Defying Gravity

In late 2008 the US credit market froze. How affected the „gravity problem“ the working of the economy and markets in the US during the financial crisis? What prevented market equlibrium from being realized?

What gravity is for scientists, equilibrium is for economists: a central and undeniable force. But what happens if this force doesn’t exist? The physicist Dr. Verlinde questions existence of gravity in science. Regarding economy the question about gravity is in the end a question about an existing market-equilibrium in the economy, the point where supply equals demand in a competitive market. In reality this point cannot be reached easily, due to the fact that the models are made under many assumptions and simplify reality. A lack of economic “gravity” means therefore uncertainties, market failures like asymmetric information and moral hazard or failed assumptions in economic models that keep supply from equaling demand.

The financial crisis and the Great Recession showed that economic theories might not entirely be true: Explanation why nearly nobody — neither economists nor regulators or investors — saw the risks in the always rising housing prices and the always getting more complicated financial instruments will keep economists and students occupied for the following years and decades. How could the crisis occur? Were there hints of a lack of gravity? In the following I want to show what influenced the markets during the financial crisis — uncertainties, market failures and failed assumptions — to loose its “gravity” during the four phases of the crisis: The bubble, the collapse, the recession and the recovery.

Examining why there is no equilibrium means watching out for market failures: During the growing of the housing bubble the there were several that prevented the financial market to work in an optimal way. First of all, the average house owner had no idea about the securitization process and the highly complex financial instruments, in which his mortgage was sold to investors. This unbalanced information situation is a typical case of asymmetric information between housing owners on the one hand and investment banks and investors on the other hand. Moreover there was a oligopoly situation and moral hazard in the rating process of bondss. The fact that financial institutions, who offered the investments paid the rating agencies, which follow — as every other company — the goal of profit maximizing, there occurred a collision of interests. By placing unrealistic positive rating signalized too low risks and created therefore wrong incentives for the financial market.

The basic assumption of all economic models is that humans are behaving like a “homo oeconomicus“, a person who maximizes his utility rationally under given circumstances. The fact that the bubble was driven by speculations contradicts the assumption of rational behaving humans: On the one hand individuals with very low financial strength were able to get credits for buying houses – as long as housing prices rose this was no problem and the system worked. On the other hand investment bankers had the incentive to create more and more riskier assets due to the incentive of personal bonuses. Anthony Cain replaced the phrase “too big too fail” with “too big to manage” to indicate the influence of human behavior.

Another big influence on the creation of the bubble was the highly suboptimal regulation of the financial system in the United States. The problem of regulation based on a decentralized and microprudential approach by having eight institutions that are responsible for different areas of the financial market. For example, the SEC (Securities Exchange Commission) sets the rules for securities, while the CFTC (Commodity Futures Trading Commission) is monitoring the Trade with Futures. This led to overlapping jurisdications and mandates and even regulatory competition between the specific agencies. This made it easier to financial institutions to avoid certain rules by “shopping“ around and choosing the “offer” that fit best and made it harder for the regulators to detect risks. Additionally, there were parts of financial transactions that weren’t covered by the regulators at all. Especially in the over-the-counter trading of derivatives the lack of regulation was disastrous. These bilateral transactions played a very important role in the financial crisis, like Credit Default Swaps, that work like insurance securities. Basically, there was no regulation within this market, that grew over the last years to the amount of roughly 20 times of the size of American economy. Aggressive and comprehensive regulation of these derivates would have been absolutely necessary to protect the economy.

The system worked – until the housing prices started to decrease in 2007. This was the signal for bubble to burst. The securitization of loans by banks served a catalyst in breaking the system: In a diversification process financial firms broke single mortgages in different parts and sold them to investors. Consequently there was a strong interconnection within the financial institutions that had a huge influence in the development of the financial crisis: After the negative shock of falling housing prices which affected in the beginning only a small group of institutions spread to others by contagion. For example, a bank wanted to get rid of its assets with falling value by selling them. These transactions affected the prices and the forced sale harmed all the other institutions, who owned that toxic asset with an unknown value. The combination of confidence, counterparty and coordination contagion created such heavy externalities that the US credit market froze.

The situation got worse and the government under President George W. Bush decided in October 2008 to purchase assets and equity from financial institutions in order to strengthen the financial system. This Troubled Asset Relief Program (TARP) was the largest component of the measures to fight the subprime mortgage crisis. It addressed the systemic risks of institutions, that were too big to fail. As chairman Ben Bernanke of the Federal Reserve argued the bailout was necessary, because the government recognized that the consequences for the broader economy of allowing a disorderly failure greatly outweigh the costs of avoiding the failure in some way. Nevertheless this policy causes a moral hazard in the way that financial institutions expect that if they should get in trouble the US-government will bail out them anyway and take therefore more risks than desirable.

