By Jeffrey Friedman Saturday, December 5, 2009
Filed under: Big Ideas, Boardroom, Culture, Economic Policy, Government & Politics, Public Square
A BBC poll conducted in 27 countries found last month that only 25 percent of Americans think capitalism is working well—and that this is the highest proportion of any country in the world. Overall, 51 percent of those interviewed thought that “regulation and reform” are needed to fix the problems of capitalism, and 23 percent maintained that an entirely new economic system is in order.
This is the intellectual toll taken by the financial crisis. But the people of the world, including most of its intellectuals, are simply wrong to think that capitalism caused the crisis. And once we understand what really happened, we get a rather different conception of capitalism than those entertained by either its conservative defenders or its liberal critics.
What Really Went Wrong
The actions of some well-known federal agencies—Fannie Mae, Freddie Mac, and the Federal Reserve—do help to explain the housing bubble. The Fed kept interest rates extraordinarily low from 2001 to 2006, making mortgages that much more affordable. And government-sponsored enterprises Fannie and Freddie encouraged mortgages with absurdly low downpayments. But while a popped housing bubble might explain a recession in the construction industry, it does not explain a worldwide collapse of the banking system.
The heart of the matter is that most mortgages written during the housing boom were pooled into enormous mortgage-backed securities (MBS). Fannie and Freddie securitized mortgages, but so did investment banks, such as Bear Stearns and Lehman Brothers. Shares of these MBS were then sold, as bonds, to investors around the world—but primarily to the world’s commercial (lending) banks. When subprime mortgage defaults began to spike in the summer of 2007, the value of all MBS began to be doubted. By September of 2008, doubt had turned to rout. Nobody wanted to buy the MBS inventory held by Lehman Brothers, since nobody knew how far home prices would drop, and therefore how low the value of MBS might go.
Federally mandated mark-to-market accounting translates temporary market sentiment into actual numbers on a bank’s balance sheet, so when the market for MBS dried up, Lehman Brothers went bankrupt—on paper. Mark-to-market accounting applies to commercial banks as well, however, and after Lehman failed, commercial banks worried that their own MBS holdings, and those of their counterparties, might bankrupt them, too, at least on paper. So they freezed lending. Hence the Great Recession.
Thus, any explanation of the financial crisis has to tell us why so many mortgage-backed bonds wound up in the hands of the world’s commercial banks.
For American banks, the answer seems to be an obscure regulation called the Recourse Rule. The Rule was enacted by the Fed, the FDIC, the Comptroller of the Currency, and the Office of Thrift Supervision in 2001. It was an amendment to the international Basel Accords governing banks’ capital reserves—and all over the world, these regulations appear to have caused the crisis.
A bank’s capital reserves represent funds that aren’t lent out or invested. This means that they are unprofitable, but they also might come in handy should a bank’s loans or investments turn sour. By reducing their reserves—and thus increasing their leverage—banks can, at least in principle, increase their profitability. But under the Recourse Rule, American commercial banks were required to hold 80 percent more capital against commercial loans, 80 percent more capital against corporate bonds, and 60 percent more capital against individual mortgages than they had to hold against asset-backed securities, including mortgage-backed securities rated AA or AAA. The Rule thus created a 60-80 percent incentive to buy highly rated MBS for any bank that wanted to reduce its capital reserves.
Now, the purpose of capital reserves is to cushion against unexpected trouble. So banks that increased their leverage by reducing their capital reserves were, in principle, exposing themselves to trouble. But that didn’t turn out to be the problem. At the beginning of 2008, the aggregate capital cushions of American commercial banks were 30 percent higher than required by bank-capital regulations. The problem was not the depth of the cushions or, conversely, the height of the banks’ leverage. It was the composition of this leverage, which is to say, its overconcentration in mortgage-backed bonds. And without the Recourse Rule, there is no reason that American banks that were trying to leverage up would have converged on mortgage-backed bonds. No other group of investors—not hedge funds, not pension funds, not mutual funds—were, as a whole, so overinvested in mortgage-backed bonds. But then, only banks were subject to the Recourse Rule.
