Richard A. Posner, A Failure of Capitalism (Cambridge: Harvard University Press) 2009
Chapter 1: The Depression and Its Proximate Causes
A sequence of dramatic events has culminated in the present economic emergency; low interest rates, a housing bubble, the collapse of the bubble, the collapse of the banking system, frenzied efforts at resuscitation, a drop in output and employment, signs of deflation, an ambitious program of recovery. I need to trace the sequence and explain how each stage developed out of the preceding one. This chapter opens with a brief sketch of the basic economics of depression and the and of fighting depression and then turns to the particulars of this depression.
Suppose some shock to the economy–say a sudden fall in the value of people’s houses and securities–reduces the value of personal savings and induces people to spend less so they can rebuild their savings. The demand for goods and services will therefore fall. Before the shock, both demand and supply were both X; now the demand is X - Y. How will suppliers respond? If–a critical assumption–all prices, including the price of labor (wages), are completely flexible, suppliers, including suppliers of labor–workers–will reduce their prices in an effort to retain as many buyers as possible. With consumers saving more because they are buying less, and at lower prices, interest rates–earnings on savings–will fall because there will be a savings glut. The lower interest rates will induce borrowing and with more borrowing and lower prices, spending will soon find its way back to where it was before the shock. One reason this will happen is that not all consumers are workers, and those who are not, and those whose incomes are therefore unimpaired, will buy more goods and services as prices fall.
The flaw in this classical economic theory of the self-correcting business cycle is that not all prices are flexible; wages especially are not. This not because primarily because of union-negotiated or other employment contracts. Few private-sector employers in the United States are unionized, and a few non-unionized workers have a wage guaranteed by contract. But even when wages are flexible, employers generally prefer, when demand for their products drops, laying off workers to reducing wages. Think of all the financial executives who have been laid off even while bonuses–often amounting to half the executive’s pay–were being cut, sometimes to zero.
There are several reasons that employers prefer layoffs to cutting wages. (1) Layoffs reduce over-head expenses. (2) By picking the least productive workers to lat off, an employer can increase the productivity of its workforce. (3) Workers may respond to a reduction in their wages by working less hard, or, conversely, may work harder if they think that by doing so they may reduce the likelihood that they will be laid off. (4) When the wages of all workers in a plant or office are cut, all are unhappy, with layoff, the unhappy workers are off the premises.
If wages fall far enough, many workers will lay themselves off, finding better uses of their time (such as getting more schooling) than working for a pittance–and they may be workers whom the employer would have preferred to retain.
The reason for employers’ preference for layoffs are attenuated when instead of a worker’s wage being cut, he is reduced from full-time to part-time status. He is still part of the team; and he may be able to assuage his distress at his lower wage by adding another part-time job and thus restoring his full income. So reduction from full-time to part-time employment are more common than wage cuts. Similarly, a reduction in bonus is less demoralizing than a cut in salary. There is less of an expectation of receiving a bonus than of continuing to receive one’s base salary, and so there is less disappointment when the bonus is cut.
When, in order to reduce output from X to X-Y in my example and thus restore equilibrium, producers and other sellers of goods and services, such as retailers, begin laying off workers, demand is likely to sink even further; that is, Y will be a larger number. Unemployment reduces the incomes of the formerly employed and creates uncertainty about economic prospects–the uncertainty of the unemployed about whether and when they will find comparable employment, the uncertainty of the still-employed about whether they will retain their jobs. Worker who are laid off spend less money because they have less to spend, and those not laid off feat they may be next and so begin to save more of their income. The less savings, especially safe savings, people have, the more they will reduce their personal consumption expenditures in order to increase their savings, and therefore the more output will fall. Interest rates will fall too, but many people will be afraid to borrow (which would increase economic activity by giving them more money to spend). So spending will not increase significantly even though low interest rates reduce the cost of consumption; people will want to have precautionary savings because of the risk their incomes will continue to decline.
Still, the downward spiral is unlikely to become uncontrollable even without radical government intervention unless the shocks that started the economy on the path to depression either were extremely severe or, because of widespread over-indebtedness, created default cascades that reduced banks’ capital to a point at which they could no longer lend money in quantity. For then consumers who wanted to borrow to maintain their level of consumption could not do so, and their inability would accelerate the fall in demand for goods and services. Commercial activity would fall dramatically; it depends vitally on credit, in part just because costs of production and distribution are almost always incurred before revenues are received.
With demand continuing to fall, seller lay off more workers, which exerts still more downward pressure on demand. They also reduce prices in an effort avoid losing all their customers and be stuck with unsalable inventory. As prices fall, consumers may start hoarding their money in the expectation that prices will keep falling. And they will not borrow at all. For with prices expected keep falling, they would be paying back their loans in dollars with greater purchasing power because the same number of dollars will buy more goods and services. That is deflation–money is worth more–as distinct from inflation in which money is worth less because more money is chasing the same quantity of goods and services.
