Upside Down CAPM, Part 3A: Sympathy
In yesterday’s post, in a digression about the 2000s boom and bust, I wrote:
One way to compare the Covid event with the Great Recession is that Covid was an event where policy was built on a consensus of shared sympathy. The Great Recession was built on a consensus of the lack of it. We collectively built economic narratives as we navigated these events that were meant to create or destroy sympathy. Again, something I outline in Building from the Ground Up is that one thing that everyone from Rick Santelli and the Tea Partiers to the Occupy Wall Streeters had in common was an explicit and all-encompassing opposition to sympathy. If only they had the Upside-down CAPM to guide them. :-/
Below are some excerpts from Building from the Ground Up on the topic.
There are a series of associations in conventional macroeconomics:
The Fed controls interest rates.
By pushing rates down, it encourages leveraged investment.
Leveraged investment drives the business cycle.
Low rates and lending activity are signs of over-stimulus.
The losses associated with cyclical reversals re-establish capital discipline.
I am surprised at how commonly these points are accepted and presumed in discussions about monetary policy. To my eye, every one of these bullet points is wrong, confused, and/or not strongly supported by historical economic evidence.
In the previous posts (1, 2, 3), I have argued that interest rates mainly reflect sentiment (lower rates reflect pessimistic sentiment). And the quantity of low-risk borrowing is mostly determined by public debt, private collateral, and mature corporate earning power.
In post #3, I suggested that a healthy dose of “Upside-down CAPM” thinking could have prevented the misguided pro-crisis policy direction that the US headed down before the Great Recession. The complicated CDO markets which rose up in 2006-2007 and then blew up were part of the bust, not the boom. They were mostly created because poor economic sentiment and risk avoidance created a surge of demand for low-risk securities. They blew up because they were treated as part of a bubble and their collapse was pre-determined and popular.
When they did collapse, they then became scapegoats confirming the need for the pro-crisis policies that had collapsed them.
These excerpts from Building from the Ground Up reflect the financial moral panic that led to the 2008 crisis. As you read this, consider the ways in which an Upside-down CAPM approach could have tempered the motivations that led to the series of catastrophic policy errors of the crisis.
The Upside-down CAPM approach is conceptually and empirically useful and reasonable. It also lends itself to a mutual sympathy and for a support for mutual welfare. The marginal gains of additional at-risk investment are shared gains.
Covid, being a natural real shock, allowed for a sympathetic policy response. The Great Recession, being self-imposed, was a reflection of lack of sympathy engendered by the confused conventional models of the business cycle, Fed policy, and home values.
These excerpts are from Chapter 10: No Bailouts!
On August 6, 2007, on the cusp of the first round of panic in mortgage securities markets and some corporate financing markets, the Wall Street Journal’s editors demanded instability:
[N]aturally the wounded are clamoring for the Federal Reserve to ride to the rescue with easier money when it meets tomorrow, even though the Fed helped create this mess.
Credit panics are never pretty, but their virtue is that they restore some fear and humility to the marketplace…
Current Fed Chairman Ben Bernanke was along for the Greenspan ride, so he’s hardly blameless. No doubt he’d love to play the hero role now, signaling easier money this week.
This sort of rhetoric was common during the crisis. Loose money and credit-fueled speculation were blamed for the housing bubble. What they cynically called Bernanke “playing the hero” might more accurately be called “doing his job.”…
That August 2007 meeting was immediately followed by panic in private mortgage markets…
A year later, in September 2008, the Federal Reserve again held interest rates stable, which again led immediately to market panics. This time the decision was followed by the most jarring collapse in economic activity in generations. The Wall Street Journal, for one, remained firm in their resolve:
These columns have been tough on the Federal Reserve in recent years, so it’s only fair to praise the central bank when it does the right thing. And that’s what it did yesterday by holding the federal funds rate stable at 2%, despite the turmoil in financial markets and enormous Wall Street pressure to reduce rates further.
Our view is that 90% of central banking is about character. Can a Fed chairman stand up to the inevitable lobbying from business and the political class when the economic moment demands a hard line for hard money? Any central banker can say yes to easier money. The great ones can also say no.
The following three months saw the worst decline in nominal economic activity since the Great Depression. The housing price collapse worsened, and defaults accelerated. Unemployment started to rise by nearly ½ percent a month.
Timothy Geithner referred to this view as “Old Testament” thinking. As Geithner writes, “The narrative of good-versus-evil was irresistible: We were saving irresponsible bankers while they continued to pay themselves huge bonuses. The conventional wisdom hardened quickly, and with a few honorable exceptions, the media rarely tried to explain that the situation was not so black-and-white.”
