Fault Lines: How Hidden Fractures Still Threaten the World Economy (22 page)

One reason is simply moral. No modern economy should force workers who lose their jobs to make such painful decisions as choosing which of their children to protect with medical insurance. Not only is this situation barbaric, it is also unsustainable, for those who lose out economically have every incentive to use political means to regain what they have lost. While a democratic system eventually responds, the response can be unpredictable, adding to worker uncertainty. There is a strong case for strengthening the U.S. safety net in ways that will not hamper the flexibility of the economy greatly.

Another problem with a weak safety net is that the United States tends to overreact, and other nations underreact, to downturns. Because every country knows that the politically vulnerable United States has to respond with expansionary policies and that some U.S. demand will spill over to the rest of the world, their incentive to change the structure of their economy, or their policies in downturns, is commensurately less.

But perhaps the most important problem is that the ad hoc policies the United States is forced into do enormous damage to the long-term health of the economy, both directly and through their effects on the financial sector. One could argue that discretionary fiscal and monetary policy in the midst of a downturn gives the United States the ability to calibrate its response to the severity of the downturn. But fiscal policy undertaken at the point of a gun is rarely as dispassionate or as well thought out as one might like. Yes, Congress could simply extend unemployment benefits, as it has done in the current recession. But politicians often want to do more. And the public’s anxiety gives them the license to bring out all their pet projects, all the favors to special interests, and all the schemes their ideological leanings and political connections predispose them to.

Similarly, as we have seen, the Federal Reserve, though ostensibly independent, has a very difficult task. It is extremely hard to ensure rapid job growth in an integrated, innovative economy where firms use recessions to refocus on becoming more productive or to strengthen their global supply chains, shifting jobs elsewhere. Moreover, the new technologies employed in hiring allow firms the luxury of waiting to fill positions. The sustained easy monetary policy that is maintained while jobs are still scarce has the effect of increasing risk taking and inflating asset-price bubbles, which again weaken the fabric of the economy over the longer term. If the United States cannot tolerate longer bouts of unemployment, but those bouts are here to stay, we risk going from bubble to bubble as the Federal Reserve is pressured to do the impossible and create jobs where none are forthcoming.

It is now time to turn to vulnerabilities in the financial sector to see why the fault lines came together to make banks take the risks they did. I focus on two issues. First, why did mortgage lending go berserk (which is the subject of the next chapter)? Second, why did the banks take on so much default and liquidity risk (which is the subject of
Chapter 7
)?

W
HEN THE FRENCH MONARCHY
was strapped for money in the eighteenth century, it found more and more creative ways to raise funds.
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One of these was to sell annuities—government bonds that paid out a fixed amount until the death of the person on whom the annuity was written. Annuities were very popular with the public, for they offered beneficiaries a guaranteed income for life in a time before there were old-age pensions. The monarchy liked them because it received payment up front.

The monarchy targeted these annuities at wealthy men—typically in their early fifties—who had the means to buy an annuity and who, given low life expectancies at that time, typically did not have very long to live. Annuities were priced so that they were a fair deal for such men. However, it was possible for the buyer of the annuity to make the payments dependent not on his own life span, but on that of someone else. Perhaps this loophole was not inadvertent, for it increased demand for the annuities: for example, it might have made annuities attractive to a wealthy merchant who wanted to settle his daughters for life. But it did mean that the clever investor could make money off the government. He could pick as beneficiaries healthy young girls (then as now, women lived longer than men) whose family history suggested a genetic predisposition to long life, and who had survived early childhood (infant mortality was very high in those times) as well as the dreaded smallpox. He could then buy annuities on their lives from the French government. A carefully selected, healthy ten-year-old girl would have much higher odds of surviving for a long time than the typical beneficiary of the annuity, and the payments received during her lifetime would far exceed the cost of the annuity.

This is indeed what a group of Geneva bankers did. They selected groups of thirty suitable girls in Geneva and purchased a life annuity on each from the French government. They then pooled the annuities so as to diversify the risk of accidental early mortality among the girls and sold claims on the resulting cash inflows to fellow citizens of Geneva. This early form of securitization thus allowed the bankers to create a virtual money machine, buying policies cheaply from the French government and reselling them for a higher price to investors. The investments were popular—especially because the bankers were reputable and the underlying annuities were claims on the government—and sold well.

However, buyers had not reckoned with the risk of government default. When the French Revolution broke out in 1789, the monarchy was overthrown, and the revolutionary government soon fell behind in its annuity payments. It eventually made payments in worthless currency. The Geneva bankers, who owed investors in harder Swiss currency, did not have the wherewithal to pay, and they defaulted, as in turn did many of the investors who had borrowed to invest in the “sure” thing.

There are four important and enduring lessons from this historical mini-crisis. First, few have a better nose for a good moneymaking opportunity than bankers. It is not that bankers are excessively greedy. Even though Adam Smith did put self-interest at the heart of capitalism when he wrote, “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest,” few businesspeople are entirely without concern for the impact of their activities on their societies.
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Rather, their willingness to exploit any advantage that will help them make money, however dodgy (albeit legal) it may be, stems partly from the nature of competitive banking, where there are few easy opportunities to make money, and partly from the way banker performance is measured—almost exclusively by how much money the banker makes rather than by her impact on real activity. The disconnect between banking and real lives and livelihoods is most apparent in the arm’s-length financial systems that are found in countries like the United States and the United Kingdom.

