This is a guest post for The Washington Note by businessman and regular TWN reader Richard Vague. Vague is the founder of AmericanRespect.com, author of “Terorrism: A Brief for Americans“, and publisher of DelanceyPlace.com.
On the eve of the invasion of Iraq, the price of oil was $28 per barrel. If the war had never happened, the current $40+ price would seem painfully high.
The price of oil didn’t rise because of supply and demand–since demand didn’t increase but about 1% per annum during that period–but instead because of war risk, a weakened dollar, and the speculation that invariably follows a rising price trend. Several months ago, when the price of oil was still well above $100, we wrote in these pages that the price of oil would come down closer to its March 2003 price once the risk of wider wars abated and the dollar strengthened against other currencies.
Now our global economic collapse has pushed discussion of oil prices to the sidelines, and a rash of explanations and proposed solutions for this collapse are being urgently debated. It is rightly the center of attention, for it is one of the worst in U.S. history and will likely last at least another year or two, since–among other things–the oversupply of housing that is at the heart of the problem is not projected be absorbed until the end of 2010.
Stated simply, we got into this mess because lending institutions were operating with far too much leverage (the ratio of loans against the capital a lender is required to maintain) which allowed assets such as subprime loans to be overbought. Now that the inevitable crash has occurred, some lending institutions have failed, and fear has brought in a contraction in even the sound lending activity so necessary for a sound economy. Lending institutions became over-leveraged because they used complex financial instruments such as credit default swaps that allowed more loans without requiring enough additional capital — and because some of these institutions and instruments were outside of the purview of regulators and thus able to operate without appropriate capital levels. Lenders and borrowers were further strongly incented down this precarious path by the negative real interest rates in place during much of this past decade, an unfortunate product of Greenspan’s easy money policies.
Some believe that it was lending that got us into this trouble to begin with, and therefore believe that part of the solution is to constrain lending. But a careful examination of the numbers will show that it was almost entirely the unprecedented excesses in mortgage loans that led us to this point. And, with proper capital levels, lending remains integral to economic growth. Restricting sound lending to worthy borrowers will significantly exacerbate our problems, and in fact, across the country, bank loans are now contracting.
To restore the economy, we need to get the banks lending again. Properly, prudently, but lending again. The problem is severe enough to need job creation programs as well, but all the public works projects we can muster cannot preserve or create as many jobs as a restored level of sound lending can. Estimates for the number of jobs that will be lost in this recession range as high as 6 million, and the new administration’s jobs program is rather optimistically targeting the creation a number of jobs far short of that–2.5 million.
Like the Crash of 2008, the Crash of 1929 was initially caused by high leverage–as evidenced by the 90% margin loans on purchased stock. But the Crash of 1929 didn’t have to turn into the Great Depression. It could have been just another nasty recession that took a few years to dig out of, and by 1932, the economy would have been sailing along again. Instead, the Depression ground cruelly along for the entire decade. And a decade’s worth of domestic public works projects–the PWA, the WPA, the TVA, and on and on–did not pull the country out of the Depression.
There were two major reasons the Crash of 1929 metastatized into the Great Depression. The first was that the nascent Federal Reserve Bank acted to contract the money supply by as much as 25% believing it was the correct thing to do. This was such a destructive and misguided strategy that in some parts of the country currency itself was literally no longer available. This is the one lesson of the Depression that the Fed has truly internalized, and it has acted in almost every crisis since then–the Crash of 1987, the Internet bubble of 1999, September 11, 2001 to name a few–to rapidly increase the money supply and flood the market with new money. In fact, M2, the measure of the money supply, has increased almost 4% since Lehman Brothers failed in September, and 8% since the beginning of the year–a huge increase by historical standards designed to help stave off the contraction from reduced lending and economic activity.
The second reason was the contraction in lending from banks. This lesson should have been as remembered as indelibly as the money supply lesson, but has not been. In the Depression, this contraction was reinforced and exacerbated by a string of bank failures–most indelibly the failure of the Bank of United States, which failed not because of any bad loans it had made, but instead because of a run on its deposits. The BOUS could have been saved through an extension of liquidity from the Fed or from the New York Clearing House banks–which had acted in that role for other banks on previous occasions–but instead it was allowed to fail, in some respects as a misplaced moral judgment against the bank. The result was that scores of the bank’s small business customers who were operating profitable businesses lost their access to credit–and as a direct result failed.
In 2008 this principle of preventing loan contraction was abandoned when the government allowed Lehman Brothers fail, and markets across the board have been fearful or frozen since that day. This was the major turning point–the point at which confidence disappeared–and without this mistake we would be in far better condition today. As a result, the contraction in lending seen in the Depression is being seen again–if in somewhat different forms. In my own recent experience, I am aware of a number of small to medium size businesses that were profitable and strategically sound, but have failed or are failing because their banks are reducing or cancelling their working capital loans. In addition, car lenders, including GMAC itself, have made across-the-board increases in credit score requirements above what I would view as needed, resulting in fewer loans and fewer cars being sold. Leasing companies are slowing their level of leasing–I am familiar with sound small businesses that have used leases to readily obtain business equipment such as photocopiers, but can no longer obtain such a lease. Further, mortgage lending markets are still in disarray and creditworthy customers are still finding difficulty borrowing, with unfavorable implications for the housing recovery.
In many cases, the reasons these lenders have pulled back is that their capital has been depleted because of large losses, and they must reduce lending until that capital can be replaced. In other cases, depleted capital levels or the fear that has gripped the banking system has meant that they themselves don’t have access to funding to make the loans.
It is this multiplying effect of loans that makes it crucial to preserve lenders in the face of a crash. But, as I have argued in these pages previously, preserving the operations of a lender does not also mean that management or shareholder value has to be preserved. And thus the “moral hazard” aspect of a rescue can be avoided. The management of a firm that took it to ruin can be ousted, and the shareholders that funded that firm can lose their investment without the borrowing customers and counterparties of that firm being punished as well. A path along these lines was successfully taken in the rescue of both Bear Stearns and Countrywide Mortgage. (And, on a much different note, this path could arguably be taken with the Big Three automobile companies)
To get lending institutions lending again, they must be fully capitalized. Much has been done in this area, most of it good, and the support that is in place should remain. But the task is not fully done. One key and completely free source of capital is for regulators to change back the relatively recent “mark-to-market” accounting regulations to the “held-to-maturity” accounting that was previously in effect.
The regulatory community has often overreacted detrimentally to credit problems and should not do that here. My experience has long been that regulators were too lenient when times were good and too tough when times were bad–the proverbial case of closing the barn door after the cow has already gone.
Alongside this, since the government still controls so much of the mortgage market, it should move to make sure loans are more widely available to worthy borrowers.
The tendency of our politicians will be to focus primarily on public works–which is where they feel most sure of themselves. But they should pay as much attention to lending markets, where greater gains can be achieved. With the continued monetary policy support of the Fed and movement to insure sound, properly capitalized, but robust credit markets, our economy will return to health. And sound job creation programs which focus on projects with enduring value–especially infrastructure projects–will add beneficially to this.
POSTSCRIPT: Once we our economy has recovered, we will have two major problems yet to deal with–inflated currency from the decade-long high growth in the money supply, and unprecedented levels of government debt. But first things first.
— Richard Vague