This is a crisis of the state as well as the market

This article is republished from the December 2010 issue of the spiked review of books. View the whole issue here.

Following the financial meltdown in the US that began in the spring of 2008 with the demise of Bear Stearns, a slew of books was hastily published in 2009, trying to capitalise on the new-found interest in economic matters. The fact that they were rushed out did not necessarily mean they weren’t good. But authors in 2010 certainly had more time to investigate the inner workings of finance, and more time to reflect on the causes of the crisis. Here we consider four of the most prominent books, all of them spending time on the New York Times bestseller list during the past year.

We begin with The Big Short by Michael Lewis. This was the most popular of all business books in 2010, and there is a good reason why: Lewis is one of America’s best non-fiction writers, and he can’t help but tell an engaging story. The fact that he can take an arcane subject filled with terms and acronyms like credit default swap (CDS) and collateralised debt obligation (CDO) and make it understandable and even highly entertaining is a testament to his skill. The key to his compelling narratives is that he builds them on interesting characters, and he does so again in The Big Short.

By late 2008, there was, Lewis writes, ‘a long and growing list of pundits who claimed they predicted the catastrophe, but a far shorter list of people who actually did. Of those, even fewer had the nerve to bet on their vision.’ Lewis decides to focus on three of them who had that nerve to take a ‘big short’ and bet millions against the housing bubble: Steve Eisman, the feisty analyst from Queens who lacked social graces; Michael Burry, the physician-turned-fund manager and anti-social nerd (later diagnosed with Asperger’s syndrome); and the unconventional ‘garage band’ fund of partners Charlie Ledley, Jamie Mai and Ben Hockett, who started with $110,000 working out of a friend’s shed in California, before moving to a Greenwich Village art studio. All were misfits, all performed proper credit analysis, all ignored the consensus about the mortgage market – and all made a fortune from the crash.

Lewis’ micro-view of these characters is a way for him to convince readers to join him in a deep dive into the otherwise-daunting world of bond and real estate markets. And focusing on the few who saw what was really happening also enables him to illuminate the blind-spots of other actors, especially the Wall Street firms that are at the heart of the financial system. As the author of Liar’s Poker – a book that helped to define the image of 1980s Wall Street – Lewis is quick to recognise the origins of the recent crisis in the mortgage-backed derivatives that were created some 30 years ago. And he also notices an important way in which Wall Street had changed since that time: increasingly relying less on traditional sources of income from brokering stocks and bonds, and more on short-term profits utilising greater leverage (that is, bigger bets using higher levels of credit).

Lewis shows how the crisis exposed the ‘masters of the universe’ as far from smart or sophisticated. Yes, Wall Street firms were able to convince rating agencies like Moody’s and Standard & Poor’s to apply their highest rating (triple A) to their complex packages of subprime mortgages (that is, mortgages with a high likelihood of defaulting), and then sell them on to unsuspecting investors who thought they were buying something safe, and thus garnering massive fees in the process. But this was not just a ruse: Wall Street bought into, big time, the myths of the ever-rising housing bubble, holding lots of these securities themselves. Unlike Lewis’ oddball heroes, they did not do their due diligence. As Charlie Ledley says: ‘The big Wall Street firms, seemingly so shrewd and self-interested, had somehow become the dumb money.’ One of the dumbest that Lewis profiles is Howie Hubler, the ‘highest-status bond trader at Morgan Stanley’, who makes a staggering $9 billion trading loss – ‘the single biggest trading loss in the history of Wall Street’.

But while there are many upsides to Lewis’ micro-perspective, there is a major downside, too: he does not provide a macro outlook on all the players in the game (nor, I should add, does he even attempt to). If understood as just one aspect, his take is valuable. However, his focus on the world of Wall Street is, unfortunately, likely to fit too neatly with the pedestrian view that the bankers are entirely to blame for the crisis. And Lewis’ obvious relish in telling stories about the Street’s lack of moral scruples would do nothing to dissuade someone who puts it all down to greedy bankers.

To obtain a more comprehensive view of what led to the meltdown, you would do well to turn to All the Devils Are Here by veteran financial journalists Bethany McLean and Joe Nocera. Indeed, as the title indicates, McLean and Nocera find many ‘devils’ had a hand in causing the meltdown: mortgage companies, the insurer AIG, Fannie Mae and Freddie Mac (the government-backed housing companies), rating agencies, the Federal Reserve, Congress and the White House – and yes, the banks, too. Furthermore, the authors devote most of the book to the 30-year history leading up to the crash, rather than its denouement. This results in a book that is less dramatic than those like Too Big to Fail by Andrew Ross Sorkin (reviewed on spiked here) that breathlessly describe the frantic days of collapse and bailout in 2008, but one that succeeds for those who are interested in learning about the disparate elements that combined to create the crisis.

