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March 16, 2008
David Warsh, Proprietor


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How Did It Become So Dangerous?

This was the week that the sub-prime lending debacle turned into a full-blown financial crisis.  Look beyond the Federal Reserve Board’s new $400 billion special lending facility for the holders of mortgage-backed securities that was announced last week; look beyond its bailout of Bear Stearns. Look beyond the scheduled Tuesday meeting of the Federal Open Market Committee, which is expected to cut interest rates some more.

 

William White, chief economist at the Bank for International Settlements, in an interview with the Financial Times Thursday, described the difficulties facing economic policymakers as seeming “as great today, if not greater, than at any other time in the post-war period.”

 

The next day Paul Krugman, of The New York Times, wrote that the situation “looks increasingly like one of history’s great financial crises.” And Martin Feldstein, of Harvard University, said that a recession was underway that could turn into the worst since World War II.

 

How did the consequences of a residential housing mania in the United States at last become so dire?

 

Go back, for a moment, to the Bank for International Settlements. Established Switzerland, in the 1920s, in Basel, to serve as a conduit for the reparations payments mandated by treaty at the end of World War I, the BIS has evolved into a something much more useful. Today it serves as adviser, coordinator and lender of last resort to the 55 sovereign central banks (including the US Federal Reserve Bank) who are its members.

 

BIS pronouncements, especially those of its late June annual report, are thought of as being the ultimate voice of caution in the global financial system.  (Chief economist White, incidentally, is stepping down this summer after a dozen years in the job. Brandeis University professor Steven Cecchetti, who served as research chief at the Federal Reserve Bank of New York during 1997-99, last week was named  to succeed him.)

 

So what did the BIS say last year?  Nothing to damage its reputation. Like most other discussions of international economics, its report began pondering how the rapid growth, low inflation, low interest rates and global trade imbalances of the last several years had fit together to process several extraordinary years for the world economy. It underscored issues that would become three big stories of the coming year: US home prices that had ceased to rise; the soaring issuance of structured credit products; and the appearance of sovereign wealth funds. 

The main sources of risk? “Elevated exposures to real estate, an increase in leveraged finance, including in the booming private equity market, and a worsening in the credit cycle are important areas of vulnerability” of the financial system.  No one wanted to roll back the changes in the world financial system that had occurred during the past thirty years, wrote the BIS. “Nevertheless, more skepticism might be expressed about some of the purported benefits of having new players, new instruments and new business models, in particular the ‘originate and distribute’ approach which has become widespread.”

In a conclusion titled “Prevention Rather that Cure?” the BIS signaled its preference that governments, central bankers and regulators should lean against speculative booms rather than simply wait for them to end and hope to clean up afterwards.  To be sure, vigorous monetary easing had worked “reasonably well” in many instances over the previous twenty years, notably after the dot.com crash in 2001.  

But there had been instances in which monetary policy conspicuously failed to accomplish its goal, the chief case in point being Japan, whose economy stagnated for fifteen years after a runaway boom ended in 1990. In contrast, according to the BIS, the aggressive restructuring of the Scandinavian banking system about the same time was a good example of why liquidity alone could not be expected to solve the problem of bad debts and unprofitable investment that followed an overheated boom. Measures similar to the Nordic reforms (and, for that matter, to the US savings and loan workout of about the same time) have since been adopted by the Fed. 

There are those who say that the Fed acted too slowly to flood the market with liquidity last summer. (The BIS last June expected trouble to materialize only in the medium term, even though Bear Stearns was being forced to bail out two of its hedge funds even as the bank’s report appeared.) Harvard’s Feldstein sounded a loud alarm in August at a central bankers’ meeting in Jackson Hole, Wyoming. Feldstein had been a disappointed candidate for the job that Fed chairman Ben Bernanke got. And his argument that a credit market crisis could be averted did not carry the day.

 

Since then, the great danger has become the possibility is that the Fed is spread too thin to be able to force Wall Street to fully write down its losses, with the result that an atmosphere of crisis persists and recently has intensified. It’s not that the losses themselves are so great; it’s that nobody knows which confidence where they are. Meanwhile, as it cuts interest rates, the central bank risks accelerating the decline of the dollar, coming ever closer to the dreaded fail-safe point at which the Fed must raise rates sharply in order to stop the fall. And in offering last week to take on board up to $400 billion in illiquid mortgage-backed securities as collateral in order to enable banks to begin confidently lending for housing again, the central bank has loaded up fully half its $800 billion portfolio with assets of dubious worth.

 

So suppose this really is “one of history’s great crises.”  How did it get that way? There can be only one answer here, and it isn’t the bad conduct of monetary policy.  It wasn’t Ben Bernanke who put the Fed up there on the high-wire. 

Recall the broad outlines of the Bush administration’s economic policy since 2001, when the White House inherited a substantial budget surplus and a rapidly slowing economy.  The decision to reverse the Clinton tax increases of 1993 was easy to sell, in the name of stimulating the economy, but it left it the government somewhat vulnerable after 9/11. A second round of tax cuts on the eve of a war in Iraq that turned out to be far more expensive and longer than expected only left the US government more exposed.  (Oil was $25 a barrel when the US invaded.) The decision to greatly expand elderly pharmaceutical benefits with no corresponding means to pay for them exacerbated the long-term Medicare deficit; the ill-fated attack on Social Security after Bush’s 2004 re-election postponed indefinitely the day when a compromise can be achieved. All the while, pressure on Alan Greenspan at the Fed to get the economy growing again produced the real estate bubble. Only the administration’s mid-term Congressional defeat prevented the appointment of a much less able man than Bernanke (or Feldstein) to the Fed. 

Could the Bush administration have run American economic policy any worse? Welcome to a recession that threatens to be both deep and long, the result of  bungling not seen since the presidency of Jimmy Carter.

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The University of California at Berkeley announced last week that it has raised a $1.1 billion fund to fight raids on its faculty by wealthier private universities, such as Harvard, Yale, Princeton and Stanford. The money will endow chairs for 100 professors and facilitate raises for Berkeley professors who now often earn as much as 30 percent less than their counterparts at private universities.

Chancellor Robert Birgeneau said Berkeley would revamp the management of its $2.9 billion endowment, too, in hopes of matching the 25+ percent returns achieved in recent years by the most successfully-managed private university portfolios.

It is a hopeful sign for the nation’s highest-ranked public university.  Perhaps it will be enough to counter over the next few years the threat reported here last week to one of the nation’s most creative economics departments.

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