The Sound of Air Escaping
If the previous chapter had been written as a novel, one wouldn’t have to read long before concluding that it is a story unlikely to end well. But it is not just a story, it is a description of the system in which our lives and the lives of everyone we care about are embedded. How economic events unfold from here on is a matter of more than idle curiosity or academic interest.
It’s not hard to find plenty of opinions about where the economy is, or should be, headed. There are Chicago School economists, who see debt and meddling by government and central banks as problems and austerity as the solution; and Keynesians, who see the problem as being insufficient government stimulus to counter deflationary trends in the economy. There are those who say that bloated government borrowing and spending mean we are in for a currency-killing bout of hyperinflation, and those who say that government cannot inject enough new money into the economy to make up for commercial banks’ hesitancy to lend, so the necessary result will be years of deflationary depression. As we’ll see, each of these perspectives is probably correct up to a point. Our purpose in this chapter will be not to forecast exactly how the global economic system will behave in the near future—which is impossible in any case because there are too many variables at play—but to offer a brief but fairly comprehensive, non-partisan survey of the factors and forces at work in the post-2008 world financial economy, integrating various points of view as much as possible.
To do this, we start with a brief overview of the meltdown that began three years ago, then look at the theoretical and practical limits to debt; we review the bailout and stimulus packages deployed to lessen the impact of the crisis; and finally we explore a few scenarios for the short- and mid-term future.
Houses of Cards: The Last Bubble
Lakes of printer’s ink have been spilled in recounting the events leading up to the financial crisis that began in 2007-2008; here we will add only a small puddle. Nearly everyone agrees that it unfolded in essentially the following steps:
- Easy credit (due to Fed’s lowering of interest rates in an attempt to limit the consequences of the dot-com crash of 2000) led to a
- Housing bubble, which was made much worse by sub-prime lending.
- Partly because of the prior deregulation of the financial industry, the housing bubble also was magnified by over-leveraging within the financial services industry, which was in turn exacerbated by financial innovation and complexity (including the creation of derivatives, collateralized debt obligations, and a dizzying variety of related investment instruments)—all feeding the boom of a shadow banking system, whose potential problems were hidden by incorrect pricing of risk on the part of ratings agencies.
- A commodities boom (which drove up gasoline and food prices) and temporarily rising interest rates (especially on adjustable-rate mortgages) ultimately undermined consumer spending and confidence, helping to burst the housing bubble—which, once it started to deflate, set in motion a chain reaction of defaults and bankruptcies.
Each of the elements of that brief description has been unpacked at great length in books like Andrew Ross Sorkin’s Too Big to Fail and Bethany McLean and Joe Nocera’s All the Devils Are Here: The Hidden History of the Financial Crisis, and in the documentary film “Inside Job.” It’s old, sad news now, though many parts of the story are still controversial (e.g., was the problem deregulation or bad regulation?). It is important that we review this recent history in a little more detail, and it is even more important that we understand that these events were merely the manifestations of a deeper trend toward dramatically and unsustainably increasing debt, credit, and leverage, in order to see why, from a purely financial point of view, growth is currently on hold and is unlikely to return for the foreseeable future.
Starting in the 1970s, GDP growth rates in Western countries began to taper off. The U.S. had been the world’s primary petroleum producer; now its oil production was sliding into permanent decline, and that meant that oil imports would have to grow to compensate, thus encouraging trade deficits. Moreover, markets for major consumer goods were starting to become saturated.
In the U.S., wages—particularly for the hourly workers who comprise 80 percent of the workforce—were stagnating after two decades of major gains. Relatively constant wage levels meant that most households couldn’t afford to increase their spending (remember: the health of the economy requires growth) unless they saved less and borrowed more. Which they began to do.
With the rate of growth of the real economy stalling somewhat, profitable investment opportunities in manufacturing companies dwindled; this created a surplus of investment capital looking for high yields. The solution hit upon by wealthy investors was to direct this surplus toward financial markets.
