A year ago last month, I attended two international conferences, in Istanbul and Oxfordshire, England, that concentrated on the economy. The consensus was that there was a capital surplus around the world, with people looking desperately for places to invest and not demanding much in the way of a risk premium. There was concern about what would happen when a crisis—a financial breakdown of some sort—might occur. No one, as I recall, mentioned American subprime mortgages.
Well, the crisis came two months later with the collapse of the subprime mortgage market and much else besides. I don't claim to understand all of this, but it has been a fascinating ride, and it is probably far from over. The proximate cause of the subprime mess has seemed to me something that is eminently fixable. The agencies that rate the creditworthiness of packages of securitized mortgages have been paid by the sellers of the packages. In retrospect, it seems obvious that they should be paid by the buyers. And, perhaps, that the number of ratings firms, now strictly limited by the SEC, should be increased. I gather that this will probably be done, sooner or later (a high Treasury official told me last year we should wait till the crisis simmers down), but intuitively it seems far from sufficient to get financial markets fully functioning again.
For guidance in my thinking, I have come to look to my American Enterprise Institute colleague Peter Wallison, whose latest long paper is titled, "For Financial Regulation, the Era of Big Government Really Is Over." Wallison notes that for all the financial roilings, the "real economy" keeps rolling along. "The picture this suggests is of a globalized economy that is far more flexible, diverse, nimble and robust than most observers would have imagined." This is one of Alan Greenspan's themes in his memoir, which in my view should not have been titled The Age of Turbulence but The Age of Resilience. Growing up in Detroit in the 1950s, I saw how the metro area's economy was subject to sharp contractions when the macroeconomy slowed down and demand for new cars suddenly dropped off. The Big Three auto industry worked on three-year product development cycles and its three- or five-year contracts with the United Auto Workers. That economy was very inflexible and had little resilience. In contrast, the economy of the last decade has mostly produced low-inflation economic growth despite a series of shocks—Long-Term Capital Management in 1998, the bursting of the high-tech bubble in 2000, Sept. 11, 2001, the prolonged Iraq war, and now the subprime mortgage crisis.
Writing from long experience (he was a year or two ahead of me at Harvard and served as general counsel to the Treasury 25 years ago), Wallison notes that our economic world is much different from the one we grew up in. "First, the financial resources of the government today are no longer large in relation to the size of the private sector." The Federal Reserve's balance sheet is $800 billion while the real assets of the 10 largest private-sector banks are $17.4 trillion—more than 20 times larger. Currency markets trade something like $618 billion every day. The Fed can take on loans from Bear Stearns. But its capacity for intervention is limited.
The second factor "is that governments cannot control where financial transactions occur." This is not entirely a new thing: In his work on the Mediterranean in the 16th and 17th centuries, the French historian Fernand Braudel wrote, "Capitalism laughs at frontiers." But the statism inaugurated in response to the world wars of the 20th century erected some pretty strong barriers against capital and currency movements. I remember that in the early years of Harold Wilson's first Labor government, in 1964 or 1965, the United Kingdom prohibited its citizens from taking more than £100 out of the country. Imagine if a major government tried to do that today! The government would have to confiscate the credit and debit cards of every outgoing traveler. The Bretton Woods structure that was set up by John Maynard Keynes and others after World War II—fixed-exchange controls pegged to the dollar, GATT, and the IMF—worked pretty well for a quarter century, until it was abruptly dismantled by Richard Nixon and John Connally in August 1971, and depended on government control of the flows of money, which simply could not occur today. A world accustomed to global depression and world war was willing to accept such controls. Ours isn't.
Wallison's third point is that "financial innovations are making private risk management more effective than government regulation." He points especially to credit default swaps that enable private parties to slough off risk onto other private parties. Trying to set up a regulatory mechanism to achieve the same goals, he argues, would be impossible and would almost certainly have unfortunate side effects. Banks are currently much more heavily regulated than investment banks (and for good reason), he points out; but banks were hit as badly by the subprime crunch as investment banks. In his conclusion, Wallison quotes the warning against overregulation by New York Fed President Timothy Geithner (a Clinton appointee, by the way) and goes on:
Regulatory policy, then, as Geithner suggests, should focus on things markets themselves cannot solve, not on those problems markets—and market discipline—can effectively address. This means policies that enhance transparency to make market discipline more effective, avoid moral hazard and encourage the development of clearinghouses for [credit default swaps]. Above all, it means that government regulatory policies should not make things worse by failing to recognize government's own limitations in an era when private markets have grown so large.
