrast, home mortgages required only 4 percent; they were considered safer. Later, “securitizations” of “prudentially” made mortgages required only 1.6 percent; they were judged even safer. And most government bonds required no capital; that’s how safe they were rated.
    Not surprisingly, banks favored investments with low capital requirements. American banks liked mortgage-backed securities; European banks gorged on sovereign bonds. The perverse result: The very securities — mortgage debt, government debt — considered safest became the vortex of the crisis.
    And if you do agree with Samuelson, isn’t it logical to assume that, had capital and reserve requirements been identical for all types of loans and restrictive enough that banks would not have been able to lend to all comers, that banks would have automatically been more choosy about who they lent to?
    The point of the Harvard/Wisconsin Madison comparison was to show that the only regulation necessary for college admissions is to keep admission limited. There is no government agency monitoring Harvard’s student admissions qualifications. No government agency is slacking off on qualifying students for admission to Wisconsin. Why is lending different? Why do histories such as Prof. Chinn’s give short shrift to what is seemingly the most important point of all?
    Economists seem like the blind men touching the elephant. Each has his pet theory and all argue with one another. But if you think that an elephant is a snake and so you apply snake control measures to keep down the snake infestation, don’t be surprised when the “snake” evades your controls.

  26. James

    Dear Dr. Chinn,
    Congrads on the book. Also, heard you on Money Talk radio program on Sunday. I thought you gave a very level and thoughtful presentation.
    Thanks!

  27. Get Rid of the Fed

    colonelmoore said: “If a bank lends Joe $10,000 through the agency of his credit card, the bank has created $10,000 in currency. If Joe pays off his balance, he does not put that $10,000 into a savings account. He destroys $10,000 in currency.”

    And, “And if you do agree with Samuelson, isn’t it logical to assume that, had capital and reserve requirements been identical for all types of loans and restrictive enough that banks would not have been able to lend to all comers, that banks would have automatically been more choosy about who they lent to?”

    Let’s go thru a simple example that is a little unrealistic. Joe borrows $10,000 on his credit card from a bank. He spends it on some service (Service, Inc.) and immediately defaults with no collateral. Joe gets a demand deposit account markup of $10,000, and the bank has a loan asset of $10,000. For this example, the bank has a 10% capital requirement, so $1000 is set aside. The place where Joe spent the $10,000 puts the $10,000 right back into the same bank in a savings account. Joe gets a demand deposit account markdown of $10,000, and (Service, Inc.) gets a savings account markup of $10,000. Savings accounts have a 0% reserve requirement, so central bank reserves are not affected. Next, the loan asset of the bank now gets valued at $0, and the bank is insolvent. It has $1,000 in assets and $10,000 in liabilities (the savings account). Without some kind of further help, Service, Inc. is out $9,000 for “lending” (accepting the demand deposit and choosing the savings account at that same bank) to the bank even though it wanted a virtually risk-free asset. This example would need to be expanded to cover many credit cards and the idea someone may not default immediately for it to be more realistic.

    In the USA, I believe you need to consider lending based on collateral. Geekspeak said there was no housing bubble but just some forth. That meant the collateral was good so don’t worry about the ability to repay. Just get a new loan or sell the house (collateral). I also agree that gov’t bonds should NOT have a 0% capital requirement for default. Similar to my comment above, would the fed (and geekspeak in particular) have gotten the blame if not enough private debt was created to prevent price deflation and/or negative real GDP because the fed kept capital requirements and reserve requirements too high?

    Now let’s look at your example. First, the $10,000 should be considered demand deposits. Demand deposits went up by $10,000 and then down by $10,000. There was no net pay down of household debt. Notice it was demand deposits and not currency. It seems to me that currency can’t be directly defaulted on and can’t be paid down to “destroy” it.

