Observations on the Financial Crisis by Distinguished Professor of Economics
Brian Goff, September 25, 2008

Is the economy in worse shape than any time since the Great Depression?  Employment,  income, and output – what economist term the “real side” of the economy – have slowed down over the past year.  Nonetheless, setting empathy politics and hyped-up media stories aside, the current 6% unemployment and small positive growth in GDP does not even reach the mild recession levels of 1990 or 2001 much less the double digit unemployment rates of the 1970s or 20-something percent of the 1930s. 

With the financial problems, could we be headed there? Extreme financial instability of the current sort can result in the funds for all sorts of new investment to dry up and lead to severe real side problems.  Fed Chairman, Ben Bernanke, detailed these kinds of connections in his most influential academic works, showing the links from stock market crash, to bank failures, and the decade-long drying up of funds for new projects whether from lenders or stockholders.

Why not let private markets sort things out, after all financial panics in the 19^th century and early 20^th century did not lead to big real side effects?  The financial sector is much more interconnected today than in 1907 or even 1929.  The same speed and connectivity that benefit economies also promote the rapid spread of financial contagion.   

Do financial markets really stand in a precarious position? Unequivocally, yes.  In a 24/7 cable news world where the sky falls every other day, we may become jaded.  The situation last week teetered on the edge of the abyss.  Exactly how near to the cliff and how deep the abyss, I don’t know. The shortest term lending markets of all sorts (London interbank market, Eurodollar, CD markets, even U.S. interbank markets) shrunk to dangerous levels.  These markets provide the daily and weekly liquidity that keep deposit-type accounts fully redeemable on demand.  Last week, Primary Reserve Trust, the originator of money market deposit accounts, could not redeem accounts at face value.  While not as publicized as AIG’s problems, this marked the real trigger behind the Treasury and Fed actions.  When depositors cannot redeem their accounts on demand, it causes panic.  With these institutional deposit-type accounts in jeopardy, consumer bank deposits stood next in line.  That’s about as on the edge as it gets. 

My banker assures me that everything is fine with my institution and accounts, so why should I be concerned?  Yes, different institutions stand at different risks, primarily based on how much capital (stockholder equity) they have relative to their debt.  However, if lots of depositors want their money at once and the overnight lending markets dry up, the seemingly most secure bank could face a crisis.  A Wall Street saying goes, “the market can stay crazy longer than you can stay solvent.” 

How can our system be at such risk?  Don’t safeguards exist?  In our banking-finance system, funds do not just sit in a secure room.  Most are lent out.  This has huge benefits in funding all sorts of loans and payments.  Yet, we’ve all seen “It’s a Wonderful Life.” If everyone wants their money at once, the setup collapses even with deposit insurance.  That’s where we stood last week.  Even yesterday, the international interbank market shuddered once again.    

How did we get in such a situation? Detailed examinations exist.  Here’s a highly condensed version:    From 2000-2005, housing prices exploded, more than doubling in some markets. Government fueled this explosion and excessive risk taking with subsidies and mandates for home loans and the expansion of and implicit guarantees for mission-driven, government-sponsored mortgage holders Fannie Mae and Freddie Mac.  The private sector played an enabling role also by originating loans without proper vetting and by thinking that the pooling of risky mortgages into bond-like instruments diversified the risks more than they really did.  As housing prices slowed and fell, homeowners defaulted on mortgage payments.  Financial institutions holding the mortgage debt such as Northern Rock in Britain, Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, AIG, and others, began scrambling for short term cash and defaulting on their own payments.  Soon markets and lenders seemingly removed from mortgage debt began to find short term funds drying up and defaults on receivables. 

Is this market failure?  One should not try to absolve private markets from blame, but those who would use this as an example of why markets don’t work ignore the fundamental contributions of government and political motivations. Unfortunately, some of the key enablers and expanders of the problem with Freddie Mac and Fannie Mae now sit as judges over the market.  As Solomon said, what is crooked cannot be made straight.

Didn’t the Fed contribute by keeping interest rates too low?  This has become a common charge from several sides, including economic circles.   Interest rates were, indeed, low.  Yet, the facts do not indict the Fed.  The best measure of the looseness of Fed policy is the inflation rate.  From 2001 to 2005, inflation  ranged between 1.6% and 3.4% annually and 13% for the whole period – a little loose but only a little.  I don’t know of any economic model in which a 13% rise in the average price level can account for a significant amount of a 100% increase in the price of a specific asset like housing.  I’ve put this question to a couple of highly regarded macro specialists and have not received an adequate answer. 

