Econ Books

152 T18eturn of Depression Economics

market and the general sluggishness of the economy,which seemed

all too reminiscent of Japan in the 1990s. Greenspan would later

write that he was concerned about the possibility of "corrosive

deflation." So he kept cutting rates, eventually bringing the Federal

funds rate down to just 1 percent.

When monetary policy finallydid get traction, it was through the

housing market. Cynics said that Greenspan had succeeded only

by replacing the stock bubble with a housing bubble-and they

were right. And the question everyone should have been asking

(but few were) was, What will happen when the housing bubble

bursts? The Fed was barely able to pull the economy out of its

post-stock-bubble slump, and even then it was able to do so only

because it was lucky enough to have another bubble come along at

the right time. Would the Fed be able to pull off the feat again?

In the event, the consequences when the housing bubble burst

were worse than almost anyone imagined. Why? Because the finan-

cial system had changed in ways that nobody fullyappreciated.

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BANKING IN THE SHADOWS

B anks are wonderful things, when they work. And they llSU- ally do. But when they don't, all hell can break loose-as

it has in the United States and much of the world over the course of the past year.

But wasn't the age of banking crises supposed to have ended

seventy years ago?Aren't banks regulated, insured, guaranteed up

the wazoo?Yesand no. Yesfor traditional banks; no for a large part of the modern, de facto banking system.

Tounderstand the problem, it helps to run through a brief, selec-

tive history of banking and bank regulation.

The History of Banking, Simplified

Modern banks are supposed to have originated with goldsmiths,

whose primary business was making jewelry but who developed

154 Th.turn of Depression Economics

a profitable sideline as keepers of other people's coin: since gold-

smiths' shops had good safes, they provided more secure places

for the wealthy to stash their cash than, say,a strongbox under the

bed. (Think of Silas Marner.)

At some point goldsmiths discovered that they could make their

sideline as keepers of coin even more profitable by taking some

of the coin deposited in their care and lending it out at interest.

You might think this would get them in trouble: what if the own-

ers of the coin showed up and demanded it right away?But what

the goldsmiths realized was that the law of averages made this

unlikely: on any given day some of their depositors would show up

and demand their coin back, but most would not. So it was enough

to keep a fraction of the coin in reserve; the rest could be put to

work. And thus banking was born.

Every once in a while, however, things would go spectacularly

wrong. There would be a rumor-maybe true, maybe false-that

a bank's investments had gone bad, that it no longer had enough

assets to repay its depositors. The rumor would cause a rush by

depositors t<rgettheir-money out before it was all gone-what we

call ((run ~n the ban~.:}And often such a run would break the bank "even if the-original rumor was false: in order to raise cash

quickly, the bank would have to sell off assets at fire-sale prices,

and sure enough, at those prices it wouldn't have enough assets

to pay what it owed. Since runs based even on false rumors could

br~ak healthy institutions, bank runs became self-fulfillingprophe-

cies: a bank might collapse, not because there was a rumor about

its investments having gone bad, but simply because there was a

rumor that it was about to suffer from a run.

And one thing that could cause such a rumor is the fact that

other banks had already suffered from bank runs. The history of

the U.S. financial system before the Great Depression is punctu-

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ated by "panics": the Panic of 1873, the Panic of 1907, and so on.

These panics were, for the most part, series of contagious bank

runs in which each bank's collapse undermined confidence in other

banks, and financial institutions fell like a row of dominoes.

By the way, any resemblance between this description of pre-

Depression panics and the financial conta~ion that swept Asia, in the late 1~.l)Osis not at ali coincidental. All financial crises tend to

-'- .. ~ -

b~~r a family resemblance to one ano~her. '

The problem of banking panics led to a search for solutions.

Between the Civil War and World War I the United States did not

have a central bank-the Federal Reserve was created in 1913-

but it did have a system of "national banks" that were subject to a modest degree of regulation. Also, in some locations bankers

pooled their resources to create local clearinghouses that would

jointly guarantee a member's liabilities in the event of a panic, and

some state governments began offering deposit insurance on their

banks' deposits.,.

