If They Tell You They Predicted the “Financial Crisis,” They’re Lying
A man must learn from his mistakes . . . from MAKING THEM, not from being saved from them.
—Shelby Foote, letter to Walker Percy, 1952
Experience . . . was merely the name men gave to their mistakes.
—Oscar Wilde
“Your No. 1 client is the government,” John J. Mack, Morgan Stanley’s chairman and chief executive from 2005 to 2009, told current CEO James Gorman in a recent phone call. Mr. Gorman, who was visiting Washington that day, agreed.
—Wall Street Journal, September 10, 2013
In a December 2012 television interview with Ben Affleck, who had just turned forty, Barbara Walters asked the talented actor-screenwriter-director, “If you could give advice to your twenty-five-year-old self, what would you say?” Perhaps she expected him to rue the myriad errors that had reduced him to a Bentley-driving, J-Lo-dating, bad-script-chasing joke after he won a best screenplay Oscar for Good Will Hunting. As Ross Douthat summed up those years, “Affleck spent the next decade embodying Hollywood as we wish it weren’t. He starred in bad action movies, mediocre dramas, lousy comedies, and bloated Titanic wannabes. He made not one but two bad movies with Michael Bay. . . .”1 And that’s going easy on Affleck. The attachment of the painfully overexposed Affleck’s name to any project in the early 2000s was a box-office death sentence, and most people think his career bottomed out with 2003’s universally panned Gigli. Then he made Argo, which won the Academy Award for best picture soon after his interview with Walters.
Affleck didn’t answer as you might have expected—that he’d tell his younger self to avoid the bad scripts and embarrassing tabloid covers. Instead, he said that his mistakes had made him, that he wouldn’t change much of anything, and that failure is ultimately the best teacher. Affleck’s answer was entirely correct.
Affleck’s story of redemption speaks to the value of letting failure run its course. Indeed, what a shame if Affleck’s falls had been cushioned, if he’d been bailed out, because bail-outs perpetuate the very actions that lead to failure in the first place. It’s reasonable to suppose that Affleck’s decline as an actor spurred his desire to reinvent himself as a director, that the painful attention of his tabloid joke phase helped restore his focus as he sought to prove his countless critics wrong. Failure is merely a harsh word for the experiences that animate the constant drive for self-improvement.
Ben Affleck’s story brings us back to the end of the last chapter. Housing was all the rage by the mid-2000s, signaling that the economy was in trouble. The manic flow of investments into housing was related to the eventual “financial crisis,” but indirectly. There would have been no rush to housing if the dollar been strong and stable. With a healthy dollar, stocks and bonds, which fund future wealth creation, would have won out over consumption, as they did in the 1980s and ’90s. The over-consumption of housing was bad for the economy, so a correction of that over-consumption, which was a barrier to growth, would not have been a “crisis.”
It’s unfortunate that six years after the “financial crisis,” we’re still pairing the words “financial” and “crisis.” Despite what the mainstream media tell you, the crisis was decidedly not financial, nor was it caused by a crackup in the housing market, nor was it caused by the failure of Lehman Brothers.
Recall the economic impact of the bankruptcy of Blockbuster Video in 2010—there wasn’t much to report. Any sensible observer recognizes that the bankruptcy of the video rental behemoth was an example of a healthy capitalist system’s working as it should, replacing one form of commerce with a better one. The same is true of the more spectacular bankruptcy of Enron, which was financially connected to firms all around the world. Its collapse barely disturbed the markets or the global economy.
It’s true that Blockbuster was irrelevant by the time it went bankrupt, while banks such as Lehman, Citi, and Bear Stearns were relatively large. Yet the size of those banks made their decline even healthier for the economy than the end of Blockbuster. Successful economies are about the efficient allocation of capital, and a large business that is destroying capital hurts an economy more than a small one. Historically, if failure was unthinkable, then we would have bailed out buggy manufacturers at the expense of the nascent car makers Ford and GM. Commodore and Kaypro, two long-dead computer makers, would have been saved at the expense of Apple and Dell. And Ben Affleck would have received a government subsidy to write, direct, and act in—God forbid—Gigli II.
