Book review of Crisis Economics

Since the 2008 financial meltdown, there have been a lot of debates and discussions on what happened and what should be done to check the next financial crisis. The book Crisis Economics by professor Nouriel Roubini, nicknamed Dr. Doom due to his bearish economic view, and journalist Stephen Mihm, contains review of the 2008 crisis and pro-regulation suggestions to fix the market.

The central thesis of Crisis Economics is that financial crises are inherent in capitalism and predictable¹. After a recap of significant financial crises in history, they claimed that they found patterns of a typical financial crisis. In their model, a financial crisis starts with an asset bubble, which results from excessive credit supply or optimism about one technological innovation. Believing that asset price will never go down, investors borrow more and buy more. At some point, the bubble implodes, sending some highly leveraged investors to bankruptcy. Creditors realize the problem of bad loans and demand investors to put up more funds and collateral to compensate for falling price, which incentivizes them to fire sell the asset. A sudden increase in asset supply drives down price further and stirs panics in the market. More and more investors default, and banks are unwilling to loan out. As a result, liquidity crunches and crisis occurs.

This model seems compelling, but it doesn’t elaborate a couple of important aspects. First, where does excessive credit supply come from? A lax regulation of government or a loose monetary policy by Fed? If this is the case, can we blame market for being greedy? Besides, just because it is cheaper for investors to get credits doesn’t necessarily mean that people will demand a whole lot of them. In other words, what the authors missed in their model is a discussion of elasticity of credit demand curve. In addition, what is the crucial turning point? The authors just said that we could use various economic indicators to discern the turning point, but they didn’t articulate how to do the prediction. It is easy to deduce what would happen after bubble implosion, but predicting the timing of bust is a totally different issue. In my opinion, this lack of discussion attenuates their argument that financial crises are predictable.

In the next couple of chapters, the authors turned to analyze the financial meltdown in 2008. They claimed that lots of parties were culpable for the crisis. Considering that the reasons are manifold, I will first lay out their arguments, and then present what other economists think and my thoughts.

Alan Greenspan’s monetary policies

In the book, Alan Greenspan was blamed for adopting an easy-money policy by keeping interest rate too low for too long, which help expand the credit, incentivize irresponsible investment and foster the housing bubble.²  But some economists argue that Greenspan’s policy was actually tight and that critics made a classic mistake for using interest rates to evaluate monetary policy. ³ After a check of monetary base during Greenpan’s period, economist David Henderson found out that the inflation rate was stable and the change between the amount and velocity of M2 coincided with scenarios within a free banking system.⁴ In other words, though the interest rate during Greenspan’s era was low, it didn’t necessarily inject a huge amount of money in the housing market and start the bubble. In defend of his actions, Greenspan was actually right in attributing the low interest rate to a massive flow of savings from Asian economies and Latin America⁵. One problem of Crisis Economics is that the authors didn’t mention much statistical measure of monetary bases. Layman readers thus are very easy to be frightened by the unusually low interest rate and guided to believe that money and credit exploded during Greenspan’s period.

Payment mechanism in Wall Street

Roubini and Mihm criticized that big bonuses in Wall Street incentivize bankers to take more risks and higher leverage on a massive scale⁶. Similarly, celebrities like President Obama and vice president Biden considered big bonuses as “shameful irresponsibility”. However, such fury might have missed the target. Economist Alan Reynold explained that those big figure bonuses were actually paid to a large number of employees within the Commerce Department’s North American Industry Classification System (NAICS) rather than merely high-profile investment bankers⁷.

In addition, a second thought may justify such compensation mechanism. Bonuses, different from fixed salaries, are variable costs for banks doing business in financial industry known for its high volatility. Paying big bonuses and not-that-big salaries does two good things for banks. First, it keeps them from having to predict the future. Instead of having to budget money for all employee pay in at the start of the year, managers can look back at the end of year, figure out what final revenues are, and set pay levels accordingly. Such payment strategy limits the risk of over or underpaying to employees.  A widely ignored fact was that after the financial crisis, many Wall Street firms didn’t cut employees’ overall pay by much; instead, they shrank the cash portion of bonuses and paid more in salaries to compensate for the missing bonuses.⁸

Another advantage of this payment system is that it makes banks easier to cut variable costs very quickly when necessary. When the chips are down, cutting bonuses instead of salaries means that the firms don’t have to lay off too many employees. Recently, increased regulation of employee bonuses compensation has triggered increasing salaries and led to a higher proportion of deferred compensation levels, leading to a concerning highly fixed cost base for a volatile revenue business. 