One of the best aspects of All the Devils Are Here is that it not only meticulously studies each of the pieces of the puzzle, but also shows how they fit together. For example, it delineates how Wall Street’s securitisation of mortgages directly affected Main Street’s lending. Securitisation created demand for new mortgages, especially subprime mortgages, and facilitated a new class of loan originators in firms like Ameriquest and Countrywide. These new companies shunned traditional methods of assessing creditworthiness, doing away with documentation of income (when not deliberately falsifying income) and interviews, because they didn’t have to: they could simply turn around and sell the mortgages on to Wall Street. Combined with other outside factors, such as the Fed’s low interest-rate policies, it was no wonder that such poor lending practices spread across the country.

All the Devils Are Here is especially useful in highlighting the role of government in the financial mess, and in doing so it provides a necessary corrective to many earlier accounts that look exclusively or primarily at the role of the banks. Clearly, there was a lack of government oversight and regulation, as most commentators have noted. But McLean and Nocera show that the state did not simply commit a sin of omission: politicians from both major parties actively promoted the financialisation of the American economy.

In the mid-1990s, Clinton’s deputy treasury secretary Larry Summers squashed the efforts of Brooksley Born, head of the Commodity Futures Trading Commission, to regulate derivatives. Why? Because Summers was defending what was widely understood as a desirable profit centre of the economy: derivative trading made up to 40 per cent of profits at some banks, and he argued that regulation would lead to US businesses moving to London. And even though the Long-Term Capital Management bust in 1998 would clearly demonstrate the destabilising consequences of derivatives, Clinton went on to sign the Commodities Futures Modernization Act in 2000, which enshrined that derivatives could not be regulated by any government body. More than the 1999 repeal of the Glass-Steagal law that had long separated investment banking from other activities, this Act revealed that both parties took a positive view of ‘financial innovation’ and sought to bolster the financial sector.

Furthermore, government’s role in fomenting the crisis is best highlighted by the government-sponsored enterprises (GSEs) known as Fannie Mae and Freddie Mac. These are private companies that benefit from government support, the hybrid product of a bipartisan effort since the 1930s to promote home ownership. Once known as a standard for sound loans, Fannie and Freddie over time loaded up their holdings of subprime mortgages, and in doing so ‘gave their imprimatur to what had previously been a separate universe’. And they would continue to buy and guarantee mortgages well into 2008, long after others had abandoned the scene, becoming the buyers of four out of every five mortgages.

At the same time, while recognising the distorting role that Fannie and Freddie played, McLean and Nocera rightly do not lay the blame wholly on their shoulders. Republican critics argue that the GSEs caused the crisis, by taking on subprime to meet the political objective of increasing home ownership among the poor. But, argue McLean and Nocera, ‘this is completely upside down; Fannie and Freddie raced to get into subprime mortgages because they feared being left behind by their non-government competitors.’ They aptly describe the investment banks and GSEs as ‘magnifying each other’s sins’. ‘Without the GSE’s buying power, the private market would never have been as big as it got. And without Wall Street, there would never have been all those bad mortgages for the GSEs to binge on.’

All the Devils Are Here makes clear that the crisis was a failure of both the market and the state. And it is not as if the two are clearly distinct: they are better understood as inextricably linked (and in the case of Fannie and Freddie, merged into one). The elites of politics and business were both responsible. A reasonable conclusion one can draw from this is that the problem is systemic in nature.

While the book is superb on the details of how it all happened, it falls way short on explaining why. With only three pages to go, the authors ask ‘What was the point of it all?’ – and of course, they cannot adequately address their question in such a short space. Moreover, for all its strengths, the book is too centred on the issue of housing. In one sense, this is understandable since housing was the immediate site of the blow-up, but in fact it can be considered as one of many financial bubbles that have emerged in recent decades. Indeed, as the authors themselves point out many times, most of the subprime lending was not really about facilitating housing: about 80 per cent was either for re-financings or second homes. In other words, this lending was just a source of extra credit or speculation.

To examine the broader forces at work, economic analysis needs to be applied, and that’s what two other high-profile books of 2010 aim to do. Crisis Economics is written by the New York University economist Nouriel Roubini, along with historian Stephen Mihm, while Fault Lines is written by Raghuram Rajan, the former chief economist at the International Monetary Fund and now a professor at the University of Chicago’s Booth School of Business.

