international analysis and commentary

The US and the origins of the economic crisis, Interview with Allen Sinai


Aspenia: Recent steps by the U.S. Treasury had been presented as essentially emergency measures, linked to market conditions but also to the p­articularly central role of Fannie Mae, Freddie Mac, and AIG in the American financial system. What do these measures have in common with the Bear Stearns? And how would you then describe the overall pattern, based on the criteria that has now been adopted (whereby Lehman Brothers was not bailed out)?

Sinai: Initially, the U.S. Treasury dealt with the problems of Bear Stearns, AIG, Fannie and Freddie as one-off separate events, case-by-case. But, with lightening speed the central and generic problem for all these firms, namely mortgage-based debt and credit instruments of varying kinds and complexities, was common to all these firms and events. The collapse in housing and in the values of residential real estate—a true bust and bursting of an asset price bubble—took down the values of any paper, indeed firms, directly or indirectly tied to this asset and this could be seen to be one primary source of the crisis. Apparently, it took the Treasury awhile to realize this. Financial market volatility, the freezing-up of credit within the financial system, and credit crunch to borrowers outside the financial system led to the current attempt at a more full, and bigger, policy reaction aimed at what the Treasury perceives to be the heart of the problem—the potentially worthless collateral of complex securities that were created during the housing boom and real estate asset price bubble without regulation and oversight, i.e., any “vetting” of the products and implications of their invention. And so, the Treasury, as well as the U.S. Federal Reserve, have appeared to be inconsistent, and ad hoc: indeed thus far that has been the case. Bear Stearns was the first problem and appeared suddenly, leaving virtually no time for the Treasury to respond, along with the Federal Reserve, and so a kind of “shotgun wedding” was arranged. AIG was not going to be supported, at least initially, but then the Treasury and Federal Reserve learned how big AIG was in counterparty relationships, in the investment holdings of their financial instruments, and how exposed were other bank and nonbank financial institutions to an AIG failure. AIG was perceived as “too big to fail” as a result. In the case of Fannie Mae and Freddie Mac, funders of three-quarters of new mortgages being written in the U.S., some remaining on Fannie and Freddie books but most being sold elsewhere, separately or in packaged instruments, the chance that an already depressed housing sector would become more so with even bigger declines in home prices and then its attendant consequences, simply could not be allowed to occur. The U.S. Government acted to be sure the mortgage-supply process stayed intact. On Lehman, some six months after Bear Stearns, perhaps the U.S. Government felt that enough time had passed and enough cushions and stopgaps erected to contain the damage that would come from a bankruptcy filing. In any case, with all that has happened and continued failure fallout as well as consolidations of financial institutions, the U.S. Treasury has now decided to use U.S. taxpayer monies, in size, to try to remove the bad mortgage-related assets from the balance sheets of bank and nonbank financial institutions to unfreeze the seized-up credit function within the U.S. financial system. Without unfreezing the unwillingness of these institutions to lend to one another and the hoarding of cash and liquidity of whatever comes from central bank funding, credit could stay frozen until an irreducible minimum of primary financial firms would be left. The risk of this to the economy is perceived as too great—the consequences are unknown and thus too risky to take a chance. The U.S. Government thus will attempt to essentially take off the books of financial institutions bad real estate-related collateral and replace it with U.S. Treasury securities. The pattern has been one of eclectic and hurried-up reactions in the absence of full understanding events, not well thought-through responses. This is not unusual for policymakers in any country when the economy and financial system are under extreme stress. The extended deliberations in the U.S. Congress with the Administration have helped to make the original full proposal of the Treasury and Federal Reserve a better package, however.

Aspenia: To what extent do you expect these recent cases to become dangerous precedents? How serious is the risk of moral hazard, given that markets may assume there will be more federal interventions?

Sinai: The failure fallout and consolidation of U.S. and some global financial institutions is a by-product from the unwinding of the housing boom, real estate asset price bubble, credit and debt bubble, and a bubble in the new businesses and innovations that surrounded these phenomena. Indeed, the collateral innovations that stemmed from the booms and bubbles served to intensify the booms and bubbles, particularly in residential real estate prices. This is not new in the history of booms and bubbles. Neither is the housing and residential real estate bust in the United States nor bursting of the residential real estate asset price bubble. What is new in its extent is the implosion and contraction in the financial instruments levered off these activities and of the financial institutions, old and new, that evolved in pursuit of the profits stemming from the booms and bubbles. The “failure fallout” represented in the Bear Stearns, Fannie and Freddie, AIG and Lehman situations has happened many times before—it is just that these financial institutions were much larger and played a more significant role within the financial system than has been the case in other similar types of situations. And, in the context of the capital markets-centric funding of financial intermediary businesses, a “credit crunch” within the financial system, is itself a source of recession, given how big these businesses had gotten in the economy. So these cases are not unfamiliar, at least to this analyst, and in that sense are not becoming a dangerous precedent. The intervention of the U.S. Federal Government and Federal Reserve to “save” the financial institutions, “bail” them out, or “manage” their failure, and now stepping-in to directly purchase the bad mortgage-related paper seems necessary to prevent these individual cases from cascading into a complete systemic failure of the U.S. financial system with all of its negative ramifications for the U.S. and global economies. Moral hazard becomes somewhat of a moot issue, at this point, since those financial institutions that have failed have brought huge losses in wealth and income, as well as lost jobs for the executives, and pretty much a complete wiping-out of equity shareholders. It is true that some salvaging has occurred in these situations, but it does not make sense to think that in the future financial or other firms will take so much risk as to court the kind of fallout and pain that have occurred here. In a tradeoff between moral hazard and the risk of systemic failure of the U.S. financial system, with the evidence from the Bear Stearns, AIG, Fannie and Freddie and Lehman situations, as well as others, e.g., the swallowing-up of Merrill Lynch by Bank of America, a probable sale of Wachovia to-come, the FDIC takeover of Washington Mutual, moral hazard has to be taken at this point in order to prevent a further cascading of negative financial and economic effects.

