JANUARY 6, 2014
FOR 30 YEARS, we borrowed and spent. Bond prices went up, stock prices went up, house prices went up. We borrowed more than our parents ever dreamed, but few of us worried. The more debt you took on, the richer you became. Bankers borrowed more than anybody else, and we thought they were geniuses. Then, it all fell apart.
Trillions of dollars of wealth evaporated. Six years after the financial crisis, men and women who never played the market or paid attention to the business pages are still unable to find decent jobs. It seems surreal that a relatively small decline in suburban house prices in Florida, Nevada, Arizona, and California so devastated the entire world’s economy.
For those of us not educated in finance, the crisis and subsequent recession seem almost like acts of God, random and inexplicable. Most explanations of the crash are either moral (“we borrowed too much and now we must pay the price” or “evil bankers gamed the system and ripped off the rest of us”) or so technical they are beyond most peoples’ understanding. Actually, we do know how we got here. It is not a mystery, but grasping it does require a certain vocabulary. Below, in one short paragraph, a straightforward, and generally accepted explanation.
The proximate cause of the financial crisis was an old-fashioned bank run by wholesale lenders fearful of dubious securities in counterparties’ balance sheets. Since banks were highly leveraged, it took only a relatively slight drop in asset prices to render them insolvent. The Minsky moment came on August 9, 2007. Interbank lending froze so both banks and households were forced to deleverage. Without the stimulus of debt-fueled consumption, GDP collapsed. Central bankers promised massive infusions of liquidity but markets were not reassured. Even unprecedented interest cuts did not restore confidence. Monetary policy proved ineffective at the zero lower bound. Fiscal policy was hamstrung by calls for austerity and we remain mired in the longest economic slowdown since the Great Depression.
Umm, say what?
Sometimes I think bankers earn all that money because they make what they do seem both tedious and unintelligible. Banking may be the only business where boredom is something to strive for, so its jargon both obfuscates and sends you to sleep. But six years of pain forces us to realize that economics is too important to be left to the bankers. If the rest of us keep bailing them out, we might as well know what they do. Fortunately, finance isn’t as complicated as its practitioners pretend. It does, however, have its own language, and if you don’t understand it, it sounds like gobbledygook.
So below are a few definitions. Grasp them and not only will you be able to read the Financial Times (the best newspaper in the world, and surprisingly left-wing), you will finally understand how close we came to financial cataclysm and why, even though we avoided meltdown, the entire world remains poorer than it was six years ago. Once you learn the language it really isn’t all that complicated. Let’s start with banks.
BANKS: An entity that borrows money at one rate, lends it at a higher rate, and pockets the difference.
Banks don’t lend their own money; they lend our money, the depositors’ money. A bank’s only “skin in the game” is a tiny fraction of its entire loan book. Intermediaries between savers and borrowers, banks turn cash into capital, and without this “liquidity and maturity transformation” the economy would collapse. Hating bankers can be fun, but we shouldn’t forget that we need them.
LIQUIDITY AND MATURITY TRANSFORMATION: The fundamental function of banks. They take deposits that must be turned into cash at a moment’s notice and transform them into loans that don’t need to be repaid for a long time and can be difficult to turn back into cash.
Liquidity, a term that bankers bandy about all the time, means easy to turn into cash. It is a bit of an amorphous concept so let me explain by example. Imagine you owe a big scary man a large sum of money, and he wants it back, by tomorrow. To make the story more piquant, let’s pretend he threatens to break your legs. You don’t have enough cash sitting around, but your house and your business are worth considerably more than you owe. Unfortunately, you can’t unload them in time, and your creditor knows that. So, he takes them off you at a fraction of their true value, and there is not much you can do about it. Whenever buyers know you are desperate to sell, they certainly aren’t going to pay top dollar. Something is liquid if it is easy to turn into cash. Something is illiquid if trying to sell it takes time, and the very act of wanting to sell reduces its price.