During the phase of recession the financial crisis developed to a crisis of of the real market as well. Before the crisis the US economic growth was built on consumption: About 70 percent of the national GDP was consumption, but because of the lower income of many households and an unemployment rate around 10 percent led to its sharp decrease. Therefore the governmental stimulus program tried to jump-start the economy by revitalizing consumption demand. One example for a fiscal stimulus is the “Cash for Clunkers” program providing incentives to buy new vehicles by trading in old ones. The purpose was boosting car sales, what should support the domestic car production industry, that was hit hard by the crisis. (How serious the situation was shows the fact that General Motors, the largest US-automaker, became temporarily majority owned by the US Treasury. On the one hand this bailout saved GM from bankruptcy, on the other hand it created the market failure of public goods.) Moreover the “Cash for Clunkers” program should safeguard employment in manufacturing plants of foreign producers within the US. According to John B. Taylor’s testimony before the Committee on the Budget the program had moved purchases forward by a few months and they hadn’t increase economic growth on a more permanent basis. So the “Cash for Clunkers” program was only a non-sustainable rise in demand that did not solve underlying problems. Besides fiscal policies by the government the Federal Reserve tried to stabilize the markets during the recession and after the panic by monetary policies. The mortgage backed securities (MBS) program for instance is a large scale asset purchase programs by the Federal Reserve with an amount of $1.25 trillion. In order to avoid inflation through the higher amount of money in the market, the Federal Reserve has to unwind it. But this is associated with uncertainty, and therefore with a lack of “gravity”. Taylor argues that the impact of the purchases on mortgage interest rates were unknown, and thus there was uncertainty about how much mortgage interest rates will rise as the MBS are sold.

The current step of the crisis is the recovery with slow progress. The largest problem is the historically high unemployment rate with 9.6 percent according to the latest figures of the Bureau of Labor Statistics in September 2010. The underemployment rate is even at 16.9 percent in March 2010 (PEW Institute). This figure includes people who stopped discouragingly seeking employment or early retireds as well as young people who delay their entry to work force and people who are forced to work part-time even though they would prefer a full-time employment. Within these bad figures is the long-term unemployment especially alarming, because nearly 41.7 percent of all unemployed persons had been jobless for 27 weeks or more. Regarding the fact that the natural unemployment rate is around five percent in the US and the actual rate is nearly twice as high, it is obvious that supply does not equal demand on the labor market and thus there is no equilibrium. It seems that there is the perceivable risk of a shift in labor structure in the United States. Before the crisis in the late 2000s long-term unemployment has never been a serious problem – owing to the willingness of high mobility of the working force. But now many people are tied down in their worthless houses and moving in other parts of the country to follow job opportunities is no longer a real option. If there should be formed a structural unemployment on a significantly higher level than the natural unemployment rate this will consequently change the overall equilibrium on the labor market as well as in the overall economy.

The passed bill of the new financial regulation in July 2010 tries to address many of the aforementioned market failures and lack of regulations in order to bring the economy back to its equilibrium by creating a macroprudential regulation approach by the Council of Federal Regulators, more transparency by a consumer protection agency and the implementing of a regulation for derivatives. The Volcker Rule should to keep high flying traders away from old-fashioned savings of average depositors. Furthermore regulators will be able to impose restrictions on large, troubled financial companies that are “too big to fail”. This bill was an important step to a more secure financial system, nevertheless regulations are always a respond to a previous crisis and financial institutions will for sure try to find ways to avoid them. However, now it is time for the financial market to adjust to the new rules after they wanted to defy gravity and overcome economic laws by creating more and more complex and riskier instruments to get more profit, but the burst of the bubble and the following recession brought them back down to earth again.

Reference List:

  • Anthony Cain, Speaker, Sept 14, 2010
  • Ben S. Bernanke, Chairman of the Federal Reserve, Testimony Before the Financial Crisis Inquiry Commission, Sept 2, 2010
  • Bureau of Labor Statistics, The Employment Situation – September 2010
  • Economy Report of the President, Council of Economic Advisers
  • Timothy F. Geithner, Welcome to Recovery, The New York Time, August 2, 2010
  • Gary Gensler, Chairman of the Commodity Futures Trading Commission, Testimony Before the Financial Crisis Inquiry Commission, July 1, 2010
  • PEW: A Year of More: The High Cost of Long-Term Unemployment, April 2010
  • Spin-Free Economics, Nariman Behravesh
  • John B. Taylor, Testimony Before the Committee on the Budget, United States Senate, Sept 22, 2010

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