The most important financial development during the 1970s was the growth of securitization—a financial practice of pooling various types of contractual debt (such as residential mortgages, commercial mortgages, auto loans, or credit card debt obligations) and selling it to investors in the form of bonds, pass-through securities, or collateralized mortgage obligations (CMOs). The principal and interest on the debts underlying the security are paid back to investors regularly. Securitization provided an avenue for more investors to fund more debt. In effect, securitization caused (or allowed) claims on wealth to increase far above previous levels. In the U.S., aggregate debt began rising faster than GDP, and the debt-to-GDP ratio began to grow from about 150 percent (where it had been for many years until 1980) up to its level of about 300 percent today.
Also starting in the late 1970s, economists and policy makers began arguing that, in order to end persistent “stagflation” largely caused by high oil prices, government should cut taxes on the rich—who, seeing more money in their bank accounts, would naturally invest capital in ways that would ultimately benefit everyone. At the same time, policy makers decided it was time to liberate the financial sector from various New Deal-era restraints so that it could create still more innovative investment opportunities.
Some commentators insist that the Community Reinvestment Act of 1977 (with updates in 1989, 1991, etc.)—which was designed to encourage commercial banks and savings associations to meet the needs of borrowers in low- and moderate-income neighborhoods—would later contribute to the housing bubble of 2000-2006. However, this notion has been widely contested. Nevertheless, the chartering of Fannie Mae (the Federal National Mortgage Association, or FNMA) and Freddie Mac (the Federal Home Loan Mortgage Corporation, or FHLMC) by Congress in 1968 as government-sponsored enterprises (GSEs) with the purpose of expanding the secondary mortgage market by securitizing mortgages in the form of mortgage-backed securities (MBSs) would certainly have implications much later, when the real estate market crashed in 2007. But we are getting ahead of ourselves.
The process of deregulation and regulatory change continued for the next quarter-century, and included, for example, the Commodity Futures Modernization Act, drafted by Senate Republican Phil Gramm and signed into law by President Bill Clinton in 2000, that contained an “Enron loophole” (so-called for its treatment of energy derivatives), and that legalized the trafficking in packages of dubious home mortgages.
These regulatory changes were accompanied by a shift in corporate culture: executives began running companies more for the benefit of management than for shareholders, paying themselves spectacular salaries and putting increasing emphasis on boosting share prices rather than dividends. Auditors, boards of directors, and Wall Street analysts encouraged these trends, convinced that soaring share prices and other financial returns (often via derivatives) justified them.
America’s distribution of income, which had been reasonably equitable during the post-WWII era, began to return to the disparity seen in the 1920s, in the lead-up to the Great Depression. This was partly due to changes in tax law, begun during the Reagan Administration, that reduced taxes on the wealthiest Americans. In 1970 the top 100 CEOs earned about $45 for every dollar earned by the average worker; by 2008 the ratio was over 1,000 to one.
In the 1990s, as the surplus of financial capital continued to grow, investment banks began inventing a slew of new securities with high yields. In assessing these new products, rating agencies used mathematical models that, in retrospect, seriously underestimated their levels of risk. Until the early 1970s, bond credit ratings agencies had been paid for their work by investors who wanted impartial information on the credit worthiness of securities issuers and their various offerings. Starting in the early 1970s, the “Big Three” ratings agencies (Standard & Poors, Moody’s, and Fitch) were paid instead by the securities issuers for whom they issued those ratings. This eventually led to ratings agencies actively encouraging the issuance of collateralized debt obligations (CDOs).
The Clinton administration adopted “affordable housing” as one of its explicit goals (this didn’t mean lowering house prices; it meant helping Americans get into debt), and over the next decade the percentage of Americans owning their homes increased 7.8 percent. This initiated a persistent upward trend in real estate prices.