As for the argument that big bonuses encourage reckless behavior by incentivizing traders to swing for the fences in an effort to juice their own pay, theoretically a bonus-based compensation system should actually reduce the risk of bad behavior, as bonuses can claw back when something goes horribly wrong. What’s more, a recent research conducted by Cheng, Raina and Xiong showed out that mid-level securitization agents were unaware of the danger of housing sectors since they also bought a lot in housing market.⁹ In other words, the reasoning presented by Roubini and Mihm can at most partially explain the over-issuance of toxic securities. In this case, changing the payment system might not check the occurrence of the next financial crisis.

Ownerships and sizes of investment banks

Roubini and Mihm believed that huge principle-agent problems within the investment banks partly led to over-issuance of securities of bad quality. Shareholders didn’t have much incentive to monitor the banking business because firms relied on borrowed money for operations so heavily that shareholders didn’t have much skin in the game.¹⁰ They doubted that managers could manage big and complicated investment banks and suggested that it was a disaster to allow investment banks to go public in 1970s. As a remedy, they called for a more responsible mechanism, namely partnership, to incentivize shareholders to monitor their firms’ business.¹¹

Roubini and Mihm were right that investment banks should have more capital for cushioning the possible liquidity shock, but turning investment banks back to partnership might not be the best way. Back in 1998 when Goldman Sachs decided to go public, some economists had guessed that the decision was a response to technological change and competitors’ expansions.¹² Research later conducted by Morrison and Wilhelm Jr. confirmed the previous conjecture. They discovered that that advances in information technology (especially the fast development of computer technology since the late 1960s) and codification of tacit human capital in financial services increased the cost for investment banks to maintain partnerships and incentivized them to go public to expand and enjoy benefit of economies of scales.¹³ From this perspective, forcing investment banks back to partnership may result in unintended consequences like diseconomies of scales.

One suggestion Roubini and Mihm gave was to break up banks that are “too big to fail”.¹⁴ They reasoned that the collapse of Lehman Brothers and the resulting panic of financial market showed that some financial institutions had become so big and interconnected that their collapse would cause systemic effects. ¹⁵ But some economists present their worry and doubt about such radical move. Peter J. Wallison thought that the idea of too big to fail is at best a plausible theory. ¹⁶ The collapse of Lehman Brothers didn’t drag down any other financial firms. None of the institutions rescued after Lehman—Wachovia, WaMu, and AIG—were made insolvent or unstable or had to be rescued because of exposure to Lehman.¹⁷ Historical evidence revealed that unless the market is already in a panic, with many firms insolvent, the notion of too big to fail lead regulators to overreact. Besides, breaking up big banks may lead to big consequences like lack of diversification of risks and renegotiations of financial contracts. Breaking up big banks may not necessarily be a bad idea, but without a complete cost-benefit analysis the unintended costs may jeopardize the whole financial market.

Problems of credit rating agencies (CRAs)

Roubini and Mihm were critical of the role CRAs played in the financial crisis. They criticized CRAs for taking hefty fees from issuers of securities and letting toxic derivatives flow to the market. They called for a complete reform in rating system, namely that CRAs should be forbidden to offer any consulting or modeling services, more agencies should be allowed to evaluate the derivatives, and change in payment systems.¹⁸

