Wednesday, October 28, 2009

Is the Financial Crisis Over or Just Beginning?

This is the text of a speech I gave today at the South Dakota Chamber of Commerce's Third Annual conference on the economic outlook in Sioux Falls, SD.

Let me answer that question in three words: I don’t know. Unlike my erstwhile colleague Bruce Bueno de Mesquita, I do not try to predict the future. I do have something to say about the question, however, much more, in fact, than I could possibly say in the time allotted. Although I rarely teach history courses per se, I am an historian by training so my approach to the future is to look to history for analogous situations and then outline the paths that the economy may take while assigning rough probabilities to each.

The first path or scenario I call The Fairy Tale because the gist of it is that they all lived happily ever after. In other words, the economy is going to rebound robustly and we won’t experience another major financial panic during our lifetimes. To be perfectly blunt, I think the Fairy Tale scenario is about as likely as a scullery maid getting to wear glass slippers in a coach and four created from a pumpkin and four rats. Or, if you prefer, about as likely as an adolescent girl with 40 feet of hair capable of bearing the weight of a full grown prince. The U.S. financial system suffered major crises in the 1760s, 80s, and 90s, the 1810s, 30s, 50s, 60s, 70s, 80s, and 90s, the 19 aughts, teens, 20s, 30s, 70s, 80s, and the two thousand aughts. There is absolutely no reason to believe that we have reached the end of financial history and one very big reason to suspect that another crisis will hit us again, sooner or later: to date, none of the causes of the most recent financial crisis have been mitigated, much less rectified.

I have a book coming out next year called Fubarnomics that discusses the causes of economic sectors that are FUBAR – which is an acronym that stands for fouled up beyond all recognition, at least in polite circles. You know, hyper-dysfunctional sectors where costs consistently outstrip inflation such as construction, retirement savings, healthcare and insurance, higher education, and the like. Such monstrously messed up sectors all result, I conclude, from hybrid failures, or complex combinations of market failures like asymmetric information, externalities, market power, and public goods, AND government failures such as inappropriate and ineffective regulation and highly distortionary taxation. Despite partisan narratives from the Left that focus exclusively on market failures and from the Right that concentrate on government failures, the financial disruptions of 2007 and 8 were actually caused by eleven hybrid failures, not one of which has yet been adequately addressed. First,

1) The housing bubble. It’s pretty clear that in 2005 and 2006 many Americans paid waaaaaaaay too much for houses, especially in the New York City metro area, parts of Florida, Vegas, Southern California, and other hotspots. Nevertheless, many economists still believe that asset bubbles are impossible, that prices always reflect so-called fundamentals like interest rates and expectations of future prices. Following their lead, the Federal Reserve does not try to identify bubbles ex ante, which is to say before they burst and cause trouble. No other part of the government does much of anything to prevent or deflate bubbles either. That might not be such a big deal if it were not for:

2) Numero Dos -- rampant financial illiteracy. The U.S. economy works despite the fact that very few Americans understand economics. We’re sort of like the dog that manages to consistently catch a thrown Frisbee in its mouth. The dog can’t describe the physics involved but it doesn’t need to in order to get what it wants, the approbation of its owner and a Scooby snack. American consumers know that it is better to buy low than to buy high, and to sell high rather than to sell low, and that is enough to ensure reasonably efficient markets for most physical goods, professional and semi-professional services, and labor. But finance is different. It is more like rocket science. Just as the dog will never get a Frisbee into orbit, America will never have a stable financial system until most citizens thoroughly understand at least the bare basics of investing. At present, they clearly don’t. Many confess to dumb mistakes like putting all of their savings into a single investment such as Enron, staying invested in stocks as their retirement looms, and, like Buzz Lightyear, extrapolating trendy trends to infinity and beyond. They are so daft that they believe that traditional stockbrokers provide sound investment advice. Many institutions, including the Museum of American Finance, with which I am associated in various ways, are trying to increase financial literacy but the going is tough. Because it controls most education K through 12 and even much of the college market, the government could work wonders here, but it hasn’t. Most people never take a course in finance, a subject that is so little understood that most people who learn that I teach financial history and political economy are dumbfounded at the very notion that such disparate concepts as finance and history or political and economy can be combined into a course of study. Which leads me to:

3) Macro-incentives. Although many Americans are ignorant enough of finance to be easily suckered into fueling asset bubbles, be they tech stocks or spec houses, they are not stupid. They can be taught and they do follow their self-interests when the rational path is unambiguous. When the government basically told them via the IRS code to borrow to the hilt on their houses in order to invest in the stock market, they did so. I refer, of course, to the combination of the mortgage interest deduction and the ability to make pre-tax contributions into 401ks, 403bs, and other retirement accounts. No longer rewarded for striving to own their homes outright as they once were, Americans in the final quarter of the last century increasingly rented – for lack of a better term -- their homes from mortgage lenders and bought equity shares in corporations over which they had no control. The ability to put little or nothing down and to easily tap accrued equity through lines of credit of course fueled the real estate bubble and made the resulting downturn in the housing and stock markets much more traumatic than they traditionally would have been. Those tax distortions have not been addressed and are unlikely to be anytime soon. Moreover, many other potentially destabilizing distortions undoubtedly lurk in our massive tax code, awaiting only the right circumstances to sally forth and bite the economy in the posterior. I don’t know whether to laugh or cry when people claim that the recent crisis shows that free markets don’t work. They were far from unfettered. In addition to distorting macro-incentives there was also the problem of:

4) Macroeconomic (mis)management. Low interest rates provided yet another macro-incentive impetus for the bubble. From 2001 until 2005, the Federal Reserve and world trade patterns kept interest rates extremely low, which is just another way of saying rewarding people and firms for borrowing. Recently hurt by the bursting of the tech stock bubble, many investors used the opportunity afforded by the low rates to speculate in housing, a tangible asset that could not possibly lose value, or so many believed. By raising interest rates in 2005 and 2006, the Fed effectively punished new borrowers and those who had borrowed short-term via adjustable-rate mortgages. That of course decreased demand for houses and increased defaults, both of which led to the price collapse. Overnight interest rates are now near zero and the Fed shows no signs of increasing them anytime soon. So once again the government is encouraging investors to borrow to the hilt in the apparent hope of ending the ill effects of one bubble with yet another. It isn’t yet clear which assets will puff in price, but gold and the so-called rare earth elements are currently hot, hot, hot and insurance-linked securities, like catastrophe and death bonds, bear resemblance – or should I say resemble bull resemblance? -- to the securitized mortgage products that Wall Street banks and their apologists were all agog about just a few years ago. I should note here, again, that I see all of these causes as hybrid failures, not pure market or pure government failures but rather failures of both. Nowhere is that clearer than in:

5) Government Sponsored Enterprises or GSEs. Colloquially known as Fannie Mae and Freddie Mac, the GSEs were privately owned but publicly backed and as such were abominations of nature that should never have been countenanced, much less nurtured for decades. In his veto of the Second Bank of the United States, America’s second major GSE, President Andrew Jackson noted that QUOTE the powers, privileges, and favors bestowed upon it in the original charter, by increasing the value of the stock far above its par value, operated as a gratuity of many millions to the stockholders. UNQUOTE Such a subsidy, he argued, was an unwarranted redistribution of wealth from taxpayers to stockholders. Moreover, the bank was unconstitutional because it was neither necessary nor proper. The same argument can, and in fact has, been made against Fannie and Freddie. The GSEs did provide an important service, securitization, or the bundling of individual mortgages into bonds for resale to institutional investors worldwide. It is not at all clear, however, why the market for such securities needed to be duopolistic and subsidized with the full faith of the U.S. government, or in other words with taxpayers’ wallets. The original Fannie Mae was a government agency and should have remained as such. Or, conversely, securitization should have been opened up to free entry and no government guarantees granted to Fannie, Freddie, or any other mortgage securitizer. The government again nationalized the GSEs after their failure in 2008. Their future, however, remains murky. Fannie was spun off in 1968 to get it off the government’s books, which were under a bit of pressure due to LBJ’s Great Society programs and the Vietnam War. With the government’s financial position again rather tenuous – have you seen the budget deficit and the size of the national debt recently? -- there will be tremendous pressure to spin the GSEs off again and no guarantee that it will be done properly this time. Another prime example of the mixed or hybrid nature of the financial crisis is:

6) Government protected credit rating agencies. Of the many institutions responsible for the financial crisis of 2007-8, the big U.S. credit rating agencies (Standard & Poor’s, Fitch, and Moody’s) rank among the most odious because they appear unworthy of the trust many investors reposed in them. The agencies profited by giving high ratings to securities that ultimately proved toxic, or in other words nearly worthless and practically impossible to resell. An overabundance of such assets ultimately killed Bear Stearns, Lehman Brothers, AIG, and other major financial services firms and touched off a financial panic the likes of which had not been witnessed since the darkest days of the Great Depression. In addition to injuring investors, who lost trillions, the agencies’ errors also harmed many innocent bystanders who lost their jobs in the sharp worldwide recession caused by the financial system’s woes. The entire melancholy episode raises several important questions: Why do rating agencies exist? How did they come to have such power? What should be done about them? Financial securities are as old as the nation itself. During the Revolutionary War, government bonds lost most of their value because the rebel state and federal governments could not borrow or tax enough to make scheduled interest payments. The bonds traded only occasionally and at pennies on the dollar until after passage of the Constitution, when Treasury Secretary Alexander Hamilton took them in exchange for new bonds solidly backed by tariff revenues. The new bonds soon rose to par and traded frequently in the nation’s nascent securities markets in Philadelphia, New York, Boston, Baltimore, and Charleston, S.C. They were soon joined by the equities of scores, then hundreds, then thousands of business corporations, including banks, insurers, manufacturers of numerous stripes, mining companies, utilities (water and later telegraph and gas), and transportation companies like canals, turnpikes, and, eventually, steamship lines and railroads. Many of the last mentioned group also issued prodigious quantities of bonds. By the Civil War, over 20,000 corporations had formed and most of them issued at least one type of security. The markets for most early corporate securities were local or regional, however, so investors usually dealt directly with issuers. Before the Civil War, most companies sold securities themselves through a direct public offering or DPO rather than through an investment bank-intermediated initial public offering or IPO. Investors could assess the risk posed by securities without outside help because they often knew company organizers personally, understood the issuer’s business plan, and/or thoroughly knew its market. As companies, particularly manufacturers and railroads, grew larger and more complex in the second half of the nineteenth century, however, investors increasingly relied on third parties. Investment banks sprang up to intermediate offerings and information sources -- including industry journals and investment manuals -- proliferated. The best of them quickly grew more comprehensive and sophisticated. In the 1860s, for example, railroad journal editor Henry Varnum Poor and his son Henry William began the annual publication of the financial statistics of almost all U.S. railroads. In 1909, John Moody went a step further and began to rate bonds, or in other words to evaluate their risk of default. In 1916, the Poor Company also made the leap from information provider to securities evaluator. In 1941, it merged with Standard Statistics to form Standard & Poor’s, which McGraw-Hill acquired in 1966. The ratings business thrived because collecting and assessing financial information was costly and difficult. It therefore made economic sense for specialized firms to do it and to sell the results to investors. The original business model closely aligned the incentives of the rating agencies and investors. If the ratings were generally accurate, investors would continue to subscribe. If they were not, investors would switch to another, more accurate rating agency. Due to those incentives and that competition, ratings were as reliable as market prices and other performance indicators. Through the first three quarters of the twentieth century, the rating agency business was pretty sleepy. The rating agencies weren’t blamed for the Great Depression and shouldn’t have been. They completed their analyses, published their increasingly mammoth ratings books, and collected their subscriptions, increasingly from institutional investors like insurers, savings banks, and pension and mutual funds. But then two disasters struck. The advent of cheap photocopying made it easy for illicit entrepreneurs to make a fast buck by selling photocopies of ratings for a fraction of the price they cost the rating agencies to produce. That cut into revenues and profits, which sent the rating agencies scurrying for a new business model. Unfortunately, the one they hit upon – charging issuers -- was highly problematic to say the least. No sensible person or business bites the hand that feeds them. The new model therefore transformed rating agencies from pro-investor watchdogs into pro-issuer lapdogs. Before that happened, however, the government aided the then-struggling rating agencies by designating five of them -- the aforementioned big three and niche players A.M. Best and Dominion Bond – as Nationally Recognized Statistical Rating Organizations or NRSROs. The government also effectively perpetuated that cartel by barring new entry and forcing institutional and public investors, like public pension funds, to rely on the NRSROs’ ratings when making investment decisions. Even large, well-known issuers like General Electric had to pay for their securities to be rated or face loss of the institutional market. With such strong government support and an almost complete lack of market competition, rating agencies waxed complacent while the financial instruments they ostensibly graded grew ever more complex. The agencies even began to bill companies for unsolicited ratings! Since the late 1990s, a number of observers, including law professor and former investment banker Frank Partnoy, financial historian Richard Sylla, and hedge fund manager David Einhorn have argued that the new institutional arrangements dulled rating agencies’ incentive and ability to accurately assess the risk of issuer default. Ratings downgrades almost always occurred only after adverse news caused large price declines, many noted. Critics’ views gained credence when the rating agencies grossly overrated the securities of Enron, Worldcom, and other companies headed for bankruptcy early in the Third Millennium. On 29 September 2006, the government responded by passing the Credit Rating Agency Reform Act. The legislation, which quickly and easily sailed through Congress, facilitated new entry and abolished NRSRO-status. It did nothing, however, to change the perverse incentives at the heart of the system. The Reform Act of 2006 was a good start but in retrospect was too little, too late. The ideal regulation would support competition, freedom of choice and action, and transparency. Anyone who wants to rate corporate securities should be allowed to. Anyone who wants to use those ratings should also be allowed to, provided they properly disclose that fact to their investors. Nobody should be forced to use the ratings of any particular agency or agencies or indeed any ratings at all, again provided they disclose their practices if applicable. In addition, rating agencies should be free to sell their services to issuers, investors, or both but they should have to disclose the sources of their income. They should also be able to choose if, when, and how to guarantee their ratings. Agencies should not be forced to disclose their methodologies but book authors, journalists, bloggers, brokers, and others should be allowed to freely discuss the information the rating agencies disclose -- or don’t as the case may be -- and the pros and cons of their business models. An open approach like that just advocated would make the money and capital markets freer and hence less distorted, more like the svelte models of financial economists and less like binge and purge realities of the last three decades. It would also give rating agencies incentives to find less corruptible business models and perhaps even return to their original, investor-based model. Photocopies are cheaper than ever but encrypted databases are difficult to crack and nearly impossible to monetize. They can also be infinitely partitioned, from full, unlimited access for a big hedge fund to a single query on a single security by an individual investor. As soon as investors, especially institutional ones, make clear that they will no longer invest based on ratings that issuers have paid for, change will come rapidly and will be more efficient than reforms mandated from on high. The government is unlikely to follow the path just described, however, because rating agencies have large incentives to prevent it. Businesses generally dislike competition and typically expend much money and effort to avoid it – when it comes to themselves and not their suppliers or distributors, of course. Collectively, investors would benefit from fighting such special interests but a collective action or free-rider problem will likely prevent them from doing so effectively. It is possible, however, that a few large institutional investors could pull together and encourage more competition. The scope and nature of any new legislation or other policy changes are therefore difficult to predict but history suggests that the odds of marked improvement are low. The same could be said of:

7) Pathetic corporate governance. Far be it for me, or anyone else for that matter, to dictate how much a corporation pays for its talent. Unless, that is, I’m a stockholder. Then it seems like I should have some say. A lot of say in fact. But I don’t, and neither do other stockholders, unless they are controlling ones or the government. In fact, common stockholders these days have very little say in the management of the corporations they own. That was not always the case. Before the Civil War, stockholders reigned supreme. Small stockholders were protected from large ones by so-called prudent mean voting schemes, where the number of votes any one stockholder could cast was capped or where it took 5 or 10 more shares to get another vote in director and other corporate elections. Back then, directors consulted stockholders about everything important, including their wages. Stockholders could and frequently did call special meetings and conduct thorough investigations of the doings of managers and Board members. The situation changed in the second half of the nineteenth century, however, so that by the Great Depression Adolph Berle and Gardiner Means could complain, and rightly so, about the separation of ownership and control. At the same time, government regulations purposely stripped institutional investors of their governance rights due to some overblown fears about J. P. Morgan and his crew. As a result, we have a system of weak owners and strong managers. It is not surprising that those strong managers rigged the game in their favor with big bonuses, golden parachutes, and perks galore, like $35,000 dollar commodes. And what has the government done about this deplorable situation? Exactly nothing. Instead of making it easier and cheaper for stockholders and institutional investors to look after their own property themselves, it threatens to limit executive pay, at least at the companies that imbibed deeply of the government’s largesse last year. Of course all that it may end up doing is inducing those companies to return the government’s money ASAP, even if it threatens those companies’ recoveries. As for more general limits on executive pay, I hope that the government will never have the temerity to go there. But don’t get me wrong -- that doesn’t mean that some governmental oversight of compensation isn’t need to combat:

8) Distorted executive compensation systems. The structure of executive compensation, as opposed to the amount of compensation, I take to be a matter of public interest because of its clear connection to financial system stability. If their compensation structure rewards them for making short-term profits but doesn’t punish them for making long-term losses, managers will take big, short-sighted risks, thus greatly exacerbating systemic fragility. The proper policy here is fairly simple. Managers should not receive bonuses on the basis of alleged accounting profits. Such a system is too easy to game, either by manipulating the accounting assumptions or by deliberately backing projects that are short-term winners but long-term losers like -- oh I don’t know – subprime mortgages, CMOs, and other risky crapola. That’s not a technical term by the way. Deferred compensation, clawback, bonus-malus -- call it what you will – they all mean no more big paydays today on the basis of loans or other contracts with 15, 30, or more years to run. Stockholders liberated from the straitjackets I just described would push for more incentive-compatible contracts but while they rebuild their management monitoring skills the government should step in and force compensation deferment. And it should get other governments to sign on too, lest we lose some of our most innovative financiers and most important financial companies to London, Zurich, or Shanghai. And please do note that I refer here only to publicly-traded financial services companies, not to closely-held family firms or partnerships, which can take care of themselves as the big investment banks did from their formation in the nineteenth century until the 1980s and 90s, when they switched to the joint-stock form without, apparently, giving any thought to the implications for management incentives. Here again, the government has not even begun to move us in the right direction. Even if it does, there is still the problem of:

9) Static regulatory cling. Regulators are problematic for many reasons but primarily because they breed complacency. Why most investors believe that salaried government bureaucrats care more about their money than the investors themselves do is a difficult question to answer. I suspect that many people reason that because the U.S. government has the capability of putting a man on the moon, destroying the planet 100 times over, and so forth, it can surely stop financial fraud. Of course such reasoning is a tragic non sequitur. Regulators are not rewarded for stopping fraud or crises so they don’t do it. They are rewarded for upholding the letter, rather than the spirit, of the law, so that is what they do. As currently constituted, the government can no more stop financial fraud than it can catch Osama bin Laden. Like generals, regulators are prone to prepare to fight the previous war rather than the forthcoming one. With that analogy in mind, Sarbanes-Oxley was the Maginot Line of the 2008 financial panic. In the 1990s, companies incentivized managers with stock options. Some managers responded as hoped and increased the efficiency of their firms by lowering costs, expanding into new markets, gaining market power in established markets, and so forth. Others, however, found that to be too much work and instead increased stock prices with shady accounting practices. Sarbox stopped that from happening again, just as the Maginot Line prevented the Nazis from invading France directly. But it didn’t stop the other major way of getting stock prices up, by undertaking risky projects. Just as the Germans swept through the Ardennes and the Low Countries and from there moved into France, U.S. financiers simply outflanked the regulators sitting complacently behind Sarbox. Meanwhile, some observers complained that if only the government hadn’t repealed Glass Steagall, the New Deal legislation that separated investment from commercial banking, the crises of 2007 and 2008 would have been averted. That is a little like saying that if only French soldiers had stood in a line and fired their muskets in a volley at the German tanks and airplanes Paris would not have suffered the indignity of four years of German occupation. The Fed had already rendered Glass Steagall a dead letter by the early 1990s. Besides, the real culprit in the most recent crisis was not the large size and complexity of financial services firms per se but rather:

10) Too Big To Fail policy. There is a notion, not necessarily a bad one, that the government should prevent the financial system from freezing, exploding, or otherwise causing negative externalities for economies foreign and domestic. The Federal Reserve was created, in part, to serve as a so-called lender of last resort, as a safety net for the financial system. As part of that mission, the Fed announced in the mid-1980s that it would allow small banks to fail but in times of trouble it would step in to save the 11 largest banks on the grounds that their failure would threaten the stability of the entire financial system. The problem with the policy -- which is not only still in effect but has apparently metastasized into investment banking, hedge funds, and insurance – is two-fold. First, because the government offered its guarantee free of charge those institutions that are clearly “too big to fail” can pursue risks with reckless abandon, safe in the knowledge that ole Uncle Sam has their back. Second, those institutions that think that they are close to being considered “too big to fail” have major incentives to grow bigger so that they too can reap the rewards of taking on more risk – free of cost and, ironically enough, free of risk! The government thinks that it can offer the Too Big to Fail guarantee because of:

11) The Hubris of Planners. The government thought that it could raise homeownership rates by implementing a number of policies, including the tax breaks and GSEs formerly alluded to. Via policies like the Community Reinvestment Act, it also encouraged lenders to make loans to weaker borrowers when it should have instead eased entry requirements for credit unions and community banks. It also allowed the doctrine of secret liens to erode, thus enabling the growth of “silent second” and “piggyback” mortgages, or loans for down payments. When you let a borrower borrow the down payment you don’t really have a down payment, which was traditionally the number one defense against default because it served as a sort of life jacket that kept the borrower above water or with positive equity. Finally, the government allowed the development and proliferation of non-recourse loans. Essentially, it gave borrowers a free put option on their homes by allowing them to walk away when they are under water or in the bucket -- or in other words have negative equity – and to do so without serious adverse consequences. Such largesse certainly did increase homeownership rates, however temporarily, but did not increase the total amount of equity in homes. The put options, the silent seconds, and the Community Reinvestment Act all remain more or less intact.
Clearly, then, there is no Fairy Tale in our future. In fact, we should count ourselves lucky if our story ends they all lived rather than they all lived happily ever after.

At long last we come to the second scenario, which I call “Turning Japanese.” In this scenario, the financial system achieves stability but the economy remains stagnant, with an extended period of low or no growth, much like the Japanese economy has experienced for about two decades now. That is a sobering prospect but I believe that the probability of the U.S. economy turning Japanese, while greater than the “Fairy Tale” scenario, is nevertheless low. The people who most fear this scenario are macroeconomists fond of talking about liquidity traps, the inability to push on strings, and similarly inscrutable concepts. I think Helicopter Ben Bernanke of all people knows that he can lower real borrowing costs by increasing inflation expectations and the actual price level in a variety of ways even if overnight lending interest rates are near zero, something the Japanese could never quite bring themselves to do.

Moreover, I believe the stagnation of the Japanese economy runs much deeper than monetary policy. For starters, I think the Japanese economy simply outran its educational system, which focused far too much on rote memorization at the expense of creative or integrative thinking. America’s educational system, from K to Ph.D., is far from perfect but it does a much better job of nurturing creative genius. The United States also enjoys much more flexible labor markets and a superior system of entrepreneurship. It also traditionally did a better job of preventing the government from meddling too much in the economy, generally avoiding the trap of thinking that the economy needs the guidance of a Ministry of International Trade and Industry. If the U.S. economy does stagnate, it will be due to the ossification of overzealous bailout initiatives like that ridiculous [insert the name of your least favorite bailout here].