  28. don

    Menzie & Frieden:
    “For us, we find key blame in a toxic and synergistic mixture of ample foreign savings, a profligate fiscal policy (EGTRRA, JGTRRA, Iraq, Medicare Part D), a debt-biased tax code, and most importantly regulatory disarmament.”
    In my view, lax regulation helped bring to a head a crisis that was in the making and is now in the re-making. An important part of the global savings glut is something like $5 trillion in foreign reserve accumulations since 2000 (Japan and China being the main culprits). Setser and Roubini were waiting for the lenders to become wary of our ability to repay. I was waiting for unemployment to bring political pressure to bear to halt the reserve accumulations, which are trade distoritions an order of magnitude greater than the existing trade barriers covered by the WTO. Now, the unsustainable U.S. current account imbalance is back.
    2slugs:
    “At the macro level the economy cannot save its way out of debt.”
    You appear to have a closed economy model in mind. We are even less likely to spend our way to prosperity if burdened with a responsive current account leakage. We have recently been borrowing from abroad to the tune of something like $600 billion per year (which amounts to de-stimulus of the same amount)- an unsustainable situation and one that is particularly vexing given our current excess desired saving.

  29. Bryce

    Many of those factors mentioned no doubt exacerbated the debt bubble. But Dr. Chinn seems to be losing in the forest the sine qua non of the bubble: loose money growth by central banks globally, not simply the Fed but practically every central bank–especially Asian central banks (contributing to lower long-term rates with their purchases of US & European debt).
    If you are a bank & you are getting seed money from the Fed for nothing, you have a lot of incentive to get it lent out.
    Having identified in the subtitle that it was “Debt Crisis”, surely Dr. Chinn hones in on what is central & important in the book. But his comments above don’t imply as much.

  30. Wisdom Seeker

    Professor Chinn, congratulations on giving birth to your book!
    2SlugBaits “please explain how anyone EVER saves without another party accepting an exactly equal and offsetting debt obligation?”
    Break the fiat-dollar mindset and the answer is obvious: A nation can save by producing more than it consumes, and storing the surplus production as tangible capital.
    Even with a fiat-currency mindset, if you break the US-only mindset, another answer is obvious: The U.S. can only save more if it restores the balance of trade. (e.g. if China and the oil producers save less, or if we convince someone else to save less and buy our products). This flip-side of the U.S. trade deficit is a huge imbalance that needs to be addressed before we can return to sound global economy.
    Even with a U.S.-only, fiat-dollar mindset, there is a solution: The poor and middle class must save more (or become elites?) if the elites are forced to dis-save. Note that there is a huge amount of fraudulently obtained paper wealth on the books, so this is a rule-of-law, justice issue… as well as an distribution-of-wealth issue.
    A fourth way would be for current goods and production to be valued more relative to future goods and production. By increasing the value of current capital and devaluing future obligations, inflation can creates a net “savings effect”. And it will be how things rebalance if nothing else is done…

  31. 2slugbaits

    So why is it true that at the macro level a country cannot save it’s way to prosperity? I am of course referring to the case in which demand for saving at a given national income exceeds the investment demand for that saving. As an aid folks might want to dust of Menzie’s notes from last spring’s Econ 302 course. He was good enough to post his lesson on the multiplier. But you can find the same derivations in almost any macro textbook. So if you want the algebra, either relook Menzie’s notes are consult a macro 101 textbook. It’s the standard thing where in equilibrium I=S, but what happens when they’re not in equilibrium? The answer is that income must fall unless government spending increases.
    But let’s deal with the basic intuition. Suppose an economy is in balance and savings exactly equals investment demand. Then suddenly there’s a demand shock that causes people to pull back spending and save more in order to repair balance sheets. That’s a rational response. Except that since consumer demand is less, so too will be investment demand. No point in expanding capacity if demand falls. Well, normally the interest rate would fall as people save more. At the margin this would make it attractive for businesses to expand now even though demand is down. But now suppose the interest rate goes to zero and cannot go any lower. People are saving like mad. Consumption demand keeps falling as people save, so businesses no longer invest. At some point those dollar bills with images of dead Presidents just sit in the bank’s vaults accumulating dust. They are no longer part of the income flow. They’re just pieces of paper. They might as well be Confederate dollars. The nation’s capital stock does not grow. The income is lost forever. Yes, the pieces of paper may survive in the vaults, but the income stream that should have been generated is completely lost. At some point you might want to withdraw those dollar bills, but because the capital stock has fallen, so too has the purchasing power of those dollar bills. If those dollar bills reenter the economy you end up with too many dollars chasing too few goods. Saving has not increased the real economy, and has in fact made everyone poorer. That’s the paradox of thrift. The paradox does not say people should go out and spend, it says that government should accept debts, which are simply the flip side of saving. Government should take the extra saving that no one else wants and borrow it. The citizen gets a nice bond as a store of value, but the really critical thing is that the money is put to use building stuff and increasing the capital stock. Yes, government debt increases, but so does the nation’s capital stock. Yes, government debt increases, but lenders also hold an exactly offsetting asset. That asset is, effectively, a claim against the benefit stream from whatever bridge or road the government built with the borrowed money.
    In equilibrium, for everyone that wants to save $1, there must be someone or some entity willing to borrow $1. The government should be the borrower of last resort.

