NBER WORKING PAPER SERIES

THE BIG CON – REASSESSING THE "GREAT" RECESSION AND ITS "FIX"

Laurence J. Kotlikoff

Working Paper 25213http://www.nber.org/papers/w25213

NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts Avenue

Cambridge, MA 02138November 2018

I thank Boston University for research support. This article is forthcoming in Ten Years After the 2008 International Financial Crisis, a special Issue of Acta Oeconomica, Peter Mihályi, ed. 2019. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research.

NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

© 2018 by Laurence J. Kotlikoff. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

The Big Con – Reassessing the "Great" Recession and its "Fix"Laurence J. KotlikoffNBER Working Paper No. 25213November 2018JEL No. G01,G1,G2

ABSTRACT

Most economists differ, not on the causes of the Great Recession, but on their relative importance. They concur, though, on the basic problem, namely human, not market failure. This study applies the evidence, some new, some old, to re-try the usual suspects. It finds none guilty. Instead, it identifies broadly defined multiple equilibrium, mediated by opacity, false rumors, and panic, as the real culprit. There are many models of bank runs. But each can trigger firing runs – firing someone else’s customers for fear that others are firing your customers. Firing runs, in turn, exacerbate bank runs, producing a vicious cycle. This cycle can be manipulated by those who benefit from economic distress (short sellers). If the banking system, not the banking players is the problem, the solution surely lies in fundamental banking reform. This paper concludes by pointing out that a reform that shifted to 100 percent, equity-financed mutual-fund banking with government-organized, real-time asset verification and disclosure could preclude financial runs and their ability to induce firing runs.

Laurence J. KotlikoffDepartment of EconomicsBoston University270 Bay State RoadBoston, MA 02215and The Gaidar Institute for Economic Policyand also NBERkotlikoff@gmail.com

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IntroductionTenyearsaftertheGreatRecession(GR),economistsstilldebateitscausesandpolicymakersstillwonder how to prevent the next financial crisis. MIT finance professor, Andrew Lo (2012),reviewed21booksonthefinancialcrisisbyeconomists,bankersandjournalists.Heconcludedthat1

…(thereis)significantdisagreementastowhattheunderlyingcausesofthecrisiswereandevenlessagreementastowhattodoaboutit.Butwhatmaybemoredisconcertingformosteconomistsisthefactthatwecan’tevenagreeonallthefacts.

ThispaperarguesthattheallegedcausesoftheGRareeithera)unsupportedbythefacts,b)disconnectedfromeconomictheoryorc)descriptionsofGRoutcomes,notGRcauses.Next,itpointsoutthatthe“Great”Recessionwasnotparticularlygreat,suggestingthatitsverytitleispartoftherecession’sself-generatedhysteria.Thisdebunkingofthe“bigcon”–thestandardnarrativeoftheGRandtheallegedDodd-Frankfix--isfollowedbyanalternativeandseeminglyobviousviewofwhatproducedthislatestinalonghistoryofU.S.bankingfailuresandeconomicdownturns–pure,misinformedpanicthatflippedtheeconomy’sequilibrium.Tobesure,mytakeisanoutlierrelativetothestandarddiagnosisoftheproblemanditscure.Thestandardviewisthatthehousingmarketexperiencedabubble,thatregulatorswereasleepat thewheel, lettinghouseholdsandbanksoverleverage, thatWall Streetmanufacturedandovervalued dangerous, complex derivatives, that conventional and shadow banks issued andthen sold fraudulent subprimemortgages, that rating companieswere routinely bribed, thatfinancialtraderstradedtoomuch,thatshadowbanksoperatedoutsideofregulatoryscrutiny,thatCongressforcedFannieMaeandFreddieMactoencouragesubprimes,andthattherewastoomuchrisktaking.TheFinancialCrisisInquiryCommission’sPostmortemTheFinancialCrisisInquiryCommission’s(FCIC)wasestablishedin2009toinvestigatethecausesofthe2007-2010financialcrisis.Itsreport,deliveredinJanuary2011,includesthissummary,Therewasanexplosioninriskysubprimelendingandsecuritization,anunsustainablerisein housing prices, widespread reports of egregious and predatory lending practices,dramatic increases in household mortgage debt, and exponential growth in financialfirms’tradingactivities,unregulatedderivatives,andshort-term“repo”lendingmarkets,amongmanyotherredflags.Yettherewaspervasivepermissiveness; littlemeaningfulactionwastakentoquellthethreatsinatimelymanner.2

1 Lo, Andrew W. "Reading about the financial crisis: A twenty-one-book review." Journal of economic literature 50, no. 1 (2012): 151-78. 2http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf

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Thealliteration,“pervasivepermissiveness,”hasaniceringtoit.Italsosumsupintwowordsthestandardassessmentandlaysthefoundationforthechosenremedy.Itimpliesthattheproblemlaywithpeople,notwiththeintrinsicnatureoftheeconomyorthebankingsystem.Italsosaysthat banking’s fix is to ensure that people, including bankers, raters, regulators, investors,politiciansandborrowers,behave.LiarLoans,NoDocLoans,NINJALoansandOtherSubprimeMortgagesRashesareasymptom,notthecauseofmeasles.Nomedicaltextbookwouldmistakethetwo.Yet the causes of the great recession seem largely a description of what transpired, not anexplanationforwhyeventsunfoldedastheydid.Oftenthesedescriptionsarepoorlydisguisedexaggerations.Takesubprimemortgages.ToreadtheFCICreport,letalonewatchthemovie,TheBigShort,onemightconcludethatamajorityofoutstandingmortgagespriortotheGRweresubprimes.Indeed,theFCICreportfeaturestheword“subprime”on41.5percentofits662pages.Itmentionstheword“mortgage”on69.9percentofitspages.Hencesubprime-mortgagereferencesrepresentalmost60percentofallFCICreferencestomortgages.Thisdramaticallyoverstatestheimportanceofsubprimes.IntherunuptoLehman’sbankruptcy,subprimesneverexceeded14percentoftotaloutstandingmortgagesandtheirsharewasbelow12percentonSeptember15,2008whenLehmanshutitsdoors.3Furthermore,notallsubprimesweresubprimewhenmeasuredbyforeclosurerates.Atitspeak,thesubprimeforeclosureratewasonly15percent.4Foreclosureratesonprimemortgagespeakedatabout3.5percent.5Sinceatmost,14percentofoutstandingmortgagesin2009weresubprime,atmost,2.1(.15x.14)percentofallmortgagesattheheightoftheGreatRecessionrepresentedforeclosedsubprimemortgages.Thisseemslikeaverysmallnumbergiventhetremendousattentionpaidtosubprimes.At the recession’speak, roughly4.8percentof allmortgageswere in foreclosure. Subprimesconstituted almost half of these foreclosures. This oversized share of subprimes in totalforeclosuressuggests they ignitedtherecessionorat leastmadehelpedmake it“great.”Butsubprimesconstitutedover60ofallforeclosuresin2004whentheeconomywasdoingjustfine.

3https://www.frbsf.org/education/publications/doctor-econ/2009/december/subprime-mortgage-statistics/Note,the FCIC report suggest that subprimes represented half of all outstanding mortgages in 2008. That’s a hugedifferencebetweenthefigurecitedhere,whichwascalculatedbytheFederalReserveBankofSanFranciscobasedondataobtainfromtheMortgageBankersAssociation.4 .15 x .14 divided by .05 x .86 equals .488. https://www.google.com/search?tbm=isch&q=mba+chart+subprime+series+delinquency+chart&chips=q:mba+chart+subprime+series+delinquency+chart,online_chips:delinquency+rates,online_chips:subprime+mortgages&sa=X&ved=0ahUKEwi_yb-XzMTdAhXOmuAKHfb7BkwQ4lYIKigB&biw=1261&bih=710&dpr=2#imgrc=jmEmu25vcPO3RM:5https://www.google.com/search?q=prime+mortgage+mba+delinquency+rates+chart&source=lnms&tbm=isch&sa=X&ved=0ahUKEwiZ46SmzcTdAhUqmuAKHYLZDnYQ_AUIDygC&biw=1261&bih=710#imgrc=HFZyDsi6Gmu9iM:

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Subprimeswereandarebuilttoberisky.Noonewasshockedabouttheirhighforeclosureratein2004anditcertainlydidn’tsparkarecession.Furthermore,onecan’tclaimsubprimedefaultscausedtheGRbyconsideringdefaultsduringtheGR.WhentheGreatRecessionbegan,thedefault(mortgagedelinquenciesplusforeclosures)rateonallmortgageswasonly3.7percent.6Itroseto11.5percentoverthenexttwoyearsascloseto9millionworkerslosttheirjobs.7I.e.,theGRcauseddefaults,nottheotherwayaround.In2007,beforetheGR,thesubprimeforeclosureratewas5percent.Itrosebyafactorofroughly3duringtheGR.Butthe2007foreclosurerateforprimemortgageswas1percentandrosebyafactorofmorethan4.Hence,onecanarguethatifbadmortgagescausedtheGR,itwasprimemorethansubprimemortgagesthatwereatfault.Yes,therewasanincreaseby2percentpointsinsubprimeforeclosureratesintheimmediaterunuptotheGR.Butthatmeantthatonly0.3percentmoremortgageswereinforeclosure.AnotherpieceofevidenceontheactualasopposedtoallegedproblemswithsubprimesecuritiescomesfromtheFed’spurchasefromJPMorgan(JPM)of$29billionworthofBear’ssubprimesecuritiesaspartofitsbribingJPMtobuyBearStearnsfornexttonothing.TheseassetswereplacedinafundcalledMaidenLane.TheobscurenameforthisfundreferenceswhatlaysattherearendoftheNYFederalReserve,namelyMaidenLane.Wasthisnameaninside-the-FedjokesuggestingthattheMaidenLaneassetswerefinancialexcretion?Certainly,JPMhadthatview.It refused topurchaseBear Stearnsat even$2per sharewithout the Fed firstbuyingBear’ssupposedlymosttoxicsubprimes.Intheevent,MaidenLane’scollectionofsubsubprimemortgagesdidn’tloseapenny.Indeed,theFed’s$29billioninvestmentrepaid$31.5billionoverthefollowingdecadefora$2.5billiongain.8Thefactthatthisfigure ispositive isremarkablegiventheGR-inducedrise insubprimeforeclosures.Moreover, theFedclearlyoverpaid for theseassets.Certainly, JPMorgandidn’twanttogetanywherenearthem.Iftheywerereallyworththe$29billioninvestment,JPMwouldhavereadilyacquiredandresoldthem.Supposethattheseassetswereworthonly$15billionatthetimeoftheirpurchase.I.e.,supposethattheFedpaidJPM$14billionthroughthebackdoor(withitsoverpaymentanotherpossibleexplanationforthenameMaidenLane,whichliterallylies at the NY Fed’s back door), then the ex-post return earned on these securities wassensational.Ifsubprimeswereirrationally,ifnotdramaticallyundervaluedandweren’ttheproximatecauseoftheGR,whataboutotherallegedboogeymen? 6Ibid 7https://www.cbpp.org/research/economy/chart-book-the-legacy-of-the-great-recession8 https://247wallst.com/banking-finance/2018/09/18/new-york-fed-sees-2-5-billion-profit-on-bear-stearns-in-final-maiden-lane-sales/Tobeprecise,theFedestablishanLLCtopurchase$30billionofBear’s“junk”assetswitha $29 billion loan from the Fed and a $1 billion loan from JP Morgan. (seehttps://www.federalreserve.gov/regreform/reform-bearstearns.htm)

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The“Unsustainable”RiseinHousingPricesTheFCIC’sstatementthattheriseinhousepriceswasunsustainablesuggeststhathousepricescan’tkeeprisingoverlongperiodsandweregoingabsolutelycrazypriortotheGR.Infact,realhousepricescanriseforyears, indeed,decades.Theydidsoessentiallyeveryyearforthe32yearsbetweenQ11975andQ12007.9Therisewasbothsmoothandgradualwithrealhousepricesonly64percenthigherinQ12007thantheywereinQ11975–thisdespiterealGDPrisingby170percentoverthesameinterval.Theonlyperiodofarapidriseinrealhousepricesinthis32-yearperiodoccurredbetweenQ12003andQ12007whenrealhousepricesroseby22percent.ButoverthisperiodrealGDProseby14percent.Hence,realhousepricesroseonly2percentfasterperyearthandidtheeconomyduringtheperiodof“unsustainable”housepriceincreases.Onecanwritedownmodelswithafixedsupplyofhousinginwhichhousepriceswillriseparipassuwithoutput,atleastinthelongrun.Onecanalsowritedownmodelsinwhichthereisavariablesupplyofhousingandthepriceofhousingstaysfixed,whilethequantityofhousingriseswithoutput.Asoureconomyhasbecomemoreurbanized,thefixedsupplyofhousingmodel,whichpartlyreferencesfixedcentralcityurbanland, isarguablybecomingmorerelevantandmayhelpexplainthemorerapidhouse-priceincreasesthatwe’veseennotjustpriortotheGR,butinthepost-GRperiodaswell.Inshort,reasonableeconomicmodelscanreadilydebunkoratleaststronglyquestiontheviewthathousepricesrising2percentagepointsfasterthantheeconomyforfouryearsafterrisingfarmoreslowlyfortheprevious28yearsis“unsustainable.”Indeed,whattheFCICviewedasahousing-pricebubblemightbetterbedescribedasaperiodofnormalhousing-priceincreasesfollowing28yearsofabnormallylowhousing-priceincreases.Certainly,atemporarydropinhousepricescouldhaveproducedacontractioninconstruction.But contractions in construction have also arisen, indeed they’ve generally occurred, in thecontextofrisinghouseprices.Moreover,adeclineinagivensectordoesn’tauguraneconomy-wide recession. Indeed, every expansion features a recession in particular sectors, just asparticularsectorsexpandduringeveryrecession.Furthermore,adropinthepriceofhomesdoesnotadverselyimpactmosthomeowners.Yes,thevalueoftheirassetfalls.Buttheimplicitcostofhomeownership(imputedrent)fallsaswell.And, ifwe’retalkingaboutanationwidedecline inhouseprices,aswearewiththeGR,eventhosewhomovedexperiencednoeconomicharmbecausetheirabilitytobuyatalowerpriceoffsettheirneedtosellatalowerprice.10

9https://fred.stlouisfed.org/series/USSTHPI10Whataboutpeoplewhodieandleavealowerpricedhome.Thisharmstheirheirsbutthosewhoarebuyinghomesarebenefitbylowerhouseprices.Thefactthatthehouseisphysicallyintactimpliesthatthereisnooveralllosstotheeconomyfromchangesinhouseprices.

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AstheGRtookhold,manyhomeownerswentunderwaterontheirmortgages.Thissurelyledtotheabove-documentedriseinforeclosuresasmortgageeswalkedawayfromtheirobligations.Butforeclosuresdon’trepresentalosstotheeconomy.Theforeclosedhouseis,afterall,stillstanding. Its ownership just switches hands. Of course, creditors lose due to the mortgagedefault.Buthomeownerswinbecausetheyridthemselvesoftheirmortgageliability.In short, risinghousepricesarenot required tokeep theeconomyoutof recession.Noraredeclining house prices, even accompanied bymortgage defaults, an automatic harbinger, letaloneadirectcauseofrecessions.Thehousing-pricedeclinemayhavebeenstimulated,inpart,bydirestatementsfromsupposedexperts.TakeAnthonyMozilo’spronouncement,inJuly2007,that“Weareexperiencinghomepricedepreciationalmostlikeneverbefore,withtheexceptionoftheGreatDepression.”Mozillawas,atthetime,theheadofCountrywideFinancial--thecountry’sthenlargestmortgagelender.ThisstatementwasallthemorecrediblesinceitsmakingwashardlyinCountrywide’sinterest.WhereMozillagothis“facts”isn’tclear,butthereisnoevidencein the data of anything like whatMozilla stated. The Case-Shiller national home priceindexedpeakedinJuly2006.Ayearlater,itwasjust2percentlower–nothingremotelylike Mozilla claimed.11 Moreover, according to the Federal Reserve’s All-TransactionsHousePriceIndex,housepriceswereactuallyhigherintheQ32007thanQ32006.12Butherewasthecountry’s topmortgageexecutiveclaiminghousepriceswereplummetingandinvokingtheDword–theGreatDepression.Thedayofhisstatement,Countrywide’sstockdropped10percent.13RatingsShoppingTheFCIC’sreportstatesthatfailuresofthebig-threeratingcompanieswere"essentialcogsinthewheeloffinancialdestruction"and"keyenablersofthefinancialmeltdown."ButacarefulstudybyeconomistsEfraimBenmelechofHarvardUniversityandJenniferDlugosz,oftheFederalReserveSystemconcludes,“Itisnotclearthatratingshoppingledtotheratingscollapseasthemajorityofthetranchesinoursampleareratedbytwoorthreeagencies.”14Theauthorspointoutthatwhereasre-rantingswerehistoricallyhighin2007and2008,theyweren’tdramaticallyhigher than in 2002 and 2003. Moreover, 80 percent of the ratings of structured-financesecuritiesweredonebymorethanonefirm.Sincestructured-financesecuritiesrepresentedonly35percentoftheU.S.bondmarketin2008,sinceonly7percentofthesesecuritieswerere-rated,andsince,atmost,20percentwereover-ratedduetoratingsshopping,overratingaffectedlessthanonehalfofonepercentoftheU.S.bondmarket.Furthermore,thissmallfiguresurelyoverstatestheimportanceofratingsshoppingasmanyofthedowngradeswerecausedbytheGRitself,thankstotheGR’smassivejobslosses.

11https://fred.stlouisfed.org/series/CSUSHPINSA12https://fred.stlouisfed.org/series/USSTHPI#013http://fortune.com/2010/12/23/how-the-roof-fell-in-on-countrywide/14http://www.nber.org/chapters/c11794.pdf,p.203.