The third scenario I call “Louisville, 1839.” In 1837, the United States had been rocked by a financial panic so severe that many people, like O. D. Battle of Kentucky, could not even afford postage. By early 1839, the economy appeared poised to rebound so merchants in Louisville and elsewhere began to stock up in expectation of a strong recovery in 1840. You might think that their optimism was self-fulfilling, that their orders put factory and dock hands, clerks, and others back to work, and that those workers, paychecks in hand, increased employment for barbers, waiters, lawyers, and so forth in a virtuous and self-reinforcing cycle. ‘Twas not to be. Another round of financial troubles struck later in 1839 and quickly squelched all hope of quick recovery.

By 1840 things were so bad again that when Dr. Thomas C. Mercer of Louisville begged Norvin Green, who would later create Western Union, for a $25 loan, Green replied on the same sheet of paper that QUOTE so impoverishingly pinching are the Van Buren times that neither am I able to comply with your very urgent wishes, or to furnish a sheet on which to reply UNQUOTE and then he beseeched Mercer QUOTE pray don’t reply til fall when I shall probably be better able to pay the postage UNQUOTE. As one observer later recalled, early optimism actually delayed recovery because it meant that merchant shops bulged with goods purchased on credit that customers would not or could not buy. The streets of Louisville remained nearly deserted and real estate prices remained on the decline for several years after. As late as 1842 every day looked like Sunday in the streets of Louisville and other market towns as nominal per capita incomes fell from $97 in 1837 to $83 in 1843.

My fear, of course, is that another round of financial troubles will strike while the economy is still recuperating from the events of last autumn. The 1890s, 1930s, and 1980s also witnessed multiple financial crises spaced a few years apart and so-called double-dip recessions, long recessions with a period of slight growth in the middle. The most important questions we face, I believe, are: When will the next crisis occur, where will it strike, and how severe will it be? Again, I don’t make predictions but I am reminded of an old song by Merle Haggard called If We Make It Through December. <> Unfortunately, I don’t know which December will signal the all clear. Certainly not this one, but maybe next. Of course that will not mean that we’ve landed in the Never, Never Land of the “Fairy Tale” scenario, merely that we’ve avoided “Louisville, 1839” and probably also “Turning Japanese.”

That leads me to the final scenario, which I call “Return to Normality.” In this scenario, the economy is not subject to any major shocks -- financial, swinish, or otherwise -- and slowly returns, with some relatively minor ups and downs, to full employment right about the time the Mayans – the Hollywood version anyway -- say we are all going to be dead anyway. Of course I don’t really believe the Hollywood Mayans are right because if I did I would be surrounded by fishing poles, guns, beer, and women right now. In any event, employment is a lagging indicator so if and when the unemployment rate gets back to around 5 percent we can close this unhappy chapter in our economic history and look forward to the next unhappy chapter.
The only other scenario that I can think of is that a major war might break out and quickly drive the economy to full employment, much as World War II did. I sure hope that doesn’t happen as it is better to suffer from high unemployment and remain at peace than to suffer the deaths and dangers of full scale conflict, especially in this nuclear age. Placing a probability on large-scale war is notoriously difficult. On the eve of World War I many people argued that a major power war was impossible because globalization rendered it too costly. Boy were they wrong.

In conclusion, obviously I am not in the Obama administration. But if I were, I would strive to achieve the “Return to Normality” scenario. That would basically entail allowing the recession to run its course while simultaneously trying to foresee and prevent or at least mitigate potential shocks. To date, the government appears to have done a good job combating the swine flu and restoring some confidence in the financial system. The administration’s ill-conceived healthcare agenda, however, has created uncertainty and distracted attention from the desperately needed financial reforms that I discussed earlier. Cap and trade has the potential to do likewise. I conclude, therefore, that businesses should prepare for both the “Louisville, 1839” and “Return to Normality” scenarios. We could well muddle through this one without further incident but we might also face another large financial crisis and concomitant recession.

On that note, thank you for your time and attention and have a wonderful afternoon.

Sunday, October 25, 2009

Finance and Economic Growth

A week ago in Mexico City John Lipsky, IMF First Deputy Managing Director, made some interesting remarks on finance and economic growth. During the speech, he cited work by Richard Sylla, Peter Rousseau, and yours truly:

"The Wealth of Nations Rediscovered, by Robert E. Wright,16 is a fascinating and convincing portrayal of information efficiency in early (pre-1850) American capital markets, that in fact were subject to very light regulation."

No wonder Cambridge University Press has (finally) brought WONR out in paperback!:

Sunday, October 11, 2009

The Circulation of Money in North America Before the Revolution: (Economic) Boundaries and (State) Borders

Below is the full text of the paper I presented at the MWASECS conference yesterday in Fargo, N.D. It is an elaboration of the 1760s episode that I relate in Bailouts and discuss in more detail in the forthcoming Fubarnomics as well as a forthcoming book with UVA's Ron Michener.

The Circulation of Money in North America Before the Revolution: (Economic) Boundaries and (State) Borders