In the late 1990s investors piled into Internet-related stocks, creating a speculative bubble. The dot-com bubble burst in 2000 (as with all bubbles, it was only a matter of “when,” not “if”), and a year later the terrifying crimes of September 11, 2001 resulted in a four-day closure of U.S. stock exchanges and history’s largest one-day decline in the Dow Jones Industrial Average. These events together triggered a significant recession. Seeking to counter a deflationary trend, the Federal Reserve lowered its federal funds rate target from 6.5 percent to 1.0 percent, making borrowing more affordable.
Downward pressure on interest rates was also coming from the nation’s high and rising trade deficit. Every nation’s balance of payments must sum to zero, so if a nation is running a current account deficit it must balance that amount by earning from foreign investments, by running down reserves, or by obtaining loans from other countries. In other words, a country that imports more than it exports must borrow to pay for those imports. Hence American imports had to be offset by large and growing amounts of foreign investment capital flowing into the U.S. Higher bond prices attract more investment capital, but there is an inevitable inverse relationship between bond prices and interest rates, so trade deficits tend to force interest rates down.
Foreign investors had plenty of funds to lend, either because they had very high personal savings rates (in China, up to 40 percent of income saved), or because of high oil prices (think OPEC). A torrent of funds—it’s been called a “Giant Pool of Money” that roughly doubled in size from 2000 to 2007, reaching $70 trillion—was flowing into the U.S. financial markets. While foreign governments were purchasing U.S. Treasury bonds, thus avoiding much of the impact of the eventual crash, other foreign investors, including pension funds, were gorging on mortgage-backed securities (MBSs) and CDOs. The indirect consequence was that U.S. households were in effect using funds borrowed from foreigners to finance consumption or to bid up house prices.
By this time a largely unregulated “shadow banking system,” made up of hedge funds, money market funds, investment banks, pension funds, and other lightly-regulated entities, had become critical to the credit markets and was underpinning the financial system as a whole. But the shadow “banks” tended to borrow short-term in liquid markets to purchase long-term, illiquid, and risky assets, profiting on the difference between lower short-term rates and higher long-term rates. This meant that any disruption in credit markets would result in rapid deleveraging, forcing these entities to sell long-term assets (such as MBSs) at depressed prices.
Between 1997 and 2006, the price of the typical American house increased by 124 percent. House prices were rising much faster than income was growing. During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006. This meant that, in increasing numbers of cases, people could not actually afford the homes they were buying. Meanwhile, with interest rates low, many homeowners were refinancing their homes, or taking out second mortgages secured by price appreciation, in order to pay for new cars or home remodeling. Many of the mortgages had initially negligible—but adjustable—rates, which meant that borrowers would soon face a nasty surprise.
People bragged that their houses were earning more than they were, believing that the bloating of house values represented a flow of real money that could be tapped essentially forever. In a sense this money was being stolen from the next generation: younger first-time buyers had to burden themselves with unmanageable debt in order to enter the market, while older homeowners who bought before the bubble were able to sell, downsize, and live on the profit.
Wall Street had connected the “Giant Pool of Money” to the U.S. mortgage market, with enormous fees accruing throughout the financial supply chain, from the mortgage brokers selling the loans, to small banks funding the brokers, to giant investment banks that would ultimately securitize, bundle, and sell the loans to investors the world over. This capital flow also provided jobs for millions of people in the home construction and real estate industries.
Wall Street brokers began thinking of themselves as each deserving many millions of dollars a year in compensation, simply because they were smart enough to figure out how to send the debt system into overdrive and skim off a tidy percentage for themselves. Bad behavior was being handsomely rewarded, so nearly everyone on Wall Street decided to behave badly.
By around 2003, the supply of mortgages originating under traditional lending standards had largely been exhausted. But demand for MBSs continued, and this helped drive down lending standards—to the point that some adjustable-rate mortgage (ARM) loans were being offered at no initial interest, or with no down payment, or to borrowers with no evidence of ability to pay, or all of the above.