The Main Street versus Wall Street meme has been central to critiques of the period. Even the doves had to couch their positions with statements reiterating that their final aim was not to support Wall Street. Bernanke told 60 Minutes “You know I come from Main Street. That’s my background. And I’ve never been on Wall Street. I care about Wall Street for one reason and one reason only—because what happens on Wall Street matters to Main Street.”
Geithner especially was derided as the king of bailouts, and he had to frequently promise that helping Main Street was his ultimate goal. “[N]othing we did during the financial crisis was motivated by sympathy for the banks or the bankers. Our only priority was limiting the damage to ordinary Americans and people around the world.”
In the defense of his own record, Geithner writes, “[They] thought we were feckless…But a panic tends to make everyone look feckless in the same way a mania makes everyone look brilliant.” If only Geithner’s critics had managed some sympathy. And, likewise, if only Geithner and his critics could have managed that same sympathy toward the banks. (Here, I might suggest that the most fitting definition of sympathy is the definition relating to persons or objects being in relationship with one another, where they are similarly affected by changing conditions.) One might respond that banks did this to us and didn’t deserve our sympathy. But what if the idea that the banks were fundamentally the cause of the boom-and-bust is not as strong as we thought? What if they looked feckless, in part, because of the mistakes of federal policymakers? If those mistakes made the crisis worse (And of course they did. Making the crisis worse was explicitly the point. “Discipline,” “panic,” “fear,” and “humility” weren’t unintended consequences. They were the stated goals.) then in the end, marginalized and vulnerable families would be hurt the most. Of course, they were.
“A panic tends to make everyone look feckless in the same way a mania makes everyone look brilliant.” This is the central problem of the crisis. Panics were viewed as helpful or necessary, and the more feckless they made everyone look, the more it seemed that those who were beyond the reach of our sympathy deserved to fail.
Tim Geithner argues again and again against that tendency. “There was intense pressure on us to punish the Wall Street gamblers who had gotten us into this mess—to nationalize or liquidate floundering firms or force bondholders to accept ‘haircuts’ rather than the face value of their bonds. Those get-tough actions would feel resolute and righteous, but in a time of uncertainty, they would damage confidence and accelerate the downward spiral. As we had seen in the panic of the fall, that would hurt Main Street, not just Wall Street.”
But even Geithner regarded lending as the fundamental cause of the boom-and-bust. He wrote, “Borrowing frenzies are prerequisites for financial crises, and too many Americans were using credit to finance lifestyles their salaries couldn’t support. From 2001 to 2007, the average mortgage debt per household increased 63 percent, while wages remained flat in real terms. The financial system provided this credit with enthusiasm even to individuals with low or undisclosed incomes, then packaged the loans into securities that were also bought on credit.” Later, under his tenure as Treasury Secretary, the GSEs would greatly shrink funding for affordable homes for borrowers without pristine credit. The ability to counter “Old Testament” thinking was hamstrung because the belief in the wrong premise about the cause of high prices was universal. In the end, even Geithner was taken in by it.
. . .
Yet so many critics, such as the Wall Street Journal editorialists, reacted to Fed stimulus with cynicism—the Fed was propping up Wall Street. This is why the crisis was inevitable. Their demands were quite explicit. Many Americans would be satisfied with nothing less. The Wall Street Journal serves as a valuable historical record of the frame of mind during the moral panic. They reserved their praise for the Federal Reserve for Fed actions that immediately led to the worst moments of the crisis. Crisis was a sign of character.
In chapter 6, I wrote that “once the country was committed to countering wealth-funded consumption with tight monetary policy, it was pragmatically committed to creating a financial crisis in real estate.” Maybe that seemed like an overstatement. My point was that by mistakenly trying to deflate the housing market with monetary policy, we could accidentally create a financial crisis in real estate. What is strange, in hindsight, is how many Fed critics were demanding panic and crisis.
. . .
Eventually, federal funds would be used to rescue AIG and others, and the national discussion would revolve around the problem of letting firms get too big, so that they are “too big to fail.”
The actual Federal Reserve policy which Bernanke was inadvertently describing above, was a policy of “too small to save.” From the summer of 2007 through early 2008, panics were rolling throughout financial markets, expanding beyond the mortgage markets that were thought to be the problem into markets such as corporate paper and auction-rate securities, which are liquid credit markets generally only used by the most financially stable lenders and borrowers. The fact that markets for these securities were freezing up was clear evidence that circumstances were dire.
“Too big to fail” was simply the back side of the coin of the “too small to save” policy. If small firms are routinely left to fail when they are “caught up in a panic not of their own making” precisely because they are “unlikely to have a broad economic impact,” and if the primary policy that an economy needs is for the central bank to intervene in order to introduce calm and to stop the panics, then the inevitable final act of that “too small to save” policy will eventually be the imminent failure of a firm that is deemed “too big to fail,” which will finally trigger sufficient monetary intervention. And by September 2008, when the Federal Reserve and the Treasury began to routinely engage in “bailouts,” the damage from the panics had finally reached firms that weren’t too small to save.