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Indeed,hadtherebeennorecession,therewouldhavebeennoreasonfortheratingcompanies,who had allegedly been bribed to overrate the securities, to jeopardize future bribes bydowngradingthesecurities.IncreasedBankLeverageSky-highbankleverageisanotherpartofthestandardGRexplanation.Bankswere,weweretold,leveraged33to1in2008comparedwith12to1in2004.15Theonlyproblemwiththisviewisthatit’snottrue.Bankleverageactuallyfellovertheperiod1988through2008.16Equityrosefrom6percentofbankassetsinQ11988to10percentinQ12008.Furthermore, leverage ratios, likemortgage default rates, are endogenous to the economy’sstate.Leverageistheratioofdebttoequity.Butequityisthevalueofacompany’sassetslessitsdebt.Hence,ifthevalueofacompany’sassetsfall,itsleverageratiorises.Takeahighlyopaqueandleveragedbank,X,thatisbeingshortedbyhedgefunds.Supposethemanagersofthesefundsvigorouslytalkuptheirpositions,tellingallwhowilllistenthatthey’vecheckedextensivelyonX’sassetsandfoundthemtobedeeply“troubled.”17FurthersupposeenoughtradersofbankX’sassetsbecomeconvincedthateithera)X’sassetsaretroubled,b)othertradersbelieveX’sassetsaretroubledorbelieveothertraderssobelieve,orc)Xneedscritical-mass refunding frommultiple funders,manyofwhommaydecline to refundbecausetheyareworriedotherswon’trefund.Inthiscase,thetraderswillsellthetypeofassetsheldbyXbecausetheyrealizeXwillneedtodumpitsassetsonthemarkettostayliquid.TheresultisafiresaleofX’sassets,adrop,potentiallyprecipitous,inthepriceofX’sassets,andariseinX’sleverage.18GiventheseverityofthestockmarketcrashsubsequenttoLehman’sfailure,onemightthinkthatleverageratiosrosedramaticallyduringtherecession.Notthecase.FederalReservedatashowstheequityratiofailingfrom10tojust9percent–ahighervaluethanwasregisteredintheprior16years.TheFeddatasuggestthatbanks,asagroup,were leveragedonly10to1atthebeginningof2008, when the GR officially began. But what about the large investment banks?Was theirleverage exceptionally high prior to the GR? Actually, no. William Cohan debunked thiswidespreadmythinanAtlanticarticleentitled,“HowWeGottheCrashWrong–LeverageWasNottheProblem–IncentivesWereandStillAre.”19

15https://www.theatlantic.com/magazine/archive/2012/06/how-we-got-the-crash-wrong/308984/16https://fred.stlouisfed.org/series/EQTA17 “Troubled assets” is, of course, the term the U.S. Treasury and Federal Reserve applied to subprime mortgages and other securities in seeking support for TARP, the Troubled Asset Relief Program. 18This,ofcourse,doeswhattheshorterswant–itraisesthevaluesoftheirshortpositions.Talkingupone’sshortis, incidentally,exactlywhat’sportrayed inTheBigShort.Whatwedon’tknowandprobablyneverwill know iswhetherthosewhoshortedthemarketliedormassagedthetruthabouttheassetstheydenigrated.19https://www.theatlantic.com/magazine/archive/2012/06/how-we-got-the-crash-wrong/308984/

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Cohan’spointissupportedbyanApril2008paperissuedbyLehmanBrothers,entitled“LehmanBrothers–LeverageAnalysis.”20ThepapershowsthatLehmanwasnomoreleveragedin2007thanin2003.21Moreover,BearStearnswasonlyslightlymoreleveragedin2007thanin2003.And,asCohanpointsout,BearStearnswasmoreleveragedin1998thanin2008.Interestingly,thethreelargeinvestmentbanksthatdidn’tfaceruns–GoldmanSachs,MorganStanley,andMerrillLynch–didmaterially increasetheir leverageintherunuptotheGR,butnotbeyondleverageratesseenyearsinthepast.Stillthefactthattheinvestmentbanks,whichmaintainedtheirleverage,cameunderattack,buttheinvestmentbanksthatraisedtheirleveragedidnot,providesmoreevidenceagainst increasing leverageasareal,asopposedtomisperceivedGRculprit.TooLittleCapitalAnotherviewofGR’scauseisthatbanksfailedduetoinsufficientcapital.Capitalreferencestheratioofabank’sequitytoitsassets.22Abankwithasufficientlyhighcapitalratioisviewedassafe fromfailure.This,afterall, is thegoalofDodd-Frank’sstresstests– insuringbankshavesufficientcapitaltopreventareplayofthe2007-2009financialcrisis.TheWikipediaentryforBearStearnsindicatesthecompanywasleveraged36to1leadinguptoitscollapse.23That’sacapitalratiooflessthan3percent–farbelowtheregulatorystandardsofthetime.ButChristopherCox,ChairmanoftheU.S.SecuritiesandExchangeCommission(SEC)atthetime,adisagreed.AccordingtoCox,BearStearnswaswellcapitalizedwhenitfailed,withacapital ratioover13percentandadebt-equityratioof6 to1. Indeed, itappears thatBearStearns could have easily passed the current Dodd-Frank stress test immediately prior to itsdemise.24ConsiderthisstatementfromChairmanCox.

ThefateofBearStearnswastheresultofalackofconfidence,notalackofcapital.Whenthetumultbeganlastweek,andatalltimesuntilitsagreementtobeacquiredbyJPMorganChaseduringtheweekend,thefirmhadacapitalcushionwellabovewhatisrequiredtomeetsupervisorystandardscalculatedusingtheBaselIIstandard.25

Thesameappears,oncarefulreadingofSECChairman,MarySchapiro’s,2010testimonytotheHouse Financial Services Committee, to have been true of Lehman Brothers. That testimonyincludesthisstatement.

TheimmediatecauseofLehman'sbankruptcyfilingonSeptember15,2008stemmedfromalossofconfidenceinthefirm'scontinuedviabilityresultingfromconcernsregardingitssignificantholdingsofilliquidassetsandquestionsregardingthevaluationofthoseassets.

20https://web.stanford.edu/~jbulow/Lehmandocs/docs/DEBTORS/LBEX-DOCID%201401225.pdf21Ireferenceheregross,notnetleverage.22 Regulators have developed different capital ratio measures, including Tier 1 and Tier 2 capital ratios. Seehttps://www.investopedia.com/terms/t/tier1capital.asp23https://en.wikipedia.org/wiki/Bear_Stearns24https://www.sec.gov/news/press/2008/2008-48.htm25Ibid

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Thelossofconfidenceresultedincounterpartiesandclearingentitiesdemandingincreasingamounts of collateral and margin, such that eventually Lehman was unable to obtainroutinefinancingfromcertainofitslendersandcounterparties.26

Thereare,ofcourse,differentleverage/capitalratiomeasures.Moreover,thesemeasurescanbemanipulated by banks’ accounting practices and riskweighting decisions.27 The completedisconnectbetweentheWikientryandthestatementofChairmanCoxmayreflectadifferenceinfacts,adifferenceinthecapitalratiomeasure,adecisiontoconsidergross,notnetdebt,oradifferenceinriskweightingofassets.Theimportantpoint,though,isthedisagreement.TheWikientry as well as Cohan’s article reference debt-equity ratios that are 5 to 6 times the ratioreportedbyChairmanCox.Thisenormousdiscrepancytellsusthatthepubliccaneasilyreachandmaintainincorrectconclusionsaboutabank’sabilitytowithstandarun.ThereisanevenmoreimportantmessageinChairmanCox’sadditionalstatementthat“ThemarketrumorsaboutBearStearnsliquidityproblemsbecameself-fulfilling.”28CoxissayingthatBearStearnshadverylittledebt,butthatitsactualcapitalratiodidn’tmatter.Creditors,pastandprospective,cametobelieve,basedonrumors,thatothercreditorswerepullingtheplug.This ledthemtodothesame.Since it literallyonlytakesonedollarofoverduedebtrepaymenttorenderabanklegallybankrupt,thisdynamiccansinkanybank,nomatteritscapitalratio,atanytime.Thus,leveragedbanksareunsafeatanyspeed,i.e.,theyhaveandwillfailregardlessoftheirtrueleverage.Lehmanwasalsowellcapitalizedpriortoitsdemise.Ithadtier-1capitalof11percentwhenitscreditorspulledtheplug.29An11percentcapitalratioisclosetothecurrentbankingsystem’stier-1capitalratioof12.3percent,calculatedbasedontheFederalReserve’srecentstresstests.This indicatesthattoday’sbankingsystemisnosaferthanwasLehmanBrotherswhenitwasdrivenoutofbusiness.30EgregiousandPredatoryLendingTheFCICcites“egregiousandpredatorylending”asanotherofthecausesoftheGR.Suchlendingreferences adjustable-rate mortgages, mortgages with balloon payments, interest-onlymortgages,piggy-back,andso-calledpay-optionARMloans.Loansofthesetypewereandare

26https://www.sec.gov/news/testimony/2010/ts042010mls.htm27Lehmans’Repo105transactionsisacaseinpoint.28https://www.sec.gov/news/press/2008/2008-48.htm29 https://www.americanrhetoric.com/speeches/richardfuldlehmanbrosbankruptcytestimony.htm Here is Fuld’srelevanttestimonyreits11to1Tier1capital.“Asfarastheleverage,andIspokeaboutitearlier,there'saverybigdifferencebetweenthe30timesandwherewewerewhenwefinishedinthethirdquarterat10\1/2\.Abigpieceofwhat that 30was, again,was thematch book,whichwas governments and agencies. So that should not beconsideredasanadditionalpieceofriskyleverage.Again,IwillsaythatonSeptember10thwefinishedwiththebestoroneofthebestleverageratiosonthestreetandoneofthebesttier1capitalratiosonthestreet.And,eventoyourquestion,that'showIviewedthecompany,andthat'swhyIvieweditasstrong,Mr.Congressman.Thosewere themetrics.Thosewere themetrics that the regulatorsused.Thosewere themetrics thatallofus in theindustryused,andourswereoneofthebest.” 30https://www.federalreserve.gov/newsevents/pressreleases/bcreg20180621a.htm