I agree with the authors that more competition should be introduced in credit evaluation business. Historically, regulators have been using credit evaluation to oversee the financial market. During Great Depression, the Office of the Comptroller of the Currency (OCC) stipulated that banks not obtaining credit evaluation would be panelized, which introduced CRAs into financial regulation framework. In 1970s, regulators set up Nationally Recognized Statistical Rating Organization (NRSRO) to oversee the ever-increasing volume of securitization. Issuers of securities have to obtain rating from NRSRO in order to maintain the operation. This legislation was intended to help investors understanding the underlying risks of various derivatives, but for NRSRO members (S&P, Moody’s and Fitch), lack of competition led to oligarchic profits, which incentivized them to produce worse services. Credit ratings were severely inaccurate in the incidences of WorldCom, Enron, Parmalat and 2008 financial crisis, and it is hard to believe these are just random errors of CRAs. ¹⁹ However, NRSRO CRAs’ fees and profitability increased during 2002 and 2008. ²⁰ This implies that government-granted oligarchy in credit rating business has skewed initial objective as to provide accurate information; instead, issuers pay CRAs in order to issue the derivatives. In my opinion, introducing more competition can incentivize CRAs to develop better models to evaluate the bonds and stocks, and issuers can have more freedom choosing CRAs that provide better services.

“Deregulation” of financial sector

The authors’ argument on deregulation is in fact a widely accepted narrative why 2008 financial crisis. They attributed the cause to the repeal of Glass-Steagall Act and the failure to regulate the shadow banking systems, which incentivized excessive financial innovations like credit default swaps. (CDSs) I think it hilarious that authors argue that regulation was weak. Financial sector is the most regulated sector in America. Any responsible banking textbook would list page-long regulation implemented. During the so-called “free banking” era banks had to observe strict rules. Even the Glass-Steagall Act is only partially repealed: banks are still prohibited from underwriting or dealing with securities (Section 16) and securities firms cannot take deposits (Section 21). ²¹ Roubini and Mihm proposed that investment banks should be regulated like commercial banks and have access to deposit insurance, but I strongly oppose to this idea. Regulation is supposed to protect depositors from bad loans, but it is meant to protect commercial bank investors. Investors of securities should bear cost by themselves rather than rely on the lender of last resort. What’s worse, the new legislations are often superimposed on the current regulation mechanism, leading to massive overlapping and waste of resources.

As for the argument that fancy derivatives sprouted in lieu of loose regulation, I would say the opposite. The regulation has been strong over time, and to gain profit, firms have to figure out other ways to gain profits. Offshore banking emerges for regulatory arbitrage and rent seeking abounds because of tight regulation on branching and banking business. The regulation record is disastrous, but it seems that every time a crisis occurs, people long for another piece of law with no scrutiny of what the real cause is in the first place.

Roubini and Mihm criticized that collapse of CDSs led to market crisis, but such claim is questionable. Lehman Brothers was the biggest CDS player, but its bankruptcy didn’t drag down many of its counterparties. Nor did many firms it guaranteed CDSs for defaulted during the crisis. As for AIG, although most of its CDSs were written to guarantee the CDOs backed by MBS that were backed by toxic assets, it screwed up mainly because it didn’t hedge risk when writing swaps, which was a rather unusual case. Since most of the CDOs AIG was covering had lost value during the crisis and it didn’t sufficient collaterals to pay the counterparties, its bankruptcy would jeopardize market. However, considering that the obligation of the CDSs was between 25 and 41 billion, it might not cause systemic risk, which was the reason why the Fed bailed out AIG. ²² The two incidents might imply that CDSs are not as dangerous as many people assumed, but can we actually find out a way to make them safer? The authors discussed about the idea of having these fancy derivatives traded in a central clearinghouses.²³ Clearinghouses can mandate member banks to put in collaterals, assume the burden of the contracts if counterparty failed. But the authors’ worries were that clearinghouses might fail and investment banks would come up with other ways to avoid clearinghouses’ requirement. Some other economists have proposed some supplement strategies. Jeremy Kress argued that central clearinghouses should have access to emergency credit from central bank. ²⁴ (My worry about this proposal is moral hazard.) Professor Rizzo thinks that bailing out central clearinghouse would be easier than bailing out multiple individual banks. Peter J. Wallison worries about the potential cost for clearinghouse to oversee the CDS trading. ²⁵

Conclusion

One big impression I feel about Crisis Economics is that it is a book from the perspective of legislators. Roubini and Mihm seem to have a craving for legislation and additional regulation. Though they endorse the thinking by acknowledging that a necessary reckoning must take place over the longer term in order to achieve a return to prosperity²⁶, throughout the book I could only read recommendations for more government intervention and the notion that financial sector cannot correct itself, and it seems their mention of Austrian School thoughts was just a superficial courtesy to historical figures.