By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College SD

The denizens of eighteenth-century North America, be they European or Amerindian, used three different types of money: commodity, fiat, and credit. Rather than being confined largely within political borders, as often assumed, colonial monies circulated within ever fluctuating economic boundaries, some local, some regional, and some international. The complicated but flexible system functioned tolerably well until British imperial policies effectively throttled it shortly after the French and Indian War. The widespread economic disruption that followed led directly to the Imperial Crisis that culminated in the American Revolution.
Anything with intrinsic value that is in general demand and has a relatively stable value can serve as a commodity money, or in other words as a medium of exchange in economic transactions. Animal pelts, copper, corn, ginger, gold, indigo, molasses, silver, tobacco, wampum, and a wide variety of other physical goods served as commodity monies at times in different parts of colonial North America. Colonists increased the liquidity or money-ness of commodities in several ways, including rating, standardization, and authentication. Rating was a law or community norm that specified that so much of commodity X was worth Y, usually stated as an abstract measure of value, or unit of account in the parlance of economists.
The moment a bushel of corn or a beaver pelt is fixed at, say, one shilling in the repayment of debt or the purchase of other commodities the debtor or buyer has an incentive to adulterate his payment, or in other words to tender his most rat-infested corn and his smallest, thinnest pelt. Standardization and authentication sought to mitigate adulteration. Payments made at prevailing ratings had to be of good, merchantable quality. Of course parties to a transaction could disagree over what was good and merchantable and what was trash. In some places, that problem was effectively solved by creating warehouses and appointing inspectors who gave out bearer receipts in exchange for deposits of goods that met minimum quality specifications. People then exchanged the paper receipts rather than the commodity itself, thereby economizing on freight, portage, and storage costs. Such systems worked best for hearty commodities sold in international markets, like tobacco.
Most other commodities were too perishable, too local, or simply too variegated to support a warehousing system so colonists generally preferred the precious metals as the commodity money par excellence. Gold, silver, and copper were extremely durable, came in standardized values known commonly as coins, and despite some counterfeiting, clipping, and other forms of adulteration were relatively easily authenticated with scales. They were heavier than warehouse receipts but had a far higher value to weight and bulk than other commodity monies. Moreover, unlike fiat or credit monies the ultimate value of the precious metals was unquestionable due to steady worldwide demand. By about 1700, gold, silver, and copper were the preferred media of exchange for large, modest, and small transactions, respectively. Other forms of commodity money did not disappear, especially in remote rural areas, where so-called country pay persisted, and in mercantile circles, where molasses and other relatively homogenous commodities remained trade goods throughout the century. Nevertheless, most Europeans and Amerindians tied to trade networks preferred the precious metals to all other types of commodity money.
The rest of the world felt likewise, so the colonists found that they did not so much own full-bodied gold and silver coins, known as specie, as they had the use of them for short periods of time. Coins that the colonists earned in trade with the West Indies, for example, were soon exported to Britain or other distant lands. The soliloquy of a debtor about to part with a gold Johannes, or Joe for short, published in the Connecticut Gazette in 1768 captured the essence of the situation:
QUOTE We are come to the unhappy parting hour. Lately I received you into my house as a Traveller, and almost a Stranger; you was welcome and have been a pleasant guest; I delighted in your countenance, and your very looks seem’d to bespeak me and say; I will do you some good Jobb before I leave. … I must tell you, I am now obliged to sell you to a Merchant, don’t think I do it of choice. … I hoped you might have remained an inhabitant of the country, that I might have receiv’d some visits from you, but now I expect you will have a quick dispatch to Boston, or New York; immediately take ship and I shall see you no more. … Think not hard of me for putting you under this sentence of Banishment, necessity knows no Law. Farewell, my friend Jo. UNQUOTE
The full-bodied coins of the eighteenth century knew no state borders but rather flowed constantly towards their highest valued use. In fact, an insignificant fraction of the coins in circulation in the trans-Atlantic economy were minted in North America. Most came from Europe proper or from European mints in Latin America, though some originated in Arabia and other exotic places. Where coins traveled partly depended on trade and migration patterns. New York had a good supply of Arabian gold in the 1690s, for instance, because some New Yorkers set up posts in Madagascar from which they engaged in piracy in the Red Sea and off the coast of eastern Africa. [What, you thought the Somalis thought that one up?] When the Yorkers returned home, their ill-gotten booty entered circulation but of course was soon sent abroad again to pay for British manufactured goods, slaves, and so forth.
For some decades, colonial legislators believed that they could increase the total purchasing power of coins in domestic circulation by raising their ratings. Like other commodities, coins were rated in terms of the local unit of account, so many pounds, shillings, or pence of the local currency, typically denominated as “Pennsylvania money,” “Virginia currency,” “Massachusetts pounds,” “New York shillings,” or similar iterations. By the early eighteenth century, most of the colonial currencies or units of account were worth somewhat less than sterling, the unit of account of Great Britain – analogous to the Canadian dollar or Australian dollar typically being less valuable than the U.S. dollar – because of repeated competitive currency devaluations.
In other words, the colonies raised the rating of coins in terms of the local unit of account in the hopes of attracting and retaining more of them. Such policies often siphoned off some of the coins of neighboring colonies but were ultimately self-defeating because the nominal prices of other commodities, real estate, and labor usually increased by the same percentage as the rating. In the end, then, devaluation provided the colonies with no real, long-term gains, just higher nominal prices and retaliatory neighbors. And of course devaluation did great injustice to creditors, who might lend 10 coins only to be legally repaid 7 or 8 at the end of the contract. For those reasons, imperial regulators constrained colonial legislatures from rating coins. They succeeded, however, only in driving the rating process underground, into the hands of private associations of merchants and/or attorneys.
One of the best documented cases of a private association changing coin ratings comes from the British Leeward Islands – Antigua, St. Christopher’s, Nevis, and Montserrat -- in the latter half of the 1730s. It enforced -- extra-legally -- a rating law passed by the assembly of Antigua that the King refused to approve. Similar associations appeared in some of the mainland colonies and left evidence of their work in the coin rating tables published in almanacs.