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subprimes.Thereisnodoubtthatmanyoftheseloansweremadetoborrowerswhotookontoomuchriskoragreedtopayinterestratesthatwerepredatorilyhigh.Certainly,ifonereadstheviews of The Center for Public Integrity, one comes away believing that all subprime loansinvolvedtermsthatwereimpossibleforthepublictounderstand.31Butsuchloanshadbeeninexistencesince1982,i.e.,26yearsbeforetheGR.32Moreover,theshareofsubprimeloansthatwerepredatorycouldnothavebeenthatlargesince,atmost,15percentwentintoforeclosureduringtheGR.Buttheydidsointhecontextofanunemploymentratethatreached10percent!Asmentioned, in 2007, before theGR, the foreclosure ratewas 5 percent. Its lowest value,between2002and2007,was3percent,whichwasobservedinQ32005.33Ifoneassumesthatallofthe2percentage-pointincreaseinsubprimesinvolvedpredatorylending,we’restilltalkingabout predatory lending causing, atmost, 0.3 percentmoremortgages to definitely default,namely,enter foreclosure.This issimplytoosmalla figuretomattertotheoveralleconomy.Indeed,giventhesizeofthe2007mortgagemarket,itrepresentsjust$32billion.34In2007,U.S.GDPwas$14.4trillion.Theeconomy’s2007totalnetwealthwas$68trillion.Hence,$32billionistriviallysmallcomparedtothesizeofthe2007overalleconomyoritstotalnetwealth.DramaticIncreasesinHouseholdMortgageDebtAnother GR “smoking gun” is the pre-GR run up of mortgage debt, which roughly doubledbetween2002and2007.35Surely,theadditionofover$750billioninmortgagedebtinthecourseof6shortyearsmustrepresentapriorievidencethatamassiverecessionwasintheworks.Notso.There isnothing ineconomic theory that suggests that increasedborrowingshouldcauserecessions. The increase inborrowing topurchasehomeswasnot associatedwith amassivespendingspreeonthepartoftheAmericanpublic.Indeed,theshareofGDPconsumedbythepublicremainedfixedatroughly67percentbetweenearly2002andlate2007.Thismeans that Americans, as awhole, borrowedmore, not to spend, but to invest. Stateddifferently,theirdecisiontoborrowmoreontheirhomeswasnotaccompaniedbyadeclineintheirnetwealth.Collectively,theysimplyborrowedandlent.Infact,Americans’netwealthroseby over $6 trillion between 2002 and 2007. This represented an 83 percent increase. And,althoughtheratioofmortgagedebttohouseholdnetwealthrose,itdidn’trisebymuch–from17percentin2001toonly20percentin2007.

31https://www.publicintegrity.org/2009/05/06/5452/predatory-lending-decade-warnings32Ibid.33https://www.google.com/search?tbm=isch&q=mba+chart+subprime+series+delinquency+chart&chips=q:mba+chart+subprime+series+delinquency+chart,online_chips:delinquency+rates,online_chips:subprime+mortgages&sa=X&ved=0ahUKEwi_yb-XzMTdAhXOmuAKHfb7BkwQ4lYIKigB&biw=1261&bih=710&dpr=2#imgrc=jmEmu25vcPO3RM:34https://fred.stlouisfed.org/series/HHMSDODNS35https://fred.stlouisfed.org/series/MDOTHIOH

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Whatabouthouseholddebtpaymentserviceasashareofdisposablepersonalincome?TherewasanincreasepriortotheGR,butnothingextraordinary.BetweenQ42001andQ42007,theratiotroughedat12.1percentinQ22004andpeakedinQ42007at13.2percent.A13.2percentratioissmallandtheincreasefromtroughtopeakisonly9percent.36ExponentialGrowthinTradingActivitybyFinancialFirmsHere, again,we have a supposed reason for theGreat Recession that has no counterpart ineconomictheory.IfJoeandSallysellthesameshareofstockbackandforthtoeachotheraninfinite number of times in, say, a second, nothing real will happen to Joe and Sally or theeconomy.BothJoeandSally,aswellastheeconomy,havethesamenetworthbeforeandaftertheirinfinitenumberoftrades.Hence, the volume of trade, in securities or anything else, is not evidence of an economicproblem.Onemightclaimthatthevolumeoftradewascoincidentwithanirrationalbubbleinfinancialmarkets.Butthetradesbeingcountedarethoseinvolvingstockandtherunuptothegreatrecessiondidnotreflectunprecedentedlyhighstock-marketvaluations.37Themarketwas1.5timesGDPin2000,1.4timesGDPin2007,and1.5timesGDPin2017.Thestockmarketispro-cyclical, but there is nothing in the stockmarket data thatwould presage the supposedgreatnessofthe“Great”Recession.UnregulatedDerivativesandtheRepoMarketTheGRwasmarkedbythedisseminationofnewsaboutderivativeswithexotic-soundingnames,suchasRMBS,CDOs,syntheticCDOs,CDOsquaredsandCDS.Becausemanywerecomplexandnot all subject to much regulation, they were singled out repeatedly by the press andcommentatorsduringtheGRandincludedintheFCIC’sfavoritelistofGRbêtenoires.IfthesesecuritiesactuallyhelpedcausetheGR,onewouldexpecttheirvaluetohavepeakedbefore,notduringtheGR.Butnetfinancialderivativeswere126percenthigherattheendoftheGRthanatthebeginning.38Furthermore, inthetwoyears leadinguptotheGR,net financialderivativesroseonly7.7percent.Thereigningnarrative–thatderivativesweremisunderstoodandoverratedbycompliantratingcompanies – has been questioned in a recent study by economists JuanOspinal and HaraldUhlig.39 They examined 8,615 residentialmortgage-backed securities (RMBS) over the period2007-2013, almost all ofwhichwere ratedAAA.Through2013, the cumulative losson these“toxic” securities was only 2.3 percent. Some three quarters of the AAA-rated RMBS hadessentiallyzero lossesthrough2013.Onaprincipal-weightedbasis,theaveragelossratewasonly0.42percent.Moreover,ratingsdidnotworsenclosertotheGR.LossratesforAAA-RMBS 36https://fred.stlouisfed.org/series/TDSP37https://fred.stlouisfed.org/series/DDDM01USA156NWDB38https://fred.stlouisfed.org/series/IIPFINANCNQ39Ospina,Juan,andHaraldUhlig.Mortgage-backedsecuritiesandthefinancialcrisisof2008:apostmortem.No.w24509.NationalBureauofEconomicResearch,2018.

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issuedbetween2006and2008werenohigherthanthoseissuedinprioryears.Moststriking,AAA-ratedRMBSactuallyoutpreformedtheuniverseofAAA-ratedsecurities.Yes,losseswerefarhigherfornon-AAAratedsegmentsoftheRMBSmarket.Butthat’swhatonewouldexpectfroma“great”recession.However,thesesecuritiesrepresentedasmallfractionofthe RMBS market. In summarizing their findings, the Ospinal and Uhlig state, “these factschallengetheconventionalnarrative,thatimproperratingsofRMBSwereamajorfactorinthefinancialcrisisof2008.”WhataboutREPOs?DidtheycausetheGR?Well,theycertainlyincreasedintherunuptotheGR.Butshort-termfinancial-companyborrowinghasbeengrowingfarfasterthantheeconomyfordecades.40ThefactthatsomeeconomicvariableroserapidlypriortotheGRisnotevidencethatitcausedtheGR.Smartphonesalestripledbetween2005and2008,butnoonewouldlinkthattotheGR.41Ofcourse,ReposwouldbeimplicatedincausingtheGRhadtheybeenpartofexcessive leveraging by financial intermediaries. But, as discussed above, overall financial-companyleveragefell,notrosepriortotheGR.InvestorsMispriced/IgnoredRiskTheOspinalandUhligpaperalsospeakstotheassertionthatWallStreetprofessionalsactedlikerankamateursinthesupposedfinanciallendingeuphorialeadinguptotheGR.Hadthatbeenthecase,theRMBSassetswouldnothavedonesowelldespitetheoutsizedrecessionandmajorreduction in housing prices starting in 2006. As Lo (2012) points out, in 2007, CDOs paidsignificantlyhigherreturnsthanequally-ratedcorporatebondsduetotheirextrarisk.UnalignedCEOIncentivesYetanotherexplanationfortheGRisthatCEOsoffinancialinstitutionshadtoolittle“skininthegame.”JimmyCayne,formerheadofBearsStern,wouldsurelydisagree.Caynelostcloseto$1billionashisbankcollapsed.KenLewis,CEOoftheBankofAmerica,had$190milliontolosebymaking wrong decisions and succeeded in losing $142 million. Lehman Brothers’ Dick Fuldreceivedmostofhis2007compensationintheformofLehmanBrothers’stock.42Orconsiderthe2011 studybyeconomists,Rüdiger FahlenbrachandRenéM. Stulz,whoexaminedexecutivecompensation contracts of 95 banks. The stock and option compensation in these contractsexceedswagesbyafactorofeight.43Inshort,thereisnopersuasiveevidencethatshadoworconventionalbankershadtoolittleskinthegame.

40https://fred.stlouisfed.org/series/FBREPOA027N41https://www.statista.com/statistics/191985/sales-of-smartphones-in-the-us-since-2005/42 https://pubs.aeaweb.org/doi/pdfplus/10.1257/jel.50.1.151, Green, Joshua (September 12, 2013). "Where Is Dick Fuld Now? Finding Lehman Brothers' Last CEO". Bloomberg Businessweek. 43 Fahlenbrach, Rüdiger, and René M. Stulz. "Bank CEO incentives and the credit crisis." Journal of financial economics99, no. 1 (2011): 11-26.