Bear, Lehman, and Citi did not collapse because they were effectively using the capital entrusted to them. They imploded because the markets had decided they were not using it well. So how could the failure of one, or even all three, have caused what is now known as a financial crisis? A former senior Fed official told me off the record in 2013 that Citi has been bailed out five times in the last twenty-two years. Can anyone explain why bailing out this most errant of banks is economically beneficial or how it has deterred a “financial” crisis?
As a matter of logic, Citi’s fall could only help the economy by eliminating a massive waster of capital. The surest way to foster a financial crisis is to perpetuate the failed practices of Citi, not to mention Lehman and Bear, by propping them up with taxpayer funds. As will become apparent, that is exactly what happened.
Many financial institutions were exposed to the housing market, and it is still said that a moderation of home prices in 2007 led to an economy-crushing crisis in 2008. Really? That view assumes that massive lending for the consumption of a good that does not make people more efficient, does not lead to cancer cures or software discoveries, and does not open up foreign markets for trade is somehow a source of economic dynamism. In truth, the rush of capital from 2001 until 2007 into housing instead of productive entrepreneurial ventures was a recipe for recession.
The multitude of pundits who say the “crisis” was born of a housing correction are turning basic economics on its head. Even the most ardent defenders of bank bailouts acknowledge that mortgage lending had grown out of control by 2007. How could a correction of this imbalance have caused a crisis, or even an economic slowdown? Let’s return to reality: the 2007 housing moderation signaled an economy fixing itself. This included bankrupting the financial institutions whose errors had made all the housing consumption possible.
An economy robbed of failure is also robbed of success, because failure provides knowledge about how to succeed. Failure is the healthy process whereby a poorly run entity is deprived of the ability to do more economic harm. In sporting terms, it means that Mike Shula is relieved of his Alabama Crimson Tide coaching duties so that Nick Saban can take over.
The implosion of Bear Stearns in 2008 was beneficial because it was the kind of development that is necessary for economic growth. The firm was not going to disappear. If it had been allowed to go under, the management of its assets would have ended up in the hands of people more skilled. Sadly, the Bush Treasury and the Bernanke Fed blinked. Laboring under the delusion that Bear’s failure would precipitate a financial meltdown, the government brokered an economy-weakening deal in which J. P. Morgan acquired Bear in return for the Fed’s exposing itself to Bear’s undesirable balance sheet. At that point, a frequently inept federal government turned a healthy corporate implosion into a crisis.
If Bear had folded, better managers would have acquired its assets at a very cheap cost, enhancing their odds of success. Failure contains the seeds of success because quality assets that have been poorly managed are purchased cheaply. USC football’s revival under Pete Carroll initially cost the university little since Carroll, having been fired by the Jets and the Patriots, was a “damaged” asset. In fact, his reputation was in free-fall. Getting him on the cheap enabled USC to reap huge dividends when the football team’s return to glory opened the wallets of the university’s alumni.
The failure of Bear Stearns would have signaled to Lehman, Citi, and everyone else that bailouts were not an option. A struggling bank would need to find a buyer soon to avoid Bear’s fate. Investment banks have been failing regularly for as long as they have existed, so the resolution of these institutions’ difficulties would have been an orderly process.
Instead, the bailout of Bear, and especially the bailout of Bear’s counterparties, signaled to the market that the feds were ready and willing to “save” ailing financial institutions. Thus informed, the management of Lehman Brothers made no provisions for bankruptcy. Lehman, you must remember, was in trouble because it had deployed the funds entrusted to it in a faulty way. Its implosion in a normal—yes, capitalist—world would have been cause for cheer. But since capitalism’s abundant powers of self-healing were being overridden by slow-growth government intervention, its collapse created crisis conditions.
