The Peter Pan School of Economics

This has all happened before, and it will all happen again.

Ever since the financial crash of 2008, the chattering classes have been looking for someone to blame.  This is a natural reaction to disaster - if we can blame someone, we'll feel more in control.  If we can pass laws against whatever they did, we'll be less worried about a similar disaster in the future.

Although everyone agrees that someone's to blame, opinions differ on who that someone is.  Democrats argue that Republicans let greedy bankers get around prudent financial regulations; make risky, high profit trades; reward themselves; and stick us with their losses after the crash.  Republicans point out that the bust started with the "housing bubble" and blame government interference in the mortgage market for creating and then popping that bubble.

Democrats forget that President Clinton (D) signed the repeal of the Glass-Steagall act which separated investment banking and deposit banking and also allowed the government to buy shoddier mortgages than before he relaxed lending standards.  Both of these actions by a Democratic administration allowed financial institutions to take on more risk.

Republicans overlook the minor detail that there were disastrous housing bubbles in Ireland, England, and in Spain, and that the Chinese government is desperately trying to keep their exploding real estate market from causing a collapse there.  These other countries have vastly different lending systems from ours.

Although the actions of the US Government made our bubble worse than in other places, the fact that so many countries with such different banking and lending laws had housing bubbles at the same time argues that government mistakes weren't the sole cause.

Voodoo Economics

Unfortunately for both sides of this argument, "Rethinking the Great Recession," pp 16-24 of the Wilson Quarterly of Winter, 2011, presented the theories of the late Charles Kindleberger, an economic historian whose 1978 book Manias, Panics, and Crashes argued forcefully that financial cycles always go in three stages no matter what government does:

  • Displacement - something happens to improve the economic outlook such as the end of a war, a new technical development, or a change in government policy.
  • Euphoria - as the economy improves, people forget the lessons of the past, become more and more optimistic, and take on more and more risk.
  • Revulsion - when enough people realize just how risky the system has become, people panic, try to get their money out, and the speculative bubble collapses.

In the case of the crash of 2008, displacement came about when President Reagan tamed inflation.  He boosted interest rates up to 17-19%.  Many banks failed and unemployment flirted with 10%, but his policies wrung inflation out of the economy.  With inflation tamed, a long period of prosperity began.  With the exception of a few short-term declines, we had an unbroken period of prosperity as businesses stopped worrying about inflation stealing the gains from their investments.

Prosperity went on so long that euphoria came about as real estate and stock prices kept going up.  People felt wealthier, so they spent more.  As profits rolled in, people took on riskier and riskier amounts of leverage.  Toward the end, Bear Stearns and Leman Brothers were leveraging their risks 30:1, that is, for every 30 dollars invested, they put up only one dollar of capital.  When prices went up, they made huge profits, but when prices fell only a little, they couldn't cover their losses and failed.

Kindleberger suggests that there's nobody to blame because crashes are inherent in any economy where people are allowed to take risks.  His ideas are about as popular among economists as the idea that earth temperature changes as the sun's output changes gladdens climate scientists.

If climate change is driven by changes in the sun, there's no point in taxing carbon to save the planet.  If there's no hope of more tax revenue or more government power, there's no reason for politicians to support climate change.  Anybody who argues that changes in the sun drive changes in the earth's temperature threatens to derail the gravy train, so climate changers heap scorn on anyone who does that.

Similarly, if there's no way to prevent market crashes because people always forget earlier crashes, become euphoric, and take on too much risk, then there's no reason for the government to listen to economists much less employ them.  Why does the President have a Council of Economic Advisers?  Because Americans expect prosperity and tend to vote out politicians who don't deliver prosperity.

Anyone who can convince the powers that be that he has some magic potion to prevent crashes can find a job in Washington.  He may be respected for a time, but it won't work forever.

The book The Great Depression: A Diary is a collection of notes made by Benjamin Roth, a lawyer who practiced in Youngstown, Ohio, during the Depression.  He noted that lawmakers always try to keep crashes from happening:

Jan 9, 1937

Each time in a depression new theories and "New Deals" are tried out but rarely do they seem to change the basic structure of the economic cycle.

As John Kenneth Galbraith put it, "The foresight of financial experts was, as so often, a poor guide to the future."  The New Economics At High Noon, p. 269.  He also said, “The only function of economic forecasting is to make astrology look respectable.”

The "Chicago School" of Economics

This is not to say that economic theory is useless - it's useful in keeping government out of the economy.  Milton Friedman became famous as the father of the "Chicago School" of economics.  These theorists embraced market-based capitalism as the best way to increase national wealth.

Letting people become as rich as they are able reduces government power, of course, so leaders who're more interested in maintaining power than in economic development tend not to favor the Chicago school.  Market-driven ideas found great success in countries such as Chile whose governments favored economic growth over state power.

Unfortunately for politicians, there's no tax revenue, political power, or campaign contributions when government gets out of the way and lets greedy businessmen make the economy grow as they look for profits.  Thus, politicians always have a built-in bias towards regulation, taxation, government spending, or anything else that will get them more campaign contributions.

We saw this plainly with the Obama stimulus.  We were promised that our $800 billion would revive the economy.  Instead of spending the money on measures which would build the economy, however, the Democrats routed the money to state governments who used federal money to reduce their borrowings.

Using our money to prop up local public-sector unions prevented layoffs among the unionized government employees who'd spent a lot of money electing Mr. Obama, but did nothing whatsoever for economic recovery.

Off to slay inflation!