  32. 2slugbaits

    Question for Menzie: Why is the book so reasonably priced?
    If your academic colleagues get word that you’re publisher is not overcharging for a book you wrote, then they may not speak to you in the faculty lunchroom.

  33. 2slugbaits

    Wisdom Seeker Break the fiat-dollar mindset and the answer is obvious: A nation can save by producing more than it consumes, and storing the surplus production as tangible capital.
    You’ve assumed away the problem, so that’s why the answer seems obvious. The central problem is that there is already too much privately owned capital stock. Why would a business already sitting on excess capacity increase capital? The normal way that is done is by lowering the interest rate to induce more investment even in the face of depressed demand; but what happens when the interest rate is already at zero? What happens when businesses will only expand the capital stock if the interest rate were negative? That’s the part that you’re missing. There is an obvious answer…it’s that government should provide savers with the desired financial assets (i.e., govt bonds) and use that borrowed money to increase the public’s capital stock. The rule of thumb is easy. In the boom times the govt should scale back on infrastructure spending; in the bad times the government should increase infrastructure spending.

  34. Frank in midtown

    I must echo Rob’s comments as a generally non-contributing follower, but Ricardo’s assertion of the cost of SOX ignores the rise of hedge funds/private equity investment vehicles as an alternative to IPO’s. IPO’s have largely been regulated into having equal access across investor classes. This lack of exclusivity has acted against the marketability of IPO’s. The logic is “how can this be such a great deal if anybody can get in on it?” Investments are sold, not bought. It is the time of the hedge fund, the time of the IPO has past. Lastly, Ricardo, can you spare us the theft rhetoric, the rest of us are still somewhat stunned by the social costs of an under-regulated over-leveraged subprime debt market.
    Households prefer to fix their balance sheets by increasing income and cutting costs, this means the Government has to be decreasing its income and its increasing costs. The demographic drag of the Gen-X is still causing loss of economy of scale in businesses serving that cohort.

  35. colonelmoore

    I wrote: 2slugs, I am having a hard time understanding you on the matter of paying down household debt versus savings. You say, “please explain how anyone EVER saves without another party accepting an exactly equal and offsetting debt obligation?”
    I did not get a response. Instead you repeated your same comments about the government needing to run deficits to counter private saving, as if paying down a debt is the same as putting money in a savings account.
    Paying off a debt does not create a deposit in a bank somewhere. It is the exact opposite. When a bank loans money it goes into an account somewhere. When the loan principal is repaid, the money that was created ceases to exist.
    Get Rid of the Fed had written, Lastly, the solution to too much lower and middle class debt is NOT more gov’t debt. There was no mention of savings. Therefore your notion that that the government must run a deficit is a response to something that was never said. I am guessing that this was not an intentonal straw man argument but merely an oversight on your part.

  36. ragweed

    “I urge Prof Chin to examine the real effect of dismantling the Glass-Steagall Act. I contend this unleashed unfettered institutional speculators who not only manipulated stock prices here and abroad, but far more dangerously wreaked havoc by raising funds via securitisation activities on the wholesale debt markets and plundered central banks’ foreign exchange reserves across the globe. ”
    I think Prof. Chin is mostly correct, though I think he is talking about a very different scope of what it means to “repeal Glass-Steagall” Technically the Gramm-Leach bill repealed the Glass-Steagall separation between investment and commercial banking. But, by before Gramm-Leach, the horse was already let out the door through a number of deregulations that allowed for the development of the shadow banking sector. The problem with the financial crisis was not because commercial banks were getting into investment banking activity, though I don’t think that helped. The problem was that investment banks and related financial entities were taking over commercial banking functions through money-market funds, REPO, and structured finance. The result was a shadow-banking sector that was woefully under-regulated, and did not have the lender-of-last-resort protections that commercial banking had. Thus the run on REPO after the Lehman Bros. bankcruptcy.
    One could reduce the absolute wall of Glass-Steagall in a way that did not put the public at risk. There is really no reason why someone shouldn’t be able to have a single bank that could provide a checking account and manage their investments – provided it were properly regulated. The real risks come from letting CDSs, securitization and structured finance run amok with little regulatory oversight.
    John

