Inside Job (31 page)

Source: Bureau of Economic Analysis; Federal Reserve

So then the US government spent $800 billion in emergency stimulus at a time when tax receipts were sharply contracting, while Republicans blocked efforts to return taxes for the wealthy back to
their pre-Bush levels. As a result, deficits continued to widen and the US national debt has grown by roughly 50 percent as a result of the crisis (again, depending on how you count
it).
⁴
  Then, with the end of federal government stimulus spending, many local governments went into crisis, leading to severe cuts in education,
child care, and other services critical to economic welfare. And the pain continues. Poverty rates have soared, millions of American homes are in the midst of repossession—with only
friendlier laws keeping British homes out of banks’ hands. As of early 2012, official unemployment remains at more than 8 percent, US economic growth is anaemic, and Europe is slipping into
recession.

Europe was forced into massive stimulus spending too, which increased their debt loads and contributed significantly to European sovereign debt problems. Indeed, the effects of the US housing
bubble and financial crisis deserve far greater attention in the debate over the Eurozone debt crisis. It is true that the EU system and many Eurozone nations have various structural rigidities
that have reduced growth and increased borrowing. It is also true that some of these nations, particularly Ireland and Spain, experienced property bubbles of their own. However, it is also true
that, with the exception of Greece, most of them (including those whose indebtedness is now so extreme) had perfectly manageable debt levels until the financial crisis.

At the beginning of 2008, Greece had the highest ratio of debt to GDP in the Eurozone—and its ratio was less than 110 percent. Italy’s was slightly lower, just over 100 percent.
Ireland’s debt to GDP ratio was under 70 percent; Spain’s was about 40 percent; and Portugal’s was only about 25 percent—far lower and more conservative than the US,
Germany, or most other developed nations. But by the start of 2012, Greece’s debt level was 170 percent of GDP, Ireland’s was over 100 percent, Spain’s was over 60 percent, and,
stunningly, Portugal’s debt
to GDP ratio had more than quadrupled to 110 percent. These catastrophic increases were not caused by sudden, simultaneous outbreaks of
lavish spending—nothing like, say, the borrowing and spending binge that characterized the US during the bubble. Rather, this huge, sudden increase in Eurozone debt to GDP ratios was caused
by the Great Recession, combined with the need for emergency stimulus (deficit) spending to avert total economic collapse. In other words, it was caused by the US financial sector.

As of this writing, we do not yet know how the Eurozone debt crisis will play out. But its effects have already been horrific. Much of the Greek population now lives in misery, with rioting
increasingly frequent. Youth unemployment in Greece, Spain, and Portugal now exceeds 50 percent. Several nations in Eastern Europe, including Hungary and Latvia, were economically devastated, and
the crisis pushed Hungary into an extremist government that is threatening its status as a democracy. Extremist political movements have gained surprising strength across Europe, including in
France and even Scandinavia, especially Finland.

Asia was less affected. Even so, ten million migrant workers in China lost their jobs virtually overnight in 2008–2009. But China recovered more quickly than other nations, in part due to
a $500 billion emergency stimulus programme initiated by the Chinese central government.

It’s impossible to come up with a single, reliable number for the cost of all this, but it is certainly trillions of dollars, probably tens of trillions. Beyond the economic costs, there
has been a great deal of human suffering, and America’s financial and economic institutions and reputation have been discredited in the eyes of the world.

And who benefited from the predatory bloating of American finance? Mainly a relatively small number of people in the financial sector—maybe fifty thousand, a hundred thousand at
the very most—became very wealthy on the backs of your pain. At the peak of the bubble, the
average
annual income of a Goldman Sachs employee was $600,000; and even within investment
banking, incomes are heavily skewed toward the very top. (Recall Mr Thain’s bonus decisions at Merrill Lynch, where about half of total bonus payments went to the top
thousand people.) Over the course of the bubble a larger group of people, perhaps half a million in total, made
some
money, perhaps averaging $500,000 each, by accident, petty
dishonesty, and speculation—lowerlevel bankers, dishonest appraisers, mortgage brokers, house flippers, subprime mortgage loan officers, estate agents in bubble regions. But this was not an
industry or an endeavour that benefited millions of honest, average Americans. Only the suffering was widely distributed.