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RegulatoryCaptureThisphrasepointstoregulatorsbeinginthefuturepayofWallStreetthankstotherevolvingdoor between Wall Street and Pennsylvania Avenue. Yet the biggest factor that regulatorsneeded to oversee was Wall Street’s leverage. As discussed, it was not historically highproceedingtheGReitheracrosstheboardorinthelargeinvestmentbanksthatfailed.Onecouldwellarguethatitwasalwaystoohigh,butthatdoesn’thelpusexplaintheGR.DemocratizationofFinanceUnder this theory, government sponsored enterprises (Fanny and Freddie) and governmentregulatorsweretoopermissivewithbanks intheirquesttohelpthepoorget intoaffordablehousing.Onecanargueeitherway,dependingonone’sinterestinredistributionandpreferredmethodto redistribute.But if thiswere thechieforevenamajorcauseof theGR,subprimemortgageswouldneedtohaveplayedamuchlargerrolethantheydid.TheFederalReserveKeptInterestRatesTooLowManycommentatorsplacetheblamefortheGRsquarelyonthegovernment,particularlytheFEDandFannieMayandFreddieMac,ourmajorgovernment-sponsoredenterprises,whichhelpinsuremortgages.Thirty-yearmortgageinterestrateswerecertainlylowerbetween2000and2007 than in the prior quarter century.44 But they weren’t that low especially adjusted forinflation.Inthe1990s,thereal30-yearmortgagerateaveraged7.91percent.Itaveraged6.27betweenJanuary2000andDecember2007.45Thisdecline ishardlysomethingtowritehomeabout,letalonepretendistheunderlyingGRculprit.Furthermore,theFederalReservecontrolsshort-term,actuallyovernight,interestrates.Itdoesn’tdirectlycontrollong-terminterestrates,includinglong-termmortgagerates.Asforadjustablerate5/1-yearadjustableratemortgages(ARMs),theirrealrateaveragedbetween5and6percentinthetwoyearsprecedingtheGR.Realratesofthismagnitudearenotlow.46SummaryoftheGR’sUsualSuspectsTheaboveinterrogationofthestandardGRsuspectsfindsnoneofthemguilty.Subprimesthatwentintoforeclosureweren’talargeenoughfactorinthemortgagemarket,thehousingprice“bubble,”ifyoucancallitthat,wasminor,ratingshoppingwasn’tabigdealgivencrossratingandtheex-postperformanceofratedsecurities,increasedfinancialleverageisamyth,egregiousandpredatorylendingwastoosmalltomatter,therunupinmortgagedebtwasinlinewiththerise inthecountry’snetworthanddidn’tsignalaconsumer-spendingspree,derivativesweregenerallyproperlyratedandnottoxic,reposdidn’tleadtoexcessivefinancialleverage,investorsdidn’tignorerisk,CEOincentivestoplayitsafewereinforce,regulatorsdidnotpermitfinancialcompanies to expand their leverage, the democratization of finance did not make a majordifference,andrealmortgageinterestrates,bothshort-andlong-term,weren’tlow.

44https://fred.stlouisfed.org/series/MORTGAGE30US45Seehttps://fred.stlouisfed.org/series/MORTGAGE30US#0andhttps://fred.stlouisfed.org/series/PCEPI.46https://fred.stlouisfed.org/series/MORTGAGE5US#0andhttps://fred.stlouisfed.org/series/PCEPI.

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PerhapsthebiggestmythofallabouttheGRisthatitwastruly“Great.”ThedeclineinrealGDPover thecourseof theGRwasonly3.1percent.This isnot remotelycomparable to the25.9percentplungeinoutputrecordedduringthefirstfouryearsoftheGreatDepression.Andit’slessthantwicetheaveragepercentagedeclineinoutputrecordedinthepriorfiverecessions.It’salsonotmuchlargerthanthe2.5percentrealGDPdropinthe1981-82recession.Yes, during the GR, the stock market fell by almost one third and the unemployment ratedoubled.Butstockpricesfellbyafar largerpercentage(40percent)between2000and2002and,inthe1981-82recession,theunemploymentratepeakedatahigherlevelthanintheGR.LikethesupposedcausesoftheGreatRecession,thesize,itself,oftheGRappearstohavebeenhyped.Stateddifferently,ifonewantstoclaimthe2008-2009recessionwas“great,”the81-82recessionshouldatleastbecalledthe“ImpressiveRecession.”IntheImpressiveRecession,stocksfell24.6percent, real GDP fell 2.5 percent, and unemployment rose by 3.3 percentage points. TherespectiveGreatRecessionfiguresare43.6percent,3.1percent,and3.1percent.Yes,GRfiguresarealllarger,butnotbythatmuch.Andhousingprices?TheyfellbetweenQ12007andQ22012by19percent.But,asarguedabove,adeclineinhousingpricesdoesn’tconstituteamacroshock.Andformosthouseholdsitdoesn’tevenrepresentamicroshock.Thisisreadilyseenbysimplylookingatthestockofhousing.Thefactthatitspricechangeddidn’tmove,letaloneeliminateasinglebrick,stone,plankorshingleonanyofthetensofmillionsofhomesacrossthecountry.MultipleEquilibriaIf, as argued above, the evidence rules out theusual suspects,what actually caused theGR,whose size, itself, seems to have been hyped? My answer is multiple equilibrium, broadlydefined.Sheerpanic, facilitatedbyopacity, false rumors,misinformation,exaggerationandastrong assist from interested parties, flipped the economy to a very bad equilibrium. Thisdiagnosisimpliesadeepstructuralprobleminthefinancialsystem---onethatseeminglycan’tbeaddressedbyDodd-FrankorsimilarreformsproposedorenactedinEurope.47Economicshasmanytheoriesofeconomiesrapidlyflippingfromgoodtobad.Theygoundertheheadingsmultipleequilibrium,contagion,self-fulfillingprophecy,panics,coordinationfailures,strategiccomplementarities,sunspotequilibria,collectiveaction,sociallearning,andherding.Below I reference all these mechanisms for rapid economic transformation as “multipleequilibrium,”ratherthanstickingwithanarrow,technicaldefinitionofmultipleequilibriumasmorethanonesolutiontoagivenmodel’sequations.Thefactthatthefoundationalbank-runmodels---Bryant(1980),Diamond-Dybvig(1983),Pechand Shell (2003) and relatedmodels – admit multiple equilibrium in which financial-market

47SeeKotlikoff(2012)foradiscussionoftheBritishVickersCommissionreform.

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collapse arises absent any fundamental financial- or real-sector problem is striking.48 Thesemodelstellusthatabankruncanariseasnaturallyasnot.49Theyalsotellusthatthebankingsystemisinherentlybuilttofailandthatfocusingexclusivelyonthemodels’goodequilibriumisfolly.I.e.,fromtheperspectiveofthesemodels,thequestionisnotwhetherthebankingsystemwillfail,butwhen.Hence,it’spassingstrangethattheFCICreportmakesnomentionwhatsoeverofeitherpaper,letalonethetheoryunderlyingbankruns.ThisisakintotheFederalAviationAdministration investigating a plane crash due to structural failure without referencing theplane’s blueprints. This, presumably, reflects the makeup of the FCIC whose ten membersincludedjustoneeconomist.Theeconomist,whileoutstanding,hadnobackgroundinbankingorfinance.The original bank-runmodels are now four decades old. Other,more realistic versions haveemerged.TheytoowereignoredbytheFCIC.AnexampleisGoldsteinandPauzner(2005),whomodelcoordinationfailuresinwhichagentsreacttopubliclyavailablenewsbased,inpart,ontheirbeliefsabouthowotheragentswillreact.Suchnewscanbeabouteconomicfundamentalsor,simply,thatafiringrun,whichwillaffectfundamentals,ison.50BebchukandGoldstein(2011)studycreditmarketfreezes.Theirfocusisonbanksdefundingnon-financialfirmsbecausetheybelieveotherbanksaredoingthesame.Theyreferencethisasself-fulfillingcreditfreezes(creditfreezesinwhichbeliefsaboutotherdefundersarecorrectinequilibrium.)Buttheirframeworkcanappliedtobanksdefundingbanks.Anothermechanismfordrasticeconomicadjustmentinvolvesinformationcascades.Inmodels,such as Bikhchandani, et. al., (1992), cascades involve economic agents ignoring their owninformationandinferringthe“truth”basedontheactionsotheragentsaretaking.51Thisinducesherdbehaviorasinastampedeinacrowdedtheatre(financialmarket)whensomeoneshoutsFIRE(BANKRUPT).Thekeyherdingpoint,forourpurposes,isthatpeoplecangettrampledintheabsenceofanyfirewhatsoever,i.e.,regardlessofthefundamentals. 48Diamond-Dybvig(1983)explainbankrunsasdepositorscollectivelyrunningtoclaimtheirmoney,whichthebankinvested,ontheirbehalfilliquidlywiththepromisetogivethosewithunexpectedlyhighshort-termliquidityneedsahigherreturnontheirsavings.ButtherunsonBear,Lehman,AIG,andmostoftheother29majorinternationalfinancialcompaniestofailbeforeandduringtheGRwerecreditordefundingruns.Theycanbeeasilymodeledifoneassumesthatleveragedbanksneedacriticalamountofcredittooperate.Thus,ifnoonerunson(i.e.,runsawayfrom)LehmanBrothersinSeptember2008,it’ssafeforeveryonetostaywithLehman.Butifothersrunormayrun,it’sbesttoplayitsafeandrunaswell.IfenoughplayersfailtoprovideLehmansufficientfunding,anyindividualfunderwhocan’tprovidecriticalfundingontheirownwillchosenottofund. 49Multipleequilibria,inthesimplestframework,areformallytwoormoresetsofsolutionstothesameunderlyingequations. Thismeans that the economy can flip fromone equilibrium, say A, to the other, say B, simply if itsparticipantsallcometobelievethattheequilibriumisnowB.Again,inthesimplestframework,thisflippingwon’tbebasedonsomethingfundamentalsinceeverythingthat’sfundamentalisincludedintheequations.Instead,itwillbebasedonsomething,liketheappearanceofasunspot,thathasnothingintrinsicallytodowiththeeconomy. 50InGoldsteinandPauzner(2005),commonnewsisabouttheproductivityofcapital.Butinarichermodel,inwhichtherearefiringruns,thefundamentalshockcouldbethatafiringrunhasstarted,perhapstriggeredbythefailureofoneormoremajorfinancialinstitutions.51 Intuitively,ifsomeoneyellsFIREinacrowdedroom,everyonerunsevenifnoonesmellssmoke.Thesameistrueofbankcreditors,whenitcomestorefinancingaBearStearnsoraLehmanBrothers.