The Rule did not apply outside America, but the first set of Basel Accords on bank capital, adopted in 1988, included provisions for even more profitable forms of “capital arbitrage” through off-balance-sheet entities such as structured investment vehicles, which were heavily used in Europe. Moreover, in 2006, a second set of accords began to be implemented outside the United States. Basel II took essentially the same approach as the Recourse Rule, encouraging foreign banks to take on-balance-sheet leverage in the form of mortgage-backed securities, just as in the United States.
Here we have the genesis of the global financial crisis. And it has nothing to do with capitalism.
Regulation Caused Systemic Risk
It is true that capitalists—bankers—who took advantage of the Recourse Rule turned out to be making a grievous mistake. But not all capitalists made this mistake, and that is where the story gets interesting.
Consider Citigroup, which jumped into mortgage-backed bonds with both feet, as opposed to J. P. Morgan, which lost potential revenue for years in order to avoid MBS. Morgan’s Jamie Dimon was among those who recognized the danger; Citigroup’s Chuck Prince apparently recognized the danger, but calculated the odds of disaster as lower than the profits to be made. Staking out the far end of Dimon’s side of this disagreement was Andrew Beal, of once-tiny Beal Bank in Texas, who virtually shut down his bank, avoided the whole housing boom, and has now made his bank one of the most profitable in America.
What explains this diverse behavior is that different bankers had different perceptions of risk.
In unregulated markets, this diversity of viewpoints is precisely what makes capitalism work. One capitalist thinks that profit can be made, and loss avoided, by pursuing strategy A; another, by pursuing strategy B. The heterogeneous strategies of different capitalists compete with each other, and the better ideas produce profits rather than losses.
In a complex world where nobody really knows what will succeed until it is tried, competition that pits people’s ideas against each other is the only way to test these ideas. Competition among capitalists spreads society’s bets among different, fallible ideas about where profit—and loss—might be located. For this reason, herd behavior among capitalists may cause systemic risk. But regulations, by their very nature, homogenize the behavior of those being regulated, automatically increasing systemic risk.
The Recourse Rule, Basel I, and Basel II loaded the dice in favor of the regulators’ ideas about prudent banking. These regulations imposed a new profitability gradient over all bankers’ risk and return calculations, the better to align their behavior with regulators’ ideas about prudent banking. The regulators assumed that almost nothing could be safer than a highly rated bond backed by a pool of mortgages. That assumption turned out to be wrong. But in the meantime, the regulations showered profits on banks that leveraged up by buying MBS. Only bankers with the most extreme perceptions of the downside, such as Dimon and Beal, escaped unharmed.
The bank-capital regulations inadvertently made the banking system more vulnerable to the regulators’ own errors. But this is what all regulations do. Whether by forbidding one activity or by encouraging a different one, the whole point of regulation is, after all, to change the behavior of those being regulated. And the direction of change is inevitably the one that the regulators think is wise.
How Conservatives and Liberals Get Capitalism Wrong
So the Great Recession was a regulatory failure, not a failure of capitalism. But it is also an occasion for rethinking capitalism—by both its conservative defenders and its liberal critics.
Let’s start with the conservatives, many of whom mistakenly extol the brilliance, wisdom, or heroism of capitalists. They forget that for every Jamie Dimon, there is a Chuck Prince. Capitalists are as fallible as anyone else. Collectively, they possess no superior powers; their profitable guesses, no matter how educated, are still guesses. Everyone can see this in the wake of the crisis. Paeans to capitalist genius will no longer do.
Seventy-three percent of the successful entrepreneurs recently surveyed by the Ewing Marion Kauffman Foundation said luck was an important factor in their success. These successful capitalists’ own assessments happen to be congruent with the standard liberal view. John Rawls—the great philosopher whom conservatives love to loathe but hate to read—pointed out that good luck, including even the good luck to have a strong work ethic, confers no moral claim. Winners of the genetic lottery are not thereby entitled to be rewarded, Rawls said—unless their talents serve those less happily born.
