Crisis Economics

Crisis Economics by Nouriel Roubini and Stephen Mihm1

Roubini issued a warning about the coming collapse as early as September 7, 2006. Collapses are consequences of bubbles: the stock market bubble, the housing bubble. Note that many economists thought the problem was just a liquidity crunch, where people cannot sell assets. But a credit crunch is more serious. "Many people who inhabited those worlds [economics and finance] ignored those warnings because they clung to a simple, quaint belief: that amrkets are self-regulating entities taht are stable, solid, and dependable."2

Leverage was one of the culprits. People borrowed as much as they could to invest in assets, "betting on the dubious yet curiously compelling belief that prices could only go up."

Roubini's main point is that financial crises are not rare: "In the history of modern capitalism, crises are the norm, not the exception".

He says that "most crises begin with a bubble.." "Many bubbles…gain force from changes in the structure of finance." New forms of credit or debt allow investors to participate in the speculative bubble. When the bubble stops growing, the falling value of the asset triggers margin calls (requests for more cash from borrowers), forcing borrowers to sell, further depressing prices. Banks curtailed lending, thus making the problem worse.3.

Roubini argues that short-term rewards created incentives for traders to take risks, and that corporate governance did nothing to rein in the risk-taking.

The authors' eclectic approach gives me confidence; they don't attempt to force the crisis to conform to a dogmatic theory. They review several economists' work:

  • Shiller and behavioral finance: particularly the "feedback theory" that shows how people that see rising prices jump on the bandwagon, further pushing prices higher.
  • John Stuart Mill's views were similar to the feedback model
  • Marx: capitalism is inherently unstable
  • Keynes: importance of aggregate demand
  • Minsky: inherent instability causes by financial institutions
  • Austrian school: let "creative destruction" do its work to purge the economy of failed businesses and households

The also look at history, referring to Charles P. Kindleberger's Manias, Panics and Crashes (1978) and Carmen Reinhart and Kenneth Rogoff's This Time is Different: Eight Centuries of Financial Follies (2009).

Cause of the Current Economic Crisis

The author's "conventional wisdom" explanation of the causes of the crisis is admirably succinct; they also say it is "reassurning but wrong":

A housing bubble in the United States got out of control sometime around 2005 or 2006. People took out mortgages they couldn't afford and eventually defaulted on them. Having been securitized, however, these mortgages went on to infect and topple the global financial system.4

Securitization reduced the incentive to properly monitor the underlying risks of a mortgage a bank originated, as the bank no longer faces the consequences of making the bad loan. Ratings agencies had an incentive to give securities high ratings. Securities "became so fiendishly complex and unique that it became difficult to value them by conventional means…financial firms resorted to mathematical models to value them…these models relied on optimistic assumptions that minimized measured risk." "The net results was an utterly opaque, impenetrable financial system ripe for panic."

Roubini and Mihm also refer to the well-know problem of corporate governance and incentives: "The collapse of AIG may be the most extreme example of the dangers of moral hazard, principal-agent problems and asymmetric information."5. As for government intervention, the authors see moral hazard as a real problem:

If there was ever an argument for tightly regulating banks and other financial firms, this is it. Banks have to be forced to hold enough liquidity, and shareholders must have enough skin in the game and an incentive to monitor the firms they supposedly supervise. And these requirements mean that the government must play a major, if controversial, role.6

They say that "the overblown claims that Fannie Mae and Freddie Mac single-handedly caused the subprime crisis are just plain wrong." Private mortgage lenders like Countrywide were the primary underwriters of the huge growth in the subprime mortgage market.

They cite Minsky's classification of borrowers, which bears repeating:7

  • hedge borrowers: those who can make payments on both the interest and the principal of their debts from their current cash flow
  • speculative borrowers: those whose income will cover interest payments but not the principal; they have to roll over their debts
  • Ponzi borrowers: their income covers neither the principal nor the interest; their only option is to mortgate their future finances by borrowing still further, hoping for a rise in the value of the assets they purchased with the borrowed money

Summary of Causes

  • Financial innovation created assets that were hard to value
  • Reduce incentive to scrutinize borrowers' credit-worthiness due to "originate to distribute" instead of "originate and hold" loans, made possible by securitization
  • Easy money from the Fed
  • Shadow banking system: unregulated financial institutions that borrow short and lend long (invest in illiquid assets), hence making them vulnerable to a bank run
  • Moral hazard of bank traders
  • Bank deregulation
  • Cash from emerging economies financed the growth in debt
  • Increased leverage
  • Margin calls creating asset "fire sales", leading to a death spiral of asset values
  • Opaque bank balance sheets undermined confidence

The Failure of the System

Roubini and Mihm's overview of the sequence of failures and "slow motion bank runs" in their chapter "Things Fall Apart" is well worth reading.

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