With demand continuing to fall, bankruptcies soar, layoff increase, incomes fall, prices fall further, and so there are more bankruptcies, etc.– the downward spiral continues. Adverse feedback loops–"vicious cycles" in an older vocabulary–are a formula for catastrophe; other examples pandemics and global warming. Irving Fisher, writing in the depths of the Great Depression, said, that a depression was "something like the ‘capsizing’ of a ship, which under ordinary conditions, is always near stable equilibrium but which, after being tipped beyond a certain angle, has no longer the tendency to return to equilibrium, but, instead, a tendency to depart further from it."
So it is not really the initial shock to a robust system that is the main culprit in a depression; it is vulnerability of the process by which the system adjusts to a shock. This makes the adequacy of the institutional response to that vulnerability critical.
One institutional response to a deflationary spiral is for the Federal Reserve to increase the supply of money, so that a given number of dollars doesn’t buy more goods than it used to. The Federal Reserve creates money in various ways. The most common one, but not the most intuitive, is by altering the federal funds rate; I discuss this later. Another way is by buying federal securities, such as T bills (T for Treasury), from banks. The cash the banks receive from the sale is available to them to lend, and loan proceeds, deposited in the borrower’s bank account, increase the number of dollars available to be spent. Fearing deflation, the Federal Reserve has been expanding the money supply in the current crisis, but with limited success. Because banks are on the edge, or even over the edge, of being insolvent, they are fearful of making risky loans, as most loans in a depression are. So they have put more and more of their capital into short-term securities issued by the federal government–securities that, being backed by the full faith and credit of the United States, are safe.
The effect of competition to buy these securities has been to bid down the interest rate on them virtually to zero. Short-term federal securities that pay no interest are the equivalent of cash. When banks want to hold cash or its equivalent rather than lend it, the action of the Federal Reserve in buying cash-equivalent securities does nothing to increase the money supply. So the Fed is now buying other debt, and from other financial firms as well as from banks–debt that has a positive interest rate, the hope being that if the Federal Reserve buys the debt for cash the seller will lend out the cash in order to replace the interest income that it had been receiving on the debt. But this program has not yet had a great deal of success either. If people and firms are extremely nervous about what the future holds for them, low interest rates will not induce them to borrow.
If monetary policy does not succeed in equating demand to supply by closing the gap between demand of X-Y and supply of X, maybe government spending can do the trick. The government can buy Y worth of goods and services, thus replacing private with public demand, or it can reduce taxes by Y (or give people after-tax income in some other form, such as increased unemployment benefits), so that people have more money to spend, or it can do some of both. Whichever course it follows, it will be engaged in deficit spending. The buying part of the program, like the tax cuts, can be financed only by borrowing (or by the Federal Reserve’s creating money to pay for the program) and not by taxing, for if financed by taxation it would not increase aggregate demand; it would inject money into the economy with one hand and remove it with the other. (It was always obvious that the government could reduce unemployment by hiring people, what makes it a device for fighting a depression is doing so without financing the program by means of taxes.) At this writing [February 2009], Congress is on the verge of enacting a massive deficit-spending program involving public spending on infrastructure improvement and other public-works-type projects, plus tax cuts and other subsidies. [The American Recovery and Reinvestment Act of 2009 in the amount of $787 was signed by President Obama on February 17, 2009.]
Since is the anatomy of depression, and of recovery from depression. But there are different types of depression or recession and we must distinguish among them. In the least interesting and usually the last serious, some unanticipated shock, external to the ordinary workings of the market, disrupts the market equilibrium. The oil-price surges of the early and then the late 1970s, and the terrorist attacks of September 11, 2001 (which deepened a recession that had begun earlier that year), are illustrative. The second type, illustrated by the recession of the early 1980s, in which unemployment exceeded 10 percent for part of 1982, is the induced recession. The Federal Reserve broke what was becoming a chronic high rate of inflation by a steep increase in interest rates. In neither type of recession is anyone at fault, and the second was beneficial to the long-term health of the economy.
The third and most dangerous type of recession/depression is caused by the bursting of an investment bubble. It is depression from within, as it were, and is illustrated by both the depression of the 1930s and the current one, though by other depression and recessions as well, including the global recession of the early 1990s. A bubble is a steep rise in the value of some class of assets that cannot be explained by a change in any of the economic fundamentals that determine value, such as increased demand due to growth in population or to improvements in product quality. But often a bubble is generated by a belief that turns out to be mistaken that fundamentals are changing–that a market, or maybe the entire economy, is entering a new era of growth, for example because of technological advances. Indeed that is probably the main cause of bubbles.
