Robert Samuelson

I’ve just finished reading Nicole Gelinas’s “Surveying the Wreckage” in the latest issue of City Journal. It’s a very good piece, well-written, provocative, informative, and authoritative—but, I think, also misleading and, in its fundamental thesis, wrong.

I regret that the essay did not include the recently revised edition (paperback) of my book, The Great Inflation and Its Aftermath: The Past and Future of American Affluence. This book tells a very different story, one that, I think, will ultimately be accepted as explaining the recent crisis, rather than the prevailing stories that have now become competing versions of the conventional wisdom.

One prevailing story is: Wall Street greed ran amok; blame the overpaid and reckless bankers. The other (Gelinas’s version) is: blame the government and the pervasive moral hazard it created. The bankers were only reckless because the government conditioned them to be so by a) unwise and risky subsidies to the housing market, and b) the creation of moral hazard, via repeated instances in which bankers and investors were rescued from their own folly by government.

These are narratives with natural appeal to large constituencies. Because they clearly fix blame on identifiable parties, they satisfy the political and journalistic need to create a plausible morality tale with good guys and (more important) bad guys.

But the flaws in these stories are obvious. To the story that “greed did it,” the obvious question is: people (and bankers) are always greedy; why was it fatal in this instance? The answer given by the proponents of this story is: deregulation. The trouble is that, though the financial sector was “deregulated” in some respects, it was hardly completely deregulated, and much of the crisis had its genesis in regulated sectors: Fannie and Freddie; bank holding companies (regulated by the Fed). The signs of trouble were missed by the regulators.

The problem with Gelinas’s story is just the opposite. First, it assumes that government regulation of the financial sector had increased, when it hadn’t. Over the decades beginning in the mid-1970s, there was consistent relaxation of regulation. To take just three large events: the end of fixed commissions for stock purchases in 1975; the end of “Regulation Q” bank interest-rate ceilings in the 1980s; and the end of the Glass-Steagall separation between commercial and investment banking in 1999. There were others, but the notion that the financial sector became progressively more regulated simply does not fit the facts.

The second part of the argument, moral hazard—that is, that Wall Street operated according to the principle that profits were privatized and losses socialized—presumes that “Wall Street” was a lot smarter than it was and also does not fit the facts. Losses were not entirely socialized. Huge losses occurred to private investors, most conspicuously equity investors in banks and other financial firms. Much of the mortgage sector was wiped out. The securitization market (and all the jobs and firms that depended on it) virtually disappeared. Creditors were often shielded, but this could not be known with absolute certainty in advance. Just as important, many of the people making decisions were equity holders (that is, their wealth was concentrated in the stocks of the firms for which they worked). It is true, as everyone recognizes, that Wall Street took excessive risks. But the explanation is not the “moral hazard” story that Gelinas and others tell.

What is it, then? The central question that must be answered in any post-mortem of the crisis is: Why was almost everyone fooled? By “almost everyone,” I mean economists, government regulators, Wall Street titans, ordinary investors, the Federal Reserve and its then-chief, Alan Greenspan, Clinton-era Treasury Secretary Bob Rubin, and many others.

The basic answer, as I argue in my book, is that the suppression of double-digit inflation in the early 1980s set off a 25-year economic boom that slowly convinced people (including all those mentioned above) that we had entered into a new, lower-risk economic era. Business cycles were kinder and gentler: there were fewer recessions, and those that occurred were historically mild.

Economists pronounced this the Great Moderation. Financial markets had gradually become (so it seemed in 2003 and 2004) less volatile. When there were recessions (after, say, the tech bubble) or financial problems (the Asian financial crisis of the late 1990s, the implosion of the Long-Term Capital Management hedge fund in 1998), the Federal Reserve would contain the damage. (No, the Fed didn’t always rescue investors. The investors in LTCM lost a bundle. But the Fed did prevent any side effects from crippling the larger economy.)

During this period, financial markets boomed, because the gradual disinflation brought down both real and nominal interest rates and resulted in an explosion of asset prices that were vastly enriching to Wall Street and created an understandable sense of mastery and superiority. Recall that the Dow Jones Industrial Average in 1982 was less than 1,000; by 2000, it exceeded 10,000. Housing prices followed at a slower pace.

The real problem of moral hazard is a political one that exists at the level of the nation and society. Everyone supports the pursuit of prosperity, but the achievement of too much prosperity for too long plants the very seeds of greater instability by weakening self-restraint and prudence. If the economy has become less risky, then people will take more risks. Sooner or later, those greater risks can snowball into a major crisis.

The irony here is palpable: the suppression of double-digit inflation was one of the great triumphs of economic policy since World War II; but it led, with a long lag, to one of the greatest failures of economic policy since World War II.

Robert Samuelson, a columnist for Newsweek and the Washington Post, is the author of The Great Inflation and Its Aftermath: The Past and Future of American Affluence.

Nicole Gelinas

I thank Robert Samuelson for his thoughtful response. He writes, “the notion that the financial sector became progressively more regulated simply does not fit the bill.” I agree. In addition to Congress’s dismantling of Glass-Steagall, as Samuelson describes, the rules and regulations that remained on the books—among them limits on borrowing and requirements for public disclosures of financial activities—failed to keep up with the instruments that Wall Street firms began creating in the 1990s.

Turning to moral hazard, Samuelson suggests that investor expectations of extraordinary government intervention in financial markets to avert losses couldn’t have played a role in the crisis because stockholders lost substantial amounts of money. He notes further that any moral-hazard theory rests on an assumption that “‘Wall Street’ was a lot smarter than it was.” It’s true that shareholders lost money, but not through a consistent regime of free-market discipline. Lehman shareholders lost everything; AIG shareholders lived to see another day.

More important, it doesn’t matter whether shareholders and managers were smart or stupid, or what they thought, or if they thought at all. It matters only what lenders thought: after all, the world is not experiencing the results of an equity crisis, but of a debt crisis. Bondholders and other creditors, including derivatives counterparties, lent excessively and cheaply to financial firms, without troubling themselves about what, exactly, the firms were doing with all that money. The lenders were lax because they could reasonably think that Washington would rescue them in a financial crisis.

As Samuelson writes, government’s willingness in this respect “could not be known with absolute certainty in advance.” But almost nothing can be known with such certainty. Investors, like anyone else, must imperfectly predict the future, based partly on past behavior.

As for that past behavior: before 2008, a quarter-century’s worth of financial history—from the Reagan administration’s rescue of bondholders of the failing Continental Illinois bank in 1984 to the Federal Reserve’s marshalling of a rescue of the lenders to the Long-Term Capital Management hedge fund in 1998—demonstrated that it was rational to expect that the feds, in seeking to ward off a major crisis, would save creditors to large or complex financial firms from the normal bankruptcy process. Washington would step in even if it contributed to another, long-term problem: too much debt, created in part by this implicit government protection. In fact, part of the reason that Lehman’s failure unleashed such a panic is that bondholders and other creditors, including derivatives counterparties, were shocked that the government did not step in to protect lenders.

Samuelson is right that complacency contributed to the crisis, and that the government’s success in keeping inflation so low for so long helped foster that mindset. Human nature is precisely why we need the twin disciplines of consistent government rules and creditor fears of market losses to serve as counterweights—albeit imperfect ones—to overconfidence in financial markets.

Samuelson’s explanation, then, does not contradict others, but complements them.


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