Self-Fulfilling Financial Crises

Many mistaken assumptions about the 2008 financial crisis remain in circulation. As long as policymakers believe the crisis was rooted in the housing bubble rather than human psychology, another crisis will be inevitable.

.. Recall that by mid-2008, home prices had returned to, or even fallen below, levels supported by their underlying fundamentals, and employment and production in the residential construction industry had declined to levels far below trend. The work of rebalancing asset valuations and reallocating economic resources across sectors had already been accomplished.
.. To be sure, there still would have been around $750 billion worth of financial-asset losses in the form of defaults on subprime mortgages and home-equity loans. But that is only one-quarter of what global equity markets lost in seven hours on October 19, 1987. In other words, it would not have been enough to sink the global financial system.
.. Ben Bernanke, then Chair of the US Federal Reserve, seemed confident in the summer of 2008 that the correction in housing prices had not triggered any unmanageable financial crisis. At the time, he was mainly focused on the dangers of rising inflation.
.. And then the bottom fell out. The reason, Gennaioli and Shleifer show, is that beliefs changed.
  • Investors came to believe that financial markets were saddled with highly elevated risk, owing to a number of factors.
  • The interbank market had seized up,
  • homeowners were defaulting on their mortgages,
  • Bear Stearns had collapsed,
  • the US Treasury had intervened to rein in Freddie Mac and Fannie Mae, and, above all,
  • Lehman Brothers had declared bankruptcy.
.. All of this led to the sudden run on both the shadow and non-shadow banking systems, as investors scrambled to dump assets. The increased risk that they had imputed to the system became a reality.
.. And yet nothing about the fallout from the crisis was inevitable. Had the Fed been in possession of contingency plans for putting too-big-to-fail institutions into receivership and becoming the risk-bearer of last resort, we would probably be living in a very different world today.
.. Gennaioli and Shleifer’s second important contribution is to show that “crises of beliefs” like the one that precipitated the disaster of 2008-2009 are deeply rooted in human psychology, so much so that we will never be free of them.
.. Crises of belief are manifestations of a chronic condition that must be managed.
.. When fundamental beliefs have shifted permanently, one should not expect the same policy mix that supported full employment, low inflation, and balanced growth before the crisis to do so afterwards.
.. For a decade now, people have been looking for a silver lining to the disasters of 2008-2018, hoping that this period will bring about a more productive integration of finance, behavioral economics, and macroeconomic orthodoxy. So far, they have been searching in vain. But with the publication of A Crisis of Beliefs, there is hope yet.

The dangerous myth we still believe about the Lehman Brothers bust

The central error in the popular post-crisis consensus was the idea that naive believers in the self-policing efficiency of markets led us over the precipice. Greenspan was painted as the high priestof this laissez-fairy-tale delusion, and people seized on a moment when he appeared to plead guilty: Under the pressure of congressional questioning, he confessed to a “flaw” in his pro-market ideology. What Greenspan meant was that all belief systems — whether pro-government or pro-market — are imperfect. But that subtlety was lost. Quoted and requoted without proportion or context, Greenspan’s purported mea culpa threatened to define his legacy.

.. Bestsellers by two Nobel Prize-winning behaviorists — Daniel Kahneman and Richard Thaler — encouraged people to see the crisis as proof that this new science had been ignored, as did contributions from the sublime storyteller Michael Lewis.

.. Contrary to myth, Greenspan himself never believed that markets were efficient. In his youth, he wrote lucidly about bubbles and crashes and regarded market inefficiencies as so obvious that he sought to exploit them by day trading

.. As Fed chairman years later, Greenspan frequently reminded his colleagues that periods of prosperity could be punctured by “irrational exuberance” in financial markets.

.. political constraints, not intellectual failures, prevented policymakers from curbing the housing mania. Nobody remembers that in 2001 the Greenspan Fed banned the most abusive subprime mortgages, for the good reason that the ban was circumvented. But why was it circumvented? The answer is that the capture of Congress by financial lobbies ensured the balkanization of regulation into an alphabet soup of agencies, many of them underfunded and ineffective.

.. Nonbank mortgage lenders, for example, came under the authority of the Federal Trade Commission, which had no resources to conduct preemptive supervision. Small wonder that the sharp practices in the industry became egregious, or that nonbanks continue to dominate today’s mortgage business.

.. The Greenspan Fed also tried to force more capital into the banks it supervised, but it soon realized that this would drive risk-taking into various “shadow banks” that lay outside its authority

.. Greenspan also pushed for tougher regulation of the Federal National Mortgage Association and Federal Home Loan Mortgage Corporation (a.k.a. Fannie Mae and Freddie Mac), the government-backed mortgage giants, presciently observing that they posed “a systemic risk sometime in the future.” Fannie’s lobbyists hit back with a TV ad warning Congress not to back the Greenspan plan. That buried it.

.. The important lesson of the crisis is not that markets are fallible, which every thoughtful person knew already. It is that essential regulations — the sort that the supposedly anti-regulation Greenspan actually favored — are stymied by fractured government machinery and rapacious lobbies.

.. Even today, the financial system has multiple overseers answerable to multiple congressional committees, because all this multiplying produces extra opportunities for lawmakers to extract campaign contributions.

.. Vast government subsidies still encourage Americans to take big mortgages; Fannie Mae and Freddie Mac still operate, despite endless talk of breaking them up. And although post-2008 regulations have ensured that banks are better capitalized, the lobbyists are pushing back. Merely a decade after the Lehman bankruptcy brought the world economy to its knees, the Trump administration is listening to them.

What effect the Trump administration will have on the housing market

At a meeting of the National Association of Home Builders in August, Trump said that “there’s no industry, other than probably the energy industry, that is more overregulated than the housing industry.” However, changing those regulations may be beyond his scope.

.. “He could try to use his power to ease it, but a lot of the problems are at the state and local levels,” Goodman said.

.. Goodman said the two biggest issues the housing market faces are supply constraints and credit availability.

.. But Trump’s stance on immigration could have a detrimental effect on housing supply.

“Immigration plays a big part in the labor force for construction,” Smoke said. “It’s one of the constraints we have in new construction.”

.. Something to watch under Trump could be what happens to Fannie Mae and Freddie Mac. Reform efforts have stalled the past several years. But hedge-fund billionaire John Paulson, who is part of the president-elect’s economic policy team, could push for action. Paulson bought shares of Fannie and Freddie in the hope of cashing in when they regained their independence. Since being placed under government control, the mortgage-backers have sent nearly all their profits to the U.S. Treasury, not investors.

“Paulson cares passionately about this, given his positions,” Goodman said.