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Chamley (2014) provides a variety of models of financial herding behavior. One of his keycontributions is showing how government policy can rule out bad equilibriums,which is thecentral motivation underlying the Limited Purpose Banking proposal referenced below. Incontrast,DoddFrank’sgoalistoreduce,noteliminatethechanceoffinancialsystemmeltdown.Jackson and Kotlikoff (2018) provide a different and very simplemechanism for landing theeconomyinabadposition.Theypositamodelinwhichhonestbankersprovideavariableshareof intermediationservices.Whenthis share is low,householdsdefundthebanksand,absentdisclosure,will,mistakenly, continue todo soevenduringperiodswhen the shareofhonestbankersishigh.Incompletelyignoringthetheoryofbankruns(Thereisnotasinglereferencetoanytheoreticalmodel.),theFCICpretendedthatwhathappenedwasn’tintrinsictohowthefinancialmarketisstructured.Instead,thecommission,forwhateverreasons,appearstohaveroundeduptheusualsuspectsandheldashamtrial.Yet,thecommissionerscouldn’tsimplyignorethepanic.Infact,intheprocessoffingeringmultipleapparentlyinnocentculprits,thereportusedthewordpanic100times.That’sroughlyoneusageeverysixpages.Hereisthefirst.

Thecrisis reachedseismicproportions inSeptemberwiththefailureofLehmanBrothersand the impending collapse of the insurance giant American InternationalGroup (AIG).Panicfannedbyalackoftransparencyofthebalancesheetsofmajorfinancialinstitutions,coupledwithatangleof interconnectionsamonginstitutionsperceivedtobe“toobigtofail,” caused thecreditmarkets to seizeup.Tradingground toahalt.The stockmarketplummeted.Theeconomyplungedintoadeeprecession.

Thisstatementcertainlyemphasizesirrationalfearandlinkspanictoopacity.Butiffallsfarshortofsayingthatthebankingsystemandeconomy,ascurrentlyconstituted,arebuilttofailwithpanicbeingthecatalyst.Lehman’sCEO,RichardFuld,gotclosertothisconclusioninthispartofhisOctober8,2008testimonytotheHouseOversightandReformCommittee.52

At Lehman Brothers, the crisis in confidence that permeated the markets led to anextraordinaryrunonthebank.Intheend,despiteallofourefforts,wewereoverwhelmed.However, what happened to Lehman Brothers could have happened to any financialinstitution.

If it’s true that what happened to Lehman Brothers could have happened to any financialinstitution,itmeansthatfundamentals,betheythedegreeofleverage,theextentofsubprimeholdings,ratingshopping,lackofbankers’skininthegame,regulatoryunder-sight,newfangledderivatives,housingprices,etc.,weren’tapre-requisitefortheGRbankruns.Italsomeansthatestablished linesofcreditareworthlessbecausebankswill runonbanksatthefirstsignofadeaththroe.

52https://www.americanrhetoric.com/speeches/richardfuldlehmanbrosbankruptcytestimony.htm

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JimmyCayne’s,BearStearns’formerCEO,echoedFuld’sviewsinhistestimonytotheFCIC.

BearStearns'scollapsewasnot theresultofanyactionsordecisionsuniquetoBearStearns."Rather,hetoldthecommittee,"themarket'slossofconfidence,eventhoughit was unjustified and irrational, became a self-fulfilling prophecy.53 Jimmy CaynetestimonytotheFCIC.

It’s tempting todismiss Fuld’s andCayne’s statementsas self-serving.But their insider viewscoincide with those of then SEC Chairman Cox, the FCIC’s emphasis on panic andcontemporaneousstatementsofimpartialobservers.Certainly,therewasnofundamentalnewsinBear’slastweekthatdroveitsstockvaluefrom$70ashareonMarch10thto$2ashareonMarch16th.54Theonlyrealnewswasthatthebankwasexperiencingadefundingrunandwasdesperatelytryingtostayafloat.BettingontheBadEquilibriumEconomists’modelsofbankrunsincorporatelotsofmechanismsandbehaviors.Whattheydon’tincludeisthepossibilitythatsomeagentsstandreadyandabletomanufacturefinancialcollapsebecausedoing sowill line theirpockets,directlyor indirectly.Consider, in this regard,hedgefunds. In the days running up to Bear’s demise, hedge funds pulled the plug on Bear bywithdrawingtheirdepositsenmassefromBear’sprimebrokerage.ThiswasdiscussedbytheBBCinanarticleentitled, “HowHedgeFundsSankBearStearns.”55What’snotknown iswhetherthesehedgefundsalsotookshortpositionsand,effectively,corneredtheshortmarket.Suchactionswould,presumably,havebeenillegal.Whatisknownisthatfalserumorswereplanted–rumorsthatimprovedthepositionoftheshorts.56AccordingtotheNYTimes,

SpeculationaboutacashshortagedroveBearstockdownalmost60percentinafewdays,adeclinethatcoincidedwithasurgeinshortbetsagainstthefirm’sstock.AlanD.Schwartz,thechiefexecutiveofBear,latersaidthatmaliciousrumorshelpedfuelthepanic.57

TheWashingtonPostwrote that theSECwas investigating short sales in conjunctionwithBear’sfailure.

AnunusualspikeintradingofBearStearnssharesprecededthecollapseofthe85-year-oldWallStreet institution lastweek,and theSecuritiesandExchangeCommission islookingintothisactivity,saidapersonfamiliarwiththematter.Inparticular,theSECis

53http://www.washingtonpost.com/wp-dyn/content/article/2010/05/05/AR2010050505104.html54The$2pricepersharewasultimatelyincreasedto$10inreactiontoashareholderclassactionsuit.55http://www.bbc.co.uk/blogs/thereporters/robertpeston/2008/03/how_hedge_funds_sunk_bear_stea.html56https://dealbook.nytimes.com/2008/06/30/what-really-killed-bear-stearns/57https://www.nytimes.com/2008/04/30/business/30shorts.html

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examiningasurgeinshortsellingthatoccurreddaysbeforethetroubleatBearStearnswasrevealedpublicly.58

ShortlyafterLehmanfailed,JohnMac,headofMorganStanley,memo’dhiscompanythat

What's happening out there? It's very clear to me — we're in the midst of a marketcontrolledbyfearandrumors,andshortsellersaredrivingourstockdown.59

AswithhedgefundsandbankscompetingwithBearandLehman,wemayneverlearnthefullbehaviorofshortsellers.ButVanityFairdescribedwhathappenedtoBearStearnsas“murder”–murderfacilitatedbyopacitysodeepthatteamsofpotentialsuitorscouldn’tfigureout,withinBear’ssurvivalwindow,whattheBear’sassetswereworth.60Toquotefromthearticle,

The fallofBearStearnswasn’t justanother financial collapse.TherehasneverbeenanythingonWallStreettocomparetoit:a“run”onamajorinvestmentbank,causedinlargepartnotbyacriminalindictmentorsomemammothquarterlylossbutbyrumorandinnuendothat,asbestonecantell,hadlittlebasisinfact.Bearhadenduredmorethanitsshareofself-inflictedwoundsinthepreviousyear,buttherewasnoreasonithadtodiethatweekinMarch.61

Accordingtothisview,speculatorscan,withmanufacturedbadnewsorsimplyexaggeration,takedownanybankinthecountryatanytime.Thentheycanproceedtotheirnextvictim.62Nakedshortselling–salesofacompany’sstockbyentitiesthatdon’townthesharestheyareselling--alsoplayedandcanstillplayarolein“murdering”banks.RollingStonedescribedtheshort salesofBearandLehmanas “Wall Street’snakedswindle.”63Theheadline in the2010article reads, “Aschemeto flood themarketwithcounterfeit stockshelpedkillBearStearnsandLehmanBrothers—andthefedshaveyettobusttheculprits.”That’sequallytruetoday.Indeed,theSEChasn’tevenissuedareportonitssupposedinvestigationintheeightyearssinceRollingStonecarrieditsstory.Thestorymeritsacarefulread.AsBearandLehmanreachedtheendoftheirtethers,shortsellersmanufacturedtensofmillionsofsharesofthetwocompaniesanddumpedthemonthemarket.The

58http://www.washingtonpost.com/wp-dyn/content/article/2008/03/20/AR2008032003515.html59http://content.time.com/time/business/article/0,8599,1842499,00.html60https://www.vanityfair.com/news/2008/08/bear_stearns200808-261https://www.vanityfair.com/news/2008/08/bear_stearns200808-262 This paragraph from the Vanity Fair suggests this is possibility is a common view onWall Street. “Evenwithsubpoena power, I’mnot sure the S.E.C.will get to the bottomof this, because the standard of proof is just sodifficult,”saysavice-chairmanatanothermajorinvestmentfirm.“ButIhopetheydo.Becauseyoucanlookatthisasjustanotherrunonabankorasaseminalpointinthefinancialhistoryofthiscountrythatcouldbringaboutachange,perhapsadrasticchange,inthewaywegovernfinancialmarkets.Ifthereisasolutiontothiskindofthing,itmustbe found in the rootsofwhathappenedatBearStearns.Becauseotherwise, I canguaranteeyou, itwillhappenagainsomewhereelse.” 63https://www.rollingstone.com/politics/politics-news/wall-streets-naked-swindle-194908/

