Greyhounds and bloodhounds

At a forum on the U.S. financial collapse, campus experts follow the trail to the roots of the crisis, hold their noses for a hard-to-swallow $700 billion bailout

| 09 October 2008

As an economic historian, observed Barry Eichengreen last Thursday, “every time the market turns down I get phone calls from journalists with the ‘Could it happen again?’ question,” the “it” being another Great Depression. “I respond, ‘No, it couldn’t happen again, because policymakers have learned from history.’ ”

To which Eichengreen, a Berkeley professor of economics and political science, quickly added: “I have now stopped taking those phone calls.”

The line got laughs. But Eichengreen, sifting through the rubble of America’s crumbled financial system at a forum of Berkeley experts that filled the seats and most of the floor space at the law school’s Booth Auditorium, saw nothing funny about what he called U.S. lawmakers’ “truly breathtaking, extraordinary failure of leadership” in their stewardship of the U.S. economy.

Sponsored by the Berkeley Center for Law, Business, and the Economy and the Center on Institutions and Governance, the panel discussion, conservatively titled “Global Financial Market Turmoil,” took place a day after the Senate approved a bill to buy up to $700 billion in toxic mortgage-based assets in hopes of thawing the nation’s frozen credit markets. The House of Representatives, which earlier had failed to muster the votes on a similar plan, followed suit the next day.

The Berkeley economists’ enthusiasm for the bailout — a twice-modified version of a controversial proposal announced Sept. 19 by U.S. Treasury Secretary Henry Paulson — was conspicuous by its absence. Still, the two-hour discussion produced a rough consensus that while the plan may be no more than triage, swift action is needed to bring the economy back to life following what Eichengreen termed a “heart attack in the credit markets.”

“It was absolutely astonishing to read Paulson’s plan,” declared Aaron Edlin, a professor of law and economics, of the initial proposal. One colleague, UCLA economist Edward Leamer, said “he thought it was an Internet hoax.”

Paulson, said Edlin, had asked Congress for $700 billion to spend on whatever distressed assets he chose, and with “absolutely no review of any kind.” The “one piece of discretion” the Treasury chief left to Congress was authority to fill in a blank for the name of the law he hoped would emerge from his two-and-a-half-page proposal. “The Act,” wrote the secretary, “may be cited as _____.”

“It turned out that was a strategic error, because people like me started talking about ‘blank check’ and ‘bailout,’ and it became called a bailout,” Edlin said. “They’ve recovered, and it’s now a rescue.”

Economics professor John Quigley, interim dean of the Goldman School of Public Policy, counseled that given the seriousness of the crisis — which by the following Monday had sent the Dow plummeting to its lowest close in nearly four years and was threatening economies in Asia and Europe — this is no time for schadenfreude.

“At least for some of the people in this room who have some devotion to competitive markets, this is really a sad wake-up call in the sense that given the circumstances, many people would just love to see these bad actors receive the full and complete retribution that markets would exact on their irresponsible behavior,” said Quigley, referring to Wall Street’s “masters of the universe” and their high-risk gambles in the now-cratered credit markets. “If there were no systemic risk involved, at least some people would be just delighted to watch some of these guys go under.”

Like several of his colleagues, Quigley suggested that the U.S. might have modeled its bailout plan on a far cheaper one implemented by the Swedish government during a 1992 credit crisis. “As a fraction of GDP,” he said, “you might save, oh, half an Iraqi war if you did that instead.”

Economist Brad DeLong agreed, calling a Swedish-style bailout “the cheapest and easiest and best thing to do now.” But thanks to Paulson, he lamented, such a plan was “not on the table.”

DeLong limned the magnitude of the crisis by tracing the dramatic contractions in the financial markets since early 2007, when “we had $300 billion flowing through financial markets to America’s non-financial businesses so they could hire workers and make things.” That number was halved by the second quarter of this year, and “I think we might have zero in quarter 4 of 2008.”

“This is not a good situation to be in, especially because right now we are trying to move 8 million workers out of construction, out of high-end tourism, out of other businesses — installing marble countertops in kitchens, funded by people who’ve been using their home equity as a gigantic automatic teller machine,” said DeLong. “Those 8 million jobs can’t be created unless the funds flow through financial markets to expanding businesses, and they aren’t flowing right now.”

Moderated by economics professor George Akerlof, winner of the 2001 Nobel Prize in Economic Science — who kept his own counsel on the crisis and what to do about it — parts of the discussion were best understood by those fluent in the language of the dismal science. The air was dense with references to CDOs (collateralized debt obligations), CDSs (credit default swaps), mark-to-market accounting practices, arbitrage, and the TED spread, or the difference between Treasury-bill interest rates and the London interbank rate — all of which, the group explained, contributed to the need for government bailouts of Fannie Mae, Freddie Mac, Bear Stearns, and AIG, and for federal purchases of up to $700 billion in distressed mortgage-based assets held by major investment banks and institutional investors worldwide.

“It’s a complicated problem, and it’s difficult to tell a story in simple enough terms so that it’s compelling for people,” acknowledged Nancy Wallace, a professor of real estate and urban economics at the Haas School of Business, who termed the insurance risks of so-called credit default swaps “a time bomb.” She also faulted the lack of transparency in the bond markets for out-of-control speculation on Wall Street. “We in the business school definitely saw this problem, particularly in the balance sheets of the GSEs,” or government-sponsored enterprises like Fannie and Freddie.

“We made huge efforts to try to get them to reveal more information about what the [values of] bonds really were,” Wallace said. “But the forces of enormous profitability on Wall Street and a regulatory structure and lobbying structure in Congress made it difficult for academics to get their word out.”

At bottom, said Edlin, was the “consumer fraud” perpetrated by predatory lenders. He wondered, only half-facetiously, if it might be better to allow only 30-year fixed mortgages, “or if you wanted a variable-rate mortage you’d have to get your parents to sign a permission slip.”

And he insisted that contrary to some claims, home borrowers had indeed been worried about the risks of taking out subprime loans — millions of which have gone into default, triggering a chain reaction that continues to rock the markets. “You had a bunch of mortgage brokers who told people who thought that the mortgage broker was their agent that they could afford this and just refinance in three years,” he said. “I sat in cafés, which is where I do most of my work, and listened to these meetings for the last seven years, of people meeting at coffee tables and Starbucks and everywhere, and I just wanted to scream.”

As for the steady deregulation, beginning in the 1990s, that led to the housing bubble and the now-toxic mortgage-based derivatives that will soon become the property of U.S. taxpayers, Eichengreen characterized it as a reaction to overly stringent controls put in place in the wake of the 1929 stock-market crash.

“The pendulum needed to swing back from the draconian regulation of the 1930s, but the authorities didn’t keep up with the markets,” said Eichengreen, citing what he called “the greyhounds vs. bloodhounds problem.”

“The greyhounds run very fast, and the regulators, the bloodhounds, can scent the trail but they can’t keep up,” he explained. “And now we’re paying the price for that.”