Aspenia: Is it correct to argue that the fundamentals of the U.S. economy are still sound?

Sinai: The near- to intermediate-term fundamentals of the economy are not sound. The economy is in a cyclical recession, statistically mild currently but set to intensify. Inflation and unemployment both have been rising. The U.S. financial system is consolidating and contracting, imploding to some extent after years of huge excesses. The household, or consumer, sector is the most deteriorated in its financial condition since the early 1980s. The U.S. remains a “debtor” country and that debt, relative to GDP, is going to increase, particularly for the U.S. Federal Government as it, and the Federal Reserve, step-in with taxpayer money to unfreeze a frozen credit channel, both between bank and nonbank financial intermediaries and to the nonfinancial borrowers in the economy. The U.S. has lost quite a bit of wealth and many other countries and regions of the world have accumulated wealth, most prominently showing in foreign exchange surplus and government balances across the countries and global regions of the global economy. Most fundamentally, a housing bust, bursting of a residential real estate asset price bubble, booms, now busts, in credit and debt, and falling asset prices in the balance sheets of financial institutions, households, and business threaten a new dynamic in the U.S. situation not seen since the 1930s. The U.S. process of response to crisis, incredible flexibility and the ability to change, both in politics and in economics, is a sound fundamental and huge fundamental strength for the U.S., which, if it behaves as has been true in history, suggests that longer-run the fundamentals of the U.S. economy will become sound again. The policy responsiveness, creativity, entrepreneurship and motivation of the mixed U.S. capitalistic system should, over time, transcend the current near-term to intermediate-term problems and challenges.

Aspenia: How do you view the criticism from some European central bankers regarding the Fed’s choices? Do they focus on Europe’s own priorities or do they point to a broader systemic problem with current U.S. policies?

Sinai: The policy challenges facing the Federal Reserve are extreme, ranging from recession to high inflation to financial turmoil and financial instability, to consolidation and collapse of the U.S. financial system, and to the freezing-up of liquidity within the financial system and without. This is an extraordinarily difficult set of problems for any central bank, particularly one, such as the Federal Reserve, that follows a “dual mandate” of maximizing sustainable economic growth and price stability. Added to those objectives, and related to them, is the current financial turmoil and disarray and need for the Federal Reserve to respond with policies that can work in the context of the dual mandate. It is easy to criticize whatever the Federal Reserve might do in such a situation. But, in particular, the loss of focus on inflation for the Federal Reserve, and deviation from a primary commitment to price stability to one of dealing with the financial turmoil and disarray and risks to the economy lies at the heart of the European Central Bank criticisms. So is the question of moral hazard, the entry into the private sector of the Federal Reserve as part of deals, and dealing with, the fallout of the housing bust and collapse of financial institutions whether “too big to fail,” or not. There is no doubt that the U.S. central bank is compromising its traditional role as an independent central banker, normally detached from political and societal issues, focusing only on the main objectives of the central bank and that the extraordinary measures taken endanger the price stability objective of the central bank. But, the lessons of history are that a hands-off attitude has led to results worse than a hands-on approach, with legitimate reason to quarrel with the details of the tactical mechanisms for dealing with the situation, but not the strategy. Criticisms do reflect the priorities of the European Central Bank (ECB), which is a steadfast commitment to price stability as a single goal with a “soft” inflation target of something just less than 2%. Within that framework, the approach of the ECB has been to support and provide all necessary liquidity at current interest rates, but always emphasizing price stability as the goal and, implicitly and actually, being willing to accept the short-run pain of weak or even a recessionary economy in order to achieve the longer-run goal. Within that framework, it is understandable that the ECB, much more traditional as a central bank in their viewpoint than the U.S., would be critical of the approach of the Federal Reserve. But, U.S. economists and policymakers are just as critical of the ECB practice of letting economies slide because of a too rigid fixation on price stability. The ultimate answer as to which approach is best probably will never be settled. History is on the side of a steadfast commitment to price stability by a central bank and strong central bank independence from political issues that might compromise the central bank’s role. But, the kind of financial crisis now being seen in the U.S. is not a typical one and so a “temporary” deviation from price stability, so long as it is quickly reinstated, seems to present the only choice at this point.