Cash is as liquid as it gets. So is your demand deposit at the bank, which is (almost always) as good as cash. US Treasury bonds, with their deep and constant markets, are very liquid. Your house and business and Damien Hirst dot painting aren’t liquid at all. If you need to sell a work of art quickly, you probably will get a tiny fraction of what you paid for it. For a number of years, subprime mortgage-backed securities were liquid, until one day, they weren’t. The disappearance of liquidity is a major factor in any explanation of the financial crisis. Investors assumed they could unload their subprime mortgage-backed securities whenever they wanted, but in the summer of 2007, when everybody wanted to sell, nobody wanted to buy, and liquidity evaporated just when it was most needed.
Maturity transformation is simpler to explain. The bank is obligated to turn your demand deposit into cash whenever you ask for it. If they did not, we wouldn’t put our money in the bank and would instead keep it in a safe. Your mortgage has a longer term, perhaps even 30 years. A property developer who borrows from the bank in order to buy land and pay his workers won’t be able to repay the principal for years, until he has built and sold his apartments. He would never borrow, and you would never take out a mortgage, if the bank could demand you repay whenever they ask for their money back.
This means banks are intrinsically vulnerable to “runs.” If too many depositors want their money back, the bank will have a hard time turning those loans it owns back into liquid money.
BANK RUNS: The rapid withdrawal of funds from banks by depositors, who for whatever reason suspect the bank might not be able to repay them.
If depositors fear that the bank won’t be able to return their money upon demand, they withdraw their cash. No one wants to be the last one stuck in line holding a worthless I.O.U. when the bank runs out of money. No one wants to be told they have to wait a week or two before they can access their cash. Credit comes from the Latin word for faith. Our entire economy is dependant on the fiction that the money in our bank accounts is actually there waiting for us. When that faith is shattered, the economy comes tumbling down.
Before the federal government guaranteed deposits in the wake of the Great Depression, bank runs were a common phenomenon. A rumor that a bank had made bad loans and didn’t have enough money to redeem all it owed would bring depositors into the streets. Milton Friedman’s parents lost all their savings in 1933 during a run on their local New York City bank, and look what that did to his sunny disposition.
The FDIC depositors’ guarantee has been an unquestioned success. Bank failures no longer ruin families and communities. For 80 years, bank runs seemed a thing of the past, like men in fedoras, until 2007 when a run by wholesale depositors kicked off the financial crisis.
SHADOW BANKING SYSTEM: Unregulated institutions with lots of spare cash that they lend to banks.
This is a confusing term, bandied about all the time in the business pages that many of us pretend to understand, but maybe don’t. Shadow banks, also called wholesale lenders, are institutions like pension funds, money market funds, hedge funds, and corporate finance departments with lots of cash on hand, which they lend short-term to commercial and investment banks. Remember, banks can’t create money out of thin air. They need deposits in order to make loans. Back in the day, banks funded their loans with retail deposits, that is to say you and me depositing our paychecks. Retail deposits are cheap and reliable, but they don’t grow fast. Banks wanting to expand began to borrow from wholesale lenders, who had lots of cash sitting around and wanted to park it somewhere safe in return for a competitive interest rate.
Now you and I won’t switch banks in order to gain a 0.02 percent better interest rate, but pension funds and money market funds and other large institutions will. Every little bit of extra yield, anything better than the market average, counts heavily in determining a banker’s bonus. So UK banks like Northern Rock and American banks like Washington Mutual, desperate to get bigger, could get their hands on massive amounts of capital from wholesale lenders, which they could in turn lend to their customers. When your business model is borrow at three percent, lend at sex percent, pocket the difference, borrowing more, so you can lend more, seems the obvious way to increase profits.
The problem is that deposits by wholesale lenders can be fickle, and rates can change with little warning. It was a dependence on short-term wholesale lending that doomed Northern Rock and Lehman Brothers. That is because, unlike retail depositors, wholesale lenders don’t have a government guarantee. If the bank goes bust, they can lose all their money. This makes banks reliant on wholesale lenders much more vulnerable to runs.
