By now there are few people who do not acknowledge that the major American financial institutions and the markets they dominate turn out to have served the country badly in recent years. The surface evidence of this failure is the enormous losses—more than $4 trillion on the latest estimate from the International Monetary Fund—that banks and other lenders have suffered on their mortgage-related investments, together with the consequent need for the taxpayers to put up still larger sums in direct subsidies and guarantees to keep these firms from failing. With nearly 9 percent of the labor force now unemployed and still more joining their ranks, industrial production off by 13 percent compared to a year ago, and most companies’ profits either falling rapidly or morphing into losses, it is also evident that the financial failure has imposed huge economic costs.
The government has moved aggressively, and on several fronts, to stanch the immediate damage. The Federal Reserve has not only eased monetary policy to the point of near-zero short-term interest rates but created a profusion of new programs to extend credit to banks as well as other lenders. Congress, at the Obama administration’s behest, has enacted nearly $800 billion of new spending and tax cuts aimed at stimulating business and consumer spending. First the Bush administration and now Mr. Obama’s have experimented with one new plan after another to rescue lenders and reliquify collapsed credit markets.
But despite the universal agreement that no one wants any more such failures once this one has passed, there is a troubling lack of attention to reforms that might prevent such a crisis from recurring. By now everyone realizes that excessive risk-taking, systematic mispricing of assets, and, often, plain reckless behavior (not to mention some instances of criminality, although to date surprisingly few of these have come to light) helped cause the current mess. At the same time, most people recognize both that parts of the American economy have been capable of dynamic growth and that the US financial markets have had a part in promoting that growth. The result is a reluctance to consider changes to the current system. Substantial interference with financial markets, it is said, amounts in the end to centrally planned allocation of an economy’s investment process, and will result in technological stagnation and wasted resources. Milder attempts at regulation will either prove ineffective—the private sector can afford better lawyers than the government can—or at best merely lead financial institutions to relocate to more lightly regulated jurisdictions like the Cayman Islands.
As in past financial declines, what is sorely missing in this discussion is attention to what function the financial system is supposed to perform in the economy and how well it has been doing it. Today attention is mostly focused on banks’ and other investors’ losses from buying mortgage-backed securities at inflated prices. What is neglected is the consequence: if the prices of the securities were too high, this meant that the underlying mortgage rates were too low, and so too many houses were built, and too many Americans bought them. In just the same way, when the 1990s stock market boom crashed, everyone talked about investors’ losses on their telecom stocks, not the fact that if the stocks’ prices were too high, the cost of capital to the firms that issued the stocks was too low, and so communications companies laid millions of miles of fiber-optic cable that nobody ended up using.
In both instances, the cost was not just financial losses but wasted real resources. True, over longer periods of time the American financial system has seemed reasonably effective at allocating resources rather than wasting them. The economy’s pace of technological advance and growth in production since World War II suggest that the banks and the stock and bond markets can steer investment capital reasonably effectively to firms that will use it productively, often including start-ups trying out a wholly new idea—Microsoft, or Google, or, earlier on, Apple. But the effectiveness of the economy’s mechanism for allocating capital should be a matter for serious quantitative evaluation, not a matter of faith.
Moreover, to ask just how efficient a financial system is in allocating capital leads naturally to the question of the price that is paid for such efficiency. In recent years the financial industry has accounted for an unusually large share of all profits earned in the US economy. The share of the “finance” sector in total corporate profits rose from 10 percent on average from the 1950s through the 1980s, to 22 percent in the 1990s, and an astonishing 34 percent in the first half of this decade.1
Those profits accruing to the financial sector are part of what the economy pays for the mechanism that allocates its investment capital (as well as providing other services, like checking accounts and savings deposits). But even a stripped-down version of the cost of running the financial system includes not just the profits that financial firms earn but also the salaries, the office rents, the travel budgets, the advertising fees, and all of the other expenses they pay. The finance industry’s share of US wages and salaries has likewise been rising, from 3 percent in the early 1950s to 7 percent in the current decade.2 An important question—which no one seems interested in addressing—is what fraction of the economy’s total returns to productively invested capital is absorbed up front by the financial industry as the costs of allocating that capital.
Further, the latest financial crisis is a sharp reminder that the simple operating expense of running the financial system—including profits of financial firms—is not the only cost if this system also exposes the economy at large to episodic losses in production and incomes, and to the need for taxpayer subsidies. Today those losses are mounting, and so are the subsidies. Many US banks, including some of the largest ones, are now insolvent. The bank rescue plans offered to date by both the Bush and the Obama administrations amount to ever more expensive fig leafs for avoiding concrete recognition of this sad development.
