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Martin Feldstein on the Origins of the Crash
Martin Feldstein, Harvard economics professor and former Chief Economic Advisor for President Reagan, 1982-84, was interviewed for PBS’ Frontline program, "Inside the Meltdown." Following are some excerpts from an extensive interview that provided some of the background for the expose on our financial crisis.
I think [Greenspan] was wrong in the early part of this decade, when fearing deflation, fearing of falling prices, he brought down interest rates very dramatically and announced that interest rates would be held at a low level. The advantage of that, he thought correctly, was that it would bring down medium-term rates….But by promising that those rates would be kept low for quite a while, he brought down longer-term rates. That, in turn, brought down mortgage rates; that stimulated the housing market and took us away from the deflation that he feared.
He explained at the time that it was a balance of risks. On the one hand, if you didn’t do something like this, there was the danger that the price level would continue to decline. Since you could only bring interest rates down to zero, if the price level was actually falling, the real cost of funds, meaning interest rates adjusted for inflation, would be greater than zero, and the economy could slow more and we could deflate faster, and so the real interest rate would be even higher, and we’d be in a trap from which the Fed could not rescue us. So that was the risk on one hand.
But there was also the risk that if you lowered interest rates a lot, it would lead to inflation. And he said: “There are these two risks, and I have to make the judgment about which was the greater risk.” And he said, I think correctly, that between those two risks, the greater risk was deflation, because if we had moved back up to an inflation rate of, say, 4 or 5 percent, well, the Fed knows how to cure that problem.
What he didn’t take into account was the risk of a rapid rise in asset prices….And it’s the asset bubble, particularly in housing, but also in the stock market, that has become a major problem for us now in the ending years of this decade.
[Following is a bit of a tutorial on the tools available to the Federal Reserve]
What the Fed does is called monetary policy, and more recently might be called credit market policy. What the Treasury does – taxes, tax cuts, tax increases, spending – is called fiscal policy….Monetary policy means changes in interest rates, changes in the money supply. It’s what the Fed does.
Credit policy – we’ve seen recently the Fed providing all kinds of credit and credit guarantees, offering to buy commercial paper and things like that. The Treasury can also engage in credit policies, providing guarantees to money market mutual funds as they did. And fiscal policy, actual outright purchases of goods and services, spending on everything from transfer payments to defense, that’s the job of the Treasury and the Congress, of course.
[What are credit default swaps, and what role did they play in the crisis?]
A credit default swap is a kind of insurance policy. A bank makes a loan to a company; it’s a concern that it’s a large loan….It says either I have to sell off some of this loan to others, or I have to find some way of getting a guarantee or getting somebody who will back up this loan in case it defaults.
So it buys what is called a credit default swap. It buys a kind of insurance policy that says if that loan fails, then the people who have sold the credit default insurance will pay up the amount of default to the first bank. So it’s a very good idea because it allows banks to make loans to institutions they know and yet not have to bear all of the risk, and it does it in a very efficient way.
The trouble is that once this good idea got going, people realized that this could be used not just to provide insurance for somebody who made a loan, but any two people who had different views about the likely solvency, the ability of Ford Motor Company to pay the interest on its bonds, could agree to buy and sell a credit default swap. And so we ended up having vastly more credit default swaps outstanding than there were really insurance interests, people who had the initial claims; $62 trillion of credit default swaps were out there. And anything anybody had any risk on, there was an opportunity for people to take a gamble on that, in some cases to protect a position, in other cases just because two consenting adults wanted to gamble with each other.
It was a market. We have lots of markets. We have puts and calls on stocks where you don’t have to own the stock to buy a put or a call. And so it’s not different from a lot of other markets, but it was very, very, very big.
And once defaults began to happen, then a lot of institutions that had sold this insurance were in trouble because they had to pay up to others who were recipients of this, who had bought the insurance. And it wasn’t just somebody who had an insurable interest, somebody who had made a loan or held a bond, but somebody who was just speculating on the risk that that particular default would occur.
And it wasn’t just Joe paying Peter and Peter paying Bill; some of those institutions went bankrupt. When they went bankrupt, they couldn’t pay. So half of the transaction paid and the other half didn’t pay, and that added to the chaos….
I spoke (to) a Federal Reserve conference in the summer of 2007, that this combination of credit default swaps on mortgage-backed securities…was a potentially very, very dangerous combination; that the decline in house prices that had begun in the summer of 2006 was because of these mortgage-backed securities and because of the derivatives based on these mortgage-backed securities, that this could do tremendous damage to the balance sheets of financial institutions….
Once you understood that that was out there, then you had a pretty good idea that this was a very serious problem, and that as house prices came down, we would see more mortgages becoming greater than the value of the house; we’d see more people with less equity in the house, with negative equity in their homes, meaning their loans would be greater than the value of the house, and that that would cause very serious problems….
The credit crisis in the banks, the unwillingness to lend to each other and to others, really reflected the fact that there was a lack of confidence on the part of the banks in the creditworthiness of other financial institutions. And why? Because everybody knew that everybody else had these mortgage-backed securities and fancy derivatives based on these mortgage-backed securities. They didn’t know how much, but what they knew was that those things were not worth what they claimed to be on paper, and therefore the danger was that another institution to which you lent wasn’t going to be able to pay you back…..
So, the easiest thing for a financial institution was to say: “Thanks, but no thanks. I don’t want to lend to other financial institutions.” So our credit markets really froze up, and lending stopped.