One problem I find in this book is the shortage of footnotes, making it hard to trace his sources and cross-match them with their arguments. What’s worse, the book is filled with non-innovative and costly solutions to fixing the financial system. I’m not saying that financial market shouldn’t be regulated. My point is that, given that there are already a lot of regulations overlapping one with another, superimposition of another piece of legislation might not be valuable. The causes of the 2008 financial crisis remains a puzzle for me, but some ideas that the authors presented can be excluded after a cross-matching of historical data and researches.

Overall, Crisis Economics is an easy-reading introductory book about what happened in 2008 financial market. However, I’m disappointed about this book because it doesn’t provide many refreshing thoughts and convincing evidence.

References and citations

1.  Nouriel Roubini and Stephen Mihm, Crisis Economics, (Penguin Books Ltd, 2010) pp19

2.  Ibid, pp33

3.  David R. Henderson and Jeffery Rogers Hummel, “Greenspan’s Monetary Policy in Retrospect”, Cato Institute, November 3, 2008

4.  Ibid

5.  Diego Valderrama, “Are Global Imbalances Due to Financial Under development of Emerging Economies?” Federal Reserve Bank of San Francisco Economic Letter no. 2008-12, April 12, 2008, Alan Greenspan, The Age of Turbulence: Adventures in a new world,(New York, Penguin Press, 2007), pp385-388

6.  Nouriel Roubini and Stephen Mihm, Crisis Economics, (Penguin Books Ltd, 2010) pp69

7.  Alan Reynolds, “The Truth About Those Billion Bonus”, Forbes, February 10, 2009

8.  Kevin Roose, “In Defense of Wall Street Bonuses”, NY Times, December 12, 2012

9.  Ing-Haw Cheng, Sahil Raina, and Wei Xiong, “Wall Street and the Housing Bubble”, National Bureau of Economic Research, March 2013

10. Nouriel Roubini and Stephen Mihm, Crisis Economics, (Penguin Books Ltd, 2010) pp70

11. Ibid, pp197

12. James Suroweicki, “Why Do Investment Banks Go Public”, Slate website, June 19, 1998

13. Alan D. Morrison and William J. Wilhelm, Jr., “The Demise of Investment-Banking Partnerships: Theory and Evidence”, Oxford Financial Research Centre Working Paper, July 2004

14. Nouriel Roubini and Stephen Mihm, Crisis Economics, (Penguin Books Ltd, 2010) pp223

15. Ibid

16. Peter J. Wallison, “Breaking Up the Big Banks: Is Anybody Thinking?”, American Enterprise Institute, September 18, 2012 

17. Ibid

18. Nouriel Roubini and Stephen Mihm, Crisis Economics, (Penguin Books Ltd, 2010) pp195-19   

19.  Claire A. Hill, “Why Did Anyone Listen to the Rating Agencies after Enron?”, Journal of Business and Technology Law, Vol. 4, pp283, 2009

20.  P. Jenkins, “DBRS to Challenge Big Agencies,” Financial Times (London), January 10, 2006

21.  Gramm-Leach-Bliley Act, Public Law 106-102, U.S. Statutes at Large 113 (1999): 1338.

22.  Peter J. Wallison, “Deregulation and Financial Crisis: An Urban Myth”, American Enterprise Institute, October, 2009

23.  Nouriel Roubini and Stephen Mihm, Crisis Economics, (Penguin Books Ltd, 2010) pp201

24.  Jeremy C. Kress, “Credit Default Swap, Clearinghouse, and Systemic Risk: Why Centralized Counterparties Must Have Access To Central Bank Liquidity”, Harvard Journal of Legislation, Vol. 48

25.  Peter J. Wallison, “Unnecessary Intervention: The Administration’s Effort to Regulate Credit Default Swap”, American Enterprise Institute, August, 2009

26.  Peter J. Wallison, “Does Shadow Banks Need Regulation?”, American Enterprise Institute, May-June 2012