This Financial Meltdown, and the Next One
A panel of social scientists dissects past mistakes, and sees daunting fiscal and regulatory challenges ahead for the United States and Europe.
A panel of professors convened by Faculty of Arts and Sciences dean of social sciences Stephen M. Kosslyn on February 11 analyzed the causes of the financial crisis of 2007 to 2009, the resulting near-brush with what one of them called "Great Depression 2.0," and their relatively bleak outlook for the developed nations and economies of the West.
Moderator John Y. Campbell—Olshan professor of economics, chair of the department of economics, and a member of the board of Harvard Management Company (which invests the endowment)--set the scene by noting that it is easy to ignore a financial system when it is functioning well, but when it breaks down, the consequences become apparent and painful for everyone. In the summer of 2007, he said, participants in financial markets began to see stresses, followed by a 50 percent reduction in the issuance of asset-backed securities (such as bonds backed by pools of mortgages). The following months, major investment banks, Fannie Mae and Freddie Mac, AIG, Wachovia, and Washington Mutual collapsed or were rescued or bailed out under duress, and the markets generally froze. Banks could not borrow from one another even overnight, credit contracted, and financial economists were "aghast" as pricing distortions suggested huge profits available for the taking--but confidence was so damaged that no one would invest, in effect, he said, leaving fat wallets lying untouched on the sidewalk. In quick order, the stock market declined 50 percent, and the real economy collapsed, declining at a real annual rate of 6 percent in the fourth quarter of 2008. Today, the United States struggles with 10 percent unemployment and with the effects of unprecedented government efforts to staunch the financial crisis and to stimulate growth--in face of clearly unsustainable fiscal policy and with no agreement yet on needed financial reforms.
Campbell asked Cabot professor of public policy Kenneth Rogoff, who has studied the origins of financial crises and warned about the current one before it unfolded, what his concerns had been. Drawing on his recent book on financial crises, This Time Is Different (reviewed here), Rogoff (profiled here) pointed to the run-up in housing prices and other indicators, all fueled by short-term borrowing. Repeatedly, he said, some bullish streak in human nature leads people to take long-term risks funded by short-term borrowing; absent appropriate regulation, when the borrowers' risk becomes too high and lenders head for the exits, a financial crisis ensues. "Short-termism," he said, is the most important focus of regulatory concern.
Campbell then asked to Safra professor of economics Jeremy Stein, who served briefly in the Obama administration, about responses to the crisis and about future measures to prevent or manage crises. Stein said policy had to be guided by some principles--for example, that it is imperative to strengthen the capital position of financial institutions such as banks--but implemented adaptably and opportunistically. In the recent crisis, he said, the administration was at pains not to let banks' problems linger for a decade, as they did in Japan during the 1990s deflation of asset prices. But of two means tried to shore up the banks, one failed and one succeeded: public-private partnerships to buy banks' "toxic" assets had virtually no effect; but attempts to stimulate the banks to raise private capital (at the risk of diluting their shareholders) were stunningly successful (to the tune of $100 billion), at least in part because bankers wanted to get out from under government controls on their compensation. Stein agreed with Rogoff on the need to cope with the problems of short-term borrowing, either by requiring financial institutions to hold more capital to protect against losses, or to shift more of their funding to longer-term borrowing. But he doubted that financial institutions, or politicians, would want to administer such common-sense medicine, and noted the genius of the financial system in its "shape-shifting ability" to work around regulation--in recent years, by the flight from banks to "shadow" banking players like hedge funds. The problem, he said, is "not just to make the banks safer, but to make the system safer," without unwanted side effects. Regulating only large institutions that are "too big to fail" could result in a future crisis, he said, involving the failure of 500 smaller institutions--hypothetically, hedge funds--all exposed to their own short-term-borrowing follies.
Campbell asked Niall Ferguson, Tisch professor of history and Ziegler professor of business administration (profiled here) about the prospects for the United States in the wake of the economic crisis. Ferguson traced the origins of the crisis to six factors: excessive bank leverage; fraudulent rating-agency evaluations of what turned out to be worthess securities; excessively loose credit (Federal Reserve Board monetary policy) early in the decade; the weakening of insurance through the issuance of credit-default swaps; politicians' insistence on making it possible for people to buy houses they could not afford; and China's willingness to fund U.S. borrowing, so assets could inflate to bubble prices. The resulting crisis, he said, was on the liability side of institutions' and households' balance sheets. He then observed that there had been a near recurrence of the Great Depression, as capital flows diminished 82 percent, trade shrank 25 percent, and industrial production decreased 14 percent around the world. Only last summer, he said, was it apparent that the world had escaped the trajectory that defined the 1930s.