Thc;Yani.k.ov12Q7,)towever,showed the limitations of this sys-

tem (and eerily'pre'~red our current crisis). The crisis originated

i~ij:utions i!Ll'!~ known as "trusts," bank-like institutions

that accepted deposits buLwere originally intended to manage only

inheritances and estates for w~_,!!thyc.Jients.Because they were sup-

posed to engage only in low-riskactivities, trusts were less regulated

and had lower reserve requirements and lower cash reserves than

national banks. However, as the economy boomed during the first

decade of the twentieth century, trusts began speculating in real

estate and the stock market, areas from which national banks were

prohibited. Because they were less regulated than national banks,

trusts were able to pay their depositors higher returns. Meanwhile,

trusts took a free ride on national banks' reputation fo~soundness,

with depositors considering them equally safe. As a result, trusts

156 TAeturn of Depression Economics

grew rapidly: by 1907, the total value ofthe assets in the trusts in

New YorkCity was as high as the total in the national banks. Mean-

while, the trusts declined to join the New York Clearinghouse, a

consortium of New York City national banks that guaranteed each

other's soundness, because that would have required the trusts to

hold higher cash reserves, reducing their profits.

The_Pa~ic ~017 b~~th the de~_ofthe Knickerbocker Trust, a large New Y~ City trust that failed When iffiilimce<lan

unsuccessful large-scale speculation in the stock market. Quickly,

other New Yorktrusts came under pressure, with frightened depos-

itors queuing in long lines to withdraw their funds. The New York-- Cle~~ 0 te . an t and even healthy ones came under serious assault. Within two days a dozen

major trusts had gone under. Credit markets froze, and the stock

market fell dramatically as stock traders were unable to get credit

to finance their trades and business confidence evaporated.

Fortunately, New York City's wealthiest man, a banker by the

name of J. P. Morgan, quickly stepped in to stop the panic. Under-

standing that the crisiswas spreading and would soon engulfhealthy

institutions, trusts and banks alike, he worked with other bankers,

wealthy men such as John D. Rockefeller, and the U.S. secretary

of the treasury to shore up the reserves of banks and trusts so they

could withstand the onslaught of withdrawals. Once people were

assured that they could withdraw their money, the panic ceased.

While the panic itself lasted little more than a week, it and the

stock market collapse decimated the economy. A four-year reces-

sion ensued, with production falling 11 percent and unemployment

rising from 3 to 8 percent.

Although disaster had been narrowly avoided, counting on

J. P. Morgan to save the world a second time didn't seem like a

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iL8.. 8 157BANKING IN THE SHADOWS

good idea, even in the Gilded Age. So the Panic of 1907 was fol-

lowed by banking reform. In 1913 the national banking system

was eliminated, and the Federal Reserve System was created with

the goal of compelling all deposit-taking institutions to hold ade--L ~()I)\ quate reservesand opentheir accountsto inspectionbyregulators.

1 1.tJ Althoughthe new regimestandardizedand centralizedthe hold- \a..\1, F"'" ing of bank reserves, it didn't eliminate the threat of bank runs-

\?v-J'~ and the most severebankingcrisisin historyemergedin the early

r1~~ 1930s. As the economy slumped, commodity prices plunged; this

hit highly indebted American farmers hard, precipitating a series of

loan defaults followed by bank runs in 1930, 1931, and 1933, each

of which started at Midwestern banks and then spread through-

out the country. There's more or less unanimous agre_ement_~mo~g ~ --

e~onomic historians that the Q.ankingcrisis is what turned a nasty

{Cr ~0J recession into the Great Dep~es~i~. "

~ The response was the creation of a system with many more safe- ~,... ,f "(

d2U~.

s. ,The Glass-Steagall Act separated banks into two kinds: il~(t\ S-)Ja4J ~"~~

c mmerclal banks, which accepted deposits, and investment banks,

wruch didn't. Commercial banks were sharply restricted in the risks

they could take; in return, they had ready access to credit from the

Fed (the so-called discount window), and, probably most impor-

tant of all, their deposits were insured by the taxpayer. Investment

banks were much less tightly regulated, but that was considered

acceptable because as nondepository institutions they weren't sup-

posed to be subject to bank runs.