When their assumption that the government would prevent the failure of an institution like Lehman was upended by the firm’s bankruptcy, investors panicked, and the market became turbulent. None of this had anything to do with capitalism. It had everything to do with blinding the markets by intervention. It was as if the New York Jets prepared all week to play the New England Patriots without Tom Brady and Rob Gronkowski, only for the two to show up at game time ready to play. Or imagine being told to study for a history exam on the Revolutionary War but finding only questions about the Civil War on the exam. Panic erupted because of a lack of preparation. The element of surprise—the result of the wrongheaded bailout of Bear—turned Lehman’s decline into a crisis.
Once the blaze was ignited, the Securities and Exchange Commission fanned it into a forest fire by banning the short-selling of nine hundred different financial shares. Think about that for a moment. The entrance of short sellers into the market signals the arrival of massive buying power. When short sellers “short” a stock, they borrow the shares from an owner and then sell them on the assumption that they can buy them cheaply down the line and return the borrowed shares to the owner. For short sellers to profit, they must eventually re-enter the market to buy the shares they borrowed. But rather than allow the buyers whose shorts would eventually put a floor under a falling market, the SEC banned them when they were needed most.
To put this in perspective, ask yourself what was the biggest economic story of the thirty years prior to 2008? The overwhelming victory of free markets over central planning. Doubters need only Google the image of South Korea and North Korea at night. But in 2008, a Bush administration that talked a big game about capitalism and markets ran from both as fast as it could—allegedly to save capitalism and free markets. Do you recall Ronald Reagan’s famous quip that the scariest words in the English language are “We’re from the federal government and we’re here to help”?
Bailouts are never free. Even if they were, they would still be disastrous. The bailouts of financial institutions in 2008 clearly signaled that government intervention in the economy was coming back—with a vengeance. Thus John Mack’s admonition to his successor as head of Morgan Stanley, “Your no. 1 client is the government.” When a business accepts a government bailout, it is no longer in the business of profit. Instead, it is serving political masters who do not care about profits and who view businesses as social concepts whose wealth is subject to redistribution.
Given the stupendous failures of central planning in the twentieth century, is it any wonder that the markets cracked up in 2008? They had tried to eliminate poorly run financial institutions and had signaled thereby that further lending for housing consumption would cease. Markets were working well to end the crisis of financial institutions’ chasing bad housing investments, but rather than allow markets to work, the Bush administration renounced them.
“Your No. 1 client is the government” was not a response to a “financial” crisis in 2008 but to the major problems ahead. When poorly run institutions were not allowed to fail as the consumption of housing decreased, the markets correctly convulsed as they priced in the perpetuation of faulty banking practices, Fed encouragement of more housing consumption, and the rise of the federal government as the top client of U.S. finance.
The crisis was only “financial” insofar as the bailouts weakened banks and other financial institutions that would have gained strength through failure. Silicon Valley is not the richest place in the United States because businesses there always succeed. It thrives because there has been constant failure for the last fifty years. The failures authored great success in Silicon Valley because laggards were not allowed to consume precious capital for too long.
The bailouts weakened the financial institutions that animate our economy by robbing their managers of the knowledge gained from mistakes. A great deal of talent has migrated out of the banks and into hedge funds, which are unregulated and were not bailed out in 2008. New York City is still the center of global finance, and its enormous wealth is there for all to see. But the “unseen” is how much wealthier New York would be and how much more innovative finance would be if the taxpayers weren’t always there to save financial institutions from their mistakes.
Perhaps you are skeptical about my assurances that the markets would have righted themselves in the absence of government intervention. You may recall Ben Bernanke’s dire warning to Congress as it considered the bailouts: “I spent my career as an academic studying great depressions. I can tell you from history that if we don’t act in a big way, you can expect another great depression, and this time it is going to be far, far worse.”2 That line sent a chill down a lot of spines in 2008.
