The lessons of financial history, reprise

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Article Highlights

  • With an American housing recovery under way, it is a good time to re-state the repetitive lessons of financial history.

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  • To combine risky businesses with riskless funding is impossible.

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  • However freely a central bank may be lending, it is by definition providing more debt, not equity.

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It has been almost seven years since the mid-2006 peak of the spectacular U.S. housing bubble. With an American housing recovery now at last under way, it is a good time to re-state the repetitivelessons of financial history.

The bubble, the panics and crises of 2007-09, and the extended bust and post-bubble doldrums,present a striking case of recurring financial and political patterns. This is true not only in the U.S., but also in the European housing and government debt disasters.

These patterns notably include the painful dilemmas of governments when using taxpayers’ money to offset the losses of financial firms, all in the name of financial stability. The bubble events have already filled dozens of books and thousands of articles in this cycle, but the debates go back at least to 1802, when Henry Thornton, in The Nature and Effects of the Paper Credit of Great Britain, discussed the “moral hazard,” as we now call it, necessarily involved.

Financial systems all involve an uncomfortable, and indeed a self-contradictory, combination, arising from the public’s deep desire to have short-term assets, especially deposits, which are riskless. Governments feed this desire under the rubric of promoting “confidence.” But these short-term instruments fund financial businesses which are inherently very risky, and subject to periodic losses far greater than anyone ever imagined, notably in the financing of real estate.

Consider in this respect Fannie Mae and Freddie Mac, with their government-guaranteed funding: between 2007 and 2011, they together lost $246 billion. This wiped out the aggregate combined profits they made from 1971 to 2006, or the previous 35 years, plus another $140 billion! Quite amazing: Nobody predicted that Fannie and Freddie would fail from making bad loans, and nobody predicted a collapse of this magnitude. But the U.S. government has completely protected all the Fannie and Freddie bond and MBS holders.

The repetitive lesson: To combine risky businesses with riskless funding is, in fact and in principle, impossible. But governments around the world insist on trying to do it anyway. They are therefore periodically put in the position of desperately wanting to protect the funding by transferring losses from financial firms to the public, and transferring money from the public to the financial firms, as once yet again in this cycle.

Consider the four approaches available to a government faced with an emerging financial crisis and possible collapse.

First, there is issuing official assurances. For example, this time around in the U.S., there was the official refrain that “the subprime problems are contained” of 2007. Or official statements in the summer of 2008: Fannie and Freddie “are adequately capitalized… They have solid portfolios.” Or “Let me just say a word about GSEs [Fannie and Freddie]…They are in no danger of failing.” This was just before they failed. Should anyone believe what government officials say in such circumstances?

Second, there is allowing delay in recognizing losses to avoid panic and “loss of confidence,” and hoping things will get better. This we know as both regulatory “forbearance” and also as “extend and pretend.” It sometimes involves “adjusting” the accounting to stretch losses out over time. Sometimes it works, but often it does not.

Third, there is using the central bank as emergency liquidity provider or “lender of last resort,”to expand the “elastic currency” (as the Federal Reserve Act called it in 1913). This was and continues to be energetically practiced by the U.S. and European central banks. They can and did implement Walter Bagehot’s classic 19th century advice that in a panic, central banks should lend freely on good collateral. Central banks can extend this notion to lending on dubious collateral, then to inventing new last resort lending structures, as was done in the U.S. for Bear Stearns and AIG. With all this, central bank lending may be enough.

But maybe not enough. For however freely the central bank may be lending, it is by definition providing more debt, not equity. If your equity is gone and you’re broke, no matter how much more somebody lends you, you are still broke.

In the worst cases like the most recent bust, which involve heavy asset price deflation and the destruction of financial system capital, the losses wipe out the equity of many firms whose liabilities the public thought were riskless. In such times, suddenly no one knows for sure who isn’t broke, which stokes the panic. Then something more is required.

So fourth, there is the government (really the taxpayers, needless to say) as provider of new equity capital for financial firms. If successful,this may be a bridge to private recapitalization when normal financial functioning is restored in time. Of course, all four of these government responses may be and indeed were in recent years happening at the same time.

In this cycle, the equity provision in the U.S. was in the form of “TARP,” in which the government purchased preferred stock in financial institutions--much of which has now been retired at a profit to the Treasury, as banks have recovered. The U.S. government did the same thing in the 1930s, when its Reconstruction Finance Corporation invested in about six thousand banks, and operated overall at a modest profit. Government investment in bank equity was also prominent in European countries in this cycle, and in Japan and Sweden in the 1990s. A massive government equity injection this time around was the $187 billion of senior preferred stock of Fannie Mae and Freddie Mac which the U.S. government bought and is still holding, with a large unrealized loss, so far.

It is indeed too bad that the taxpayers get transformed into involuntary equity investors in financial firms in this fashion. But no students of financial history, including the history of government guarantees of deposits and other debt, are surprised by any of the four developments we are considering.

They are even less surprised by the inevitable fifth development, which comes after the crisis: a big increase in financial regulation, with complex and costly new rules and multiplied and expanded regulatory bureaucracies. This is accompanied by the reiterated official promise that “this new regulation will ensure that a financial crisis will never happen again.” But it always happens again anyway.

The great economic historian Charles Kindleberger, considering four centuries of financial history, observed that financial crises occur on average about every ten years. More recently, Carmen Reinhart and Kenneth Rogoff, surveying eight centuries of booms and busts, reached a similar conclusion. Alas, as far as housing and debt cycles go, there is nothing new under the financial sun.

As memorable as the repetitive lessons of our recent financial adventures seem now, will future financial actors sufficiently remember them? On the historical record, one must doubt it.

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Alex J.
Pollock

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