This seems to me to get things right. Government clearly has a role in establishing regulations that structure financial markets, just as it has a role in enforcing contracts and proscribing fraud. But government can't force financial institutions to make only good bets. If the smart and highly compensated people in financial institutions can't always do so, despite the strongest incentives to try, why do we think that even the smartest government regulators (and many of them are indeed very smart but they are and will always inevitably be much less highly compensated than those they regulate) can do so?
But some, looking back on the subprime mortgage mess, may argue that at least in the highly regulated and subsidized housing markets, there may be some basis for more regulation. Here I take as my text a pessimistic article on the housing market by another AEI colleague, Lawrence Lindsey, whose tenor is illustrated by its title, "It's Only Going to Get Worse." Let me put it into perspective by going back to my law school days in the late 1960s, when I took a course in housing finance by a young professor named George Lefcoe. He was consulting with the newly named Department of Housing and Urban Development and defended his participation in the government by saying that he was trying to solve a long-term problem: that the private sector could not provide all the housing the nation needed, particularly housing for those with low incomes and the poor. That had been pretty much a standard view since the 1930s, and indeed the private sector built very little housing in the 1930s, when almost no one could afford a new house, and from 1940 to 1945, when the nation's economy was on a wartime footing. In 1949, Congress passed a housing act, providing greater funding for both public and private housing; it was sponsored not only by liberal Democrat Robert Wagner but by conservative Republican Robert Taft, who accepted the premise that the private sector could not do the job alone.
By the time I was considering the situation, nearly 20 years later, it should have been obvious that the private sector had been providing huge amounts of housing over the preceding two decades. Just drive around the suburbs and you could see it. But I didn't think to reach this commonsense conclusion, for two reasons. First, the private housing industry seemed chaotic. Growing up in Detroit, and reading my John Kenneth Galbraith, I operated under the assumption that if you wanted to get big things done, you had to have big organizations—big corporations or big government agencies—to do it. Little guys could not just get things done (although two of the little guys who got their start building houses in the Detroit suburbs, Eli Broad and William Pulte, have since become very big guys indeed). Second, our focus was on providing housing for the poor and the black, and the market didn't seem to be doing a very good job of that. Just drive around the streets of Detroit, as I often did, and you could see that. What I refused to see is that perfectly good housing structures in Detroit and other central cities were being destroyed by crime: High crime rates made properties virtually worthless, and owners allowed them to slide into ruin.
In the years since, public housing has been virtually abandoned, while government has tried with considerable success to direct vast flows of capital into the private housing market. Even by the late 1960s, it was becoming obvious that central city housing projects (except for some senior citizen projects) were hellholes, and in time we saw the spectacle of the current Mayor Daley pulling down the Robert Taylor high-rises his father had built a generation or so before. (The late Mayor Daley, incidentally, wanted to build low-rise housing instead, because he foresaw that the high-rises would be a bad place to raise children; he couldn't get enough money from the feds to do so.) Since the late 1960s or early 1970s, government has been placing public housing-eligible households in scattered rentals throughout metro areas through the Section 8 program. But Section 8 seems to have had a dreadful effect: increasing crime in heretofore low-crime areas, as Hanna Rosin reports in the summer Atlantic. Public housing advocates used to say that bad housing degraded its tenants; Rosin makes it plain that something like the opposite is the case, that bad tenants degrade housing and neighborhoods.
In recent years, politicians of both parties have wanted to encourage homeownership. The securitization of mortgages by Fannie Mae and Freddie Mac have contributed to that; so did government-encouraged subprime lending. In addition, in the months and years after September 11, low interest rates—so low that they were below zero in real terms at some points—encouraged home purchases, and in a period of increasing unemployment and low stock prices the prime engine of growth seems to have been the housing sector, with homeowners refinancing their mortgages and converting the wealth they had accumulated in housing values into cash for consumption or investment. All of this worked out fine so long as housing prices held up; when they started to fall, due to oversupply or to subprime and other mortgage defaults, we suddenly faced a macroeconomic problem. I think it may be wise to think of the bursting of the housing bubble as an aftereffect of September 11: Housing kept the economy growing for several years, but the resulting oversupply resulted in something of a crash. Our economy has proved, as Peter Wallison says, very resilient. But not totally so.
Finally, let me recommend The World Is Curved: Hidden Dangers to the Global Economy by David Smick. He started off as an adviser to Jack Kemp in the 1970s and in the 1980s set up an economic consulting business with former Fed Vice Chairman Manuel Johnson. Smick is a leading Fed-watcher, and the book is full of interesting observations he has made over the years as well as his analysis of where the world economy is now and where it may go in the future.