Scott Sumner has a post up at EconLog this weekend about the timeline of the financial crisis. He brings up the too big to fail / moral hazard issue. This is something others like Russ Roberts have focused on.
I would like to begin by saying that, in principle, I am completely on board with this issue. A regime that includes informal and implied subsidies for risky behavior is dangerous. We would expect that regime to lead to more crises and for there to be indecision and power brokering during those crises. It's not an ideal set of policies to build a financial sector around. I don't really have a problem with the historical examples of this issue.
But, on the other hand, my understanding is that the idea of a lender-of-last resort role for central banks is a longstanding legitimate function. This would especially be the case if the crisis was a liquidity crisis that the central bank is charged with avoiding. In some ways, there has been an unfortunate standard of using sloppy language to identify all of the Fed machinations toward the end of the crisis as "bailouts", and this has created a climate where legitimate stabilization operations have been tainted with negative semantics.
But, I want to take this even further. Scott has pushed back against the idea that there was a "bubble". I have been digging into the evidence all year, which I think confirms his position. Very little of the rise in home prices (and, the accompanying mortgage growth) requires any demand-side explanation. The banks weren't systematically pushing mortgages on households outside the traditional population of homeowners, and those households weren't moving into homes with rental values any higher than usual. The boom was a reaction to supply constraints in favored locations. The banks weren't the cause, they weren't taking on excessive risks, and the bust was not inevitable.
That last part is key. Practically all analysis of the crisis begins by begging the question - the bust was inevitable. And, even though Scott's EconLog post is reasonable, as far as it goes, I think he gives in too much to that notion.
This crisis was not a good example of the problems of moral hazard or of a fragile banking system. In fact, I think some evidence points to quite the opposite, and instead, we should be surprised by how devastating and persistent Fed policies had to be in order to create broad economic dislocation.
By 2007, there was a strange mood in this country that housing speculators and bankers needed to be taught a lesson. We assumed that home prices must be based on overly optimistic projections about the risk and reward of home ownership, so watching nominal home prices fall by a proportion unprecedented in modern times was not only acceptable, it was required. These speculators needed to learn that unprecedented declines in price happen, and asset prices need to reflect these black swans. But housing wasn't in a demand bubble, so a tremendous amount of damage had to be inflicted on the American economy for home prices to collapse the way they did.
About 1 million units per year has been a post WW-II floor that we generally only hit briefly before recovering - even in the 1950s and 1960s when US population was about half today's level. By the time Bear Stearns failed in March 2008, housing starts were falling below a 1 million unit rate. National home prices were down 7% and home prices in the major coastal cities were down 16%.
By September, when Lehman Brothers failed, housing starts were falling below a rate of 800,000 units. (They would remain below 1 million units for 5 more years.) Home prices were down 13% nationwide and 25% in the major coastal cities.
Even then, it isn't clear that economic problems would have expanded so broadly, even if the Fed let Lehman enter bankruptcy, if they had simply supported the nominal economy (as Scott suggests they could have done with Continental Illinois in 1984). But the day after Lehman's failure, the Fed famously took an unnecessary discretionary hawkish position followed by a questionable new policy of paying interest on reserves that they raised briefly to over 1%. Lehman was not the critical factor in the subsequent collapse. If they had managed a buyout of Lehman, but had followed it with those same hawkish interest rate policies, it seems probable to me that the outcome would have been very similar to what we experienced.
It took a 13% dive in banks' most stable and extensive base of collateral (25% in the most active real estate markets) to create the financial crisis. Call me crazy, but if you had told me in 2006 that home prices would need to collapse by that much in order to create a financial breakdown, I would have responded, "Really? You think our banks are that stable and well managed?"
As I have said before, if home prices had fallen by 5% and a financial panic would have ensued, then, yes, that would be evidence that our financial system had been fragile. But that is not what happened. And, given what did happen, the only reason we accept the fragility story is because we assume that a 13% drop in home prices was inevitable. (This eventually grew to 26% nationally and 34% in the major cities.)
Do I really have to beat back moral hazard arguments to say that it is well within the Fed's mandate to stop home prices from falling 34%, 26%, or even 13%? Really? Do we really need to worry about banks being too reckless in the future because they will be blasé about national double digit declines in real estate values?
Look, in the broad scheme of possibilities, we don't have to base our real estate markets on nominal mortgage contracts. But we do. And, as long as we do, banks will have some highly leveraged real assets on their balance sheets. It would not be realistic to expect them to manage their balance sheets to withstand national 25% declines in real estate values without expecting some nasty system-wide repercussions. In the previous century, nobody would have even suggested that we should demand that level of safety.
I support the idea of NGDP level targeting, or wage level targeting, as Scott lays it out. Isn't it funny that nobody worries about the moral hazard of having a policy where aggregate wages never decline by a penny? I think the main advantage of NGDP level targeting may be that it indirectly leads to stability in capital incomes that we cannot support directly. In a world where even just implementing stabilizing monetary expansion in the middle of a deflationary shock is labeled by many as a Wall Street bailout and where we are willing to watch millions of middle class households lose their homes without screaming for monetary expansion because the banks had it coming, its clearly not popular to support Bourgeois concerns. Because of this, I don't think we can fault the Fed too much for the crisis. If they were blamed for bailouts for their efforts after September 2008, imagine the outrage that would have been aimed at them if they had dared stabilize the economy in 2007.
I would add that securitization had risen until the early 1990's and had levelled off since then. Securitization was not at the center of the housing boom. In fact, during the height of the boom, banks were increasing their share of held mortgages outstanding. Securitization only began expanding again in 2006 and after because the liquidity crisis was hitting bank balance sheets. So, even the moral hazard issue created by securitization itself is less central to the recent crisis than it is generally made out to be.
And, many small banks failed in the crisis. Does too-big-to-fail even have that much to do with what happened?
The moral hazard issue is a real issue, but it is the wrong lesson to take from the crisis, and the treatment of Bear Stearns and Lehman Brothers are taken to be larger factors in the collapse than they deserve to be, in my humble opinion.