It's Time to Take the Losses

It's Time to Take the Losses

By Tom Kelly

The crisis currently gripping our financial markets will end. But it will not end without a “recession,” either as technically defined (two consecutive quarters of negative growth in real GDP) or as experienced by the public (a sustained period of lower stock prices, higher unemployment, lower real wages). And it will not end without a substantial restructuring of our economy. The recession can be either short and moderate, or long and deep, depending on how long the financial crisis remains a drag on the real economy. And that will be largely determined by whether the government continues to postpone the necessary economic restructuring.

The last serious recession in the United States was 1981-82. It was the third in a decade and inflation was at a peacetime record high. Unemployment reached 11.8 percent – almost double today’s rate. Economic pessimism was rampant, and many were calling for a vastly expanded government role to set the economy right. Instead, President Reagan and Fed Chairman Paul Volcker allowed the recession to run its course. Inflation was wrung out of the economy; many old-line businesses failed. They were replaced by newer enterprises that reflected the emerging information economy. By 1984, it was “Morning in America.” After 1982, we had a quarter of a century of growth with only two mild downturns.

The first of those downturns, 1990-91, was accompanied by the savings and loan crisis. A significant degree of restructuring took place in our economy despite the fact that recession was relatively mild. This was reflected in the political environment. Great anxiety about the direction of the economy led to the election of Bill Clinton in 1992. Although the government stepped in to resolve the S&L crisis, it did not “bail out” the S&Ls or the businesses they financed. It wound them up, and their shareholders and creditors took substantial losses. The economy emerged from that downturn poised for the strong growth during the rest of the decade.

The second downturn was in 2000-2002, after the dot.com bubble burst. Many enterprises failed, but they were concentrated in one segment of the economy – information technology. The government bailed out the airlines, ostensibly because of the cost of 9/11. More importantly, the Fed quickly reduced interest rates to below the rate of inflation, which helped pump up consumer spending and bailed out the rest of the economy. Economic growth resumed, although it was not as robust as it had been during the ‘90s. Nevertheless, the long period of relative stability led many observers to believe (just as a similar period had in the ‘50s and ‘60s) that government had mastered the business cycle, and that we could now avoid “recessions” and have continuous growth.

Looking back, the Fed’s aggressive response to the dot.com bust sowed the seeds of the current financial crisis. While the aggressive monetary response to the 2000-2002 downturn helped keep the recession mild, the Federal Reserve’s easy money policy lend to the much larger crisis we are facing today. Low interest rates worked their way into the economy primarily by kicking off a housing bubble. Between 2002 and 2006, house prices inflated 35percent in comparison to their historical relationship with income. The increased value worked its way into the economy through easier mortgage credit, which enabled consumer spending to grow faster than income. By short-circuiting the 2001-02 recession with this massive monetary stimulus, the government kept many enterprises alive that should have failed, leaving the economy more vulnerable the next time a slowdown hit.

Since the housing bubble burst at the end of 2006, the consequences have been working their way through the financial markets. Most importantly, leveraged investments in mortgages have declined substantially in value. Had the loss of value been easily measurable, many venerable businesses would have failed suddenly, but the credit markets would have functioned normally (creditworthy borrowers would have continued to have access to credit). But the complexity of the financial instruments through which these mortgage investments were held made the loss in value hard to measure. As a result, it was difficult to determine who was creditworthy and who wasn’t. So, lending standards for everyone tightened.

The government’s response has been to ameliorate the symptoms while postponing the inevitable economic adjustments. Beginning in August 2007, the Fed cut interest rates below the rate of inflation. The Fed also dramatically expanded its credit facilities, permitting banks and other financial institutions to pledge collateral of dubious value that could not be financed privately. When Bear Stearns teetered on the brink of collapse, the Fed stepped in and bailed out its creditors by subsidizing an acquisition by JP Morgan. Congress passed a “stimulus package” designed to prop up consumer spending with still more borrowed money. The Treasury stepped in to prop up Fannie Mae and Freddie Mac. Lehman Brothers failed, but the Fed then rescued AIG at the cost of $150 Billion (and counting). Congress authorized $700 Billion for purchases of “troubled assets,” which the Treasury used to make equity investments in banks and (now) other financial businesses. The Fed also started buying commercial paper from companies that could not find buyers on the private market. Now, as we approach the second anniversary of the bursting of the bubble, the current administration has announced a program to finance newly originated consumer loans and the incoming administration and Congress are planning to go on a spending spree (again, with borrowed money) to “stimulate” the economy.