  37. Get Rid of the Fed

    colonelmoore said: “Get Rid of the Fed had written, Lastly, the solution to too much lower and middle class debt is NOT more gov’t debt. There was no mention of savings. Therefore your notion that that the government must run a deficit is a response to something that was never said. I am guessing that this was not an intentonal straw man argument but merely an oversight on your part.”

    savings of the rich = dissaving of the gov’t (preferably with debt) plus dissavings of the lower and middle class (preferably with debt)

    Hopefully, more later.

  38. 2slugbaits

    colonelmoore I think I did answer your question. I am talking about income at the macro level. I am not talking about individual households. Obviously individual households improve balance sheets by paying down debt and the recipients of those debt payments are better off. But if those folks simply park the money in a bank or in their mattress and it is not used for investment, then from the macroeconomic view the saving is lost. You have to think in terms of saving as a flow variable. It’s not lost as a stock variable but it is lost in terms of income flow if it is not invested. When viewed as a flow variable a nation cannot save its way to prosperity if that saving is allowed to leak into the safety of bank vaults and mattresses.

  39. Get Rid of the Fed

    2slugbaits said: “Government should take the extra saving that no one else wants and borrow it. The citizen gets a nice bond as a store of value, but the really critical thing is that the money is put to use building stuff and increasing the capital stock. Yes, government debt increases, but so does the nation’s capital stock. Yes, government debt increases, but lenders also hold an exactly offsetting asset. That asset is, effectively, a claim against the benefit stream from whatever bridge or road the government built with the borrowed money.”

    This is exactly what I don’t want. If that “benefit stream” isn’t enough then the rich bond holder says cut Social Security, Medicare, and/or Medicaid so I get the return I want or I will sell the bond/not roll it over and buy real assets to drive up their price. Both of those drive up interest rates. The idiots in congress say we’ll do whatever you want just don’t let interest rates go up (with begging).

    “In equilibrium, for everyone that wants to save $1, there must be someone or some entity willing to borrow $1. The government should be the borrower of last resort.”

    IMO, an economy can be run with zero (0) private debt and zero (0) public debt. IMO, that borrow $1 should be dissave $1.

  40. Get Rid of the Fed

    2slugbaits said: “The normal way that is done is by lowering the interest rate to induce more investment even in the face of depressed demand; but what happens when the interest rate is already at zero?”

    Actually, I believe lowering the interest rate (fed funds rate) usually leads to lower interest rates “across the board”. The most likely scenario is that people go into debt because of the price/wage expectations from the 1970′s. The increase in debt leads to an increase in demand for mostly durables (especially autos and houses). These companies then see the increase in demand and then usually increase their investment (maybe with debt from low interest rates too). I believe CalculatedRisk has posts about housing leading the recovery from almost all (if not all) recessions in the post WWII period.

  41. colonelmoore

    2slugs you said “Obviously individual households improve balance sheets by paying down debt and the recipients of those debt payments are better off. But if those folks simply park the money in a bank or in their mattress and it is not used for investment, then from the macroeconomic view the saving is lost.”
    One of us is wrong. My information came from calling up the Fed and talking to an economist there. When a loan to a bank is repaid there is no “recipient” who can park the money in a bank. The bank created money by lending it and it is destroyed when it is paid back.

  42. Get Rid of the Fed

    colonelmoore said: “When a loan to a bank is repaid there is no “recipient” who can park the money in a bank.”

    If it is a bank or something bank-like, then the demand deposit is destroyed. True.