Coin ratings could not make a colony rich or affect real money balances in the long term but relative ratings could and did directly influence the types of coins in local circulation. Merchants naturally remitted coins where they would fetch the most, or in other words where they were most over-valued RELATIVE to other coins. Over time, that changed the composition of the local money supply. The smaller the degree of over-valuation the slower the adjustment process. Due to high transaction costs – like insurance and freightage -- only large discrepancies in relative coin values would induce arbitrage, or the direct exchange of over-valued coins for under-valued ones for the purpose of profit.
Due to differences in relative coin ratings, neighboring or nearby colonies could have vastly different sets of coins in circulation, like mostly gold coins in New York and mostly silver ones in Pennsylvania, or vice versa. Even more interesting still, some commercially divided colonies, like New Jersey and Maryland, had different coin ratings in different parts of the colony and hence different sets of coins in circulation. Colonies with significant numbers of Amerindians, like New York, also had areas with distinct sets of coin in circulation.
The geographical circulation of fiat paper money was almost as complex. Colonial governments issued the stuff, commonly called bills of credit, as tax anticipation scrip to finance wars and as loan proceeds to stimulate economic development. Until the late colonial period, bills of credit were typically full legal tender in the colony of issue, meaning that private as well as public creditors or buyers could be forced to accept them at face value. They were generally not legal tender outside of the colony of issue, however, inducing some scholars to claim that they rarely crossed colonial political borders. While it is true that bills of credit were almost valueless in international trade they could and did circulate in colonies where they were not a legal tender.
Before mid-century, in fact, bills of credit issued by any of the New England colonies tended to circulate in all of them. Throughout much of the colonial period, New Jersey bills circulated in New York and Pennsylvania, serving as a conduit of trade between Philadelphia, which controlled the trade of southern Jersey and New York, which controlled the trade of northern Jersey. Pennsylvania bills also often found extensively circulation in Maryland, the bills of which sometimes assumed a major importance in Pennsylvania and Virginia.
Intrinsically worthless bills of credit could circulate even when unsupported by tender laws for two reasons. First, where the volume of bills in circulation did not exceed the demand for them at prevailing prices they remained informally convertible into gold and silver at par. As the essayist Eugenio later explained:
QUOTE The people voluntarily and without the least compulsion threw all their gold and silver, not locking up a shilling, into circulation concurrently with the bills; whereby the whole coin of the government became forthwith upon an emission of paper, a bank of deposit at every man's door for the instant realization or immediate exchange of his bill into gold or silver. This had a benign and equitable, a persuasive, a satisfactory, and an extensive influence. If any one doubted the validity or price of his bill, his neighbor immediately removed his doubts by exchanging it without loss into gold or silver. If any one for a particular purpose needed the precious metals, his bill procured them at the next door, without a moment's delay or a penny's diminution. UNQUOTE
Second, citizens of the colony of issue demanded the bills to make tax or government loan office mortgage payments thus creating a secondary demand in their retail trading partners regardless of their colony of residence. So, for example, a farmer in southern Jersey might take a Pennsylvania bill of credit in payment of a debt because he knew he could use the bill to buy goods in Philadelphia. Likewise, a Philadelphia merchant would take a Jersey bill in payment for a purchase because he knew he could soon use it to pay a southern Jersey farmer for a cow or a cartload of vegetables. The same merchant would reject a Massachusetts or South Carolina bill, however, as he likely did not have any retail dealings with either place or know anyone who did. For that very reason, the bill would not have been remitted to Philadelphia in the first place.
Philadelphia merchants had many wholesale dealings with Boston, New York, Charleston, and indeed numerous ports through North America, the West Indies, and Europe. Wholesale trade, however, was conducted largely on credit. The retail trade was, too, but cash transactions were relatively more common at the retail level, especially in urban areas. Merchant-to-merchant dealings, however, typically went on for years until relatively large balances due were settled. Even then, payments were often in trade goods like molasses or bills of exchange instead of cash. Unlike bills of credit, which were bearer instruments designed to pass easily from hand to hand as a medium of exchange, bills of exchange were mercantile credit instruments denominated in major foreign currencies like sterling. A merchant with a credit in a British bank or mercantile house would draw up and sell for local currency a bill of exchange to another merchant with a sum due in London or Liverpool. The purchaser could then endorse and remit the bill of exchange to his creditor who could cash it locally much the way we cash checks today. Bills of exchange economized on the shipment of commodities, including specie, and hence were generally less costly than shipping coins or bulky goods. When bills of exchange were scarce, however, their price could rise to the point that merchants found it cheaper to export Joes or other coins instead.
Obviously, trans-Atlantic mercantile credit was international and its boundaries were largely the economic ones of trade rather than the political ones of governments. The same held within the mainland North American colonies, where Boston, New York, and Philadelphia wholesale merchants extended trade credit across colonial boundaries to retailers in Quebec, New Hampshire, Connecticut, New Jersey, and Maryland, and across international boundaries to Amerindian traders.
At the end of the French and Indian War, the money supply of New England consisted of coins, most of foreign origin, and layers of trade credit that extended from consumers to retailers to colonial import merchants to British and other European export merchants. Elsewhere on the mainland, bills of credit also circulated promiscuously across colonial political borders, circulating within the economic boundaries of trade. It was complicated enough to confuse contemporaries sometimes and later historians most of the time but all in all it worked. Then the British meddled with it, touching off a monetary crisis that ultimately resulted in the Revolution.
The famous disputes over taxation and sovereignty were not the first rounds of the Imperial crisis. “I must observe,” a colonist argued in 1768, that QUOTE it is not the Stamp Act or New Duty Act alone that had put the Colonies so much out of humour tho the principal Clamour has been on that Head but their distressed Situation had prepared them so generally to lay hold of these Occasions UNQUOTE. What was the nature of that distressed situation? As I tried to explain, the economic forces of trade, not governments, largely determined colonial money supplies and hence interest rates, real estate prices, and overall macroeconomic conditions. The British government, however, could control colonial trade if it wanted to. For a long time it remained content to fiddle around the edges but after the French and Indian War it intruded in unprecedented and highly disruptive ways. For the first time, British trade regulations had significant and palpably negative effects on colonists’ well-being.