Both Roubini (aka Dr. Doom) and Rajan stake claims to fame for predicting the crash, with Roubini the more immodest of the two: ‘Roubini’s prescience was as singular as it was remarkable: no other economist in the world foresaw the recent crisis with nearly the same level of clarity and specificity.’ Both seek to go beyond simplistic explanations, such as greedy bankers. And to do so, both use the same metaphor of earthquakes: the title of Roubini’s final chapter is ‘Fault Lines’.

Roubini and Mihm’s starting point is a call to recognise that financial crises are regular occurrences in a market economy: common ‘white swans’ rather than rare ‘black swans’. The rise of asset bubbles and their predictable collapse can be witnessed globally and through the centuries. Consequently, policymakers should recognise the inherent instability in the market and pro-actively mitigate its impact.

Specifically, the problems of the most recent crisis were ‘more pervasive and widespread’ than just subprime mortgages infecting the global financial system via securitisation. Instead, the authors point to ‘deep structural changes in the economy’, among them: financial innovation; changes in corporate governance and bonus plans; Federal Reserve monetary policy; government policies promoting home ownership; deregulation that allowed a shadow banking system to emerge; and a global savings glut that led to surplus cash going into the US. Their ideas on how to prevent meltdowns in the future include reforms that seek to address these specific problems.

Likewise, Rajan appeals for an examination of deeper causes: ‘Progressives in the United States blame the bankers, while conservatives blame the government and the Federal Reserve. The worrying reality is that both are to blame, but neither may be fully cognisant of the fault lines guiding their actions.’ Rajan cites three main pressures: growing income inequality in the US that creates political pressure for easy credit; trade imbalances between countries; and the clash of different types of financial systems in the advanced and emerging markets. Rajan says that changing the actors or their incentives will have a limited effect at best; instead, the deeper fault lines need to be bridged. For example, to address income inequality, he calls for education reforms and social safety net improvements.

Both Roubini/Mihm and Rajan provide valuable overviews of the crisis that do not rest on morality tales about greedy bankers, nor do they limit their explanations to subprime mortgages. Both books contain perceptive insights. Roubini and Mihm are particularly good on how the bailouts and massive injections of liquidity via quantitative easing have worked to stem the collapse, but have stored up potentially newer and bigger problems in the future, in the form of public sector (or ‘sovereign’) indebtedness.

The problem with both books, however, is that what they consider ‘deep structural causes’ are factors that only scratch the surface. Rajan’s emphasis on government promotion of home ownership is a partial contributor, at best. As both McLean/Nocera and Roubini/Mihm point out, the main activity in subprime was led by the private lenders like Countrywide. Similarly, Roubini and Mihm’s key changes are also limited in effect. They cite financial innovation as a main cause, even though the housing bubble occurred in Europe without going anywhere near as far in terms of securitisation. Bonus plans are also hardly a structural explanation: they were in place for many years without leading to a crash; and their seemingly radical reform that calls for bonuses to be held in escrow would not do much considering that executives at two of the biggest failures of the crash – AIG’s Financial Products unit and Lehman – held millions of dollars in stock, and that did not stop them from betting the house.

Most importantly, both books are narrowly focused on the problems of finance. Roubini and Mihm in particular explicitly establish finance as an independent driver of booms and busts. While both books identify weaknesses in the financial system, neither really investigates why the absolute size of the financial sector became so large, to the point that it was not sustainable. Indeed, neither book includes the non-financial or ‘real’ economy in their explanations in any substantial way. This approach ignores the true driving force behind the meltdown: a stagnant productive economy has pushed investment away from the non-financial sector and towards the financial sector. Roubini and Mihm refer to the Great Moderation from the 1980s until late 2000s as a period of ‘high growth’, and yet not only was it not that high (it was moderate), but more importantly it was superficial – highly dependent on personal consumption and state spending, and fuelled by credit.

All four books discussed here depict an American economy that appears to be at the mercy of Wall Street. It is remarkable how interconnected today’s financial world is with the rest of the economy: the 1987 stock market crash wiped out billions but did not have such repercussions as the popping of the most recent asset bubble did. Yet the common image of Wall Street infecting an otherwise healthy non-financial economy is a false one. The truth is that poor profitability in productive industries fed the Wall Street monster; that is why it has had so much money to play with.

The many books on the financial crisis are generally very good at describing how Wall Street built a business around one type of debt (subprime mortgages) and then grew it by more credit (derivatives and leveraging). Yes, this is a decadent form, but ultimately the problems occurring on Wall Street are really indicative of a bigger issue facing all parts of the economy: the fact that corporations, households and governments have also been living off credit rather than creating new wealth. This is the fundamental issue that remains unaddressed.

Much can be learned from these insightful books, but they will not be the end of the story.

Sean Collins is a writer based in New York. Visit his blog, The American Situation, here.