Bundled into MBSs, sold to pension funds and investment banks, and hedged with derivatives contracts, mortgage debt become the very fabric of the U.S. financial system, and, increasingly, the economies of many other nations as well. By 2005 mortgage-related activities were making up 62 percent of commercial banks’ earnings, up from 33 percent in 1987.
As a result, what would have been a $300 billion sub-prime mortgage crisis, when the bubble inevitably burst, turned into a multi-trillion dollar catastrophe engulfing the financial systems of the U.S. and many other countries as well.
Between July 2004 and July 2006, the Fed raised its federal funds rate from 1 percent to 5.25 percent. This contributed to an increase in 1-year and 5-year adjustable mortgage rates, pushing up mortgage payments for many homeowners. Since asset prices generally move inversely to interest rates, it suddenly became riskier to speculate in housing. The bubble was deflating.
In early 2007 home foreclosure rates nosed upward and the U.S. sub-prime mortgage industry simply collapsed, with more than 25 lenders declaring bankruptcy, announcing significant losses, or putting themselves up for sale.
The whole scheme had worked fine as long as the underlying collateral (homes) appreciated in value year after year. But as soon as house prices peaked, the upside-down pyramid of property, debt, CDOs, and derivatives wobbled and began crashing down.
For a brief time between 2006 and mid-2008, investors fled toward futures contracts in oil, metals, and food, driving up commodities prices worldwide. Food riots erupted in many poor nations, where the cost of wheat and rice doubled or tripled. In part, the boom was based on a fundamental economic trend: demand for commodities was growing—due in part to the expansion of economies in China, India, and Brazil—while supply growth was lagging. But speculation forced prices higher and faster than physical shortage could account for. For Western economies, soaring oil prices had a sharp recessionary impact, with already cash-strapped new homeowners now having to spend eighty to a hundred dollars every time they filled the tank in their SUV. The auto, airline, shipping, and trucking industries were sent reeling.
Between mid-2006 and September 2008, average U.S. house prices declined by over 20 percent. As prices dove, many recent borrowers with adjustable-rate mortgages found themselves “underwater”—that is, with houses worth less than the amount of their loan; this meant they could not refinance to avoid higher payments as interest payments on their loans reset. Default rates exploded. In 2007, foreclosure proceedings increased 79 percent over 2006 (affecting nearly 1.3 million properties). The trend worsened in 2008, with 2.3 million properties foreclosed, an 81 percent increase over the previous year. By August 2008, 9.2 percent of all U.S. mortgages outstanding were either delinquent or in foreclosure; in September the following year, the figure had jumped to 14.4 percent.
Once property prices began to plummet and the subprime industry went bust, dominos throughout the financial world began toppling.
In September 2008, the entire financial system came within 48 hours of complete ruin. The giant investment house of Lehman Brothers was allowed to go bankrupt, sending shock waves through global financial markets. The global credit system froze, and the U.S. government stepped in with an extraordinary set of bailout packages for the largest Wall Street banks and insurance companies. All told, the U.S. package of loans and guarantees added up to an astounding $12 trillion. GDP growth for the nation as a whole went negative and eight million jobs disappeared in a matter of months. [Both the president and Congress pledged to put in place new regulations that would make the recurrence of such a fiasco impossible. The result was a mild rewrite of laws; according to Christine Harper of Bloomberg, “Lawmakers spurned changes that would wall off deposit-taking banks from riskier trading. They declined to limit the size of lenders or ban any form of derivatives. Higher capital and liquidity requirements agreed to by regulators worldwide have been delayed for years to aid economic recovery.”]
Much of the rest of the world was infected, too, due to interlocking investments based on mortgages. The Eurozone countries and the UK experienced economic contraction or dramatic slowing of growth; some developing countries that had been seeing rapid growth saw significant slowdowns (for example, Cambodia went from 10 percent growth in 2007 to nearly zero in 2009); and by March 2009, the Arab world had lost an estimated $3 trillion due to the crisis—partly from a crash in oil prices.