This new system protected the economy from financial crises

for almost seventy years. Things often went wrong-most notably,

in the 1980s a combination of bad luck and bad policy led to the

failure of many savings and loans, a special kind of bank that had

become the dominant source of housing loans. Since S&L deposits

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158 The Am of Depression Economics

were federally insured, taxpayers ended up footing the bill, which

ended up being about 5 percent of GDP (the equivalent of more

than $700 billion now). The fall of the S&Ls led to a tempora-- -.

cr~dit crunc~_~hich ~~s ~ne majo~cause of the ~91_:ece.~- sion, visible in the figure on p. 143. But that was as bad as it got.

The age of banking crises, we were told, was over. It wasn't.

The Shadow Banking System

What is a bank?

That can sound like a stupid question. We all know what a bank

looks like: it's a big marble building-okay, these days it might

also be a storefront in a shopping mall-with tellers accepting and

handing out cash, and an "FDIC insured" sign in the window.

. But from an economist's point of view,banks .aredefined not by

what they look like but by what they do. From the days of those

enterprising goldsmiths to the present day, the essential feature of

b"lnking is-1bewayit prnmises ready access to cash for those who

place money in its care, even while investing most of that money in~

assets that can't be liquidated on a moment's notice. Any institu-

tion or arrangement that does this is a bank, whether or not it lives

in a big marble building. ~d(~-~

Consider, for example, an arrangement known as an auction- ~ rate security, which was invented at Lehman Brothers in 1984 and

became a preferred source of funding for many institutions, rang-

ing from the Port Authority of New York and New Jersey to New

York'sMetropolitan Museum of Art. The arrangement worked like

this: Individuals would lend money to the borrowing institution

on a long-term basis; legally,the money might be tied up for thirty

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. BANKING IN THE SHADOWS 859

years. At frequent intervals,however,often once a week,the insti-

tution would hold a small auction in which potential new investors

would bid for the right to replace investors who wanted to get out.

The interest rate determined by this bidding process would apply

to all funds invested in the security until the next auction was held,

and so on. If the auction failed-if there weren't enough bidders

to let every-onewho wanted out to leave-the interest rate would

rise to a penalty rate, say 15 percent; but that wasn't expected to

happen. The idea of an auction-rate security was that it would rec-

oncile the desire of borrowers for secure long-term funding with

the desire of lenders for ready access to their money. But that's exactly what a bank does.

Yet auction-rate securities seemed to offer every-onea better

deal than conventional banking. Investors in auction-rate securities

were paid higher interest rates than they would have received on

bank deposits, while the issuers of these securities paid lower rates

than they would have on long-term bank loans. There's no such

thing as a free lunch, Milton Friedman told us, yet auction-rate

securities seemed to offer just that. How did they do that?

Well, the answer seems obvious, at least in retrospect: Banks

are highly regulated; they are required to hold liquid reserves,

maintain substantial capital, and pay into the deposit insurance

system. By raising funds via auction-rate securities, borrowers

could bypass these regulations and their attendant expense. But

that also meant that auction-rate securities weren't protected by the banking safety net.

And sure enough, the auction-rate security system, which con-

tained $400 billion at its peak, collapsed in early 2008. One after

another, auctions failed, as too fewnew investors arrived to let exist-

ing investors get their money out. People who thought they had

160 Thetlturn of Depression Economics

ready access to their cash suddenly discovered that their money------.- wasJn~~ in decades-long investments they couldn't get P.uLQ(.And each auction failure led to another: having seen the

perils of these too-clever investment schemes, who wanted to put

fresh money into the system?

What happened to auction-rate securities was, in all but name, a

contagious series of bank runs.

The parallel to the Panic of 1907 should be obvious. In the early

years of the twentieth century, the trusts, the bank-like institutions

that seemed to offer a better deal be~~m~.~they.were...ablet~~p-;r-

ate outside the regulatory system, gr.~wrapjdIYI.._~I!I~to b~~ ,ij' the epicenter of a fina~~_~~~risis.A century later'

c;,

he sme-tlifug'~! happened. \f\Dh -' 6011'\ k b/iWlk~

Today, the set of institutions and arrangements t at~l.!~":~non-:-~~t

bank banks" are generally referred to either as the "parallel banking ;Ii

system"or asthe" shadowbankingsystem."I thinkthe latterterm is t ii,

more descriptive as well as more picturesque. Conventional banks,

which take deposits and are part of the Federal Reserve system, fu~<;.';

operate more or less in the sunlight, with open books and regulators \ looking over their shoulders. T~:~_perations of nonde osito insti- Nm~ tutions that are de facto banks, by contrast, are far more obscure.