The Peter Pan School of Economics

Mr. Kindleberger's ideas can be summed up by quoting Peter Pan, "This has all happened before and it will all happen again."

Regulation is no help because the regulators are no smarter than the people they're regulating.  In fact, since banking pays a lot better than regulating banks, any regulation who's as smart as a banker will leave government and work for a bank.  Across all industries, regulators are inherently less smart than the people they're regulating and always will be no matter what.

Let's review the housing crisis.  Euphoria started when Pres. Reagan tamed inflation and started the boom which ended in 2008.  Along the way, someone invented the idea of selling mortgage-backed securities which kicked off another round of euphoria by expanding the mortgage market.

Before that, when a bank lent you money to buy a house, the bank held the mortgage.  Since the bank had to bear 100% of any losses, they were careful to be sure you could pay them back before lending you the money.

If they sold the mortgage to someone else, however, they kept the monthly fees for collecting money from you while offloading the risk.  Selling the mortgage also gave them money to lend again.

Selling mortgages has been common practice for a long time.  What was new was combining a large number of mortgages into one asset and selling shares in the new asset.  These became known as mortgage-backed securities because the value of the securities was guaranteed by the cash flow from the underlying mortgages.

As pension plans, retirement funds, hedge funds, and other institutions which wouldn't write or buy individual mortgages bought these securities, more and more mortgage money became available.  Each time a bank sold a mortgage, they kept the mortgage setup fees and the monthly servicing fees which gave them incentives to write more and mortgages.

When the supply of home buyers with good credit ran out, euphoria set in, and they lent to people with bad credit.  As long as everyone believed that the mortgages would be paid, these were safe investments.  When revulsion set in, however, the market collapsed and these securities had essentially no measurable value.

When the revulsion which Mr. Kindleberger regards as inevitable came, too many people wanted to take their money out at the same time and the bubble burst.  Mortgages had been sold so often that it wasn't clear who owned what.  This made it hard to foreclose and hard to clear the market, so we're stagnating.

The only way for regulators to have prevented the housing bubble would have been for them to forbid the use of mortgage-backed securities.  This is tantamount to forbidding any and all innovation in financial services.  That would probably prevent future crashes, but would choke off any possibility of growth in the meantime.

Given that we're not willing to give up the prospect of economic growth, we'll have to assume the risks of euphoria and revulsion.  It's disquieting to realize that no matter what the government does, if we have enough economic freedom to bring about economic growth, another crash is inevitable.  History repeats itself, and each time it repeats, the price goes up.

That's the way the cycle goes - anything else is simply the belief that a handful of super-smart people who know everything can run an entire economy, which has utterly failed every time it's been tried.  As Peter Pan said, "This has all happened before and it will all happen again."

Will Offensicht is a staff writer for and an internationally published author by a different name.  Read other articles by Will Offensicht or other articles on Economics.
Reader Comments

The NYT really thinks someone did it and that they should be punished.

In Financial Crisis, a Dearth of Prosecutions Raises Alarms
Several years after the financial crisis, no senior executives of major financial institutions have been charged, and a collective government effort has not emerged.

It is a question asked repeatedly across America: why, in the aftermath of a financial mess that generated hundreds of billions in losses, have no high-profile participants in the disaster been prosecuted?

Answering such a question — the equivalent of determining why a dog did not bark — is anything but simple. But a private meeting in mid-October 2008 between Timothy F. Geithner, then-president of the Federal Reserve Bank of New York, and Andrew M. Cuomo, New York’s attorney general at the time, illustrates the complexities of pursuing legal cases in a time of panic.

At the Fed, which oversees the nation’s largest banks, Mr. Geithner worked with the Treasury Department on a large bailout fund for the banks and led efforts to shore up the American International Group, the giant insurer. His focus: stabilizing world financial markets.

Mr. Cuomo, as a Wall Street enforcer, had been questioning banks and rating agencies aggressively for more than a year about their roles in the growing debacle, and also looking into bonuses at A.I.G.

Friendly since their days in the Clinton administration, the two met in Mr. Cuomo’s office in Lower Manhattan, steps from Wall Street and the New York Fed. According to three people briefed at the time about the meeting, Mr. Geithner expressed concern about the fragility of the financial system.

His worry, according to these people, sprang from a desire to calm markets, a goal that could be complicated by a hard-charging attorney general.

Asked whether the unusual meeting had altered his approach, a spokesman for Mr. Cuomo, now New York’s governor, said Wednesday evening that “Mr. Geithner never suggested that there be any lack of diligence or any slowdown.” Mr. Geithner, now the Treasury secretary, said through a spokesman that he had been focused on A.I.G. “to protect taxpayers.”

Whether prosecutors and regulators have been aggressive enough in pursuing wrongdoing is likely to long be a subject of debate. All say they have done the best they could under difficult circumstances.

But several years after the financial crisis, which was caused in large part by reckless lending and excessive risk taking by major financial institutions, no senior executives have been charged or imprisoned, and a collective government effort has not emerged. This stands in stark contrast to the failure of many savings and loan institutions in the late 1980s. In the wake of that debacle, special government task forces referred 1,100 cases to prosecutors, resulting in more than 800 bank officials going to jail. Among the best-known: Charles H. Keating Jr., of Lincoln Savings and Loan in Arizona, and David Paul, of Centrust Bank in Florida.

Former prosecutors, lawyers, bankers and mortgage employees say that investigators and regulators ignored past lessons about how to crack financial fraud.

Much more, but you get the idea

April 14, 2011 6:52 PM
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