Then in 2010, Greece faced a government debt crisis that threatened the economic integrity of the European Union. Successive Greek governments had run up large deficits to finance public sector jobs, pensions, and other social benefits; in early 2010, it was discovered that the nation’s government had paid Goldman Sachs and other banks hundreds of millions of dollars in fees since 2001 to arrange transactions that hid the actual level of borrowing. Between 2009 and May 2010, official government deficit estimates rose from 6 percent to 13.6 percent of GDP—the latter figure being one of the highest in the world. The direct effect of a Greek default would have been small for the other European economies, as Greece represents only 2.5 percent of the overall Eurozone economy. But it could have caused investors to lose faith in other European countries that also have high debt and deficit issues: Ireland, with a government deficit of 14.3 percent of GDP, the U.K. with 12.6 percent, Spain with 11.2 percent, and Portugal at 9.4 percent, were most at risk. And so Greece was bailed out with loans from the E.U. and the IMF, whose terms included the requirement to slash social spending. By late November of 2010, it was clear that Ireland needed a bailout, too—and got one, along with its own painful austerity package and loads of political upheaval. But this raised the inevitable questions: Who would be next? Could the IMF and the E.U. afford to bail out Spain? What would happen if the enormous U.K. economy needed rescue?
China, whose economy continued growing at an astonishing 8 to 10 percent per year, and which has run a large trade surplus for the past three decades, had inflated an enormous real estate bubble (average housing prices in the country tripled from 2005 to 2009; and price-to-income and price-to-rent ratios for property, as well as the number of unoccupied residential and commercial units, were all sky-high).
In short, a global economy that had appeared robust in 2007 had become fragile, suffering from several persistent maladies any one of which could erupt into virulence, spreading rapidly and sending the world back into the throes of crisis.
The U.S. real estate bubble of the early 2000s was the largest (in terms of the amount of capital involved) in history. And its crash carried an eerie echo of the 1930s: Austrian and Post-Keynesian economists have argued that it wasn’t the stock market crash that drove the Great Depression so much as farm failures making it impossible for farmers to make mortgage payments—along with housing bubbles in Florida, New York, and Chicago.
Real estate bubbles are essentially credit bubbles, because property owners generally use borrowed money to purchase property (this is in contrast to currency bubbles, in which nations inflate their currency to pay off government debt). The amount of outstanding debt soars as buyers flood the market, bidding property prices up to unrealistic levels and taking out loans they cannot repay. Too many houses and offices are built, and materials and labor are wasted in building them. Real estate bubbles also lead to an excess of homebuilders, who must retrain and retool when the bubble bursts. These kinds of bubbles lead to systemic crises affecting the economic integrity of nations.
Indeed, the housing bubble of the early 2000s had become the oxygen of the U.S. economy—the source of jobs, the foundation for Wall Street’s recovery from the dot-com bust, the attractant for foreign capital, the basis for household wealth accumulation and spending. Its bursting changed everything.
And there is reason to think it has not fully deflated: commercial real estate may be waiting to exhale next. Over the next five years, about $1.4 trillion in commercial real estate loans will reach the end of their terms and require new financing. Commercial property values have fallen more than 40 percent nationally since their 2007 peak, so nearly half the loans are underwater. Vacancy rates are up and rents are down.
The impact of the real estate crisis on banks is profound, and goes far beyond defaults upon outstanding mortgage contracts: systemic dependence on MBSs, CDOs, and derivatives means many of the banks, including the largest, are effectively insolvent and unable to take on more risk (we’ll see why in more detail in the next section).
The demographics are not promising for a recovery of the housing market anytime soon: the oldest of the Baby Boomers are 65 and entering retirement. Few have substantial savings; many had hoped to fund their golden years with house equity—and to realize that, they must sell. This will add more houses to an already glutted market, driving prices down even further.
In short, real estate was the main source of growth in the U.S. during the past decade. With the bubble gone, leaving a gaping hole in the economy, where will the new jobs and further growth come from? Can the problem be solved with yet another bubble?