Liberals are right to notice that good luck explains many capitalists’ success, and that bad luck—accidents of birth—condemn millions to lives of misery. Conservatives who close their eyes to the accidental element in wealth and poverty make themselves appear both heartless and clueless.
In addition to their unfortunate romanticizing of capitalists, conservatives have done badly to adopt the economists’ standard explanation for the success of capitalism: self-interest. Self-interest is supposed to be the “magic of the market,” but we can safely assume that Chuck Prince was every bit as self-interested as Jamie Dimon. Both of them had equally strong incentives to save their banks, but that didn’t help Citigroup. UCLA economist Armen Alchian showed in 1950 that capitalism would succeed even if capitalists weren’t motivated by self-interest—and many capitalists, such as the founders of Google and Whole Foods, were not motivated by self-interest.
Unfortunately, economists have only grown more obsessed with self-interest, i.e., “incentives,” since 1950. This has led many conservatives to embrace the idea that “greed is good”—a woeful misreading of Adam Smith (or Ayn Rand). Smith’s parable of the baker, to whose benevolence we do not appeal when we buy our bread, is actually a lesson in unintended consequences, not in the wonders of greed.
The baker intends to make money, but he can do so only by providing his customers with bread. In his case, greed is indeed good. But that doesn’t mean that greed is always good, or benevolence bad. Nor does it mean that greed accounts for the success of capitalism.
How Liberals Get Capitalism Wrong
Liberals are correct to see through the usual defenses of capitalism. But they are wrong on the big picture. They fail to notice that there’s more to capitalism than luck and greed: there is competition—the saving grace of the whole system and, when undisturbed, the source of its strength.
Competition is the engine that turns lucky talents to the service of all—meeting Rawls’s criterion of justice. A baker who offered moldy or tasteless bread would be driven from the field by a competitor offering a better product. That is the message of Adam Smith. The successful baker, no matter how greedy, must unintentionally mimic the very actions an altruistic Rawlsian philosopher would prescribe.
The reason is the competitive nature of the capitalist system; the motives of individual capitalists are irrelevant. Competition puts capitalists’ different motives and ideas to the test of consumer satisfaction. This tends to give consumers what they want—and it diversifies a capitalist society’s investment portfolio. Capitalism thus mitigates both human greed and human fallibility. This is an amazing achievement, but there’s nothing magical about it.
Now consider the alternatives that liberals tend to favor—either the regulation of capitalism or its replacement by something more democratic.
Since regulators’ and citizens’ ideas are imposed on the whole system at once, they can’t be put to the competitive test. If their ideas are good, we all gain; if they are bad, we all lose. The whole system crashed when the financial regulators’ ideas turned out to be bad, but this is inevitable unless modern societies are so simple that solutions to social and economic problems are self-evident to a generalist voter, or even a specialist regulator.
Just that assumption is, in truth, the hidden premise of both sides in most political debates. This is why politics gets so ugly: neither side can understand why their opponents oppose what self-evidently should be done to solve our problems, so both sides ascribe evil motives to the other. But the financial crisis has exposed this simplistic view of the world for what it is. Nobody can plausibly deny any more that modern societies are bafflingly complex and the solutions to modern problems difficult to discover. So the policies that seem to voters or regulators to be so obviously needed may turn out to be disastrous nostrums—unless regulators or citizens are infallible.
That surely would be magical. But there is no more magic to politics than there is to capitalism. The question is how best to guard against human frailties: by putting all our eggs in one politically decided basket? Or by hedging our bets by setting fallible ideas into competition with each other?
Jeffrey Friedman is the editor of Critical Review and of Causes of the Financial Crisis (University of Pennsylvania Press, 2010).
Image by Darren Wamboldt/Bergman Group.
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