A second lesson is that bankers invariably find the biggest edge in taking advantage of unsophisticated players or players who do not have the same incentive to make money. Clearly, individuals who are unschooled in finance are a potential target, but often these individuals realize their ignorance and give their custom only to trusted intermediaries. Moreover, they typically have too little money to be of interest to the smartest bankers. More attractive targets are the moderately schooled managers of large pools of funds, such as pension funds or foreign state-owned funds, who know not that they know not and are thus easily taken advantage of. But perhaps the most attractive target of all is the government itself. The government has nonmarket, noneconomic objectives, and however astute its representatives may be, these make it easy prey for clever bankers. Moreover, whereas a naive individual is soon relieved of all his money, the government has deep pockets, and exploiting them can sustain many a banker’s luxurious lifestyle for a long time.

Third, banker behavior tends to be self-reinforcing, at least for a while. In the example of the annuities, as the profits from the first insurance scheme become apparent, they not only attract more bankers to the activity but also push up the prices of the securities issued by the first scheme, sending a still stronger signal to bankers. Similarly, as initial housing loans start to look profitable, more banks extend loans, thereby pushing up house prices and making the initial loan look even more solid. This behavior can exaggerate investment trends and move prices far away from fundamentals. Early movers may convince themselves they are geniuses, even though they are only the leaders of a herd that is rapidly headed toward a cliff. But the growth of the herd itself can make what would have been a minor loss by some adventurous bankers and their investors into a much more serious loss for the community.

Finally, there is safety in numbers, because the responsible government cannot let all its bankers fail, given the likely collateral damage to the citizenry. So even the revolutionary government in France continued paying the hated monarchy’s debts for as long as it was able. This is not necessarily to imply that bankers start out with the expectation that they will fail and be bailed out: bankers understand that failure is never pleasant, however forgiving the government. It may well be that the thought of a bailout really does not cross their minds. Rather, the problem created by the anticipation of government intervention is that the bankers, caught up in the herd’s competitive frenzy to cash in on the seemingly lucrative opportunity, are not slowed by more dispassionate market forces—what I have referred to as the
unintentional guidance
of the key actors’ actions by markets or voters. In such a situation, lenders to banks do not demand proper compensation for the risks the banker takes, because they know the blow will be softened by the government—and in behaving thus, lenders facilitate risk taking and herd behavior. The normal disciplinary role of markets (which themselves may sometimes be caught up in the frenzy) is dulled by repeated government intervention.

I draw modern parallels in this chapter and the next. The sophisticated U.S. financial sector responded to the government’s desire to promote low-income housing, as well as to foreign demand for highly rated debt securities. The edge the financial sector exploited was the unthinking, almost bureaucratic, way both the mortgage agencies and foreign investors evaluated the issued securities. Market discipline broke down as mortgage brokers found they could peddle all sorts of junk, especially because the deterioration in credit quality was masked by the immense amount of money pouring into the sector. When the crash eventually came, the government and the Federal Reserve, unable to stand by and see homeowners suffer, stepped in to prop up the price of homes and of mortgage-backed securities, validating much of the extraordinary insouciance of the market.

In this chapter, I explain why the fault lines we have examined earlier, acting on an amoral financial sector with a finely honed eye for opportunity, combined to cause a steady deterioration in the quality of mortgage lending. In the next, I explain why banks held on to so many of the risky asset-backed securities on their own balance sheets.

Most of us do not work for money alone. Some want to change the world, others to create objects of art and culture that will endure. Some strive to gain fame, while others are content to do good anonymously. For many people, though, the visible effects of one’s work are its greatest reward. For the teacher, witnessing the eureka moment when understanding finally dawns on a student; for the doctor, the incredible joy of saving a patient’s life; for the farmer, the sight of acres and acres of golden wheat swaying gently with the breeze—for all these people, their primary motivation is the knowledge that their work makes the world a better place.

A simple experiment done by researchers at MIT and the University of Chicago verifies the importance of larger meaning to motivation and work. Harvard students, the subjects in the experiment, were asked to put together Lego Bionicle models (small snap-together models) from kits they were given (the MIT researchers probably thought this would be a real challenge for Harvard students!). Subjects were paid at a declining rate for each additional model built, so that eventually they would stop because the effort involved in building an additional model was not worth the pay. In one version of the experiment, each completed model was placed in front of the subject, and the subject was given another identical box from which to build another. In the second version of the experiment, the subject was handed a second box, but even while he or she was putting the model together, the researcher dismantled the just-completed model and put it back in the first box, so that this box could be handed to the subject when the model built from the second box was complete.

The simple difference of whether the subject’s work was allowed to endure (at least for the duration of the subject’s participation) or whether it was undone immediately, leaving not a trace, made an enormous difference in the willingness to work, even though the monetary benefits were identical. Subjects completed an average of 10.6 Bionicles when the completed models were left standing in front of them and only 7.2 when the completed ones were dismantled in front of their eyes. Thus they continued to make Bionicles for lower wages when the experiment was structured to give the work more meaning. Seeing the fruits of your labor, even in something as trivial as model building, seems important for motivation!
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In some jobs, it is very hard to see the effects of one’s work. On an assembly line, a worker is just one cog in a huge production machine, and her role in the final product may be small. No wonder modern management techniques try to make each worker feel important both individually and as part of a team: the Japanese
kaizen
system of continuous improvement, for example, involves all workers in making changes to enhance productivity, no matter how small the changes might be.