A Stock market developed in the 1920s, powered by a plausible optimism (the years 1924 to 1929 were ones of unprecedented economic growth) and enabled by the willingness of banks to lend on very generous terms to people who wanted to play the stock market. You had to put up only 10 percent of the purchase price of the stock; the bank would lend the rest. That was risky lending, since stock price could and did decline by more than 10 percent, and explains why the bursting of the stock market bubble in 1928 precipitated widespread bank insolvencies. New profit opportunities and low interest rates had led to overindebtedness, an investment bubble, a freezing of credit when the bubble burst because the sudden and steep fall in asset prices caused a cascade of defaults, a rapid decline in consumption because people could not borrow, and finally deflation. Overindebtedness leading to deflation was the core of Irving Fisher’s theory of the Great Depression, and there is concern that history may be repeating itself.
The severity of the 1930s depression may have been due to the Federal Reserve’s failure to expand the supply of money in order to prevent deflation, a failure connected to our adherence to the gold standard: a country that allows its currency to be exchanged for a fixed amount of gold on demand cannot increase its money supply without increasing its gold reserves, which is difficult to do. The United States went off the gold standard in 1933, and there was an immediate economic upturn. Yet the depression persisted until the United States began rearming in earnest shortly before it entered World War II; its persistence may have been due to the Roosevelt Administration’s premature abandonment of deficit spending, employed at the outset of the Administration along with the abandonment of the gold standard with apparent success in arresting the economic downturn.
There was a smaller bubble, in stocks of dot-com, telecommunications, and other high-tech companies, in the late 1990s. But its bursting had only a modest adverse effect on the economy as a whole, as did the sharp drop in the stock market triggered by the terrorist attacks of September 11, 2001.
The current economic emergency is similarly the outgrowth of the bursting of an investment bubble. The bubble started in housing but eventually engulfed the financial industry. Low interest rates, aggressive and imaginative marketing of home mortgages, auto loans, and credit cards, diminishing regulation of the banking industry, and perhaps the rise of a speculative culture–an increased appetite for risk, illustrated by a decline in the traditional equity premium (the margin by which the average return on an investment in stocks exceeds that of an investment in bonds, which are less risky than stocks)–spurred speculative lending, especially on residential real estate, which is bought mainly with debt. As in 1929, the eventual bursting of the bubble endangered the solvency of other banks and other financial institutions. Residential-mortgage debt is huge ($11 trillion by the end of 2006), and many defaults were expected as a result of the bubble’s collapse. The financial system had too much risk in its capital structure to take these defaults in stride. The resulting credit crisis–a drastic reduction in borrowing and lending, indeed a virtual cessation of credit transactions, for long enough to disrupt the credit economy– precipitated a general economic downturn. The downturn depressed stock prices, which exacerbated the downturn by making people feel poorer; for when they feel poorer, even before they become poorer, they spend less, as a precaution.
As the downturn deepened, bank solvency received a second shock: the default rate on bank loans secured by assets other than residential real estate rose because many borrowers were in financial straits. It is expected to rise further. The financial industry is beginning to resemble an onion: one peels successive layers of debt and wonders whether there is any solid core at all. [There have been no failures or bailouts of large financial services firms since February 2009; however, failures of small banks continues.]
How severe is the economic downturn, and how much worse is it likely to get? If one looks only at statistics for 2008 (as we are still in the first quarter of 2009), the situation does not look too terrible: an unemployment rate of 7.2 percent and a gross domestic product (the market value of the nation’s total output of goods and services) that in the last three months of 2008 was 3.8 below the level in the corresponding period the previous year. [Comparable figures for July of 2009 are an unemployment of 9.4 percent and second quarter gross domestic product decrease of 1.0 percent from the second quarter of 2008.] But these snapshots of the economy are incomplete; there is also an $8 trillion decline in the value of traded stocks since 2007 to be reckoned with, together with an estimated $2 trillion of losses by American banks. The snapshots are also misleading . At the beginning of 2008, the unemployment rate was below 5 percent, and few observers think it has plateaued at 7.2 percent. And when discouraged workers and workers involuntarily working part-time rather than full-time are added to the "officially" unemployed, we discover the percentage of underutilized workers increased from 8.7 percent in December 2007 to 13.5 percent a year later, implying a significant drop in income available to buy goods and services. [As of July 2009 underutilized workers were 16.3 percent.] The 3.8 percent decline in gross domestic product is also misleading because the figure is likely to grow and because it would have been 5.1 percent had production for inventory been excluded. The buildup of inventory was the unintended result of an unanticipated fall in demand. Carrying charges for inventories are considerable, and the built-up likely inventories are likely to be liquidated at very steep discounts, which by pulling down the price level will increase the danger of a deflation. Until they are liquidated, moreover, production will be depressed, since sales from inventory are substitutes for sales of newly produced goods. [From January 2009 to July 2009 prices rose by 2.0 percent while inventories decreased by $103.7 billion.]