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saleofcounterfeitsharesexplainstheterm“naked”asinnobacking.64Fatok,et.al.(2014)claimthebulkofthenakedshortsalesoccurredwhenthetwocompanieswerealreadyontheropes.ButtheSECreachedadifferentconclusion.ThreedaysafterLehmanfailed,theSECclampeddownonmostnakedshortsales.65Todate,theSEChasengagedinveryfewenforcementactionsagainstnakedshortsellers.Thesameistrueinprosecutingshortsellerswhotransmitfalserumors.PaulBerlinerisanexception.Hiscaseillustratestheimpactofasinglerumor.In2008,Berlinerspreadaplausible,butfalsestorythatAllianceDataSystems’salepricewasbeingrenegotiateddownwardduetopurportedproblemsinthecompany’sconsumerbankingbusiness.Berlinerdispensedthisinformationwhilesellingthe company short.66Within a half hour of the rumor’s dissemination, the price of Alliancedroppedby17percent,lettingBerlinercashinandcashout.67Misinformedorexaggeratedstatementscanalsodomassivedamage.Consider,thisextendedquotefromtheveryfirstpageofWilliamCohan’sHouseofCards.68

Thefirstmurmuringsofimpendingdoomforthefinancialworldoriginated2,500milesfromWallStreetinanunassumingofficesuitejustnorthofOrlando,Florida.There,hardbythetraintracks,BennetSedaccaannouncedtotheworldat10:15onthemorningofMarch5,2008,thatvenerableBearStearns&Co.,thenation'sfifth-largestinvestmentbank,wasintrouble,bigtrouble.“Yep,”SedaccawroteontheMinyanvilleWebsite,whichisdedicatedtohelpinginvestorscomprehendthefinancialworld.Thegreatcreditunwindisuponus.Creditdefaultswapsonallbrokers,particularlyLehmanandBearStearns,areblowingout,big time. Sedacca, the forty-eight-year-old president of a $3.5 billion investmentmanagementcompanyandhedge fund,hadbeenwatchinghisBloombergscreensonadailybasisasthecostofinsuringtheshort-termobligations—knowninWallStreetargotas“creditdefaultswaps”—ofbothLehmanandBearStearnshadincreasedsteadilysincethesummerof2007andthenmorerapidlyinFebruary2008.NowhewascallingtheendofthecreditpartythathadbeenragingonWallStreetforsixyears.“I'vebeentalkingaboutit foryears,”Sedaccasaid later.“But Istartedtonotice it that fall.Because ifyouthinkaboutit,ifyouhaveallthisnuclearwasteonyourbalancesheet,whatareyousupposedtodo? You're supposed to cut your dividends, you're supposed to raise equity, and you'resupposedtoshrinkyourbalancesheet.Andtheydidjusttheopposite.Theytookonmoreleverage.Lehmanwentfromtwenty-fivetothirty-fivetimesleveragedinoneyear....”

Cohan takes Sedacca’s statement, which is a captivating introduction to his book, asunquestionablytrue.Butwhathedoesn’ttellhisreadersiswhetherSedaccahadshortedLehman 64https://en.wikipedia.org/wiki/Naked_short_selling65Ibid.66https://www.sec.gov/litigation/litreleases/2008/lr20537.htm67https://www.sec.gov/news/press/2008/2008-64.htmSomehow,theSECdiscoveredBerliner’sschemeandprosecutedhim.TheresultwasafineandlifetimebanishmentfromWallStreet.68 Cohan(2010)

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CDSorotherLehmansecurities.Nordoesheaskwhethertheuseoftheterm“nuclearwaste”todescribeLehman’sassetshadanyfactualbasisorwasjustSedaccajustifyingasuccessfulpastshortposition.Finally,Cohandoesn’tcheckifSedacca’sgothisnumbersright.AccordingtoitsApril7,2008paperonleverage–whosereleasetheSEC,whichwasmonitoringLehmanonadailybasis,surelyapproved,Lehman'sleveragewas29,not35timesin2007,onagrossbasis,and16onanetbasis.Moreover,inherApril10,2010testimony,SECChairMaryShapirostatedthat“Throughoutthesummer(of2008),Lehmanembarkedonvariousstrategiestoraisecapitalandtoreducethesizeofitsexposuretomortgage-relatedandotherilliquidassets.”69Lehmandidn’t,contrarytoSedacca’sassertion,takeonmoreleverage.TheSpreadofFeartothePublicandRealEconomyModelsofmultipleequilibrium,whetherneworold, implicitlyfeaturethespreadoffear.Thepressisavectorinthisprocess.Consider,forexample,thepress’referencestorecession.TheEconomistmagazineviews itsownandothermedia’suseofthe“Rword”aseconomicallysofrighteningandviralthatit’sturnedtheword’susageintoaleadingeconomicindicator.Here’sitsdescription.

OurgaugecountshowmanystoriesintheWashingtonPostandtheNewYorkTimesusetheword“recession”inaquarter.Thissimpleformulapinpointedthestartofrecessionin1981and1990and2001.InthepastfewyearstheR-wordindexhasbeenextremelylow.Itbegantoriseinthesecondhalfof2007and,measuredataquarterlyrate,…soaredinearly2008.70

TheEconomiststartedwritingabout itsR-word index in2001withthetitle,“WordsthatCanHarmYou.”71Buthowcanwordsharmusunlesstheycoordinatethepublictotakethewrongeconomicdecisions?InJanuary2008,TheEconomistreportedthat,“Peddlinggloomisthenewparlour gameonWall Street andbeyond.”72 Peddling gloommeans sellingdisaster.Butwhoreapstheprofitsofgloom?Theansweristhepress,whichalwaysneedafreshstory,politicians,whoalwaysneedafreshcause,andshortsellers,whobenefitfromexternalconfirmationoftheirpositions.Another indicator of fear is the VIX, which measures market expectations of stock marketvolatility.TheVIXmorethandoubledintheyearpriortotheonsetoftheGRandthenrosebyafactorofthreewhenLehmanfailed.ThisconfirmedFCICChairman,PhilAgenlides’analysisthat“panicseized themarkets.”73Therewas,ofcourse,nochangeonSeptember15,2008 in thevolatilityof the realeconomy–nonegative technology shock,nooutbreakofworldwar,noclimaticcataclysm,noannouncementoftradewar,nofreshrevelationsoffiscalinsolvencies,nounexpected wage hikes, no announcement of hyperinflation – nothing, just collective,coordinated,masspanicthatsentthefinancialmarketsreeling. 69https://www.sec.gov/news/testimony/2010/ts042010mls.htm70https://www.economist.com/graphic-detail/2011/09/16/gauging-the-gloom71https://www.economist.com/finance-and-economics/2002/11/21/words-that-can-harm-you72https://www.economist.com/finance-and-economics/2008/01/10/warning-lights73https://fred.stlouisfed.org/series/VIXCLS

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Whenthepublicunderstandsthatfear,asPresidentRooseveltsoperceptivelyandsuccinctlyputit,istheonlythingtofear,itbecomesveryinterestedinthestateoffear.Thisiswhy,intherunuptotheGR,mediamentionsofandGooglesearchesforrecession,depression,subprimes,liarloans,theVixandotherindicatorsofgloomrosesharply.September15,2008was,ofcourse,thedayWall Street’s music died, producing a huge surge in searches for the entire panoply oflinguisticgloomandkickingoffa36percent,6-monthdropinthestockmarket.74TheindexofconsumersentimentledtheR-wordindexinpredictinganR.ItpeakedinJanuary2007andfellbyalmostonequarteroverthecourseoftheyear.Itfellbyaroughlyequalamountthrough June2008and then rebounded.ButwhenLehmancollapsed, the index immediatelyplungedagaindespiteno immediatechangesofanykindto therealeconomy. I.e.,Lehman’sbankruptcydestroyednotasingleLehmanbuilding,filecabinet,computer,oranyothertypeofcapital.AnditneitherkillednorinjuredasingleLehmanemployee.Butthenon-financialeconomyhadhadenough.IntheninemonthspriortoSeptember15,2008,there had been one major bad financial news story after another. The public had beenbombardedwithstoriesaboutliarloans,nodocloans,NINJAloans,ratingshopping,regulatorycapture,crazy-sounding,hyper-complexderivativesandderivativesofderivatives,extraordinaryleverage, a massive house price bubble in the process of bursting, horribly unaligned CEOincentives, predatory lending, bank failures, widespread opacity, bonus-based, originate todistribute75mortgagesecuritizations,…Tomakemattersbothworseandhighlyconcrete,CountrywideFinancial,BearStearns,FannieMae, Freddie Mac, IndyMac, Merrill Lynch – all had been bought up at fire-sale prices ornationalized. In the days, weeks, and months following Lehman Brothers’ collapse, AIG,WashingtonMutual,Citigroup,andWachoviaallhittheskids.Theeconomysurelysawwhatwas,fundamentally,justareshufflingoffinancialplayersandassetownershipasasuresign(averybrightsunspot,ifyouwill)thatbadtimeswerehereagain.Thereactionwasshift.Employerslaidofftheirworkersindrovestolowertheirpayrollsbeforetheircustomersstoppedarriving.ThiswastheworstofthemanytypesofmultipleequilibriaassociatedwiththeGR.Havingtheeconomyfliponthebasisofbadnewsaboutthefinancialsystemis,economicallyspeaking,oldhat.In1720,insidertradingandfraudulentmisrepresentationledtocollapsesofboththeSouthSeaandMississippibubbles.TheattemptedcorneringoftheU.S.bondmarketkindledthePanicof1792.ThesaleofinvestmentsintheimaginaryLatinAmericancountryofPoyais led to the Panic of 1825. ``Wildcat banking" helped produce the Panic of 1837. TheembezzlementofassetsfromtheOhioLifeandTrustCo.instigatedtheRailroadCrisisof1857.JayGouldandJamesFisk'scorneringofthegoldmarketprecipitatedthe1869GoldPanic.Cooke 74https://trends.google.com/trends/explore?date=all&geo=US&q=great%20depression,Recession;https://fred.stlouisfed.org/series/WILL5000INDFC75 Even the concern with originate to distribute may have been dramatically overhyped as suggested inhttps://www.researchgate.net/publication/228168491_Securitization_and_Loan_Performance_A_Contrast_of_Ex_Ante_and_Ex_Post_Relations_in_the_Mortgage_Market.

