This post is almost certain to be misunderstood, but I’m not sure what to do about that, so I’m just going to write it anyway.
The ongoing financial crisis is the result of the implosion of the American real estate market, particularly the “hot” markets of California, Florida, Arizona and Nevada, in the wake of massive and imprudent sub-prime lending that drove up prices to unsustainable levels. Most folks agree on that.
Meanwhile, the causes of that orgy of imprudent lending and parabolic price increases are many, and everybody has their favorite. Is the root cause easy money from the Fed? Or lax regulation of the banking sector (and, particularly, the “shadow” banking sector that wasn’t regulated by the Fed)? Or conflict of interest at the ratings agencies? Or over-reliance on mathematical models as against simple rules for limiting risk? Or political incentives to increase lending to traditionally “underserved” communities (generally lower-income and/or racial minorities)? Or the greed unleashed by the bonus culture on Wall Street?
All of these explanations have some degree of plausibility. And all of them probably have some validity. But consider that the United States is not the only country that went through a real estate bubble and subsequent crash. Some of the other countries that had bubbles include the U.K., Ireland, Spain, Australia, Russia, the United Arab Emirates . . . it’s a long list. Lending (and borrowing) was wildly imprudent in Florida . . . but also in Hungary, not a country known for irrational exuberance, or for large-scale immigration, or for political correctness. The Fed was too easy too long . . . except that it took longer for the ECB to raise rates than for the Fed, and the ECB didn’t go as high either . . . which in turn didn’t stop the Euro from continuing to appreciate against the dollar right up to the summer of 2008, a year into the crisis, when all hell finally and completely broke loose.
And don’t forget: there was also a wild stock market bubble in China. And in Brazil. And there was a sudden and massive run-up in the price of oil, and many other commodities.
Not every country experienced a bubble, of course. There wasn’t much of a housing bubble in Canada, or in Germany. Canada’s banking system has also weathered this particular storm much better than most countries’ banks, in part because there was no domestic housing bubble and in part because of extremely strict regulation combined with protectionist barriers against foreign competition in banking . . . except that Japan has been devastated by the financial crisis, and it also has a clubby, protected banking sector and didn’t have the kind of housing bubble that many other countries experienced.
There is a very real sense in which it feels like there are too many explanations, such that all are, in some sense, besides the point; there’s a sense that too much money was chasing too little opportunity for productive deployment, resulting in a variety of bubbles around the world, the structure of said bubbles dictated by the particularities of local conditions. This is the “savings glut” hypothesis, which has some plausibility . . . until you think about it and say, was there really a shortage of ways to productively deploy capital in China, in India, in Southeast Asia, in Africa . . . really? The savings glut had to be deployed in chasing ever higher property values in London and Las Vegas, Dublin and Dubai?
Right now, the United States has a real dilemma. In retrospect, it will seem obvious what we should have done, but prospectively it’s very unclear. We are going to run up enormous debts in the short term, and these debts are overwhelmingly going to be financed overseas. A necessary but not sufficient condition to restoring budgetary equilibrium is restoring economic growth. A necessary but not sufficient condition to restoring economic growth is to restore bank lending. The things we would normally do to reassure creditors – cutting spending, raising rates, being hawkish about future inflation and erosion of the value of the dollar – are all things that would send us back into a deep recession, which in turn will make it difficult for us to service our debt. The things we would normally do to boost growth – keep rates as low as possible (effectively even lower than that, through “quantitative easing”), increase spending and lower marginal tax rates, targeting higher levels of inflation and letting the dollar fall – are all things that will alarm our creditors, and in turn make it difficult for us to finance the debts that we are going to have to incur in the short term no matter what we do. And, incidentally, tighter regulation of the banking system – precisely what you would want in the wake of a banking crisis – in precisely what you don’t want in the wake of a recession, because it necessarily reduces the amount of lending the banking sector can engage in, the opposite of the desired policy outcome in the short term.
The Obama Administration is going to make some choices. Ten years from now, we’ll know what the economic future brings, and we’ll have our explanations as to why things went well or poorly, and some clear ideas about what Bernanke and Summers and Geithner and the rest of them should have done differently, and what future managers of the macro economy should emulate about their policies. But to an alarming degree, no matter what, we’ll still be guessing.
Finally, consider the following cheery thought.
Our biggest worry right now is that everything we’re doing won’t work: either the economy will simply sink back into recession, or we’ll be forced back in by our creditors, or we’ll succeed in sparking growth at a price of suddenly resurgent inflation – the scenarios for possible failure are manifold.
Our second-biggest worry, though, is that what we’re doing will work – because then the game starts up again. We survived the worst economic crisis since the Great Depression. Policy works. We now know what to do. And isn’t that sense of confidence just what lays the groundwork for the next crisis?
Don’t forget, Alan Greenspan got his initial reputation for wizardry for successfully navigating the crash of 1987, the S&L crisis, and the peso crisis that followed his big hike in short-term rates in 1994. The great economic performance that followed for the rest of the 1990s was punctuated only by the brief blip of LTCM and the Russian default in 1998, another crisis handled beautifully by the maestro. These were genuine successes. Success is what you want; you don’t want to aim for failure. But the people who say that a string of successes are precisely what lulled the market into thinking failure was impossible are not wrong.