The distinguished macroeconomist Robert Lucas estimates that in 2008 the gross domestic product was 4.1 percent below where it would have been in an average year (that is 4.1 percent below the long-term trend line of gross domestic product, which is upward), and that if one may judge from consensus forecasts of economic activity it will be 8.3 percent below the trend for 2009. That is nothing to write home about if your benchmark is 1933 (34 percent [below the potential output]), but it is greater than in any year since the end of the Great Depression. [As of March 2009, the Congressional Budget Office estimates the GDP gap – difference between potential output and actual output–will be about 7.4 percent below potential output for 2009 and 6.3 percent below potential output for 2010.] Another ominous sign is that almost every economic estimate of the economic situation has later been revised downward, which feeds pessimism both directly and by revealing that financial experts have an imperfect grasp of the situation; if they don’t know what’s happening, they’re unlikely to be able to provide much guidance to arresting the downward spiral of the economy.
Personal consumption expenditures and consumer prices are falling significantly, which is uncharacteristic of mere recessions and is worrisome because deflation can greatly darken the economic picture. The consumer price index (seasonally adjusted) stopped rising in September 2008 and then fell 1.0 percent in October, 1.7 percent in November , and .7 percent in December. [Comparable data for January through July 2009 are: January 0.3, February 0.4,March -0.1, April 0.0, May 0.1, June 0.7, July 0.0] Another symptom of deflation is that many employers are cutting wages as well as laying off workers. [From the fourth quarter 2007 to second quarter 2009, the index of seasonally adjusted wages and salaries of all civilian workers did not decrease in any quarter-to quarter comparison workers index; so while some employers may have reduced wages, overall wages and salaries did not decrease.] This is an unusual response to economic adversity but makes sense in a deflation, when the purchasing power of money increases because prices are falling. For then a reduction in nominal wages need not mean a reduction in purchasing power (real wages). Indeed, unless nominal wages are cut in a deflation workers will be receiving higher wages in real terms–and for an employer to pay his workers more in an economic downturn would be anomalous.
What is important is not the price declines for the last three months of 2008 as such but whether they will engender expectations of further declines. If so, as we will see in chapter 5, the result is likely to be hoarding of cash on a large scale, which would dry up economic activity. If one averages the declines in the consumer price index for the last three months of 2008 and projects them out for a year, the result is a more than 12 percent decline in consumer prices. That would be catastrophic. I am not predicting such a decline; I make no forecasts. [Using the above data, for January through July 2009, consumer prices for all of 2009 will increase by 1.1 percent.] But only deflation anxiety can explain the extraordinary efforts that the Federal Reserve has been making to increase the supply of money. The fact that the entire world has been caught up in our financial crisis is a further danger sign, because it foreshadows an economically disruptive reduction in foreign trade. [Based on the more recent trends of consumer prices and wage rates, by Posner’s definition a depression has not materialized, although that was not evident at the time (early 2009) he was writing.]
Still another portent is that it is a financial crisis rather than some other shock that is convulsing the economy. A similar financial crisis ushered in the deflationary stage of the Great Depression. The reason a financial crisis is such a downer is that the usual means by which the Federal Reserve pulls the economy out of a recession is by expanding the supply of money so that interest rates fall, which stimulates borrowing and hence, because most borrowing is for spending, whether for consumption or production, economic output [increases]. But the Federal Reserve does its money creation through the banks, and if the banks have solvency problems that make them reluctant to lend, the Fed’s efforts to expand the money supply are impeded.
To understand the central role of banks’ problems in our economic plight, we need to understand the contemporary meaning of "bank" and how that meaning was produced by the movement to deregulate the financial industry. The genus of bank which "bank" is one of the species is "financial intermediaries" –firms that borrow money and then lend (or otherwise invest, but my focus will be on lending) the borrowed money. The difference between the cost of the borrowed money to the firm [(bank)] and the price it charges when it lends out the money that it has borrowed covers the firm’s [(bank’s)] other costs and profit. There are many different types of financial intermediary–commercial banks, trust companies, home-loan banks, ("thrifts"), custodian banks, investment banks and other security broker-dealers, money market funds, other mutual funds, hedge funds, private equity funds, insurance companies, credit unions, and mortgage lenders (in the 1940s and 1950s my father had a successful business of making second-mortgage loans on commercial properties). But today the regulatory barriers separating the different types of financial intermediary have eroded to the point where, for most of my purposes in this book, all financial intermediaries can be regarded as "banks," even when different types of bank are combined in one enterprise–and that has become common too.
There isn’t that much difference anymore even between a commercial bank and a hedge fund. Not that there is no difference. Commercial banks tend, paradoxically, to have riskier capital structures than hedge funds, in part because they have less equity capital and make longer-term loans and in part because some of their capital (demand deposits–the money in checking accounts) is federally insured. Commercial banks differ from all other financial intermediaries in only a few ways that remain important. The most important is their role, which I will be touching on from time to time, in expanding and contracting the supply of money in the U. S. economy.
We need to consider why–the answer is not obvious–the bursting of a housing bubble should cause banks to go broke. Long-term lending secured by mortgages on residential real estate has traditionally been a low-risk business activity. If the homeowner defaulted, the lender would (in effect) seize and sell the house. If real estate prices had fallen, the house might not be worth the unpaid principal of the mortgage, but this risk was minimized by the unwillingness of mortgagees (the lenders–the borrowers are mortgagors) to lend the entire purchase price of a house, or its entire market value if the house had been acquired earlier. The mortgagee would usually require the mortgagor to make a 20 percent down payment on the purchase, so that the mortgagee would be safe as long as the house did not lose more than 20 percent of its value.