    If it is not a bank or something bank-like, then the demand deposit is returned to the lender. For example, a company sells a bond to me for one year at 5% interest, which I buy with my SAVED demand deposit. At the end of one year, hopefully I have a total of $105.

  43. Rob

    Thanks to all; I have some reading to do…
    I am endlessly thankful for all the erudite Posts (Prof’s posts) and the comments.

  44. Menzie Chinn

    Rob: In general, to understand a subject, I recommend reading a textbook, in order to get a systematic overview. I suggest Hall and Papell, Macroeconomics (W.W. Norton), or Blanchard’s text.

    Thanks to ab, Charles ppcm, and James for the congratulations.

    ab: A depreciated dollar would induce greater production of traded goods and services, much of which would be in manufacturing.

    colonelmoore: I don’t know if you have much familiarity with the admissions process at Harvard, but let me just say not all admissions are purely merit based. So when you say selective, you might be careful, and think about a not-insubstantial share of applicants who get “preference” for admissions on the basis of whether their parents attended Harvard. Well, maybe you like that sort of particularism to be the general basis for operation of the economy. If so, well, I’d prefer to be in a different economy.

    Tyler Durden: Academics “captured” by Fed’s visiting scholar money? Man, you make me laugh and laugh and laugh. For sure, that’s not the way to get rich. Work for an investment bank as an economist, consult for a private firm — that’s the ticket.

    Stormy: The trade deficit shows up as the current account deficit, which is the mirror image of the capital account surplus (i.e., borrowing from the rest of the world).

    2slugbaits: The pricing is a mystery to me. But I hope the “reasonable” price is helpful in spreading our assessment more widely.

  45. colonelmoore

    Prof. Chinn said: “colonelmoore: I don’t know if you have much familiarity with the admissions process at Harvard, but let me just say not all admissions are purely merit based. So when you say selective, you might be careful, and think about a not-insubstantial share of applicants who get “preference” for admissions on the basis of whether their parents attended Harvard. Well, maybe you like that sort of particularism to be the general basis for operation of the economy. If so, well, I’d prefer to be in a different economy.
    Description of Red Herring
    A Red Herring is a fallacy in which an irrelevant topic is presented in order to divert attention from the original issue. The basic idea is to “win” an argument by leading attention away from the argument and to another topic. This sort of “reasoning” has the following form:
    Topic A is under discussion.
    Topic B is introduced under the guise of being relevant to topic A (when topic B is actually not relevant to topic A).
    Topic A is abandoned.
    This sort of “reasoning” is fallacious because merely changing the topic of discussion hardly counts as an argument against a claim.
    Prof. Chinn’s response is a classic care of the red herring fallacy. Harvard may dilute the academic merit of its freshman class by engaging in preferential admission policies, but that does not change the fact that its freehman class has a much higher proportion of students with perfect SAT scores and high school valedictorians than that of Wisconsin Madison.
    The purpose of the comparison was not to ridicule Wisconsin, whose purpose as a state institutiion differs from that of Harvard. The analogy was intended to demonstrate which forms of regulation are most effective in restricting bad lending practices. I chose the analogy to college admissions because it is a much less complex field than the global economy and anyone can see that restricting admissions results in a better level of student. Limiting the number of freshman results in a class with higher SAT scores and limiting the amount of money for lending results in a loan portfolio with better FICO scores. How can one refute that?
    Prof. Chinn needed either to show where his book discussed the primacy of Basel I and II on lending practices or else explain why my idea is wrong – that simply restricting the amount of money available for lending would have prevented banks from enaging in massive over-lending.
    To bring things back to the original point, here is a list of Prof. Chinn’s candidates for the origins of the financial crisis of 2008.
    Community Reinvestment Act (CRA)
    The GSE’s: Fannie and Freddie
    Derivatives: MBS’s, CDO’s and CDS’s
    Lax monetary policy
    Global saving glut
    Financial deregulation
    Tax cuts and fiscal profligacy
    Tax policy
    If Basel is hidden in there somewhere perhaps he can show us with an excerpt from the book, and then explain why he dismisses it as the primary cause.

  46. Menzie Chinn

    colonelmoore: If one is not in command of the facts in analogies, one wonders about command of facts in substantive areas.