But consider what Howard E. Kershner wrote about the horrid outlook for Germany after World War II:
After the war the Russian Communists dismantled many industrial plants in Germany and hauled away a great deal of the movable wealth not only from East Germany, but in a lesser degree from West Germany as well. This unfortunate country had been more nearly destroyed than any other in Europe. She had suffered the loss of many millions of her strongest young men and had seen a great part of her homes, factories and business buildings destroyed. City after city had reduced to a mere skeleton and people were living in caves, cellars, quonset huts and three or four families crowded into a dwelling intended for one.3
Japan faced similar challenges in the aftermath of the same war. Human capital is the single most important ingredient for economic growth—nothing else comes close—and Japan had lost at least a generation of its best and brightest human capital. Atomic bombs had reduced two of its major cities to rubble. Yet within a few years of the war’s end, Japan was booming again. And “in a few short years,” wrote Kershner, “Germany became the most prosperous country in Europe, if not in the world.”4 Whatever economic displacement the United States might have faced at the end of 2008 was nothing compared with the total economic devastation that Germany and Japan faced at the end of 1945, yet those two countries returned to prosperity fairly quickly. Not only that, the banks that Bernanke deemed essential to America’s economic health accounted for only 20 percent of financial lending in 2008.5 Indeed, most lending occurs outside of the banking system, from company to company, and from company to customer.
Bernanke’s assessment of the urgency of saving those errant banks was wildly exaggerated. The actions taken by Bernanke, President Bush, Treasury Secretary Paulson, and Congress did not just weaken a banking system they were trying to save. They created a crisis in the process that was not at all financial and had everything to do with government error.
Likewise, anyone who says he predicted the “financial crisis” deserves to be met with skepticism. In fact, no one did any such thing. As early as mid-2006, and many times after that, I wrote about the rush into housing in various cities, deploring it as a negative economic signal. In a column published on June 12, 2006, I noted that the housing boom of the Bush era made the economic climate of his presidency similar to that of Jimmy Carter’s.6 And in October 2007 I wrote:
Lastly, it should be remembered that housing’s greatest decade as an asset class occurred during the inflationary, malaise-ridden 1970s. With the dollar in free fall, housing served as a classic hedge for unsophisticated investors eager to shield their wealth amidst the dollar’s fall. That real estate became the asset of choice of the new millennium wasn’t so much a signal of a flush economy, but more realistically was the result of renewed dollar weakness that once again made Americans very risk averse.7
Did I foresee a “financial crisis”? Not by a long shot. All I predicted was basic economics.
The hedge fund manager John Paulson raised a $147 million fund to buy insurance on mortgages and mortgage securities that he felt would eventually go bust. Paulson wound up making billions off his trades, but did he predict the financial crisis? No. Mortgages, home construction, and housing purchases represent consumption. Paulson simply predicted an economically healthy market correction. Mass consumption of housing usually signals a capital deficit for businesses eager to attain financing to fuel their growth. Paulson’s riches, therefore, were not the cause of a crisis but provided a valuable signal to the markets that further consumption of housing and investment in mortgage-backed securities was a bad idea.
What about those people who kept saying that housing was headed for a collapse in the years leading up 2007 and 2008? Did they predict a crisis? No, they did not. For a falling market for consumption goods to cause that kind of crisis, we’d need to rewrite basic economics.