Even then the loan might be pretty safe, because banks refused to make mortgage loans to people who would be likely, because of inadequate income, heavy debts, or other serious underwriting risks, to default on a loan. Discipline in lending was reinforced by state usury laws that are now largely pre-empted by federal law as a result of the deregulation movement. By limiting the interest rate that an individual could be charged, usury laws discouraged the making of risky loans because the lender is forbidden to charge an interest rate high enough to compensate him for a high risk that the borrower will default.
We should consider why a lender would want to make a risky loan. The basis reason is the greater the risk, the higher the interest rate, to compensate the lender for the possibility that the borrower will default and as a result the lender will not be repaid unless there is an adequate collateral for the loan or the loan has been guaranteed by someone of substance. If the lender is able somehow to reduce or offset the risk, or just is lucky, or doesn’t worry about the risk because it is likely to materialize, if at all, beyond his planning horizon, the risky loan will be more profitable than a safe loan would be. But before deregulation, banks would get into serious trouble with their regulators if they made risky loans, or at least enough risky loans to create a nontrivial risk of bankruptcy.
So there was safe lending, by banks, and risky lending by other financial intermediaries. [Other financial intermediaries were not and many currently are not regulated.] One thing that made banks safe was that they were forbidden to pay interest of demand deposits, traditionally their major source of capital. Another was that they were required to hold a portion of their deposits in the form of cash or an account with a federal reserve bank. These assets constituted the bank’s "reserves" and did not pay interest. They were riskless and so reduced the overall riskiness of the bank’s asset portfolio. But then business depositors took to practicing "sweeps"–moving the money in their bank accounts into investment funds until they need to pay it to pay bills, at which point they moved it back. And money market funds arose to provide people with checkable accounts, just like bank accounts (though uninsured)– except that they paid interest. Banks responded by supplementing deposits as a source of bank capital with loans from other sources, on which they had to pay interest–and hence had to lend their capital out at a higher interest rate than they were paying for the capital furnished by their depositors. This required them to make riskier loans. The deregulatory strategy of allowing nonbank financial intermediaries to provide services virtually indistinguishable from those of banks, such as the interest-bearing checkable accounts offered by money market funds, led inexorably to a complementary deregulatory strategy of freeing banks from restrictions that handicapped them in competing with unregulated (or very lightly regulated) financial intermediaries–nonbank banks, in effect.
As regulatory and customary restrictions on risky lending by banks eroded, banks became willing to make "subprime" mortgage loans–a euphemism for mortgage loans to people at high risk of defaulting. (Some of these loans are what are called NINJA loans–no income, no job, no assets, meaning that the borrower does not have to undergo a credit check in advance of the loan’s being approved.) Such people tend not to have enough money to make a substantial down payment on a home–so suppose lenders are willing to lend them 100 percent of the purchase price. Many of the borrowers may even have trouble making monthly interest payments–so suppose the loan agreement makes the interest rate vary with the market rate of interest; the borrower pays a low interest rate now but the lender can raise it later if the market interest rate rises. The required monthly payment may even be set below the interest rate–may even be zero for the first two years of the loan–because the borrower cannot afford more. So instead of the mortgage sinking month by month because the borrower is paying interest and repaying principal, the mortgage grows because the unpaid interest gets added to the principal.
In risky mortgage lending, the lender (more precisely, whoever ends up bearing the risk of a default by the borrower) is more like a partner in a real estate business than like a secured lender. For suppose the value of the property drops, even slightly, before much of the loan has been repaid (and in the early years of the typical mortgage loan, very little of the principal is repaid because the monthly payments on a mortgage are a fixed amount and the interest component dominates at the outset when none of the principal has been repaid). The owner will find himself owing more on the house than it is worth. He may therefore decide to abandon it to the lender. If he had bought the house as a speculation, he may abandon it if its value simply fails to increase. He may have to do that, if he was counting on an increase in its value to enable him to refinance the mortgage at a lower interest rate because his equity in the house would be greater [if its value had increased possibly allowing him to qualify for a lower interest rate].
Risky mortgage lending can be extremely risky from the lender’s standpoint, because a single default can wipe out the earnings on several good mortgage loans. Suppose that after expenses of foreclosure and brokerage and the like the lender will recover only 60 percent of his loan if the owner defaults. That 40 percent loss could well exceed the annual interest earned on seven or eight mortgage loans of the same size on other houses.
So subprime lenders, and anyone else who had an interest in a subprime mortgage loan, were skating on thin ice. When it broke–because it turned out that they were lending into a housing bubble that would burst long before the mortgages were repaid–many of them were rendered insolvent because of the huge volume of risky mortgage loans. As many as 40 percent of the $3 trillion in mortgage loans made in the United States in 2006 may have been subprime or otherwise of high risk, such as "Alt-A" mortgages, where the borrower has a decent credit rating but there is some other serious risk factor.