So far, I’ve been describing banking as it used to be, in a Jimmy Stewart, It’s a Wonderful Life world. Things have changed. A generation ago, banks were very careful to whom they lent their money because those loans would be on their books for a long time. A bank would hold a 30-year mortgage for 30 years. If any time in those 30 years the borrower defaulted, the bank took the hit, and the banker lost his bonus. Securitization changed that.
SECURITIZATION: The bundling of thousands of loans, turning them into bond-like securities and selling them on to investors.
Now banks bundle loans together, create securities out of them, and sell them off to investors. A loan to a deadbeat will be somebody else’s problem within a week, so no wonder banks happily gave mortgages to so-called NINJAs, borrowers with “No Income, No Job or Assets.” No wonder many of those loans went south.
Back during the boom, apologists for the financial industry told us that securitization (and derivatives and credit-default swaps and …) made banking safer since it allowed institutions to “better manage their risk.” Those banks willing to make dubious loans in return for higher interest payments could do so, while those that wanted to shift risk to someone else could do so as well. Unfortunately, risk migrated not toward those that wanted it, but rather toward those who did not understand it.
Shifting risk is not the same as eliminating it. Indeed, loaning billions to people who could not afford to repay corrupted and weakened the entire banking system. Bankers knew they had been stuck with bad loans on their books, and they feared that the banks they were trading with might be saturated with those dubious securities as well.
SECURITY: a tradable piece of paper (or these days, electronic blip) that promises a future cash flow.
All finance in one way or another is about swapping money now for the promise of more money later. A security is the promise of a future cash flow that can be bought and sold. Back in the old days, securities mostly meant stocks and bonds. Fixed income, or bonds, is the promise of future interest payments. Stocks, or equities, are the promise of a share of the future earnings of a firm. Options are the right to buy or sell other securities at a given price and date. Derivatives are securities whose price is based on the price of other securities.
Starting in the 1980s banking got more “creative,” as all sorts of future cash flows were turned into securities. Since your mortgage (and car note and consumer loan) is just the promise of a series of future payments, banks could bundle it together with other mortgages and sell it on to investors. This not only passed on the risk that you wouldn’t pay, it also freed up money so that the bank could make more loans.
To satisfy the needs of different investors, they divided these bundled loans into various “tranches” or sections. Some tranches were riskier than others and so would pay a larger coupon or interest rate. “Equity” tranches took the first hit and so paid the highest rate. “Mezzanine” tranches came next. They paid a lower rate, but only missed a payment to investors after the equity tranche was utterly wiped out. The “super senior” tranches, which paid off first, before any of the other tranches got anything at all, were assumed to be safer than even bonds of the most established and respected corporations. That is how subprime loans made to unreliable individuals with bad credit histories, once bundled, securitized and tranched, managed to be rated AAA.
Much of what investment banks do is buy and sell each other securities. During the boom, interest rates were relatively low, so banks searching for higher yields were desperate to buy subprime securitized debt. The AAA rating made it look safe, and it still paid a slightly higher interest rate than other AAA debt. For a long time, this was quite profitable. As long as house prices kept going up, even if a borrower missed a few mortgage payments, no one got hurt. He could just sell the house, pay off the mortgage, satisfy those investors that owned his debt, and still pocket the difference. Everybody was happy.
But when house prices stopped rising, foreclosures became more painful for everybody, including investors holding AAA subprime debt. As lower rated tranches defaulted, the super senior tranche didn’t look so safe anymore either, and, inevitably, its price fell.
Securities are promises of future payments that, because they are tradable, have a market value today, based on supply and demand. When more and more investors realized that AAA securities based on subprime mortgages were riskier than they had assumed, they all started unloading them. Everybody wanted to sell, nobody wanted to buy, and so what had been a liquid market became dry as a bone. Super senior AAA debt became much harder to turn into cash. This also made it worth less as collateral.
COLLATERAL: What gives banks confidence to lend is the right to take something of even greater value from the borrower, should he or she default.