If nothing else, the experience of the 2000s should squelch the fantasy that an unregulated financial industry inevitably channels capital to its best uses, or that bankers’ concern for
their sacred reputations would prevent them from putting their institutions or customers at risk for mere money.

But perhaps the housing bubble and financial crisis were just a once-in-a-thousand-years tsunami, one of those random perfect storms that you can’t predict or control? Or an epidemic
of abuse that won’t be repeated now that everyone has learned their lesson?

Not so. First, recall the historical record since deregulation began: the S&L and junk bond bubbles and crises of the 1980s; the 1987 stock market collapse; the derivatives-driven fiasco at
Long-Term Capital Management; the Internet/technology stock bubble of 1995–2000. If we include other nations that undertook similar deregulatory experiments, we can add bubbles and crashes in
Iceland, the UK, and several other countries. So while the US housing bubble and financial crisis were worse than others, they were far from alone.

But second, if you look under the hood, as Rajan started to do in 2005, it turns out that America’s new, unconstrained financial services industry is
inherently
dangerous. The
instability, dishonesty, bubbles, and crises are not incidental; they are the inevitable result of uncontrolled greed searching for private gain at public expense, intensified by the increased
velocity and game playing created by information technology.

But
why
, exactly, is America’s financial sector now so inherently dangerous? There are five principal drivers of catastrophic risk in modern unregulated finance. They are
volatility, leverage, structural concentration, systemic interdependence, and toxic incentives. When
combined, they make for quite a wonderful high
explosive. Or perhaps a better metaphor is a cocktail laced with cyanide.

We will start with volatility, particularly the industry’s recent shift to much greater reliance on short-term financing.

Since deregulation began, banks—especially investment banks—have increasingly depended upon short-term borrowing from financial markets. In contrast, traditional
commercial banks obtain money by taking deposits from consumers. This is borrowing, too, and in principle savers can request their money back at any time. But in reality, consumer savings are
generally very stable (unless there is a panic leading to a bank run).

All financial institutions, including investment banks, also traditionally borrowed by issuing long-term bonds. But one of the striking features of the buildup to the financial crisis was the
very marked shortening of the average maturity of financial sector debt. Instead of issuing long-term bonds, investment banks began borrowing ever larger sums from short-term lenders such as money
market funds. The primary reason for this radical restructuring was simple: it was far more profitable, because short-term interest rates are lower than long-term rates.

But it was also risky and destabilizing. These short-term borrowings have to be constantly rolled over, or renewed, and if the financial system ever ran into problems, the renewals would stop,
driving the system into crisis in a matter of weeks, or even days. The graph on page 218 shows the sharp increase in this short-term borrowing.

The big American investment banks accounted for a large share of this surge in short-term borrowing. They used it to take risks—to purchase assets, some intended for eventual resale,
others that they gambled would be profitable to keep. Table 3 on page 219 shows the “trading books”—that is, the asset holdings—and short-term borrowing levels at the six US
financial firms with the largest investment banking and trading operations as of year-end 2007, when the crisis began.

Source: UK Financial Services Authority

Moreover, note that astounding $357 billion in
negative
operating cash flow. Most of that reflected the constant growth of assets. But a second reason is that banks can count unrealized
gains on their trading assets as profits in the current period, so there was often a big gap between reported profits and actual cash flows. This is another destabilizing force. In normal times, if
the banks need some cash, they can sell some of their assets. But what if those assets suddenly plunge in value because they were overvalued during a bubble? What if a crisis forces all the
banks to sell assets at the same time, causing a glut, forcing prices down? The banks loved so-called mark-to-market accounting during the bubble, but then frantically tried to ditch it
during the crisis.

As a safety measure, most of the short-term borrowing was collateralized, or secured by the banks’ posting supposedly safe securities as a guarantee. If the bank couldn’t repay its
loan, the collateral could be confiscated and sold. Originally, US Treasury bonds were the only acceptable collateral, but during the bubble lenders started to accept mortgage securities. After
all, they were rated AAA—as safe as Treasury bonds, right?

This was an accident waiting to happen, and it did. The short-term lending volumes were massive and growing rapidly. The “collateral” was composed of shakier and shakier instruments,
some of them fraudulent. Bankers were making enormous amounts of money by keeping the hamster wheel spinning. The wheel spun faster and faster until it flew off into space.