As pointed out in a prescient article by the finance theorist Raghuram Rajan in 2005, the attractiveness of risky lending or other risky investing is enhanced by the asymmetrical response of most investors to the good and bad results of an investment strategy. A strategy that produces good results attracts new investments, and the investment fund grows. If the fund (a trust fund administered by a bank, for example) does poorly, it will lose investors, but generally at a slower rate than it gains them when it does well. Investors tend to stay with a poor performer for a time, either out of inattention or because they are hoping that its performance will improve; whatever attracted them to the fund in the first place may feed that hope.
And because of economies of scale in financial management, the profit margin of an investment fund increases as the fund grows. In a rising market, the fund can grow rapidly–attracting new investors because it is earning high returns while at the same time reducing its average costs–by increasing leverage. "Leverage" is the ratio of debt to equity (borrowed to owned assets) in a firm’s capital structure. Because debt is a prescribed sum owed to a creditor regardless of how well or how badly the debtor does, the higher the ratio of debt to equity, the more money a financial firm will make in a rising market–its revenues will rise, but not its costs.
As Rajan has pointed out, banks and other financial companies have little incentive, in deciding how much risk to take , to worry about small probabilities of disaster. By definition, low-probability event occur rarely, and if they occur at all it is unlikely to be in the immediate future. Until disaster does occur, the riskiness of the firm’s investment strategy, although it may the cause of the firm’s high return, will be invisible to most investors and so it will look as if the firm is generating a high return with low risk. The higher the return on an investment is relative to risk, the more attractive the investment is to a risk-adverse investor, and so the better the performance of the financial manager seems.
That is one reason the private sector can not be expected to adopt measures, such as forbearing to engage in highly risky lending, that might prevent a depression, and thus why preventing depressions has to be a government responsibility. Even though the financial industry has more information bearing on the likelihood of a depression than the government does, it has little incentive to analyze that information. A depression is too remote an event to influence business behavior. Given discounting to present value [–determination of the current value of a future event–] and the fact that by virtue of the principle of limited liability the creditors of a bankrupt corporation cannot go after the personal assets of the corporation’s [(bank’s)]owners or managers, events that are catastrophic to a corporation if they occur but are highly unlikely to occur, and therefore if they do occur are likely to in the distant future, will not influence a corporation’s [(bank’s)] behavior. A bankruptcy is not the end of the world for a company’s executives, or even for its shareholders if they have a diversified portfolio of stocks and other assets. But a cascade of bank bankruptcies can be a disaster for a nation.
The more leveraged a bank’s (or other financial company’s) capital structure is, the greater the risk of insolvency [and hence bankruptcy]. Whether bank insolvencies, even if they precipitate a stock market crash, will trigger a depression thus depends on how widespread the insolvencies are, how deep the decline in the stock market is, and–of critical, but until the depression was upon us of neglected, importance–how much savings people have.
The balance between consumption and savings is critical to depression analysis. The higher the savings rate, the less likely it is that a difficulty in borrowing , caused by bank insolvencies, and a loss of wealth, caused by a decline in the stock market, will result in a steep reduction in the demand for goods and services. People will dip into their savings to maintain something close to their habitual level of consumption.
To understand the interplay of the depression-inducing factors I have been discussing, we now need to consider the fundamentals of borrowing and lending , and in particular their relation to consumption and savings. A person who borrows money in order to buy things (a house, a car, etc.) is increasing his present consumption at the expense of his future consumption, because he will have to pay back the loan eventually. The firm that borrows money in order to produce things (build a house for example) is increasing its present production, though most short-term business borrowing is necessitated simply by the fact that production (cost) normally precedes sale (revenue), and businesses borrow to bridge the gap between expenditure and receipt. Either way, borrowing increases current economic activity. The lower interest rates are, the more borrowing there is and therefore the more buying and selling. When rates are low, you want to be a borrower, not a lender (that is, not a saver). Interest rates were very low in the early 2000s. That was a critical factor in the credit binge that has brought the economy low. A credit binge in the 1920s is widely believed to have been a precipitant of the Great Depression.
A consumer who lends, say by placing some of his money in a money market fund, is reducing his present consumption in order to increase his future consumption; he is saving for the future. Savings are the source of money for lending to other consumers, the ones who want to consume more today. Because borrowing and lending–credit transactions–increase present economic activity, a sudden sharp decline in borrowing and lending reduces that activity–reduces both consumption and production–and can trigger a vicious cycle that produces a high rate of unemployment of both human and capital [(–production–)] resources.