Banks like to believe that we will pay back our loan, but what gives them confidence is collateral: the right to take something of ours of more value than the loan should we prove unable to make our payments. It is the rising value of collateral that created the feedback loop that allowed the housing bubble. As house prices went up, banks were willing to lend more, which pushed housing prices even further.
Banks use securities (including mortgage-backed securities) as collateral for loans with each other. The collapse in value in subprime securities affected the ability of banks to use them as collateral for the short-term deposits that financed their longer-term loans. This was the actual trigger for the financial crisis.
MINSKY MOMENT: When greed turns to fear. When boom turns to panic. Our Minsky Moment was August 9, 2007. That is the day the financial crisis began.
Hyman Minsky is one of the few economists whose reputation was burnished by the financial crisis, which he accurately predicted, even though he died a decade before it kicked off. Although an academic, he also worked in banking and so had a much more nuts-and-bolts understanding of finance than most economists. He recognized that booms could go on and on, just as long as banks kept extending credit. As long as bankers are feeling optimistic, when a loan comes due, the bank rolls it over. The bank gets paper profits, the borrower gets seemingly free money. Everybody wins. Until something changes and, instead of always lending more, banks decide to cut back.
In the summer of 2007, few economists predicted disaster. Yes, real estate prices had peaked in the fall of 2005, and the inability of borrowers to resell or refinance meant foreclosures of subprime mortgages had started to rise. A couple of hedge funds invested in subprime mortgages went bust in the spring of 2007, but policy makers remained sanguine. On August 8, 2007, Mervyn King, head of the Bank of England, declared that risks to financial stability “appeared to be low” since “our banking system is much more resilient than in the past.”
On August 9, 2007, it all went to shit.
That morning, the big French bank BNP Paribas announced it was prohibiting withdrawals from two of its funds, which had invested heavily in subprime mortgage-backed securities. That meant that investors in those funds, who had assumed they had immediate access to their money, were told they did not.
As in a classic bank run, it was the prospect of being unable to withdraw their cash that galvanized depositors. Bankers knew they had been cooking their own books, overestimating the value of subprime loans they owned. They naturally assumed other banks were doing the same. The complex web of securitization, credit-default swaps, and third party repo agreements made everything opaque. Banks had been playing a game of “pass the parcel” with dubious debt, and it was hard to tell who would end up stuck with worthless paper. No one wanted to lend to another bank that might go bust and see their capital disappear into a black pit of bankruptcy litigation. When they saw BNP Paribas prohibit withdrawals, they feared other banks would as well. So instead of rolling over their deposits when they came due, the shadow banks pulled their money out. Since much of their funds were invested overnight, the crisis came quickly.
A few months before, an extra one-hundredth of a percent interest rate (each .01 percent is called a basis point or “bp” in the jargon) tempted investors. No more. On August 9, 2007, interbank lending froze, as did commercial paper, as did purchases of asset-backed securities. What that meant was that banks, which had been able to easily attract big deposits from money market wholesalers, and then lend that money on, saw the spigots clog up and stop flowing.
CONTAGION: Minsky’s fifth and last stage of financial crisis (the other four are displacement, expansion, euphoria, and revulsion). The crisis spreads from one asset class and can infect the entire economy.
As wholesale depositors began withdrawing funds, banks had to find the money to return to them. If they did not have enough cash on hand, they needed to sell assets — the loans and securities on their books — in order to meet the call for redemptions. But needing to sell them naturally drives down their price. By the summer of 2007, no one was looking to buy subprime securities. Everybody was looking to unload them, so their prices collapsed, creating a feedback loop in which redemptions forced sales, which forced prices down even more. As the value of bank assets tumbled, more and more depositors lost confidence in the banks’ solvency, inevitably engendering more redemptions.
When the wholesale money markets got nervous and pulled their money from the banks, the banks had to cut lending to the public. For 30 years, primarily because of wage stagnation, the global economy had been dependant on ever-increasing debt levels. If an American didn’t max out his credit card, a former peasant in China lost his job in a factory. The world had become addicted to easy money and cheap loans. As a result, when the lending stopped, so did the global economy. The effects of the lending freeze are still with us. This has been the longest and deepest slowdown in the world economy since the 1930s.
