Burst Bubble policy

What To Do When Big Bubbles Burst?

Capitalism is beautiful. It is a system whereby owners of appreciating assets can sit on their hands and still increase their wealth. For example, for more than a decade, people could buy a house, and with real estate prices increasing faster than incomes in general, the house was worth more that they paid for it. Their wealth increased without any labor. Anticipation of still further increases in asset values fueled still more increases in real estate prices. This is the stuff of bubbles that the world has seen in its history ranging from the South Seas Bubble, Mississippi Land Bubble, the Tulip Bubble, and more recently, the Japanese real estate bubble in the 1990's.
But, what happens when the bubble inevitably bursts, as it did in 2007-8? It does not take much. Just a little slackening in the rate of increase is enough to begin the reverse movement. Investors head for the exit, but the exits will always be overcrowded. Holders of assets find their wealth decreasing, again without any particular action on their part. Across the country, real estate has fallen by 20 percent, and in the hottest markets such as Florida, Arizona, California, and Nevada, the decline was 30 percent. Few can survive this kind of decline, neither home owners nor mortgage holders. Worst off are homeowners and investment firms that bought with immense leverage. When the market was going up, they profited hugely with very little money down, and when the market headed down, they suffered losses that few had the capital reserves to weather.
What can be done? Some don’t want to even think about it—people and businesses must pay for their sins and excesses, even if it brings the whole economy to ruin, the foolish and the cautious as well. However, the Republican government decided it could not live with big banks going bankrupt and further loans and credit going to zero. So, they rescued the banks by buying some of their mortgages and by adding to the bank reserve accounts kept at the Federal Reserve. The result was that most of the big banks survived, but the little guys with mortgages on their houses greater than the present worth of their homes, suffered. Suffered enough to lash out at the party now in power, voting them out of office and putting in the very party that helped created the bubble in the first place.
What could have been done differently? When a commercial bank makes a loan such as to an individual wanting to buy a house, it creates money. Out of thin air, if you prefer colorful language. When the loan becomes non-performing, money is destroyed, again out of thin air. By law, a non-performing loan becomes a charge against the bank’s own capital—its reserves, its building, etc. As already noted, to prevent the bank from bankruptcy and credit freeze, the Fed gave it reserves. There is another alternative that was never discussed. If declines in home values and broken mortgages is ultimately the result of a law, then the law could be changed.
The rule now causing such chaos serves a good purpose in normal times. It makes the banks consider extending credit without good assurance of repayment. It did not work. In the hubris of get rich quick, banks (and their customers) threw caution to the wind. In crisis times, sticking to the rule adds to the chaos. The law could be changed one time to get the economy out of its morass. If loans created money out of thin air, then the financial contracts can be voided in the same way (or at least greatly reduced) and the banks could start over doing what they normally do. This would have been an alternative to the Fed injecting huge amounts of cash into bank reserves. Moral hazard would be created in any case—the banks may act irresponsibly again if they believe that they are will be bailed out—whether bailed out by the Fed or by a change in the rule of non-performing loans being a charge against their capital. This is a problem we have to live with.
The average person does not understand what drove Bush’s Republican Treasury Secretary, Paulson, to bail out the banks, so they are not grateful for something they can’t understand. All they know is that a lot of money was thrown around and they did not see any of it. None of it helped them with their mortgage payments where the mortgage was larger than the depreciated value of their homes. So they are angry with the Democrats who happen to be in power when the pain peaked. When people are angry, they lash out at whatever they can see.
If the Treasury and the Fed had created money for a larger stimulus and mortgage relief, instead of bailing out the banks (when there was a better way to save them by a rule change), people and the economy would be a lot happier today. We are not the first society to destroy itself by clinging to obsolete institutions. The barriers to full employment are symbolic (in the air, if you will), but few economists or politicians are helping the public understand its options. Treating the problem as if it were a moral failure, as Paul Krugman has pointed out, may doom us to the Japanese experience of over a decade of negative and zero growth after a real estate boom so large it can’t be accommodated with old thinking. Capitalism with its inevitable booms and busts can be saved without so much pain, but it will take bold rethinking of our institutions.