Is the Treasury-Fed plan the best option?  The financial system needs equity (capital) to grease the daily and weekly flow of funds.  Right now, it is not supplying those funds to itself as it usually does because of continuing problems in determining values and finding buyers for the bad mortgage debt.  The Paulson Plan offers a means of providing a value and market for the mortgage debt. Generally speaking, under this plan the government will buy billions of dollars in mortgage debt, essentially to guarantee the liquidity of the mortgage debt market.  The details will matter a lot but continue to evolve.  The current plan isn’t a piecemeal action – this is Normandy.  Clearly, its size and scope attempts to stop the instability in one big move.  It intends to buy the time needed to sort out the good from the bad in the pooled instruments and keep short term lending markets fluid. 

On the downside, the plan will require very, very astute management and resistance to political pressure – not always the strength of government agencies – to keep costs to taxpayers down (or, in the best case, earn them a profit).  It will increase public indebtedness and involvement. Usually, politicians and their followers tend to exaggerate concerns about the U.S. debt as a political tool to raise taxes or lower spending.  The ratio of public debt to GDP in the U.S. is not huge by international standards.  Of course, taking on a new task like this raises the stakes.

Many alternatives to the Pauslon plan exist.  Some are on point and may be improvements, and some are not.  Congressional conservatives are floating a plan by which government provides insurance for the mortgage debt, rather than buying it outright.  This provides support for the market without making the government into a big investment firm.  Another suggestion is for the Treasury to stand ready to buy new stock issued by financial firms at market values.  This would directly supply equity (capital) to the system.  This suggestion has been coupled with a mandate for all financial firms to raise additional equity from current and additional stockholders.  The mandate alleviates the appearance that a particular bank is in trouble.  The WSJ has suggested simply buying up the foreclosed property and pushing lenders to renegotiate terms with homeowners not yet in foreclosure.  This would involve a much lower expenditure – actually only thousands of houses mainly in Florida and the Southwest rather than millions of mortgages all lumped together in complex instruments, some good, some bad.  Then, the Fed could deal with money market funds or banks as problems arise.  This has the advantage of less money committed up front and much less government involvement in as financial manager/market maker but with the risk on continued instability.  Others have suggested modifying the accounting rule that requires assets like the mortgage debt to be price at today’s value – given that the market has collapsed, there is no genuine “current value”.  Instead, using a rolling average of values from the past several years might be a workable alternative.

I do think that some combination of these ideas that would provide support for the mortgage debt market without putting the government in the role of big investment firm is preferable. I would add, however, that those who think that policy makers should do nothing, other than change long run rules for the industry, are engaging in very wishful thinking.  As I discussed earlier, short term lending markets, not just mortgage related lending markets, were not working last week.

Aren’t we bailing out big bucks Wall Street?  The term, “bailout,” itself misleads.  Bear Stearns stockholders received $2 per share on stocks valued at $160 last year and $80 per  only days before their collapse.  AIG stockholders sit in a similar position today.  The Fed and Treasury have let markets punish stockholders whose executives took on the risky mortgage instruments.  A lot of highly paid executives have lost their jobs.  Has everyone been punished in proportion to their bad decisions?  Certainly not, but that will never happen on any matter.  The Fed and Treasury actions have sought to stabilize values of financial institutions who have not been holders of risky mortgage loans.  These moves, ultimately, safeguard bank accounts for all American citizens.  I would say that’s a worthwhile and broad-based goal.  In that sense, the Fed-Treasury bailed out you and me.   

Aren’t we “privatizing gains and socializing losses”? While I'm willing to concede the description, it misses the point.  The widely accepted and mandated role of the Federal Reserve as “lender of last resort” embodies  making loans and taking on costs/risks that the private sector will not.  It’s a vital role. As long time price stability proponent and former president of the St. Louis Fed, William Poole, said in a CATO Institute speech in November, even if the Fed is only interested in general price stability, failure of the banking system will not promote price stability.    

Does “socializing losses” create a moral hazard problem – the problem where the risk takers will take on more risk in the future because they have not had to bear the full consequences of their actions.  Moral hazard is real problem. Yet, it can be overused and misunderstood.  The typical behavioral problems associated with moral hazard may be of little importance when a person or a market gets scared stiff. Let me use my own mother as an example. At 6 years of age, she had a near-drowning experience after ignoring her mother’s warnings about playing too close to a big creek with her friends.  The fact that someone pulled my mom out of the water meant that she did not experience the full consequences of her actions.  Nonetheless, no moral hazard ensued.  Just the opposite, my mom developed a lifelong fear of water.  As she has said, the spanking that here mom gave her when she got home was not necessary.

Likewise, last week’s events certainly scared Wall Street stiff.  It’s hard to imagine a stockholders or executive of solvent companies are not thinking, “hey” let’s take on more risk and get the same treatment as Bear Stearns. Somewhere in the future, Wall Street suits will take on too much risk, but it won't be due to the current “bailout.”  It will be a forgetting of the event rather than the remembering that creates problems. 

Contact the Department of Economics at,
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