A Trap Baited with 3 Kinds o’Tasty Cheese: REAL Causes of Panic 2008

1. Michael C. Munger Director, Philosophy, Politics, and Economics Program Duke University A Trap Baited with 3 Kinds o’Tasty Cheese: REAL Causes of Panic 2008

2. Why have private financial corporations in the first place? • Liquidity • Prices • Intermediation --transactions costs

3. A Question • Should we bail out firms that are too big to fail?

4. The Question • Should we bail out firms that are too big to fail?

5. The Question • Should we bail out firms that are too big to fail?

6. The Question • Should we bail out firms that are too big to fail?

7. The Question • Should we bail out firms that are too big to fail?

8. Greenspan's Mea Culpa (10/23/08) "Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity–myself especially–are in a state of shocked disbelief... I still do not fully understand why it happened and obviously to the extent that I figure where it happened and why, I will change my views. If the facts change, I will change."

9. Why was Greenspan Wrong? • The only reason we need a policy of bailing out losers is that we have a policy of bailing out losers. • Greenspan assumed a limited kind of rationality. A "rational" investor would recognize that bailouts allow large losers to play with house money.

10. Why was Greenspan Wrong? • Merton's distinction: Investors vs. Customers. • FDIC and FSLIC: "bail out" customers of bad banks. Liquidity crisis protection • Moral hazard (I look for high returns, don't care if bank is solvent) is real, but manageable.

11. Why was Greenspan Wrong? • Merton's distinction needs to be expanded: Investor/Owners vs. Customers vs. CUSTOMERS. • The bailout in 2008-9 was a bailout of investors…in other firms that were major counterparties in exotic products (derivatives, CDS, CDO). Unlike moral hazard for traditional depositors, this moral hazard problem is not manageable, but unlimited.

12. Some definitions • Bailout: The use of taxpayer funds either to buy assets, or to guarantee the value of assets, of insolvent firms.

13. Definitions: TBTF • Systemically Important Financial Institutions • SIFIs will always be bailed out • Two features: Solvency/Size External effects of failure

14. Problem Systemically Important Financial Institutions: Externality more important than solvency SIFI status is therefore endogenous. Yes, investors lose, but competitive advantage in selling to CUSTOMERS My choices to select extra risk, and more leverage, make it more likely that my counterparties will be bailed out. Larger insolvency makes bailout MORE likely

15. Problem The “SIFI” designation is found in the Dodd-Frank legislation, and the language in that law says: (a) Liquidation required--All financial companies put into receivership under this subchapter shall be liquidated. No taxpayer funds shall be used to prevent the liquidation of any financial company under this subchapter. (b) Recovery of funds--All funds expended in the liquidation of a financial company under this subchapter shall be recovered from the disposition of assets of such financial company, or shall be the responsibility of the financial sector, through assessments. (c) No losses to taxpayers--Taxpayers shall bear no losses from the exercise of any authority under this subchapter.

16. Problem Mutual benefit: Exists a contract, or agreement, under which everyone would be better off. Looks like this: • Governments will not bail out firms • Therefore, firms choose best guess risk/leverage for portfolios • Insolvency reflects bad production choices, prices allocate scarce resources accurately

17. Problem • The Problem? • That agreement, on previous page, is unenforceable, because the incentives facing the enforcer (the state) are time-inconsistent • But we tried. Set up the Fed as a Lender of Last Resort • Bagehot (1897), Lombard Street.

18. Bagehot's Lender of Last Resort Bail out only for liquidity crises, not equity. LLR Regs do 3 things: • Lend as much money as necessary directly to troubled banks • At a penalty rate • And only for good collateral (the institution must be technically solvent)

19. Problem III Lender of last resort Bagehot (1897). But our standard is different: externalities! The size of the externality has (at best) nothing to do with solvency, and may (at worst) be correlated with externality In other words, using size of externality causes larger externalities

21. Problem is Time Inconsistency "what to do once there is a crisis?" Answer: there would be no crises if we could credibly commit to a policy of no bailouts. (Might or might not be true, need empirical cases) Ann is right, of course, in 2008-9. But what now?