Of all the calls for policies that should be prevented in the future, “too big to fail” is not one of them. That wasn’t Fed policy. It was only the final option left to them after they watched many other markets and firms fail. Thank goodness for “too big to fail.” What would have been left to save if failures and panics had continued? At least they were willing, finally, to stop something from failing.
In any case, “too big to fail” is not the policy of a central bank that is too aggressive. It’s the policy of a central bank that has not been aggressive enough.
At the April 2008 FOMC meeting, Geithner articulated this policy. “I think the markets now reflect too much confidence in our willingness and ability to prevent large and small financial failures. We are going to disappoint them on the small ones, which may increase the probability they attach to the large. At least I hope we disappoint them on the small ones.” Under the premise that the country was curing itself of a period of financial excess, this seemed to make sense. But since the country had mainly been struggling with an economically important lack of housing supply, which it was now inappropriately trying to cure with financial contraction, that comment is a commitment to making sure the financial contraction gets much worse before it gets better.
In his memoir, Stress Test, Geithner argues against several causes of the crisis—fraud, deregulation, moral hazard, and so forth. “The fundamental causes of this crisis were familiar and straightforward. It began with a mania—the widespread belief that devastating financial crises were a thing of the past, that future recessions would be mild, that gravity-defying home prices would never crash to earth. This was the optimism of the Great Moderation, the delusion of indefinite stability.”
Adding later, “You could say that on the front end, the long period of low interest rates in the United States and worldwide helped fuel the crisis, because it helped fuel the mania that inflated the bubble, encouraging more borrowing, more home building, more risk-taking.”
If the problem was the perception that crises were a thing of the past and recessions would be mild, then what was the solution? Surely avoiding a crisis and a deep recession wouldn’t be a solution to that problem. If the problem was the perception that home prices would never crash, then surely stable home prices wouldn’t be a solution to that problem. If stability had been a delusion, then what exactly was the Fed’s job? And if building more homes was simply part of a mania, then surely the Fed should view construction unemployment and declining residential investment as parts of the solution.
This was the consensus. The heated battles in late 2008 and early 2009 were battles about dealing with the aftermath—a game of macroeconomic chicken about how much damage one could bear before finally reinstating stability.
In 2006 and early 2007, there was a little corner of the American economy that was peculiar—a few locations where a migration event had caused local economic booms, where that event was collapsing and taking local incomes with it, where demand from the migration event had driven home values high, and where new types of lightly regulated mortgage products could be used to tap those homes for cash. That corner of the economy matched some of Geithner’s description.
But by then, well before the financial crisis, what the economy needed was “more borrowing, more home building, more risk-taking”—exactly what Geithner and essentially all other policymakers were afraid of. The 2005 Fed hadn’t been afraid of that. They had expected to stimulate the economy in order to prevent collapsing home prices from creating too much disruption. By 2007, the most dovish members of the Fed were less committed to stability than the Fed consensus had been in 2005.
Former Federal Reserve chairman William McChesney Martin is famous for saying that the Fed’s job is “to take away the punch bowl just as the party gets going.” The idea that the Fed’s job is to disappoint may have some grounding in wisdom, on occasion. But the downside of this thinking is brutal.
In his memoir, Geithner describes an argument he had with Larry Summers about a bank recapitalization program they were contemplating in early 2009. “I remember once while Larry and I were sitting outside the Oval Office, I tried to convince him that this meritocratic form of triage would be brutal to the shareholders of the institutions that most deserved brutality, while avoiding the panic-inducing consequences of nationalization or liquidation.” He told Summers, “They’re going to be diluted in proportion to their sins.”
Even Geithner had to defend his policies by promising they would be hurtful. Not only did he consider this position necessary at the time, but he considered it useful to vocalize it to garner support, and later he relayed this conversation in his book, likely hoping readers would react well to it.
Geithner was pulled to this position by a public that demanded it. To an angry populace, these sorts of statements seem like the least we can do. In his memoir, Geithner is clearly responding to a public that considered him too soft.
How confident should we be about our interpretation of events before we start to govern based on selective brutality? This isn’t the way civilized and successful societies approach each other. In the process of demanding comeuppance for those we have blamed, we have created comeuppance for ourselves. We have been brutalizing ourselves.
This sort of language is the product of a moral panic. The moral panic was so profound that the “Bailout King” himself, even in 2009 after the deepest depths of the financial crisis had been experienced, was still trying to gain favor for his attempts at stability by promising that somebody would be harmed by them.