    The US was late to final implementation of Basel II (like, November 2007! [a]) — so if that was the cause of the crisis that was centered in the U.S., it acted very quickly. I’d say things like SEC’s approval for investment banks to leverage up, failure of the Fed and OTS to rein in subprime mortgage lending directly, and the failure to regulate CDS’s were bigger contributors (to a crisis that was centered in the United States, while Basel II applied worldwide). The sovereign debt crisis of Europe (excepting Greece) is of a more recent vintage than the crisis of 2008.

    I’ll let you buy the book and make your own assessment of the evidence.

  47. colonelmoore

    Prof. Chinn said, colonelmoore: If one is not in command of the facts in analogies, one wonders about command of facts in substantive areas.
    Does this mean that if I find an instance where Prof. Chinn is not in command of the facts in an analogy that I should dismiss his command of facts in general? I would prefer to rate each of his statements on its individual merits.
    Speaking of which, he states: The US was late to final implementation of Basel II (like, November 2007!) — so if that was the cause of the crisis that was centered in the U.S., it acted very quickly.
    Is this the basis on which Prof. Chinn’s book does not discuss Basel II’s capital requirements?
    In academic literature it is customary to review the body of writing on the same subject and explain away competing assertions.
    In fact a paper by two OECD economists discusses Prof. Chinn’s exact point: http://www.oecd.org/dataoecd/33/6/42031344.pdf
    (Google Scholar shows 33 citations of this paper. The difference between the ivory tower view of regulations and the way business actually deals with them is striking in this example.)
    5.5 Off-balance sheet treatment

    Given that Basel II would deal explicitly with off-balance sheet exposures in this way, and that the time line for its introduction was clear, a rational financial organisation would not take advantage of the anomalies under Basel I by rapidly growing its off-balance sheet exposures, only to find that it had to deleverage massively or to raise capital as Basel II came into force – unless, of course, Basel II was to free up capital anyway, and off-balance sheet exposure could be concentrated in products with weights much lower than Basel I. This, of course, was exactly the situation that banks became aware of by 2005, and fits with the explosion of private-label RMBS at that time. Basel II implied:
    i. mortgages risk weights would be cut to 35 per cent under the simplified system, and much less than 35 per cent under the IRB approach, encouraging the expansion of on-balance sheet mortgages from 2004 onwards (see Figure 2);
    ii. increased scope for banks originating securitisations to reduce their exposures, or exclude them altogether, as well as the low risk weights (7 per cent to 35 per cent under IRB) for senior tranches rated BBB+ or above; and
    iii. banks would be fully encouraged to arbitrage differences in risk weights by shifting to real estate and securitised assets due to the additive nature of required capital without penalty for concentration – other than Pillar 2 requirements being imposed after the fact (see the RMBS acceleration after 2004 in Figure 3).
    It would be very naïve to believe that banks did not begin to incorporate these changes into their growth strategies. The following quote from a senior investment banker not wishing to be named, sums up the situation:
    We started looking at the implications of Basel II from the day it was published back in 2004. Changes like these have huge implications for our business, so you can’t just leave it to one side until the system is up and running. Internal seminars and meetings began even before the 2004 publication. We have been looking at this and adopting anticipatory strategies for at least four or five years. What you have to understand about complex regulations that affect our business is that we work intensively to minimise the impact they have on our bottom line. It is exactly the same as with taxation. The more complex the structure the more scope there is for finding ways around it! It amazes me that regulators asked us to set our capital regulation weights, given the way the incentives are. Of course our managers want to participate in the process, for all the obvious reasons. But good luck to any supervisors who want to find out what is going on inside businesses – that is difficult for insiders to know fully and impossible for outsiders. In our country the supervisors are thought of as excellent on a global comparison, and we think they are very smart. It is just that the scope to choose how you report and measure things is so huge. Our internal processes and resources are enormous, and we work only on our own bank. The supervisors can never match this with the best will in the world.

  48. Menzie Chinn

    colonelmoore: Monocausal explanations (which is not necessarily the OECD view, if you read the entire document you linked to) are appealing but I think unsupported. The question is whether some of the measures would have been implemented even in the absence of Basel II, and we see in the US final rulemaking occurred in late 2007 (as indicated in the link to the Fed press release) which you dismissed. Do you disagree that the crisis originated in the United States?