During the boom, households borrowed and used that money to buy or renovate homes. Since the value of homes went up faster than the debts incurred to buy them, we collectively became richer and so were willing to splash out on consumer durables or high living. That is why they call it a “boom.” The crash of home prices lowered the value of homeowners’ main asset, and the only thing they could do to stay solvent was to reduce spending and reduce debt.
This is the basic paradigm of all financial crises. During the boom, investors borrow in order to purchase an asset. During the bust, the value of the asset falls, but the value of the debt does not. Just because your house is worth less, this does not lower the cost of your mortgage. The key political question in the wake of all financial crises is who pays for the party: the borrower who purchased the now worthless asset or the lender who fronted the money?
If a business or household owes more than what it owns, its equity or net wealth is negative. It is insolvent. It is bankrupt. This is not a comfortable place to be. It is something we all strive to avoid. So the financial crisis forced households to pay down their debts, and spare cash that used to be spent in high living was earmarked for reducing debt.
On a micro level, this is very sensible. If you owe more than you own, buying more stuff is counterproductive. But when everybody is not spending, when everybody is reducing rather than increasing debt, the entire economy shrinks. Your consumption is my sales, and if my sales are going down, I’m not going to be ordering more goods from suppliers, and I certainly am not going to hire more workers. And that is why this is a “balance sheet recession.” Households are not spending because they are frightened that if they are not careful, their liabilities will exceed their assets.
Ever-increasing debt levels fueled the boom. Deleveraging, or cutting borrowing, created the bust.
LEVERAGE: The ratio between your assets and your equity.
It is worth noting that the Great Recession and the financial crisis, although causally related, are two different things. The recession is the shrinking of the world economy and the ensuing disappearance of jobs. The financial crisis is the collapse in asset values and the resultant loss of faith by investors in their ability to get their money back from financial institutions. Leverage caused the financial crisis. Deleverage caused the recession.
Banks have a little bit of their own capital (as well as all of yours) at risk, but often that is just three percent of their assets. That means that if the value of their assets falls just three percent, they are bust. Even if they sell everything they own, they still don’t have enough money left over to repay their depositors.
Increasing leverage was a brilliant strategy for the banks as long asset prices went up. But when prices went down, leverage bit them on the ass. Leverage is why a relatively small decline in house prices shut down the entire world economy.
If you buy a million dollar house and pay cash, and the house goes up $100,000, you have made 10 percent on your investment. If instead you put down $100,000 and borrow the rest, a $100,000 price hike doubles your money. If you could borrow $990,000 and just put down $10,000, and the house goes up $100,000, you will have made 10 times what you put in.
In good times, leverage, or borrowing to buy an asset, is a brilliant strategy. The highly leveraged make fortunes. Everyone thinks they are geniuses. Even a small increase in asset prices means a huge increase in wealth.
But leverage works both ways. If you buy an asset with only five percent down, a five percent increase in the asset price doubles your money, but, a five percent decline wipes you out. In 2007, most investment bankers had only experienced bull markets. In that world, increasing leverage was a sure way to boost their profits, and so that is what they did. But this left them very vulnerable to any decline in asset prices.
Lehman Brothers, for example, had a leverage ratio of 30:1. If that wasn’t bad enough, Lehman was also a big player in subprime mortgage-backed securities.
By early 2008, these bonds, even those rated AAA, were seen as dreck. Everybody wanted to sell them; nobody wanted to buy them. Although some of these mortgage-backed securities might still pay off at maturity, their present market value plummeted. And since Lehman Brothers was highly leveraged, everybody knew all it took was a three percent decline in the value of its assets for it to be bust.
