Monday, October 28, 2013

Robert Samuelson Tells Us That The Great Moderation Caused The Great Recession

There is a relationship between periods of prosperity and the willingness of investors and businesses to take risk.  During periods of prosperity we overshoot on the way up, and during bad economies we overshoot on the way down.  Robert Samuelson claims that Alan Greenspan's monetary policies produced a period of prosperity that was called "The Great Moderation".  The Fed succeeded in attenuating the business cycle.  He argues that we might have been better off if we had normal business cycles because Greenspan's policies led to over-confidence and excessive risk taking that caused the Great Recession.  In other words, Greenspan was too good at his job.

Some of Greenspan's critics accuse him of creating the conditions for the Great Recession by leading our effort to deregulate the financial system.  Samuelson dismisses these criticisms by arguing that the banks that were responsible for the financial were regulated and that deregulation could not have been one of the causes of the financial crisis.  It was Greenspan's successes and not his failures that led to the financial crisis and the Great Recession.

Greenspan was certainly a cheerleader for deregulation and he had a lot of help.  Robert Rubin and Larry Summers were important members of the team that made it easier for banks to develop and sell derivative contracts that escaped regulation.  Bank regulators, which included the Fed, also failed to do their job.  For example, the Fed was informed about problems in the origination of mortgages but it chose not to do anything about  it.  The SEC also played an enabling role by deciding that our large banks were more able to regulate themselves than was the SEC.  It is very clear that an ethic of deregulation contributed to the financial crisis but it was much more systematic than banking deregulation. I think that it makes more sense to look at the entire system that had been corrupted to enable the financial crisis and the Great Recession.

The problems begin at mortgage origination.  Banks and mortgage originators initiated mortgages but they sold them to Fannie Mae, Freddie Mac and Wall Street banks that packaged them into securities that they sold to investors.  This was a big change from the good old days when banks originated mortgages that were kept on their books.  Now they could pass the "Bad Queen" on to the next link in the chain.  They mortgage originators also had help from appraisers.  They were able to encourage appraisers to over estimate the value of the homes that they appraised for mortgages.  This enabled the originators to grant mortgages in excess of the value of the homes.  This was a big departure from past practices.  Many of the originators also provided false information about the income of those who were seeking loans.  They also sold variable rate mortgages that had low interest rates for the first few years and were reset at higher rates in later years.  This enabled many with low incomes to make the early year payments even though they were unaffordable after they were reset.

The mortgage securitizers were making a lot of money from fees that they derived from packaging and selling mortgage backed securities.  Over time the demand for the securities that they were selling became greater  than the supply of mortgages that were needed to create the securities.  In order to satisfy the demand for mortgage backed securities, they ignored the underwriting standards that they had established for the mortgages that went into the securities that they sold.  This encouraged the mortgage originators to violate those standards.  The banks also made the mortgage backed securities more attractive by getting AIG to insure the mortgages against default by issuing credit default swaps. The rating agencies were glad to provide AAA ratings for the banks that hired them. AIG did not have the reserves that were required to insure the securities but they were able to escape the regulation of insurance regulators by registering as a bank in London.

I could go on and on about the system and how it was corrupted but that would take a book.  My point is that the Great Moderation did not cause the financial crisis and the Great Recession as it is argued by Samuelson.  We had enabled a system of corruption that began with mortgage origination and extended to the process by which toxic mortgage backed securities received AAA ratings and were sold to investors who were misinformed about their quality. 

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