22. Here is Circe’s dire warning to Odysseus (Chapman 2000: Chap. XII, lines 56-89; emphasis added): First to the Sirens ye shall come, that taint The minds of all men, whom they can acquaint With their attractions. Whomsoever shall, For want of knowledge moved, but hear thcall Of any Siren, he will so despise Both wife and children, for their sorceries, That never home turns his affection's stream, Nor they take joy in him, nor he in them. The Sirens will so soften with their song (Shrill, and in sensual appetite so strong) His loose affections, that he gives them head. And then observe: They sit amidst a mead, And round about it runs a hedge or wall Of dead men's bones, their wither'd skins and all Hung all along upon it; and these men Were such as they had fawn'd into their fen,Andthen their skins hung on their hedge of bones. Sail by them therefore, thy companions Beforehand causing to stop every ear With sweet soft wax, so close that none may hear A note of all their charmings. Yet may you, If you affect it, open ear allow To try their motion; but presume not so To trust your judgment, when your senses go So loose about you, but give straight command To all your men, to bind you foot and hand Sure to the mast, that you may safe approve How strong in instigation to their love Their rapting tunes are. If so much they move, That, spite of all your reason, your will stands To be enfranchised both of feet and hands, Charge all your men before to slight your charge, And rest so far from fearing to enlarge That much more sure they bind you. .

25. Federal Trade Commission, Washington, DC

26. But…Did That Big Horse Get Loose, and Pull Us Off a Cliff? • You’ve heard it: Worst economic downturn since the Great Depression (not remotely true, not even as bad as ‘73, or ‘81, in terms of GDP decline.) • Huge financial losses, bankruptcies of hundreds of companies • Government bailouts (unprecedented!) • Record postwar unemployment (okay, THAT’s true) • WHY a crisis? Prices…No Prices, No Liquidity

27. Document Problem: House Prices

28. Stock Prices & Volume, ‘04-’09

29. Unemployment Rates, end 2008

30. Unemployment Rates, end 2011

31. Unemployment Rates, 11/07–4/09 2009

32. Three Deficits • Federal • Consumer • Trade

33. US Federal Debt/capita (‘07$)

37. 110% is the Worry Line

38. Consumer Debt

40. Student Loan Debt (US Gov’t)

41. Trade Deficit

42. Fiscal Deficit and Trade Deficit are CONNECTED

43. Competing Diagnoses • Greed, Especially Predatory Lending • Too Much Government Interference in Housing Markets • Too Little Government Regulation of Financial Markets • Too Much Debt, Not Enough Saving • Death Throes of a Dying Capitalist / Consumerist Order • Space Aliens (The “Cordato Thesis”) • Normal fluctuations of business cycle, exacerbated by policy mistakes. Inherent in capitalism

44. The Answer (correct in all unimportant respects…) Problem: Too much leverage, too little margin for error in investment and real estate markets. To take an example, a company with a net worth of US$ 25 billion borrowed 26 times its net worth and creates leveraged funds of US$ 650 billion to invest or lend them. When a small portion of the company's investments turns bad, as is the norm for the industry, the company's capital is under threat. To put things in perspective a 3.8 percent misjudgment in their books was enough to wipe out their shareholders' capital of $ US 25 billion. And leverage ratios of 40, or 50, to 1 were not uncommon. Prudence? No more than 2 to 1. (May not be comparable, since derivatives seem different from borrowing outright)

45. The Answer (correct in all unimportant respects…) The reason this is correct in “all unimportant respects” is that it makes us want to ask: “WHY? WHY DID IDIOTS DO THAT? LET’S KILL THEM ALL!” Well, even in the U.S. being an idiot is not a capital crime. In fact, if you are a BIG idiot, the government will bail you out!

46. My View: A Trap Set by the US Government, and Baited with three types of tasty Cheese

47. For the first time in history, you could be trapped even if you never leave the house. Just a computer was enough…

48. Effective? Unfortunately… Each trap could catch many!

49. Hard Not to Feel Sorry for those poor mice…. • But blaming markets for the financial crisis is a lot like blaming the CHEESE! • The Bush Administration, and Clinton Administrations, did not realize they were setting a trap. • But they were. This is a crisis where markets ran wild, and where government did nothing to control the problem. Government actually made things much worse than was necessary.

50. To Repeat: A Trap Set by the US Government, and Baited with three types of tasty Cheese