That is the principle justification for ex ante regulation of the finance industries. (A subordinate justification is that since the government insures demand deposits, it wants to make sure that banks don’t take excessive risks with that money.) By "ex ante" regulation I mean regulating behavior before anything bad happens. Speed limits are a form of ex ante regulation; liability for injuring someone in an automobile accident is a form of ex poste regulation. The latter form of regulation is cheaper because it comes into play only in the relatively rare instances in which a mishap occurs. But it operates on the principle of deterrence–the threat of liability is assumed to make people more careful–and deterrence is rarely perfect. So when the consequences of a of a single accident can be catastrophic, the emphasis shifts from deterrence to prevention. That is the case concerning mishaps in the finance industry. As we are experiencing, such mishaps can cause economic disaster. Ex ante regulation failed in this instance.
Personal savings might be expected to act as a brake on the vicious cycle that I have been describing, thus reducing the vicious cycle. If people cannot sustain their current level of consumption by continued borrowing, because the credit market has seized up, they can reallocate some of their savings to consumption– that is, shift consumption from future to present. But in the years leading up to the current depression, the personal savings rate of Americans has plummeted. From 10 percent in 1980 it dropped into negative territory in 2005 (meaning people were spending more than they were earning and thus were dissaving) and then fluctuated in a narrow band around zero percent until the financial crisis began inducing people to save more of their income–in December 2008 the personal savings rate rose to 3.6 percent. The drop was natural because, as I said, the lower interest rate s are, the advantageous it is to borrow rather than to save.
The economic significance of the decline in the personal savings rate was marked by the fact that the market value of people’s savings concentrated as those savings were not only in houses, but also in common stocks held in brokerage accounts, profit-sharing and retirement accounts, health savings plans, college savings plans, was rising because house and stock prices were rising, the first vertiginously. But it is important to distinguish between the market value of a person’s savings and the composition of the portfolio of assets that constitutes his savings. If the portfolio is risky because it is dominated by risky assets, the market value of the portfolio, and thus of the person’s savings, may fall unexpectedly, just like the market value of banks whose asset portfolios had high risk. Even if the market value does not fall a great deal, the expectation created by hard times that it will fall more may cause people to sell their assets (thus causing further declines in the market values of those assets) and invest the proceeds in safe assets, or shift some of their income from consumption to savings.
Many people don’t have much in the way of savings, risky or safe. They tend to be heavily dependent on credit to finance their consumption, and so when credit dries up they have to cut their personal consumption expenditures drastically.
When a person’s wealth increases, he can use the increment to consume more or to invest [–save–)] more, or both; probably he will use at least some of it to invest more. AS the value of a person’s house or of his stock portfolio rises, he is likely to buy more stock and more house (maybe a bigger house, or a second home, or improvements to his home). Those are the assets he is familiar with, and as they are doing well, they seem a good investment. The additional investment pushes up the price of stocks and houses, and hence the measured wealth of people who own such assets. Adjusted for risk, however, personal savings will be shrinking along with the savings rate, not growing; more precisely, precautionary (rainy-day) savings will be shrinking. Thus despite the increase in measured personal wealth in the early 2000s, debt service (interest) as a percentage of personal income rose sharply, though the rise was partly offset by the deductibility of mortgage interest from federal income tax because so much savings was in the form of home-ownership. People’s savings were at once smaller relative to their personal consumption expenditures and riskier, and both are reasons that an economic shock would cause a sharp reduction in those expenditures.
When stock prices and especially housing prices plummeted after their steep ascent fueled by cheap credit (as they had to do eventually because they had been driven up not by fundamental economic changes but by expectations that turned out to be mistaken), the market value of personal savings, concentrated in those risky assets, plummeted too. The inadequacy of people’s savings was thus exposed; and when savings are inadequate, people who lose their jobs, or cannot sell the houses they can no longer afford, cannot or dare not reallocate savings to consumption. Instead, consumption falls steeply. Some people use money they would otherwise have spent on consumption to rebuild their savings, in order to cope with the uncertainty of their economic future–and indeed, as I have noted, the personal savings rate has soared. [The percentage personal savings is of personal income in current dollars rose from the fourth quarter of 2007 to the second quarter of 2009; 2007 IV 1.5%, 2008 I 1.2 %, 2008 II 3.4 %, 2008 III 2.2%, 2008 IV 3.8%, 2009 I 4.0%, 2009 II 5.2%.] Other people, whose incomes have already fallen, reduce their consumption because they do not have enough savings to enable them to maintain their standard of living even if they reallocate all their savings to consumption.
There is a parallel between the behavior of banks and the behavior of consumers, with safe personal savings corresponding to banks’ reserves (cash or an account with a federal reserve bank, which is the equivalent of cash) and other safe assets. When savings/safe assets decline to a dangerous level, consumers buy less and banks lend less.