To paraphrase Joseph Schumpeter, there are no entrepreneurs without capital, so any correction of manic consumption could hardly have created a crisis. And contrary to most of the media narrative to this day, by 2007 and 2008, housing prices had not corrected all that much. As Michael Lewis noted in The Big Short, for the mortgage skeptics eventually to profit, “[h]ome prices didn’t even need to fall. They merely needed to stop rising at the unprecedented rates they had the previous few years for vast numbers of Americans to default on their home loans.”8
If a correction in the mortgage and housing markets didn’t cause a financial crisis, what did? First, I want to repeat that there was nothing “financial” about the crisis. To have predicted the “financial” crisis, you would have had to predict the failure of Bear Stearns or some other financial institution. Having done so, you would have had to foresee a bailout of Bear or a similar institution. After that, you would have had to predict that, the markets having priced in bailouts for everyone, a panic would ensue when an even larger financial institution (Lehman Brothers, as it turned out) was allowed to collapse. Lehman caused the markets to convulse only insofar as the markets were surprised that it was allowed to go bankrupt. Investors panic when they can’t tell what’s going on. Lehman was a crisis only for investors lacking a clear understanding of the hapless Bush administration’s policies regarding the failure of financial institutions.
Next, you would have had to sense months ahead of time that the Bush administration would not only blink on bailouts that were wholly unnecessary, but that it would make matters worse by banning short sellers too. And then having predicted a series of anti-capitalist errors, you would have had to understand the unhappy consequences for the global economy of this misbegotten intervention and that calls for massive re-regulation of the economy would quickly rise to the top of governmental priority lists, scaring markets even further. Finally, you would have to have known that those same governments would do everything possible to blunt the market corrections that would have quickly revived the global economy. No one predicted the various government mistakes in response to the markets’ attempts to correct themselves, so no one can be said to have predicted the “financial crisis.”
Nouriel Roubini is famous for supposedly having foreseen the carnage. He did not predict the mistaken government intervention that convulsed the markets, but he was correct in drawing a connection between housing health and the eventual “crisis.” The problem with Roubini is that he turned Adam Smith and John Stuart Mill upside down. According to Roubini, an eventual housing moderation or collapse would on its own have been the undoing of the financial system and the economy.
No, it would not have been. The economy’s problem in the early 2000s was the capital deficit that was starving productive new ventures as the housing market, goosed by Bush’s devalued dollar, boomed. The problem was global because the devaluation of the U.S. dollar is often a worldwide event.
Roubini predicted a crash of the housing market. But if he had truly understood the situation, he would have seen how the economy would benefit from such a correction, provided that the businesses and financial institutions most exposed to that sector were allowed to fail. Instead, Roubini called for a stimulus package triple the size of the one President Obama and Congress foisted on the economy. He also said that U.S. banks should be nationalized.9 Roubini’s reputation as a prophet of doom was made by the government intrusion that he advocated. And if we had followed his advice in the wake of the crisis, it would have been worse.
Perhaps someone somewhere predicted the government errors that turned a healthy correction into a horror show, but I have never seen any evidence of it. Count on it—if someone self-assuredly contends that he predicted the carnage of the “financial crisis,” he’s lying.
Capitalism cannot cause a financial crisis because capitalism is about markets constantly correcting errors. It is government intervention that can and often does cause crises, 2008 being a notable example. Writing about countries in dire straits, John Stuart Mill observed with warranted optimism,
The possibility of a rapid repair of their disasters, mainly depends on whether the country has been depopulated. If its effective population have not been extirpated at the time, and are not starved afterwards; then, with the same skill and knowledge which they had before, with their land and its permanent improvements undestroyed, and the more durable buildings probably unimpaired, or only partially injured, they have nearly all the requisites for their former amount of production.10
Capitalist societies can rebound from anything. In particular, they can bounce back from bank failures that do not exterminate human capital or destroy their infrastructure. An interfering government is the only barrier to any society’s revival, and that is why the global economy cratered amid all the government intervention in 2008. As Mill put it,
The only insecurity which is altogether paralyzing to the active energies of producers, is that arising from the government, or from persons invested with its authority. Against all other depredators there is a hope of defending one’s self.11
Government is the only impediment to astonishing prosperity in the United States and everywhere else. Without government’s tax, regulatory, trade, and monetary barriers to man’s natural desire to produce, the only limit we face is the limit of our imagination. Indeed, government is the crisis when it comes to slow growth. Any guarantee of future prosperity requires taming not commerce but government.