The moral is that banks need more capital, more of the shareholders money cushioning depositors (or taxpayers) from any risk of losing money. If a bank has one dollar of its own money for every four dollars of depositors’ money, 20 percent of its loans can go bad without threatening depositors with any losses. Yes, the bank’s shareholders will lose their shirts, but the depositors (and thus the taxpayers who will have to bail them out) remain safe. But if a bank only has three dollars of its money for every hundred dollars it loans out, then even a tiny drop in asset prices will put depositors (and taxpayers) at risk. Any long-term cure for the financial system will have to lower bank leverage. Bankers will complain, because leverage increases their profits. Don’t listen to them!
For a long time, money wholesalers still felt safe lending to Lehman Brothers, even though they suspected it was broke, mostly because their lending was very short term, often just overnight. As long as they could assume Lehman Brothers wouldn’t go bust tomorrow, they were happy to keep their money in. But as more and more money wholesalers began to realize Lehman Brothers was insolvent, they also realized others felt the same way. As in any bank run, nobody wanted to be stuck in line waiting when the money ran out. Once the run began, only a government loan could save Lehman Brothers.
LENDER OF LAST RESORT: In a financial crisis, when everybody wants to sell and nobody wants to buy and asset prices are tumbling, the central bank will step in and lend to troubled banks so they can repay depositors and are not forced to sell securities at fire-sale prices.
Back in the late 19th century, when financial crises were even more common than they are today, Walter Bagehot, the legendary editor of The Economist, came up with a solution: a lender of last resort. He suggested that, in order to break the feedback loop between depositors’ fear and tumbling asset prices, the Bank of England should step in and lend freely to troubled banks. A central bank can always find the money, because it, unlike everybody else, can manufacture cash at will. But Bagehot insisted that they couldn’t just give the money away. The Bank of England should only lend to banks that had good collateral, but that collateral should be valued at its pre-panic price, not at its current and artificially low price.
Illiquidity disappears because the central bank will front the money the depositors demand. The central bank, in theory, is taking no risk because it has the bank’s assets as collateral. Should the bank not repay the government loan, the government can sell the securities it holds as collateral. During this last financial crisis, the Federal Reserve lent $790 billion in the TARP program. So far it has gotten most of it back and will probably end up making a profit.
Once depositors know the central bank will backstop the troubled bank, the panic generally will subside. After all, the depositors are pulling their money only because they fear that otherwise they will have to go to bankruptcy court in order to get it back. Once they have a government guarantee, then the impetus for the run disappears. This works, not only in Bagehot’s times, but also in our own.
Sometimes it works all too well. Alan Greenspan’s archetypal triumph was his liquidity injection after the 1987 stock market crash. His quick reaction in assuring markets that the government would lend freely prevented the crash from infecting the rest of the economy. Unfortunately it also set the pattern for his entire time at the Fed. Any time markets had a wobble — in 1994, in 1998, in 2000 — they knew Greenspan was there, to provide liquidity, to cut interest rates. This gave market participants the confidence that the government provided a floor below which it would not allow the market to fall. This assurance, that the central banks had their backs, stimulated ever more risk-taking among traders. Eventually, this bit them on the ass.
After the August 9, 2007, credit freeze, the European Central Bank and the Fed once again poured billions of dollars into the financial system assuming this would alleviate the panic. It had worked before, but this time it didn’t. Part of the problem was that traders saw fear in the Central Banks’ reaction. They figured if the central bankers were panicking, then things might be worse than they had assumed. The bigger reason was this wasn’t just another liquidity crisis, but rather an insolvency crisis.
INSOLVENT: Broke, bankrupt. The liabilities side of the balance sheet exceeds the asset side. Net equity is negative. In 19th-century Britain, you would go to debtor’s prison.
ILLIQUID: A cash flow problem. Assets remain greater than liabilities, but since assets are hard to sell, banks have a problem coming up with cash demanded by depositors.
The reason an insolvent bank can’t repay its depositors is because even if it sold everything it owned, it still wouldn’t have enough cash to pay off its debts. An illiquid bank’s assets, on the other hand, are greater than its liabilities. It just has a problem coming up with the money because those assets are hard to sell.