    Anyway, read the book.

  49. Get Rid of the Fed

    colonelmoore and Menzie Chinn, it seems to me everything listed is involved in allowing for too much debt (whether private or gov’t).

  50. Anonymous

    Prof. Chinn,
    I think we are losing track of the point I was making. I thought it passing strange that you did not even discuss the role of Basel II in your book.
    You asked: Do you disagree that the crisis originated in the United States?
    What say we not conflate origin with cause?
    As my other favorite paper, the one from the BIS stated, … the difficulties in the subprime market were a trigger for, rather than a cause of, all the disruptive events that have followed.
    You said, … we see in the US final rulemaking occurred in late 2007 (as indicated in the link to the Fed press release) which you dismissed.
    See the end of my response on September 25, 2011 at09:36 AM, where I quote the OECD paper as it discusses how a regulation that goes into effect is actually being planned for long in advance. I made reference to how ivory tower academics see regulation and how it is dealt with by affected businesses.
    You said: The question is whether some of the measures would have been implemented even in the absence of Basel II…
    Your effort seems to be to get me to admit that US regulatory slackards are to blame for everything, since you overlooked Basel in your book. It is irrelevant to me whether Greenspan would have acted alone. I want to prevent future crises is to target regulation to exogenous causes, not endogenous variables.
    I agree with the OECD paper: Understanding causality is a precondition for correct policy-making. Causality in economics usually carries the connotation of ‘exogeneity’: a policy distortion, a change or a shock not caused by events, but setting them in motion. Endogenous variables respond to the shock, subject to certain parameters or conditioning factors that may restrain or exacerbate outcomes – themselves often drifting and stretching over time. The reform process needs to consider the conditioning factors, and improve them. But bubbles and crises will still occur if the causal distortions are not addressed directly. Think of the analogy of a flood of running water from a badly made and bursting dam: the gullies, rocks and branches in its way are conditioning factors that influence the speed and direction of the flow – but the excess water will always find its way around these obstacles. They only influence precisely where the inevitable damage to the landscape will occur. A bad dam is causal. The obstacles (levies etc) may moderate or exacerbate the situation, but most fundamentally we need to understand what constitutes good and bad infrastructure. So it is with liquidity, financial bubbles, crises due to excess leverage and regulation.
    It further states: The mechanisms involved in preparing for Basel II and concentrating in mortgages played a key role in some of the banks that suffered huge losses. The Basel II transition was a necessary if not sufficient condition to explain the sudden nature of the acceleration of RMBS after 2004.
    Note: The Basel II transition was a necessary … condition. The meaning of “necessary” as the antecedent is that, without Basel, the consequent would not have occurred.
    This is the only such statement in the entire paper. So although the paper discusses other issues, they are in context of its major premise, that the concentration into RMBS was in direct consequence of the transition to Basel II.
    (Footnote: It also mentions the curious case of Fannie and Freddie as a second factor in the US crisis but states that the problems in Europe’s banks were independent of this.)
    To summarize, the bone that I am picking is that your book apparently does not deal with Basel II as a causal factor. At least it could have referenced the literature on Basel II and discussed why it is irrelevant.
    Yours is not the only such omission. I maintain that incentive distortions are at work. The federal government is the largest purchaser of goods and services in the world. It differs from corporations in that every 2, 4 and 6 years, there are elections in which its management and therefore its business plan and therefore the types of goods and services it buys can change rather dramatically. A lot of folks are lined up to be suppliers of these goods and services, and so from the minute the election a lot of effort goes into sabotaging the efforts of the current management.
    There is however a second part of the government that represents the interests of the banking industry. It is unelected. It rules supreme over financial matters, which is why the old stock market adage, “Don’t fight the Fed” has the ring of truth. (Ever ask yourself why no one says, “Don’t fight the President?”)
    Because the Fed is unelected, the incentive is for the average polltician or those who want to support certain political positions to target the policies of the other party. (Blame Bush. Blame Barney Frank.) If successful at rousing the voters to their side, they get to control the spending of the world’s largest consumer.
    The unfortunate side effect of this incentive distortion is that the appearance of change substitutes for real change.

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