Ferguson discounted the prevailing explanations for how the world avoided financial collapse. Rather than saluting prudent measures to save the banking system and flood the markets with liquid funds (a combination of Milton Friedman and John Maynard Keynes), he thought that the decoupling of the West and the East--the ability of Asian nations, pursuing different economic policies, to rebound--had been the saving factor. This, he said, was a "profound" event, signaling the end of a 500-year period when "the West has dominated the rest." Now, he said, all signs point to the East overtaking the West, with China's economy surpassing America's as the world's largest by 2027. The United States could avoid that fate, he said, by turning to its "killer app"--its great strength as a source of innovation and entrepreneurship. Doing so would require avoiding policy choices that hinder those strengths. But instead, he sees unending borrowing and spending, resulting in higher interest rates and tax rates that are likely to kill off needed innovation. Soaring public debt, he said, is a "dead weight on the things that make the West succeed."
In the ensuing discussion, Stein agreed on the need to rein in public debt in a way that does not inhibit entrepreneurial innovation. Rogoff foresaw the financial crisis giving way to inevitable sovereign debt crises; a decade hence, he said, it may seem that U.S. policy did not succeed in avoiding the banking and public-debt problems that have hamstrung Japan.
An audience member asked whether Ferguson were too gloomy about U.S. debt. Britain was heavily indebted after the Napoleonic wars, after all. Ferguson said that that period (and the period after World War II, Rogoff noted) , were characterized by limited terms of accumulating debt, to wage wars, and that the public then agreed on policies to unwind the debt; today, he said, there was no end in sight to the growth of U.S. public indebtedness. The reliance on foreign borrowing was unsustainable, he said. As interest costs sopped up more of the federal budget, the military share would have to shrink, and America's international presence--important around the world--would have to diminish. Rogoff said that paying off the accumulating debt would certainly slow America's economic growth, as was the case in Great Britain from the 1940s to 1970s.
The problems of the European Union loom large, the panelists said. The economic union, Rogoff noted, is a monetary union but not a fiscal one. The member states have very different economies, populations, and government balance sheets, Ferguson said, citing "massive divergences" that underlie the problems of the southern EU nations. Given the need to improvise solutions to the problems plaguing Greece now—neither the EU nor the European Central Bank nor the member states have such a mechanism in place—he foresaw grave difficulties and tensions. The United States might see the dollar strengthen as the euro weakens, he said, but the effects of European economic weakness on U.S. exports would obviously be adverse.
What are the most important regulatory reforms? an audience member asked. Stein pointed to resolution authority: the ability to intervene in a troubled institution and wind down its affairs, as is now done for regulated banks. Rogoff aimed at deflating the reliance on short-term borrowing through the financial system. He was not particularly critical of the Federal Reserve Board and monetary policy, and warned against political "castration" of the Fed as a response to the crisis; among regulatory bodies, he said, the Securities and Exchange Commission had been "much worse," and he particularly faulted Congress for promoting homeownership excessively. The biggest reform, he thought, might be reform of campaign finances, so that Congress could in fact enact the necessary changes in regulation.
Was there a favorable scenario for the United States? Ferguson said that the solutions to the country's fiscal problems were clear: reform the tax code and reduce corporate taxation, switch to a value-added tax (VAT), and sharply rein in entitlements, particularly Medicare. In combination, that would lessen the growth in public debt and could boost the long-term economic growth rate by 2 percentage points. "The problems are fiscal, and they're fundamentally political," he said. Campbell cited the economists' joke: Democrats see a VAT as regressive, and Republicans see it as a gusher of public revenue; it won't be enacted until the two parties switch perspectives. That said, he observed that the United States had a lower tax burden than Europe, but that Europe, where the VAT is common, taxed more efficiently in economic terms; given America's deep fiscal troubles, he foresaw U.S. enactment of a more efficient tax system, heretofore impossible.
And what of China, now the world's engine of economic growth? Rogoff said it was on a classic path toward the next bubble. "Obviously, they're going to have a financial crisis," he said. The only question was how the authorities would respond. But Ferguson, so bearish on the West, was contrarian this time. China would have to cool down the excesses from its recent enormous stimulus spending, he said. But perhaps China had already had its crisis, when the collapse of exports in late 2008 and early 2009 cost tens of millions of jobs. The recovery, he judged, had been impressive, and was accompanied by enormous productivity gains, the key to long-term growth and prosperity for any economy.
The panel discussion was recorded, and will be posted at the Social Science Division website.