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It is five years since the 2006 peak of the great housing bubble and time to re-state the repetitive lessons of financial history.
The panics and crises of 2007-09 and the ensuing post-bubble housing doldrums present a striking case of the recurring patterns. These include the dilemmas of governments when using taxpayers’ money to offset the losses of financial firms in the name of financial stability.
The bubble events have already filled dozens of books in this cycle, but the debates go back at least to 1802, when Henry Thornton (The Nature and Effects of the Paper Credit of Great Britain) discussed the “moral hazard,” as we now call it, necessarily involved. Our recent financial adventures are memorable, but will they be sufficiently remembered?
Financial systems all involve an uncomfortable, and indeed a self-contradictory, combination, arising from the public’s desire to have short-term assets, especially deposits, which are riskless. Governments promote this desire in the name of “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.
“…No student of financial history, including the history of government guarantees of deposits and other debt, is surprised by the four developments we are considering.” — Alex Pollock
Consider in this respect Fannie Mae and Freddie Mac, with their government-guaranteed funding: between 2007 and 2010, they together lost $236 billion. This wiped out their aggregate combined profits of the previous 35 years, plus another $130 billion!
Now in fact to combine risky businesses with riskless funding is impossible. Governments around the world are therefore periodically put in the position of desperately wanting to protect the funding by transferring losses from financial firms to the public, as once again in this cycle.
Consider the 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, “the subprime problems are contained” refrain of 2007. Or in the summer of 2008: the assurance that Fannie and Freddie “are adequately capitalized… They have solid portfolios.” Or “Let me just say a word about GSEs…They are in no danger of failing.”
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 “forbearance” and “extend and pretend.” Sometimes it works, but often 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 calls it. This can implement Walter Bagehot’s classic 19th century advice to central banks that in a panic, they should lend freely on good collateral. It may be enough.
Or maybe not. 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, involving heavy asset price deflation and the destruction of financial system capital, when the losses wipe out the equity of many firms whose liabilities the public wishes to be riskless, something else is required. In these times, no one knows for sure who isn’t broke, which stokes the panic.
So fourth, there is the government (really the taxpayers, needless to say) as provider of new equity capital. 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 happening at the same time.
In this cycle, the equity provision was in the form of Tarp, in which the U.S. government purchased preferred stock in financial institutions (and others). It did the same thing in the 1930s, when the Reconstruction Finance Corporation invested in about six thousand banks. Government investment in bank equity was also prominent in European countries in this cycle, and in Japan and Sweden in the 1990s. Not to be forgotten this time is the $160 billion of senior preferred stock the government has bought for the taxpayers in Fannie and Freddie.
It is too bad that the taxpayers get made into involuntary equity investors in financial firms, but no student of financial history, including the history of government guarantees of deposits and other debt, is surprised by the four developments we are considering. Or by the inevitable fifth step, which comes after the crisis: a big increase in regulation, with the reiterated promise that “this will never happen again.” But it does 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, reached a similar conclusion.
Alas, as far as cycles go, there is nothing new under the financial sun.
Alex J. Pollock is a resident fellow at AEI.
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