The final point I would like to make in this series is that you cannot build and maintain a rigid financial regulatory system based on the achievement of specific outcomes if you insist on inflating the economy that includes this regulatory system and expect the regulated institutions to remain idle. This is the story of the last 50 years when the dollar lost 85% of its purchasing power. If the government creates an inflationary environment, financial institutions will not stand still, especially in this Age of Information.
Also, in my view, the United States government has injected large amounts of moral hazard into the economy and the financial markets over the past fifty years or so. And, the presence of this moral hazard has had a lot to do with the recent collapse of the financial markets and the economy.
Before going into this let me just say that I believe that almost everyone is greedy. I use the word greedy with all the bad things it conveys, because that is the word being tossed around so loosely these days. I do not believe, as the economist Joseph Stiglitz seems to, that the bankers of Wall Street are any more “morally bankrupt” than he is or any of the rest of us. We all are greedy and respond to the incentives that are placed before us. With that said, let’s now move on.
I want to concentrate on two specific areas in which the government has created moral hazard and helped to form the incentives that led to the bust of 2008. The first has to do with monetary policy and the second has to do with housing finance. Both have contributed to what I have called the credit inflation of the last 50 years.
A credit inflation occurs when the credit in an economy grows more rapidly than the economy itself or more rapidly than specific sectors in the economy. In the early part of the period under review, focus was primarily on consumer and wholesale price inflation. At this time, analysts were mainly concerned with money stock growth and the consumer price index or the GDP Deflator. Asset bubbles were not on the radar yet.
However, inflation creates the incentive to increase debt and as the amount of debt in the economy increases there is pressure on both financial and non-financial institutions to increase their financial leverage, to create a greater mismatch between the maturities of their assets and liabilities, and to take on riskier assets, to goose up returns. Credit creation thrives in an inflationary environment!
Inflation is good for credit and so the cumulative effect of a period of inflation is the creation of more debt! In the Age of Information, the incentive to create more debt is a license for financial innovation.
The dance began in the 1960s and, as former Citigroup CEO “Chuck” Prince so eloquently expressed it in the 2000s, if the music continues to play, you must continue to dance!
And, the enormous creation of credit spilled over into sectors other than consumer purchases creating a bubble here and a bubble there. The beauty about financial innovation in the Age of Information is that specific assets and specific asset markets don’t really matter because all that is being traded is information. The result: as “Chuck” Prince implied, the dance continued in the areas where the music was still playing. Credit flowed into the markets that had the most action so that you got one market “popping” at this time and another market “popping” at another time. And, innovations in new financial instruments and markets were created to help the music flow to all markets.
How does this scenario relate to monetary policy? Well, the monetary authorities acted in a very asymmetrical way. If markets seemed to be dropping, the Federal Reserve would come in and stop the fall. This was especially important if unemployment seemed to be impacted by the drop. The behavior became so predictable that it was given a name: the “Greenspan put.”
On the upside, the central bank attempted to maintain control of consumer price inflation, especially after the pain of the late 1970s and early 1980s, but believed that it could do nothing with respect to asset bubbles that inflated prices in various sub-markets, like housing.
The moral hazard that was created allowed prices to constantly rise for the Fed would always reflate the economy before there was any chance for prices to fall. And, consumers could only buy about 15 cents worth of goods and services in 2010 with what $1.00 could buy in January 1961. Also in asset markets like housing, prices rose and rose and rose during this period to the point where people were absolutely confident that housing prices could never fall. So, where are you going to place your bets after all this time which created the fundamental assumption that policymakers would continue the credit inflation indefinitely.
The other area where the government created moral hazard was in the housing market. To own your home is a big part of the “American Dream.” Owning your own home creates self-respect and stability. It is a great place to raise kids and it generates community. It produces good citizens.
So, anything that can be done to support home ownership in America is good!
The savings and loan industry was dedicated to financing homes. The Federal Housing Administration (FHA) was there to help people get mortgages for homes and played a huge role in home ownership for GIs returning home from World War II. But, Fannie Mae and Freddie Mac were created to help mortgage finance and to make sure money flowed into the industry. Then the Department of Housing and Urban Development was created and help flowed through a myriad of programs to assist low-income families to own their own homes. And, then the mortgage-backed security was created and so on and so forth.
Ultimately, we got a great information age idea, the sub-prime loan. This program combines the drive to get home ownership to more and more individuals and families, often without the needed financial wherewithal, and credit inflation, because if housing prices never go down they must be going up. And, this allows people who cannot afford the down-payment on a house to earn that down-payment through the inflation of the price of their home. Oh, by-the-way, you can originate the loans and then get them packaged and securitized to sell to financial institutions in China or Sweden.
Isn’t the Age of Information great! If the government has anything to say about it, “No downside risk!”
Well, Fannie Mae and Freddie Mac own most of the American mortgage market now and both are ‘bankrupt.’ The FHA is in deep, deep financial trouble. And, so are many banks and other financial institutions in the United States. And, the Treasury is going crazy trying to develop a program or programs that will help individuals and families stay out of foreclosure and lose their homes.
Bottom line: in the Age of Information, information spreads and spreads rapidly. Financial innovation will accelerate as we go forward for financial innovation will be applied to any area, regulated or not, that promises financial gain. Unfortunately, my guess is that the federal government and Congress will not have the discipline it needs to stop creating credit inflations and to keep from creating more and more moral hazard in the future. Consequently, the financial regulation that will be forthcoming will be backwards looking and, hence, will not prevent the next crisis.