During the war, the colonial economy boomed. To help fight the war, colonial legislatures outside New England emitted large quantities of bills of credit. In support of His Majesty’s troops, huge sums of gold, silver, and sterling bills of exchange flooded in. Simultaneously, colonial privateers plied the seas, making legitimate seizures of numerous French ships and cargoes, virtual manna from heaven. Colonial privateers also pretended to seize friendly merchant ships engaged in illegal commerce with the enemy, a ruse that protected smugglers from unfriendly privateers and the Royal Navy. Merchants also used flags of truce and falsified papers to penetrate lucrative but illegal foreign markets in the West Indies.
Thanks to the wartime economic boom, the prices of non-traded goods like labor and real estate soared by 200 to 300 percent. Returning to Philadelphia in 1763 after a long diplomatic mission in London, Benjamin Franklin reported that QUOTE The Expence of Living is greatly advanc’d in my Absence; it is more than double in most Articles; and in some ’tis treble. UNQUOTE He also noted that the QUOTE Rent of old Houses, and Value of Lands, … are trebled in the last Six Years.UNQUOTE About the same time, William Franklin, Ben’s son, noted that in New Jersey QUOTE all the Necessaries of Life in this Country are encreas’d in Price near Three fold to what they were Seven Years ago. UNQUOTE A 1763 pamphlet also painted New Jersey’s economy in glowing terms. QUOTE Your Lands are surprisingly advanced in Value, the author wrote, and … the Province is in Fact richer in a great Degree than ever it was. UNQUOTE
Like Americans today, colonists regularly bought and sold real estate to make room for children, move closer to friends and family, take a new job, build up a business, or simply show off their prosperity. Also like today’s Americans, colonists were enticed by rising real estate prices but could rarely afford to pay for their acquisitions with cash. In most parts of the continent, three types of mortgages were available, private ones callable by the lender after at most a few years, government ones that amortized over ten or so years, and private perpetual interest only (IO) mortgages called ground rents.
If mortgages are not callable, as with ground rents, colonial government mortgages, and most mortgages today, borrowers cannot be evicted from their properties, no matter how low the market value sinks, so long as they continue to make scheduled payments. Similarly, those with long-term fixed rate mortgages need not worry about facing higher payments if interest rates increase. Colonists who borrowed on callable mortgages, by contrast, faced both risks. If real estate values fell, lenders could call for the principal on the grounds that their mortgages were under-collateralized, that the properties pledged to support the loans were no longer of sufficient value in other words. If interest rates increased, lenders could also call simply to reinvest the principal at higher rates. Usury laws or interest rate caps were in place but they were as about as effective as drug laws are today.
All was well during the wartime boom but colonial prosperity, and with it the real estate boom, faded with the war. The British Army left for new battlegrounds, the heaven-sent privateering harvest faded into memory, and, thanks to unprecedented exertions by the British Navy and customs officials, the lucrative trade with the foreign West Indies declined dramatically. The crackdown was so severe that even legitimate trade suffered. British naval vessels, one contemporary complained, QUOTE cramp Trade by stopping and detaining Merchants ships and pressing their Men. UNQUOTE
Due to that unfortunate confluence of events, the colonies suddenly found themselves running huge trade deficits. At the same time, bills of credit were paid in as taxes and retired at a rapid rate, dropping in the Middle Colonies from about £2.50 sterling per capita in 1760 to £1.05 in 1763, the very year that a New Jersey pamphleteer predicted that the confluence of peace and the inability to print new bills of credit could create circumstances QUOTE when we may be exceedingly distressed for want of a Medium of Trade. UNQUOTE Colonial business conditions were indeed dismal in 1764 and grew yet worse in 1765. As the monetary contraction continued, bills of credit became almost unattainable, even among wealthy merchants. In February 1764, merchant Gerald Beekman reported that QUOTE all the money seems to be vanished out of our City and C[o]untry. UNQUOTE Despite having more than £12,000 due to him on bond, he confessed to being unable to raise even £500 at any rate of interest. Trade suffered as a consequence.
Throughout the colonies, tight money and depressed business conditions brought a wave of commercial bankruptcies. Those failures, the scarcity of money, and high interest rates drove real estate prices steadily lower. In 1765, the editor of The New York Gazette or Weekly Post-Boy claimed that QUOTE there is such a general scarcity of Cash that nothing we have will Command it & Real Estates of Every kind are falling at least one half in Value. UNQUOTE By the end of 1766, the contraction of real estate prices had cost landholders approximately £2,000,000 sterling in New Jersey alone.
As a result of falling land prices a vicious cycle took hold, one in which QUOTE the consumers break the shopkeepers; they break the merchants; and the shock must be felt as far as London. UNQUOTE Pamphleteer Stephen Sayre recounted an instance in New Jersey of QUOTE one merchant sueing seventy shopkeepers for debt; the seventy had lands, and their lands were sold at public auction for no more than the sum owing, by which means seventy families were deprived of their substance. UNQUOTE That story sounds exaggerated if not outright apocryphal but private correspondence was replete with similar tales of woe.
By 1768, the crisis finally began to run out of steam, partly because few debtors were left to sue and partly because the futility of ruining one’s debtors by forcing the sale of assets that no one could buy was apparent to all. Creditors did not recoup their full investments and had to suffer with the knowledge that they threw families out of their homes and husbands and fathers into horrid prisons. For food, water, clothing, bedding, and the other necessaries of life debtors had to rely on family, friends, and charity. Conditions ranged from cramped to fetid. In Charleston, South Carolina Anglican minister Charles Woodmason saw 16 debtors crammed into 12 square feet of jail cell in 1767. QUOTE A person would be in a better Situation in the French Kings Gallies, or the Prisons of Turkey or Barbary, he opined, than in this dismal place. UNQUOTE
Conditions were deliberately harsh in order to induce debtors to pay up. The assumption was that debtors could repay if they wanted to, with assets that they must have squirreled away. In other words, all defaults were due to moral hazard. By the late 1760s, even the dullest creditors came to understand that most borrowers could not repay due to macroeconomic conditions well beyond their control. To imprison them served no purpose. Lawsuits therefore began to taper off and Americans’ fury increasingly turned toward the real cause of their economic problems, Britain’s destructive trade policies, especially the Sugar and Currency Acts and the postwar crack down on smuggling.


Wednesday, October 07, 2009

The Incentives of Regulators

In a guest article for The Economist (Oct. 3, 2009, p. 94), Beatrice Weder di Mauro, a member of the German Council of Economic Experts, points to the importance of more closely aligning the interests of regulatory agencies with the common weal. She calls, basically, for more central bank-like independence for all types of regulatory agencies. When it comes to the incentives of regulators, to wit the individuals who compose regulatory agencies, she proffers only "higher pay and a more prominent public profile." Apparently, she is not aware that almost a year ago I suggested paying regulators based on performance with a long-term deferred compensation system combining both bonus payments and malus deductions. See "How to Incentivise the Financial System,” Central Banking, 19, 2 (December 2008), 65-67.