Blaming Things Not Named Greenspan for the Great Recession

What caused the Great Recession, anyway? Two years after it began, we don't know. (Heck, 80 years after the Great Depression, we haven't decided why it started, or lasted so long, or ended.) So Slate's Jacob Weisberg went digging for answers. Just about everybody agrees that Alan Greenspan is at fault, somehow. After that, everything is up for debate.

Conservative economists--ever worried about inflation--tend to fault Greenspan for keeping interest rates too low between 2003 and 2005 as the real estate and credit bubbles inflated. This is the view, for instance, of Stanford economist and former Reagan adviser John Taylor, who argues that the Fed's easy money policies spurred a frenzy of irresponsible borrowing on the part of banks and consumers alike.

Liberal analysts, by contrast, are more likely to focus on the way Greenspan's aversion to regulation transformed pell-mell innovation in financial products and excessive bank leverage into lethal phenomena. The pithiest explanation I've seen comes from New York Times columnist and Nobel Laureate Paul Krugman, who noted in one interview: "Regulation didn't keep up with the system." In this view, the emergence of an unsupervised market in more and more exotic derivatives--credit-default swaps (CDSs), collateralized debt obligations (CDOs), CDSs on CDOs (the esoteric instruments that wrecked AIG)--allowed heedless financial institutions to put the whole financial system at risk. "Financial innovation + inadequate regulation = recipe for disaster is also the favored explanation of Greenspan's successor, Ben Bernanke, who downplays low interest rates as a cause (perhaps because he supported them at the time) and attributes the crisis to regulatory failure.

A bit farther down on the list are various contributing factors, which didn't fundamentally cause the crisis but either enabled it or made it worse than it otherwise might have been. These include: global savings imbalances, which put upward pressure on U.S. asset prices and downward pressure on interest rates during the bubble years; conflicts of interest and massive misjudgments on the part of credit rating agencies Moody's and Standard and Poor's about the risks of mortgage-backed securities; the lack of transparency about the risks borne by banks, which used off-balance-sheet entities known as SIVs to hide what they were doing; excessive reliance on mathematical models like the VAR and the dread Gaussian copula function, which led to the underpricing of unpredictable forms of risk; a flawed model of executive compensation and implicit too-big-to-fail guarantees that encouraged traders and executives at financial firms to take on excessive risk; and the non-confidence-inspiring quality of former Treasury Secretary Hank Paulson's initial responses to the crisis.

Last year, National Journal's Jonathan Rauch wrote a killer essay on this very topic that came to an exotic, and fascinating, conclusion. Here's the quick summary: Financial innovation produced a vast network of complicated asset-backed securities traded among what insiders call "shadow banks," or unregulated banks. Shadow banks looking to park cash where it would hold value and earn interest created a short-term securities market -- much like a checking account. But unlike a regular FDIC-insured checking accounts, these deposits would not be guaranteed by the government. So investors borrowing from this shadow depository system had to put up collateral. And they chose ... their asset backed securities.

Why is that dangerous? Because in the shadow banking industry, these deposits, backed by sub-prime mortgages instead of the FDIC, acted as money. Banks relied on it for transactions. "Subprime morgage debt had entered the money supply." But then the housing bubble burst. Depositors dumped their assets to raise cash and tried to withdraw their money, raiding the shadow depository market, and the money supply crashed.

And here's Rauch in his own words:

In the so-called Quiet Period, 1934 through 2007, systemic bank runs seemed to become relics of an unmourned past. Why? Because for about four decades, banks' activities were restricted to heavily regulated ventures that were more or less guaranteed a profit -- and, even more important, because federal deposit insurance, which began in 1934, assured depositors that their savings were safe.

Financial innovation, however, could be delayed but not denied. Around the walled garden grew a forest of new competitors and products. Money-market funds and other investment vehicles took deposits without offering federal guarantees. In a process known as securitization, investment banks converted predictable streams of income, everything from mortgage payments to health club dues, into securities that investors bought eagerly. Derivatives -- securities based on other securities--arose to spread risk and hedge against volatility. In time, shadow banking, as the new institutions and instruments were collectively called, rivaled and even eclipsed old-fashioned commercial banks.

The firms and major financial players making all these trades needed to park cash where it would hold its value and earn some interest, yet be accessible on demand. In other words, they needed the equivalent of checking and savings accounts, the "demand deposits" that banks traditionally provide and that form the backbone of the money supply. But no insured depository could begin to cope with the trillions of dollars involved. And so shadow banking developed what amounted to its own depository system, a short-term securities market called the "sale and repurchase," or "repo," market. It is immense. Gorton figures its size at perhaps $12 trillion, but he says no one knows for sure.

"It's important to see that this is a banking system," Gorton says. But it is like a 19th-century banking system, because repo "deposits" are uninsured. Unable to rely on a federal guarantee, depositors who park their holdings there require that the borrower put up something of value as collateral.

Treasury bonds, because they are safe and liquid, are the ideal form of collateral, but there were nowhere near enough of them to meet the demand. So asset-backed securities -- those packages of safe-looking income from mortgages, auto loans, and all the rest -- were pressed into service as collateral. In time, the better grades of subprime mortgage-backed securities were mixed into the blend, and they, too, won acceptance as collateral.

All of these asset-backed securities were sorted and re-sorted, combined and recombined, sold and resold, until, as Gorton writes, "looking through to the underlying mortgages and modeling the different levels of structure was not possible." Users could not independently assess the value of mortgage-backed collateral any more than your grocer can independently assess the solvency of your bank before accepting your check.

You can see, perhaps, where this leads. Repo is a form of money because it acts as a store of value and financial actors rely on it to conduct transactions. But instead of being backed by a federal guarantee, it was backed by, among other things, subprime mortgages. In this way, without anyone paying much notice, subprime mortgage debt entered the money supply. As in the 19th century, the economy had become dependent upon a form of bank-issued money that was not federally guaranteed and that was not as stable as it appeared. Unlike in the 19th century, however, no one understood how vulnerable the system was to a panic.

Calamity then struck, as it had before. First, the unexpected decline in housing prices tanked the subprime market. Repo depositors knew that most collateral was sound, but they had no way to know if their own holdings were safe; so in 2007 they began what amounted to a run on the repo system, effectively withdrawing their money. To raise cash, repo depositories dumped assets, further depressing collateral values and starting a tailspin.

In September of last year, when the failure of Lehman Brothers, the mighty investment bank, convinced investors that no one was safe, the crisis turned into a meltdown. As the repo market "virtually disappeared" (in Gorton's phrase), the money supply crashed and the economy began to suffocate.

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Derek Thompson is a senior editor at The Atlantic, where he writes about economics, labor markets, and the entertainment business.

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