In the same effort, the Financial Accounting Standards Board—the independent organization designated by the SEC to set accounting standards—acting at the strong urging of Congress, recently changed its rules to allow banks more latitude to claim that assets on their balance sheets are worth more than what anyone is willing to pay for them. (Next time you apply for a loan, try mentioning FAS 157-4 and telling your banker that you should be allowed to calculate your net worth with your house priced not at what comparable houses are selling for now but at what you paid for it and what you hope you’ll get for it if you hold on to it for some years. The banker will laugh, even while the bank applies just such standards to its own balance sheet.)
Another fundamental issue that the current discussion has overlooked almost entirely is the distinction between the losses to banks and other lenders that reflect genuine losses of wealth to the economy, and other losses that don’t. When the value of your house falls, that’s a loss of wealth to the economy as a whole. If you keep paying your mortgage, you bear the loss yourself: your net worth is diminished by the amount of the decline in the home’s price. If you default on your loan, then someone else—maybe the bank that lent you the money, maybe some investor to whom the bank sold the loan—also bears part of the loss. If the government steps in and reimburses the bank, or the investor, the taxpayers will bear part of the loss as well. But however this loss is divided, what is inescapable is that someone, somewhere, will bear it. What much of today’s debate is about is how these losses should be divided among homeowners, banks, loan-purchasing investors, and the taxpayers. But the loss must be borne by someone, and America’s economy is poorer because it has occurred.
By contrast, suppose you and your neighbor have bet on whether today’s peak temperature would exceed fifty degrees. One of you was right, the other wrong. One of you won, the other lost, and the amount the winner won is identical to what the loser lost. There is no loss of wealth to the economy, merely a transfer of wealth from the loser to the winner. Many of the huge losses that American financial institutions have sustained in the current crisis are of this second kind. None of them was betting on the weather, but they were taking positions that amounted to placing bets on outcomes that represented no change in wealth to the economy as a whole. And with regard to these positions, for every loser featured in the latest newspaper story about banks posting losses and turning to the government for bailouts there is also, somewhere, a winner.
The most telling example, and the most important in accounting for today’s financial crisis, is the market for credit default swaps. A CDS is, in effect, a bet on whether a specific company will default on its debt. This may sound like a form of insurance that also helps spread actual losses of wealth. If a business goes bankrupt, the loss of what used to be its value as a going concern is borne not just by its stockholders but by its creditors too. If some of those creditors have bought a CDS to protect themselves, the covered portion of their loss is borne by whoever issued the swap.
But what makes credit default swaps like betting on the temperature is that, in the case of many if not most of these contracts, the volume of swaps outstanding far exceeds the amount of debt the specified company owes. Most of these swaps therefore have nothing to do with allocating genuine losses of wealth. Instead, they are creating additional losses for whoever bet incorrectly, exactly matched by gains for the corresponding winners. And, ironically, if those firms that bet incorrectly fail to pay what they owe—as would have happened if the government had not bailed out the insurance company AIG—the consequences might impose billions of dollars’ worth of economic costs that would not have occurred otherwise.
This fundamental distinction, between sharing in losses to the economy and simply being on the losing side of a bet, should surely matter for today’s immediate question of which insolvent institutions to rescue and which to let fail. The same distinction also has implications for how to reform the regulation of our financial markets once the current crisis is past. For example, there is a clear case for barring institutions that might be eligible for government bailouts—including not just banks but insurance companies like AIG—from making such bets in the future. It is hard to see why they should be able to count on taxpayers’ money if they have bet the wrong way. But here as well, no one seems to be paying attention.
Data are from the US Department of Commerce. "Finance" here excludes both insurance and real estate; with those additional firms included, the share of total profits in 2001–2005 was 37 percent.↩
Thomas Philippon and Ariell Reshef, "Skill Biased Financial Development: Education, Wages and Occupations in the US Financial Sector," National Bureau of Economic Research, Working Paper No. 13437, September 2007.↩
Data are from the US Department of Commerce. “Finance” here excludes both insurance and real estate; with those additional firms included, the share of total profits in 2001–2005 was 37 percent.↩
Thomas Philippon and Ariell Reshef, “Skill Biased Financial Development: Education, Wages and Occupations in the US Financial Sector,” National Bureau of Economic Research, Working Paper No. 13437, September 2007.↩