Opinion and Editorial

Dogs that didn't bark

Paul A Samuelson
Filed on September 28, 2007

ACCORDING to ancient Chinese folklore, dogs in the streets whine before an earthquake. Professional economists are supposed to serve a similar function.

Supposed to, yes. But sometimes we fail to see what is plainly looming ahead. I refer, of course, to America's pre-2006 housing and real estate bubble.

Destined to burst —as it did burst and still does fester —it surprised and shocked global central bankers and Washington bureaucrats.

More importantly, the collapse of home prices bred huge losses for both rich and poor. That was an obvious effect of plunging price drop.

However, undreamed of was the actual fact that the whole global structure of credit —including credits quite unconnected with real estate or mortgage lending —froze up so as to threaten bankruptcy and losses to ordinary businesses and families.

I will try to sketch out briefly the main macroeconomic story of the last dozen years, globally and in the U.S.

In the last half of the 1990s, innovational improvements in technology did raise U.S. and global productivity. That in turn set off a Wall Street stock market bubble.

All bubbles grow from their own momentum. I buy stocks because you have bid their prices up. You buy more stocks because I've pumped their prices up. Beautiful while it lasts.

Governor Alan Greenspan at the Federal Reserve observed this, but decided not to intervene. (Maybe he thought it would be enough to handle the mess when the bubble burst. Also, in line with his conservative youth, he would rashly say publicly: Intelligent and experienced bankers and accountants discern new sound values. Who are we to say they're wrong?)

What is forgotten is that in every bubble, the biggest fool looks temporarily like the wisest and soundest pundit.

The Wall Street bubble burst in the spring of 2000. On schedule, a global recession set in. Sensible expansion-of-credit policies by the European Central Bank, the Bank of England and the Federal Reserve were able to keep the recession short and mild.

Worldwide low interest rates then set off a real estate bubble. How fortuitous to always have a new bubble replace a vanished bubble.

It is pointless to ask why governmental macroeconomic agencies didn't try out strong preventive regulating to cool down the crazy lending and borrowing practices in the 2000-2005 mortgage markets. They did not.

Academic economists were little better than public officials. Here is just one example: A guest columnist for the New York Times —well trained and a professor at an elite university —pointed out that one virtue of the frenzied financial practices was that they broadened home ownership by less affluent folk.

Yes, but no warning was given by that expert on how home ownership, coaxed out by misleading sub-prime lenders, translates in terms of economic science into dangerous leveraged high-cost betting on a real estate bubble that is to last forever.

Now I come to the biggest surprise of all. Back in, say, 1990, when there had been a previous drop in home prices, people got mortgages from their local banks. Such bankers knew a lot about their customers and the local neighbourhoods. Lenders and borrowers had a mutual interest in avoiding and minimising foreclosures of home ownership. That was then. In the last decade, a thousand unregulated hedge funds have been born. New and non-transparent options (puts, calls, swaps) have replaced simply owning stocks and bonds outright, free of leveraging loans.

Furthermore, today's mortgages are being 'securitised.' Banks divide them into graded packets. The most sound loans promise the lowest earning yields. The inflated loans to bad credit risks are sold to pay the buyer the highest yield —highest unless it goes into default. Does all this sound innocent and safe? Readers will hardly believe it when they are told that the rating agencies —Moody, Fitch, McGraw-Hill, S&P —blindly awarded highest AAA ratings to both the good-cheese packets and the rotten-cheese packets.

Economists and bankers hailed these new ways that could spread risk-sharing efficiently. What we didn't foresee was that instead of reducing riskiness, these new instruments can tempt folks into leveraging 2 to 1, 10 to 1, and even 50 to 1.

Why would the rating agencies bless both the good and the bad? Those who sell these non-transparent packets pay the rating agencies. Common sense assures that those who rate will get the most business and the most profits if they tell their customers what those customers want to hear so that they can persuade gullible risk-takers to pony up funds to keep the housing bubble bubbly.

This kind of bad stuff we expected back in 19th-century rigged plutocratic markets. Or maybe in the post-2000 island tax havens. But surely not in the US, EU, UK, Japan or Korea.

Central banks are supposed to monitor money-market procedures. My hypothesis is that Federal Reserve Governor Ben Bernanke or Bank of England Governor Alwyn King were focusing so intensely on targeting against excessive inflation that this diverted their attention away from the looming credit crunch in private markets.

Repeatedly, we heard economists declare: Central banks ought not to bail out foolish investors from losses due to rash investing. To do that would encourage more future rashness in investing.

True enough. But once Rome was burning, Nero could not let things take their course to teach people how to be careful with matches.

Finally, late but not too late, the European Central Bank led the Federal Reserve and even the Bank of England into averting macro-financial crises by pumping newly created moneys into the banking system.

Better late than never.

2007 Paul Samuelson

Distributed by Tribune Media Services, Inc.

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