Now in finance and accounting textbooks (and in central bank regulations), insolvency and illiquidity are vastly different, and insolvency is much worse. But in the real world, things are a bit murkier. For example, today, according to many experts, most Chinese banks are insolvent. Dubious debt permeates the Chinese banking system, and were their assets valued accurately, Chinese state-owned banks would probably be broke. But since depositors are confident the Chinese government will support their banks no matter what, they feel no pressure to withdraw funds. The Chinese banks may be insolvent, but they are not illiquid, and really that is what matters. Insolvent banks can survive indefinitely as long as depositors remain sanguine someone will bail them out.
Three times in the past generation (in the early 1980s because of the Latin American debt crisis, in the early 1990s because of the commercial real estate and junk bond collapse, and today) much of the world financial system has been insolvent, at least by most measures. Each time, central banks tried to paper over the problem and find ways to make banks more profitable. Generally they did this by lending banks money very cheaply and letting them increase the spread between their borrowing and lending. As long as banks can goose their long-term lending rates, they will increase their profits and in time restore their solvency.
According to Bagehot’s Rule, the lender of last resort should only bail out illiquid, not insolvent, banks. Otherwise, the central bank could be throwing good money after bad. Lehman was insolvent, not illiquid, which is why the US government let it fail. The Fed could have held its nose, ignored that Lehman was broke, and lent them enough cash to satisfy depositors, but decided instead to teach investors a lesson in prudence. Without a government guarantee, Lehman Brothers — overleveraged and overinvested in dubious securities — was doomed.
Of course, when Lehman Brothers went bust, the money markets freaked out even more. They all wondered who would be next, which meant that no one wanted to put their money into Goldman Sachs or Merrill Lynch, either. Merrill Lynch was saved when it was bought by Bank of America, which had massive and safe retail deposits. The other investment banks, and indeed the world financial system, were saved by the US, UK, and EU central banks, which promised unlimited loans (against collateral that earlier would have been considered dubious), and this certainty of a bailout finally calmed markets a little bit. Bagehot’s “lender of last resort” saved us from calamity.
Few of us realize how close to disaster we came. The financial system is so intertwined that one big bank failure can ripple through the system and bring the whole thing down. If one bank fails, it defaults on its obligations to another bank, which could then also fail, and so forth ad infinitum.
TARP and the various bailout programs whereby the Federal Reserve created money out of thin air and deposited it into bank reserve accounts saved the system from utter collapse. In the same way that investors today are willing to buy Greek debt because of an implicit European Central Bank guarantee, it was the confidence that the Federal Reserve, scarred by the Lehman’s debacle, would not let any other big bank fail that prevented bank runs from destroying Goldman Sachs, Citibank, Merrill Lynch, et al. in 2008. Without a credible government guarantee, financial markets would have seized up, lending would have stopped, depositors would have pulled their funds, forcing banks to sell assets into falling markets. The feedback loop between falling asset prices and depositors’ redemptions would have become inexorable until, one day, you and I would have gone to the cash machine, put in our card, punched in the pin number, and realized that the money we thought was ours, safe in our bank account, was gone. That disaster was averted doesn’t mean it wasn’t possible.
One can argue that the bailout wasn’t perfect, that it rewarded those who created the problem, but without government guarantees protecting depositors, all of us would have paid an unimaginable price. For the past 30 years, we have been told that government is the problem and markets are the solution. But it was government action alone that saved markets from their self-inflicted wounds.
But it wasn’t enough to prevent the greatest worldwide economic contraction since the 1930s. Although the United States is finally seeing glimmers of growth, jobs aren’t returning to 2007 levels. We remain stuck in a pernicious feedback loop. When we fear for our jobs, we don’t spend. When we don’t spend, firms don’t hire, and so workers don’t open their wallets.
Fortunately, there is a solution. All it requires is political will. Governments have powerful tools — namely monetary policy and fiscal policy — that can restore our economy. In part two of this article, “The Road Back to Prosperity,” I’ll explain how we can break the feedback loop and return our economy to healthy, sustainable growth.