Predictably, none of this has restored normal functioning to the credit market, because it is dealing with the symptoms and not the cause of the financial crisis. Our financial system remains hobbled by hidden losses that should be recognized and wounded institutions that the government should permit to die. The government response to the credit crisis is distressingly similar to the Japanese response to the bursting of their real-estate bubble in the ‘90s. That response led to a “lost decade” of economic growth in Japan.So how do we put this crisis behind us? By recognizing the losses. The crisis today is not a result of mortgage-related losses – financial markets are designed to bear losses. One trillion dollars in losses is roughly 2 percent of the amount of financial assets outstanding – a big number, but not a catastrophe. The losses have become a crisis because they remain hidden on the balance sheets of institutions throughout the system. More than anything else, uncertainty is crippling the system. Nobody is confident of the value of the assets that banks continue to hold. As a result, interbank lending, which was historically seen as low risk, is now seen as risky.

So what should the government do?

1. Accept a recession as inevitable and as part of the normal functioning of our economy. As a result of the recession, government spending will increase to cover unemployment benefits and other assistance to displaced workers, and tax revenue will decline, both of which will increase an already substantial deficit. Regardless of whether this additional deficit spending will help or hurt recovery, the programs being financed are necessary to cushion the impact of the recession on the individuals most severely affected. But the government should avoid any additional “stimulus packages” or “emergency programs” designed to prevent the necessary economic adjustments from taking place. Incurring massive additional government debt in order to avoid a normal and necessary adjustment to the economy will make things worse. The government needs to keep its eye on the next crisis, the one that begins when the world no longer views U.S. treasury obligations as a risk free investment. Massive fiscal stimulus today will hasten the day when the U.S. dollar and Treasury obligations are seen as risky investments, without fixing the problem we face today. We have to stop paying for today’s desires with our children’s credit. If we don’t, the markets will force us to do it. Soon.

2. Force the holders of mortgage-related assets to recognize the losses. The current discussion about “mark to market” accounting rules presents an opportunity to bring this issue to a head. One of the reasons we have banks is to take short term savings and use them to meet long term borrowing needs, so marking illiquid assets to current market values is not always appropriate. But banks should be required to mark down mortgage-related assets to reflect the anticipated 35 percent drop in home values from their 2006 peak. The same principle applies to issuers of other consumer debt and related credit default swaps. The sooner that happens, the sooner lenders will be able to distinguish creditworthy borrowers from the other kind, and the sooner credit markets will begin to function normally again.

3. Use government money to limit systemic risk, not to prop up failing institutions. When the government steps in to prevent the abrupt collapse of an institution that poses systemic risk, that institution has failed. The government ought to use bankruptcy and receivership laws to wind up the institution, not simply give it money to postpone the inevitable or make new risky investments in a last throw of the dice. AIG is the best example of this to date; the cost of “saving” AIG has nearly doubled in just over two months. The way to “fix” AIG is to terminate its credit default swaps and recognize those losses, while selling off its profitable businesses to cover a portion of the losses. Bankruptcy is a vehicle for doing that. The FDIC takes exactly those steps in dealing with the bank failures, and the Treasury and the Fed ought to follow suit.

4. Come down squarely on the side of the market economy. Reforms are necessary, but the reforms we adopt should be designed to strengthen the financial system, not to “re-regulate” the economy. From 1982 to 2007, the size of our economy more than doubled in real terms – a tremendous accomplishment. If it shrinks by 5 percent during this recession, it will be the worst recession since the Great Depression. But we will lose less than one-twentieth of what we have gained over the past 25 years. We don’t want to throw out the baby with the bathwater. Reforms should be designed to reduce the likelihood that the current crisis will recur while enabling markets (including financial markets) to perform their necessary task of allocating resources and coordinating economic activity. Doing so will set the table for another long period of growth like the one we have just experienced.

Joseph Schumpeter famously described capitalism as a process of “creative destruction.” The market economic process that created today’s unprecedented prosperity has not been an easy, upward glide path. In particular, business enterprises need to fail, so that resources (people and capital) previously used in those enterprises can move to more productive uses. Recessions are nature’s way of making that happen.

Tom Kelly, a partner in the law firm of Dorsey & Whitney, is a member of American Experiment’s Board of Advisers. He’s also a director of the Minnesota Free Market Institute.
December 2, 2008