What Economic Historians Think About the Meltdown

Corporate debt. Housing markets. Foreclosures. Contracted liquidity. These terms are synonymous with one that has been flooding headlines and creating unrest for anyone with a bank account: the subprime mortgage crisis. What began as rapacious arrangements between financial institutions and under-banked borrowers led to global economies being dragged into the daunting direction that some believe could spell depression. Are we repeating history? Or is this a new breed of greed?

“The United States is in the midst of a serious financial crisis, probably the worst since the 1930s,” explains Professor Jon Cohen, an economic historian from the University of Toronto. “In addition, unemployment is up, factory orders are down, and consumers are tightening their belts.  It may not yet be official but it is fairly safe to say that the country is in recession.”

Berkeley Professor Jan de Vries opines that the United States is facing a credit crisis. “This began,” she says, “with a major under assessment of risk in mortgage lending, but extended via securitized mortgage debt instruments to the rest of the financial sector here and abroad.”

New York University Professor of Economics, Robert E. Wright concurs: “Many new types of mortgages were made on the expectation that rising home prices would cover over any problems related to lending to 'subprime' borrowers. When home prices began to fall, an unexpectedly high percentage of homeowners began to default. That caused major problems throughout the global financial system because of the widespread practice of 'securitizing' mortgages, of lumping them together, slicing them into risk-adjusted pieces called 'tranches,' and selling them to investors throughout the world.”

"It is important to note" says Cohen, "that the value of these asset-backed securities depended on the value of the underlying assets.  If the mortgagees paid their mortgages in a timely fashion, everything was fine.  If they fell behind on their payments, if, god forbid, they defaulted and foreclosure ensued, things were not so fine.  It became clear in 2007 – to many, it was clear much earlier – that things were not so fine in the asset-backed securities market. Firms with large positions in these securities saw their asset and capital base collapse and, with it, their solvency." de Vries lends a different perspective: "The proximate cause is the housing bubble, fueled by federal government policy [namely the] encouragement of  home ownership; guidance to banks to loan to marginal borrowers; [and the Federal] low-interest policy after 9-11."  

Nancy Koehn, James E. Robison Professor of Business Administration at the Harvard Business School, says there is plenty of blame to go around. "Clearly," she notes, "there was a failure of governance on the part of leaders in financial firms—executives, managers, traders, boards of directors. And in the United States, it seems the rating agencies have much to answer for in their assessment of the debt that is now so questionable. Fannie and Freddie and the political winds behind these institutions swept lending standards (and common sense) aside in a rush to promote home buying, even among households who simply could not afford to buy a home."

Professor de Vries agrees: "There are many guilty parties," she says. "The leaders of the financial institutions bear the brunt of the blame, since they either steered with open eyes into the new high-leverage environment, or they did not understand the techniques their institutions were relying on to make their high profits. More generally, " she adds, " 'deregulation' seems to be a minor player, most evident in retrospect, in this process."

Cohen doesn't believe anyone is to blame. "At least not in the conventional sense," he says. "It is argued by many that deregulation played a central role in the debacle but it is probably more accurate to say that poor and uncoordinated regulations were more responsible. In any case, by 2006, housing prices in many areas made no economic sense, access to mortgages was too easy, and huge amounts of leveraged money had gone into assets whose riskiness was, at best, difficult to assess."

Koehn believes that there is at least another factor at work here, "an overall suspension of responsibility on the part of executives who played too fast and loose with fiduciary obligations (and then took home ridiculous pay packages after destroying enormous value), on the part of consumers who have been buying more than they can afford for years (against better judgment) and on the part of  public officials who have generally been afraid to look hard and long at what was happening to the casino of capitalism and what this meant above and beyond short-term political considerations and the lobbyists' market that helps shapes these."

In short, "The financial system in the United States is in terrible shape," Cohen summarizes. Wright, who shares this belief, says that he would not go so far as to say that circumstances would lead to another Great Depression. "A recession, however, is well-nigh inevitable because our major trade partners are already in recession and the U.S. economy has stayed out of recession this year due solely to increased exports, which were largely a function of the greatly weakened dollar." Professor de Vries expands on this: "Whether it is very serious in terms of  financial and employment losses to the public at large, a depression is not entirely clear. What we do in the next months could still have an influence on this outcome."

So if not the Great Depression, what past crisis in the Unites States or elsewhere could the subprime mortgage crisis be compared against? "Mark Twain once said that history does not repeat itself but sometimes it does rhyme," Koehn says. "The panic of 1907 certainly 'rhymes' with this moment." Professor de Vries notes that although the Crash of 1929 and the subsequent Great Depression is a comparison that come readily to mind, it may be more relevant to compare it to more purely financial panics, such as 1907.

"All major panics," explains Wright, "follow the same basic outline: asset bubble, massive leverage (borrowing to buy the rising asset), bursting bubble (asset price declines rapidly), defaults on loans, asymmetric information and uncertainty, reduced lending, declining economic activity, unemployment, more defaults. In 1792, 1987, 1997-98, and 2001, the government was able to stop panics in their tracks. In 1819, 1837-39, 1857, 1873, 1884, 1893-95, 1907, and 1929-33, it either did nothing or failed to stop the panics from spreading and deepening before they severely damaged the economy."

Wright believes the mortgage crisis will be an important part of history and will be presented as the final culmination of the success of modern central banking if everything turns out okay and doesn't get any worse. Although she is sure the crisis will be taken up in future economic histories of the US and of the international economy, de Vries questions just how significant it will be. "It is possible that timely corrective policies (monetary, fiscal, and institutional) all suggested by analogy with the 1930s will prevent the worst from happening,' she says. "But, since history does not really repeat itself in such a convenient way, the odds of such a happy ending are probably not very great.  A surprising outcome will make our current situation more important historically."

"The great fear of everyone is that this is the Great Depression Redux," concludes Cohen. "It is not. We may experience a recession, but the probability of this turning into a long period of negative growth with very high rates of unemployment is close to zero. The Great Depression was, largely, a product of bad economic policies and inadequate institutions.  We have the institutions and we know what needs to be done."