,..~. .....

Indeed, until the crisis hit, fewpeople seem to have appreciated just

how important the shadow banking system had become.

In June 2008 Timothy Geithner, the president of the New York

Federal Reserve Bank, gave a speech at the Economic Club of

New York in which he tried to explain how the end of the hous-

ing bubble could have done as much financial damage as it did.

(Geithner didn't know this, but the worst was yet to come.) Even

though the speech was, necessarily, written in centralbankerese,

with a hefty dose of jargon, Geithner's shock at how out of control

the system had gotten comes through:

8 8161 I ./ I I I I I I

BANKING IN THE SHADOWS

The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets

outside the traditional banking system. This-non-bank finan-

ciCiIsystem grew tp be vel}' b~e. particularly in money and

fUQdingJIlarke.ts. In early 2007, asset-backed commercial

paper conduits, in structured investment vehicles, in auction-

rate preferred securities, tender option bonds and variable

rate demand notes, had a combined asset size of roughly $2.2

trillion. Assets financed overnight in triparty repo grew to

$2.5 trillion. Assets held in hedge funds grew to roughly $1.8

trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion.

In comparison, the total assets of the top five bank hold-

ing companies in the United States at that point were just

over $6 trillion, and total assets' of the entire banking system were about $10 trillion.

Geithner, then, considered a whole range of financial arrange-

ments, not just auction-rate securities, to be part of the "non-bank

financial system": things that weren't banks from a regulatory point

of view but were nonetheless performing banking functions. And

he went on to point out just how vulnerable the new system was:

rJ The scale of Ion -term ris and elativel L-illiquid..assets-

fi!!anced by very short-term liabilities made many of the vehi-

cles and institutions in this parallel financial system vulner-

;~l~ to a clas~i~tYPe.of run, but ~ithout the protections such

as d~p~~itinsurance that the ban~~g system_~s.ip pi~cet; reduce such risks..,.".~_._--

Indeed, several of the sectors he described have already col-

lapsed: auction-rate securities have vanished, as already described;

162 The .urn of Depression Economics .

U ~W'llv'V'}~~ ~8-~ asset-backed commercial paper (short-term debt Issued by funds ~s that investedthe money in long-termassets, includingmortgage-t-kJ.<,~'f ~b

backed securities) has withered; two of the five major investment S~,vV'"

banks have failed and another has merged with a conventionals~ in."

bank; and so on. And it turns out that Geithner was missing some :~i~ additional major points of vulnerability: the government in effect/~~t'\~. had to nationalizeAIG, the world's largest insurance company, A ~9" ~. and the carry trade-an international financial arrangement that V\lh~: .. transferred funds from Japan and other low-interest-rate nations "k {\.J..

to higher-yieldinginvestmentselsewherein the world-iinploded r~ 11"

as this new edition was going to press,

But let's postpone discussion of the crisis until the next chapter,

and instead ask about the buildup to the crisis:why was the system

allowed to become so vulnerable?

Malign Neglect

The financial crisis has, inevitably, led to a hunt for villains.

Some of the accusations are entirely spurious, like the claim,

popular Qn the Jighktbat all our problems were caused by the

~0!ll~unity Reinvestmen Act which supposedly forced banks to lend to minority home uY61'swho then defaulted on their mort-

gages; in fact, the act was passed in 1977, which makes it hard to

see how it can be blamed for a <1isisthat didn't happen until three decades later. Anyway, the act aEJilicrinnly to depository banlss,

which accounted for a small £ra.£t~~Lthe.-badJoaas clucingthe

housing bubble.

Other accusations have a grain of truth, but are more wrong than

right. Conservatives like to blame Fannie Mae and Freddie Mac,

the government-sponsored lenders that pioneered securitization,

for the housing bubble and the fragility of the financial system. The

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BANKING IN THE SHADOWS .