As consumption falls, output falls, precipitating layoffs that further reduce consumption, creating the vicious cycle dramatized by the virtual collapse of the American-owned automobile industry–already in perilous straits because of swindling demand for gas guzzlers–as people decided to postpone the purchase of new cars. Cheap credit and risky lending had created a kind of automobile bubble–not an increase in the price of automobiles, of course, because the supply of automobiles is much more elastic than that of housing, but rather an increase in the number of automobiles produced, as more people bought second and even third cars and replaced their cars more frequently. U.S. auto sales rose sharply in the early 2000s–a rise inexplicable in terms of fundamental factors–to 17 million 2005, falling to little more than 13 million in 2008 and expected to be even lower in 2009.
With the economy’s output dropping, and therefore corporate profits as well, with no end of the decline in sight and a growing aversion to owning risky assets, it is no surprise that the stock market has plummeted too. Another cause is the need for cash by firms and individuals whose income has declined. The market decline has made people reduce their spending because they are poorer and face greater uncertainty. If they do not need to use their entire reduced income for consumption, the reduction in spending will increase their savings, and what is saved does not contribute to the demand for goods and services.
The timing of the financial crisis, moreover, could not have been worse. It struck during a presidential campaign and deepened during a presidential transition. The lame-duck President seemed uninterested in and uninformed about economic matters and was unable to project an image of leadership and instead spent his final months in office in frequent trips abroad and in legacy-polishing while the domestic economy melted away. Economic officials and private business leaders alike displayed slow uptake and stumbling responses to the financial crisis, undermining confidence in the nation’s economic management. And the crisis accelerated during the Christmas shopping season, which normally accounts for 30 to 50 percent of annual retail sales of most goods and services other than food, drugs, and utilities. The buying binge that had been financed by a reduction in safe savings (because savings had been used to buy risky assets like houses and stock) and by heavy borrowing left American consumers awash in consumer durables, and this made it easy for them to postpone buying when the housing bubble burst. Consumer durables are more durable than they used to be, moreover, so that replacement–for example of cars–can be deferred without hardship longer than used to be possible.
Furthermore, for many Americans, shopping has a recreational aspect, and tastes in recreation can change rapidly. One of the extraordinary aspects of the current economic situation is that buying luxury items has become unfashionable. Many people who can afford to buy such items despite the depression are not doing so.
But wait–since savings are the source of lending, how could a decline in the personal savings rate have coincided with excessive borrowing for personal consumption? Heavy borrowing should increase interest rates, which should in turn reduce the demand for credit. But the Federal Reserve, in reaction to a recession triggered by the collapse, which began in March 2000, of a bubble in dot-com stocks, had used its control over the supply of money to push interest rates way down in order to encourage consumption and production. It kept them down for five years. And the emergence of a global capital surplus kept them low even when the Federal Reserve raised them in 2006. With personal savings by Americans a diminishing source of funds for lending, the slack was taken up by foreign owners of capital, including sovereign (government) loan funds of nations such as China and the major oil-producing countries of the Middle East that exported much more than they imported and as a result had large dollar surpluses that they were eager to invest.
China’s role in setting the stage for the current crises has received a good deal of criticism. The criticism is that by depreciating its currency relative to the dollar, China made its products very cheap to businesses and consumers in the United States and U. S. Products very expensive to Chinese businesses and consumers. The story is more complicated. Chinese incomes are very low; few Chinese can afford our goods. And China is not the only major country that exports more to the United States than it imports from us and reinvests its surplus dollars in this country. Japan and Germany are others–German state banks were big buyers of mortgages-backed securities originated by American banks.
When domestic demand is weak, moreover, as in China, encouraging exports is a way of achieving fuller employment of productive resources. We are in that position today. Our domestic demand is weak. Would that we could offset that weakness with brisk exporting. We cannot because–in another frightening resemblance to the Great Depression–we are in a global depression, which has reduced the demand for our exports.
Throughout the early 2000s, we were flooded with foreign capital. Our chronic trade deficit swelled. We were living on credit. That is a precarious state for a nation, as it is for an individual. But it is a delicious state for lenders, and therefore banks. One might think that low interest rates would hurt as well as help lenders, since competition would limit how much banks could charge for loans. But the banking industry can make more money by borrowing at 2 percent and lending at 6 percent than by borrowing at 6 percent and lending at 10 percent, because the lower the interest rate paid by borrowers, the greater the demand for loans.
It would be a mistake, however, to think that because the world was awash in money, the Federal Reserve had lost control over interest rates–that countries that had large dollar balances that they choose to invest in the United States were to blame for our low interest rates. Had the Federal Reserve feared inflation in 2000, it would have used its control over U. S. Banks to raise interest rates. It was able to raise those rates in 2006 notwithstanding the continued influx of foreign capital.
[The U.S. economy has not experienced the hallmarks of a depression (declining prices and wage rates) described by Posner, so replacing ‘depression’ in the later part of his analysis with ‘recession’ (generally consecutive quarters of declines in economic activity–consumption and production) is a more accurate current interpretation of the circumstances. He wrote in very early 2009 and did not have the more recent data available. Otherwise, Posner’s review and analysis of the factors responsible for the current recession are defensible. ]
Text in brackets [. . .] added by JGC in August 2009.
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