Recession Deniers Peddled the Same Lame Excuses: Caroline Baum

Commentary by Caroline Baum

— Every recession has its own set of drivers, its own unique circumstances, all put in motion by the central bank’s eternal quest to find the appropriate overnight interest rate to deliver economic Nirvana.

The 2001 recession witnessed the bursting of the dot-com bubble and pullback in business investment. This time it was the implosion in housing that infected banks, impairing their capital and prompting them to constrict the supply of credit to businesses and consumers.

What’s constant from one cycle to the next, however, is the elaborate web of excuses folks weave to deny reality and convince themselves that this time is different.

Now that Robert Hall, the chairman of the group entrusted with dating the business cycle’s peaks and troughs, has said he sees “conclusive” evidence of a recession, it’s a good time to look back and see where the herd went wrong.

1. The crisis is “contained.”

During the Cold War, the U.S. pursued a policy of containment vis-a-vis the Soviet Union. The idea was to maintain “a long-term, patient but firm and vigilant containment of Russian expansionist tendencies,” according to diplomat and historian George F. Kennan.

Containment may have worked in Western Europe; the Berlin Wall came down in 1989. It failed as a way of looking at the subprime crisis in the U.S.

When banks began to report losses and writedowns on their portfolio of subprime loans as early as February 2007, U.S. policy makers expressed confidence the fallout would be limited.

Guns of August

In August 2007, as a tsunami washed over the credit markets, Treasury Secretary Hank Paulson was still saying the damage from the housing correction was “largely contained.”

In May 2008, he reiterated his view that “we are closer to the end of the market turmoil than the beginning.”

Now he’s handing out cash as fast as Congress will give it to him.

A government official has to maintain something of an upbeat outlook even when times are tough. Coming across as out of touch doesn’t inspire confidence.

The crisis wasn’t contained to subprime mortgages, the residential real estate market or the country as a whole. Which brings us to…

2. The rest of the world is “decoupled” from the U.S.

Decoupling is another borrowed term, this time from the sciences. (Why do economists keep borrowing pop theories from other disciplines? Don’t they have enough of their own?)

In physics, decoupling applies to the disappearance of interactions between physical objects. In biology, it has something to do with mitochondrial proteins. Economists went right from DNA to GDP.

With emerging nations in Asia roaring these past few years, developing a middle class of consumers, the world was supposed to be less dependent on the U.S. as a destination for its exports. Thanks to decoupling, no longer would a U.S. sneeze disperse the cold virus to the rest of the world.

The reality turned out to be something different. America exported its subprime crisis (see No. 1 above) to Europe, which saw real GDP contract in the second quarter. U.K. economic growth fell in the third quarter for the first time since 1992, following no growth in the second.

Asian economies are slowing as well. Even China, which saw real GDP dip to a five-year low of 9 percent in the third quarter, announced a fiscal stimulus plan of 4 trillion yuan ($586 billion) this week.

3. The inverted yield doesn’t matter.

Two simple interest rates, so much information contained in them.

The spread between the fed funds rate, controlled by the Federal Reserve, and the market-determined 10-year Treasury note yield inverted in July 2006. When the Fed is holding the short rate above the market-determined long rate, it’s a sign policy is tight.

No matter. When the economy looks fine, as it did in 2006, economists are quick to dismiss the inverted yield curve, arguing that — you guessed it — this time is different!

That difference was articulated by Fed Chairman Ben Bernanke and a host of others as a result of a global savings glut, as if that was supposed to somehow negate the predictive powers of this leading-est of leading economic indicators.

4. Banks have no exposure to mortgages.

This was a doozy, popularized in early 2006, just as some of the more egregious mortgage-lending practices were floating to the surface. Who cares if a mortgage loan stops performing? The bank sold it a long time ago.

Something sounded very wrong, so I went to that treasury of statistics, the Federal Reserve’s Quarterly Flow of Funds report.

When I reported my findings in an April 18, 2006, column, mortgages accounted for 32 percent of commercial banks’ financial assets as of the fourth quarter of 2005. If you included agency-and mortgage-backed securities, the exposure to outright and securitized mortgage loans was 44 percent.

Banks’ mortgage exposure shrank to 41 percent in the second quarter of 2008, but it’s still far and away the biggest category of assets on the balance sheets.

Between then and now, we learned that banks were holding portions of the loans they securitized — in some cases, off their balance sheet.

5. Derivatives spread the risk.

This tenet of one-time Maestro Alan Greenspan, who argued adamantly against regulating derivatives, has come up for review.

Wall Street’s financial engineering transformed plain vanilla derivatives, or instruments derived from an underlying asset, into toxic waste that no one understood. Until they were tested in the real world — a world where housing prices fell on a national average basis — and not in the computer laboratory, no one knew how they’d perform or the extent of the risk.

Derivatives may have been designed as a hedging vehicle, but they are widely used to speculate. They “transformed a financial brush fire into a conflagration,” New York Times columnist Gretchen Morgensonwrote in the Nov. 9 Sunday Business Section.

A conflagration, of course, is anything but contained.

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