163

4

grain of truth here is that Fannie and Freddie, which had grown

enormously between 1990 and 2003-largely because they were

fillingthe hole left by the collapse of many savings and loans-did

make some imprudent loans, and suffered from accounting scan-

dals besides. But the vel)' scrutiny Fannie and Freddie attracted as

a result of those scandals kept them mainly out of the picture dur-

ing the housing bubble's most feverish period, from 2004 to 2006.

As a result, the agencies played only a minor role in the epidemic

of bad lending.

On the left, it's popular to blame deregulation for the crisis-

specifically, the 1999 repeal of the Glass-Steagall Act, which

allowed commercial banks to get into the investment banking busi-

nessand thereby take on more risks. In retrospect, this was surely a

move in the wrong direction, and it may have contributed in subtle

ways to the crisis-for example, some of the risky financial struc-

tures created during the boom years were the "off balance sheet"

operations of commercial banks. Yet the crisis, for the most part,

J:as~ involved problems with deregulated instituuons 1haf took _; _~ new risks. Instead, it has involved risks taken by institutions that ~.9 ~ I }

werel!:eve~r~gulai~~.i~~._~__~ace. ... 1 ~ f\;\~ t @.~_~.lea ~(J-zJ

And that, I'd argue, isthe core of what happened. ~the shadow ~ ;n~~,b\h'

banking system expanded to rival or even surpass conventional . .,

banking in import~~~~,politici~~s and gover~ment oificiai~sho~ld ~41 ~ 1"~I<I

have realized that we ;"ere re-creating the kind of financial vulner- i'r;Y-.y I ability that made the Great Depression possible-and they should J I have responded by extending regulation and the financial safety o~d..~ i

net to cover these new institutions. Influential figures should have 1~wJ.tw\-.;"".1 I

proclaimed a simple rule: anything that does what a bank does, f><Jf;~i'L I anythingthat has to be rescuedin crisesthe waybanksare, should(3f.~ It.- I

be regulated like a bank. . ; -h1><Vh..~

In fact, the Long Term Capital Management crisis, described in h(Nr.1So

164 .

The Return of Depression Economics

Chapter 6, should have served as an object lesson of the dangers

posed by the shadow banking system. Certainly many people were

aware of just how close the system had come to collapse.

But this warning was ignored, and there was no move to extend

regulation. On the contrary, the spirit of the times-and the ideol-

ogy of the George W. Bush administration-was deeply antiregu-

lation. This attitude was symbolized by a photo-op held in 2003,

in which representatives of the various agencies that play roles in

bank oversight used pruning shears and a chainsaw to cut up stacks

of regulations. More concretely, the Bush administration used fed-

eral power, including obscure powers of the Office of the Comp-

troller of the Currency, to block state-level efforts to impose some

oversight on subprime lending.

Meanwhile, the people who should have been worrying about

the fragility of the system were, instead, singing the praises of

"financial innovation," "Not only have individual financial institu-

tions become less vulnerable to shocks from underlying risk fac-

tors," declared Alan Greenspan in 2004, "but also the financial

system as a whole has become more resilient,"

So the growing risks of a crisis for the financial system and the

economy as a whole were ignored or dismissed. And the crisis came.

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9

THE SUM OF ALL FEARS

On July 19, 2007, the Dow Jones Industrial Average rose above 14,000 for the first time. Two weeks later the

White House released a "fact sheet" boasting about the economy's performance on the Bush administration's watch:

"The President's Pro-Growth Policies Are Helping Keep Our Economy Strong, Flexible, and Dynamic," it declared. What about

the problems already visible in the housing market and in subprime

mortgages? They were "largelycontained," said Treasury Secretary

Henry Paulson in an August 1 speech in Beijing.

On August 9 the French bank BNP Paribas suspended with-

drawals from three of its funds-and the first great financial crisis

of the twenty-first century had begun.

I'm tempted to say that the crisis is like nothing we've ever seen

before. But it might be more accurate to say that it's likeeverything

we've seen p.~(ore,all at once: a bursting real estate bubble com-