If two-thirds of a group of conspirators avoid prosecution, trial, and imprisonment, but the other third does not, has justice been served? That’s a question raised by the movie The Big Short’s treatment of the 2007-2009 financial crisis. The movie is a dramatization of Michael Lewis’s non-fiction book, The Big Short: Inside the Doomsday Machine.
This is not a review of The Big Short, which was entertaining and amusing, with clever writing and strong performances by Christian Bale, Ryan Gosling, and Steve Carell. The movie did not, however, feature a viable explanation of the causes of the financial crisis. Yes, bankers offered mortgages to people who could not afford them, bundled them into junky mortgage-backed securities and more complicated debt instruments, and with the help of asleep-at-the-switch ratings agencies, regulators, and government-blessed mortgage finance agencies, sold them to speculators and investors whose due diligence extended no further than the triple-A rating.
So The Big Short justifiably prosecutes and would like to put in jail the bankers and ratings agencies, but aside from light slaps on the wrists (a heavily leveraged, pole-dancing real estate speculator and a regulator-regulated revolving door vignette), the two other major conspirators—feckless, often dishonest mortgagees and the government—get off scot-free. However, even if the movie had figuratively hauled them off to the hoosegow, it missed entirely the real cause of the financial crisis: financial and political gravity. Gravity doesn’t make for very good cinema, but it’s an appropriate subject for an SLL piece. (SLL doesn’t have a $100 million production and advertising budget to cover, will never be in contention for an Academy Award, and only needs to appeal to an audience that’s maybe one-day’s tally of Big Short viewers at a typical Megaplex.)
Regulatory capture is the first law of political gravity. Reformers set up a regulator for a perceived social ill, pat themselves on the back, and move on to the next cause, while the regulated sabotage the scheme and turn it to their own ends. The regulated have every incentive to do so—it’s often a matter of economic survival—and everybody else, including the supposed beneficiaries of the regulation, have little incentive to engage in the constant bureaucratic, legislative, and judicial infighting necessary to force the regulators to adhere to the stated purposes of the enabling legislation. So all regulation, without exception, devolves into the cynical charade we’ve come to know and loath: lobbying, influence peddling, legal and illegal bribes, revolving doors, use of the regulatory process to cripple competitors and competition, cartelization, and an identity of interests between the regulator and regulated.
It’s no surprise, then, that the banks and their regulators, particularly the Federal Reserve, are in bed together, and have been for over a century now. There is a free market, highly effective regulator of bank behavior: bank runs. In fractional reserve banking, banks will never have enough immediately available money if a large enough percentage of depositors all want their deposits back at the same time. That possibility keeps bankers honest. They extend loans to borrowers who can pay, maintain a prudent level of cash on hand, are selective about the banks with which they establish correspondent relationships, and do their best to appear as sober, solid, confidence-inspiring members of their communities. Such bankers usually weather the inevitable financial squalls, building reputations for probity, while their intemperate, grasping brethren do not. Over time, customers, the smart ones at least, gravitate towards the former and shun the latter.
Bank regulation has replaced this highly effective free market regulatory mechanism—actually making it the enemy—with a highly ineffective, corrupt, and captured panoply of laws, regulations, and agencies. The Fed’s lender of last resort function, deposit insurance, extensive regulation, and the too-big-to-fail doctrine enshrine the political impetus to banish bank runs and their potentially destabilizing, albeit salutary, effects. The government has become the guarantor of the banking system. A second law of gravity: set up a system whereby heads, the bankers win, tails the government (and taxpayers) lose, and the banks and bankers will win and the government (and taxpayers) will lose, repeatedly, until that system is eliminated.
A third law of gravity: governments establish central banks to benefit governments. Fiat money (actually fiat debt, see “Real Money”) gives the government the first user advantage; it gets to spend it and command resources before its fiat money depreciates. That depreciation benefits debtors at creditors’ expense, and governments are invariably debtors. As debtors, governments benefit from lower, central bank-suppressed interest rates. Finally, governments realize political benefits from central bank debt promotion. An increase in debt can produce a short-term, constituent-pleasing bump in economic activity.
A fourth law of gravity: government and central bank debt divorced from the underlying economy will invariably grow faster than the economy as debt’s marginal impact diminishes, and suppressed interest rates and abundant debt-based liquidity will promote malinvestment and increase consumption and speculation at the expense of savings and investment, leading to unsustainable standards of living, indebtedness, and asset bubbles. The fifth and final law of gravity: that which is unsustainable will not be sustained; the system collapses.
These laws of gravity—not ignorant, foolish, or greedy homeowners and house flippers; not greedy, unscrupulous bankers, ratings agencies, and investors in securitized, subprime garbage; not the government’s and the housing finance agencies’ incompetent and corrupt promotion of home ownership and mortgage finance—are the “cause” of the last financial crisis. Or more correctly, the crisis was the inevitable consequence of gravity’s inexorable operation. A reliable facet of any collapse is that its leading edge will be the financial and economic sector towards which the most credit—relative to that’s sector’s ability to service debt—has been channeled. In 2000 that was the technology sector; in 2007 it was housing and mortgage finance.
SLL noted over a year ago that this crisis’s leading edge was commodities (“Oil Ushers in the Depression”), towards which superabundant credit had been channeled based on a fallacious belief in the perpetual growth of the Chinese economy at double-digit rates. That reality is still not generally grasped, even as credit and economic contraction, falling prices, and gluts have spread around the world, from commodities to transportation, production, distribution, wholesale, and retail. General recognition will leave the current, already battered levels of equity indexes as distant specks in the rear-view mirror.
There could be silver linings. After the ultimate crash, market-based money may replace worthless fiat scrip. Bank risk may be “unsocialized”: banking without government and central bank safety nets. And somebody, perhaps Michael Lewis, may write a book about the religious beliefs in the China growth story and the ability of central bankers to control the global economy; the insanity of negative interest rates; the opacity of balance sheets produced by banks allowed to mark asset values to their own assumptions and models, not to market prices, and the travesty of economic policies that reward leverage, speculation, and a small coterie of crony insiders while penalizing savings, investment, integrity, and honest economic effort. If we’re lucky, that book will serve as the source for a movie as entertaining as The Big Short.
From Daniel Durand, speaking in 1913 from the novel The Golden Pinnacle:
What the government gains from monetary debasement, the wage earner loses. Adjustments to his wage won’t keep up with money inflation. As for promoting economic stability, look at the railroads. Every line upon which the government has laid its ‘benevolent’ hand has come to ruin. You want to make it responsible for the entire economy? The Wall Street moneyed class will a field day with elastic money and financial instability. It’s your average wage-earning American who will be hurt the most.