Last Thursday, the Economics Department sponsored a lecture on the causes of the financial crisis and the policies needed to avert future crises. The speaker was Dr. L. Randall Wray, professor of economics at the University of Missouri at Kansas City, Director of Research at the Center for Full Employment and Price Stability, and Senior Scholar at the Levy Economics Institute. While most of his prescriptions for future policy action were sound, a few do not pass the test of economic logic.
First, Dr. Wray stated that “stability is destabilizing.” When market conditions remain the same or a move in a certain direction consistently for a period of years or decades, banks will become over-confident in the persistence of the status quo.
They will therefore make huge risks based on their belief that economic conditions will not change. This is what happened with the housing market — the market values of houses rose consistently and at a very fast rate over a period of a few years. Financial companies believed that this seemingly inexorable increase would never end, and thus made big bets on assets backed by mortgage loans. When the housing market went bust, the financial sector collapsed as its bets went bad.
But Dr. Wray has neglected an important element in saying that “stability is destabilizing.” Stability itself does not have a destabilizing effect on markets and the economy as a whole; stability artificially created by government policies does.
The consistent rise of housing prices did have a destabilizing effect on financial markets — but only because government policy in the realm of mortgage finance fueled the rise in housing prices in the first place.
Congress subsidized the government-sponsored mortgage lenders, Fannie Mae and Freddie Mac, in order to accomplish a political goal: to make it more affordable for potential homeowners to get a mortgage loan. The subsidy allowed Fannie and Freddie to offer lower interest rates on mortgage loans, making these loans more affordable to borrowers who wouldn’t have been able to pay off their mortgage if it had a higher interest rate, which led to an increase in the number of mortgage loans made out throughout the country.
This increase in mortgage lending, fueled entirely at first by the impact of the subsidy, led to a rapid increase in the demand for houses, which led to a rapid increase in the price of houses and the number of houses built. But this situation was unsustainable, because it was created by government policy, rather than being a reflection of the value each buyer and seller in the housing market placed on the homes they wanted to buy or sell.
And indeed, when the buyers and sellers in the real estate market realized that houses were overvalued, they all began to sell, resulting in the bursting of the housing bubble. What appeared to be a stable phenomenon was in reality highly unstable, as the direct result of government policy.
The other major mistake Dr. Wray made in his analysis was to conclude that securitization of bank loans is “useless.”
Up until about twenty-five years ago, when a bank made a loan out to a homeowner or business it would keep the loan on its balance sheet as an asset — an investment that was worth the value of the loan plus the interest the bank was charging for it. In recent decades, banks have begun to sell their loans to other financial companies, such as investment banks, hedge funds, pension funds, and university endowment funds.
By selling these assets as what are known as asset-backed securities, banks are able to lend out the money they receive in exchange for the security it has sold, and thus make a greater profit on the return these loans bring them. When Dr. Wray denounces the creation and trading of these securities, he ignores their fundamental purpose: to turn bank assets based on loans into liquid money, or liquidity, and to do something with this liquid money to earn a profit.
Banning the sale of all securities would lead to a dramatic decrease in what Dr. Wray believes is the only ‘useful’ financial activity: traditional lending. Thus, it is not obvious that such an action would have no costs, or even that its costs would be outweighed by its benefits.
This is not to say that non-traditional financial activities comprised too large a share of the financial sector in the years leading up to the crisis—it certainly did. But why did this come about? Banks are required to keep as reserves specific percentages of its deposits and of all the assets on its balance sheets.
In order to evade these requirements, banks created “investment vehicles” and rearranged their accounting so that all of their assets would appear in these vehicles instead of on their balance sheets, and thus would not be subject to the requirements. But banks had to keep all traditional loans—those made with a bank’s deposits—on their balance sheets, because government regulations require banks to do so.
This in effect made securities trading much more profitable compared to traditional lending than would naturally have been the case, which led banks to rely more on selling their assets than on attracting more deposits to finance their lending. Government regulations distorted the financial markets by favoring what was not regulated over what was.
And it is for this reason that government regulation of any consensual activity will fail: governments can only regulate an activity after it has been invented, and therefore the most recently invented activities will be favored over all others.