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andCompany'sfailuretodiscloselossesonNorthernPacificRailroadstocksparkedthePanicof1873.AfailedcorneringofUnitedCooper'sstocksinstigatedthePanicof1907.TheHatryGroup'suseoffraudulentcollateraltobuyUnitedSteel,thesaleofFloridaswampland,theMatchKingHoax,theSamuelInsullfraudandotherswindlesusheredintheGreatDepression.AndinsidertradingandstockmanipulationbroughtdownDrexelBurnhamLambert,precipitatingthelargestinsurancefailureinU.S.history.76WhenLehmanfailed,allbetswereoff,includingthoseplacedagainstfinancialcollapsebytheworld’s largest insurer,AIG,whichwasnext to go. Suddenly, it became clear that the globalfinancial system could spontaneously implode and that there wasnoguaranteegovernmentscouldstopit.Theywereluckyanddidstopit,butnotbefore29oftheworld’slargestfinancialcompanieswereeithernationalized,soldoffinshot-gunweddingsorwentbankrupt.Thefactthatthepanicmovedbackandforthacrosstheoceantellsusthatfinancialcontagionspreadsgloballyaswellasdomesticallyanddoesn’trequireinterconnectedbalancesheets.Thistoorepresentsevidenceofmultipleequilibrium.Consider, inthisregard,theCypriotbankingcrisisof late2012andearly2013.77Thepossiblefailureof twosmallbanks in that tinycountrybecame frontpageglobalnews forweeksnotbecausethetwobankswereimportantinofthemselves.Instead,afailureofthesebanks,totheseveredetrimentofdepositors,couldhaveledtoarunonGreekbanks,followedbyarunonbanksinItalyandSpain,followedbyarunon…Ratherthanletthetwobanksfail,theEuropeanCommission,EuropeanCentralBank,andIMFheldemergencymeetingsandprovidedabailout.Thiswasacaseoftoosmalltofail–anotherclearsignofaglobalfinancialsystemthatwastoounstable(toopronetomultipleequilibrium)toabsorbevenaseeminglyminorjolt.As the international financial system was effectively taken into receivership by the FederalReserve, the European Central Bank, the Bank of England and the Bank of Japan, the realeconomy ground down to a prolonged period of stagnation, and, in Spain and Greece,depression.IntheU.S.,theindexofconsumersentimentdidn’treturntoits2007peakforanentiredecade.Theslowrecoveryishardtoexplainexceptastheresultofeveryoneexpectingaslowrecovery.Economiescanstayinbadequilibriumsforverylongtimesuntilthereisenoughgoodeconomicnews to collectively galvanize animal spirits.78 This can occur, even though, aswas the case,centralbankssetinterestratesclosetozero.Suchdrasticpolicieswerearguablytakenassignsthatthingswereevenworsethangenerallybelievedandthatthiswasnotimetorehireontheassumptionthatdemandforone’sproductswasabouttopickup.BankingCrisesandPublicGoods

76ThisparagraphistakenverbatimfromTimJacksonandLaurenceKotlikoff,BanksasPotentiallyCrookedSecretKeepers,NBERworkingpaper,no.24751,2018.77https://en.wikipedia.org/wiki/2012%E2%80%9313_Cypriot_financial_crisis78TheGreatDepressionlastedadecadeuntilWorldWarcoordinatedthemovetoafullemploymentequilibrium.

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The reason that financial crisesareeconomically sodeadly is that thebanksarenotgrowingwheat,whichcaneasilybestoredorpurchasedfromabroadifthere’sashortage.Bankingpanicsare economically deadly because the banks are managing/running/providing a public good,namely the financial marketplace. Banks are intermediaries, i.e., middlemen. They connectlenderswithborrowersandsaverswithinvestors.Ifthebanksgodown,thefinancialmarketfails.Thisisakintogasstationssimultaneouslyfailingandpreventingusfromusingadifferentpublicgood – the highway system.79 Moreover, if one gas station had borrowed to gamble fromanother,thetwostationswouldhaveinterlockingbalancesheetsmeaningthefailureofthefirstcouldcausethefailureofthesecond.80Take,forexample,thisdescription,fromtheFed,ofBear’sfinancial-marketmakingpriortoitsfall.

The imminent insolvency of Bear Stearns, the large presence of Bear Stearns in several important financial markets (including, in particular, the markets for repo-style transactions, over-the-counter derivative and foreign exchange transactions, mortgage-backed securities, and securities clearing services), and the potential for contagion to similarly situated firms raised significant concern that the stability of financial markets would be seriously disrupted if Bear Stearns were suddenly unable to meet its obligations to counterparties, and the extension of credit allowed for an orderly resolution of the firm.

IntheGR,thefinancialsystemfroze.AfterLehman,everyremainingmajorbankandthousandsof minor banks would likely have failed had the government not intervened in the trulyunprecedentedfashioninwhichitdid.Thegovernment,inthiscase,wasprimarilytheFederalReserve.Itbecame,forall intentsandpurposes,theonlyfullyfunctionalbankinthecountry,makingloanstoallmanneroffinancialandnon-financialenterprises,fromthelargestsurvivingbankstocompaniessellingmobilehomes.TheFedalsobailedout,directlyorindirectly(throughothercentralbanks),foreignfinancialentities.UnsafeatAnySpeedThebanks failedbecause they could.And they could fail because theywere leveraged. Theyfalselypromisedtomakerepaymentsregardlessofthecircumstances.TheFederalReserve isalso leveraged. In the aftermath of Lehman’s collapse, the Fed effectively insured not justcheckingandsavingaccounts,butalsomoneymarket funds.Theseobligationswereofficiallyand, respectively, FDIC and Treasury obligations. They ran to some $6 trillion.81 But neitherinstitutionhad$6trillioninreadycashtomakegoodonitsinsurance.Hence,theFedwouldhavebeenonthehook.Indeed,hadthingsgottenworse,therewouldsurelyhavebeenarunonthe

79Gas stations,by theway, are intermediariesbetweendrivers and refineries.Weregas stations to collectivelygamblewiththeirbusinesses,failinconcert,andleavethepublicunabletousetheroads,Congresswouldinstantlymandatetheyoperatetheirbusinessesonafullyequity-financedbasisandthatgasstationownersgamble,iftheysochose,strictlywiththeirownmoney.80https://www.federalreserve.gov/regreform/reform-bearstearns.htm81Kotlikoff(2010)

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lifeinsuranceindustry’scash-surrendervaluepolicies,which,atthetime,alsototaledroughly$6trillion.82Nowimagine,asdiscussedinKotlikoff(2010),thatthegovernment’sexplicitandimplicitpledgesofinsurancehadbeencalledbythepublic.I.e.,supposethepublichad,despitethepromisesofgovernment insurance, headed straight to the banks, money market funds, and insurancecompaniestoemptyouttheiraccountsandcashouttheircash-surrendervaluepolicies.Inthiscase,theFedwouldhavehadtoprint$12trillionvirtuallyovernight.TheM1moneysupplyatthe time was just $1.5 trillion.83 Hence, this would have produced fully justified fearshyperinflationleadingeveryonetorunfortheirmoneybeforepricessoared. TheU.S.hasyet toexperiencearunon itscentralbank.But this iscommon incountries likeArgentina,wherethepublicandthefinancialcommunityarewellawarethatthegovernment’spledge of deposit and related financial insurance can only be honored in the context of thewholesaleprintingofmoney.Suchmoneyprintingmeansthepledgewon’tbehonoredinrealterms.Thus,withcentralbanksaswithprivatebanks,therearetwoequilibria–everyonerunsandnooneruns.TheRoleofOpacityOpacityisthemidwifeoffinancialpanics.BearStearnswasamongthefirsttobepickedoffbythosewhostoodtogainbyafinancialcollapsebecauseitwasviewedasparticularlyopaque.AccordingtoCohan(2010),nooneonthestreetor, itseems,insidethebank,knewwhatitsassetswerereallyworth.Whattheydidknowisthatitsrelativelyhighleverageandopacitymadeitvulnerable.So,too,accordingtoCohan(2010),didBearCEO,JimmyCayne’sreputationforcaringmoreabouthisbridgegamethanhisbankandhispoorpersonalrelationshipswithtopWallStreetbankersaswellasTreasuryChairman,HankPaulson.84ThefactthatBear’sstockwasvaluedat$60pershareoneweekbeforeJPMorganboughtitfor$2pershare(lessa$29billionsaleofBear’stroubledassetstotheFedvaluedatfarlessthan$29billion)tellsusthatnooneknewanythingaboutBear’sassets,eitherbeforeitdiedorwhenitdied. Itsvaluationwas, itseems,purelyamatterofconjecture.Beforeitdidn’t,themarketapparentlythoughBear’sassetswereworthsomethingbecauseeveryoneelsethoughtitsassetswereworthsomething.Thistooisthestuffofmultipleequilibria.Samuelson’s (1958)pureconsumption loanmodel, inwhichtheyoungcan’tsaveforoldage,illustratestheproblem.Money,inhismodel,hasvaluebecauseeachyounggenerationthinksthenextyounggenerationwilltreatitashavingvalueandtradefood(chocolateinSamuelson’sexample) for money. This belief makes every generation better off. But if the belief thatsuccessiveyounggenerationswillmaketheswapcomestoanend,Samuelson’selegantsolutioncollapses to the no-money, bad equilibrium inwhich all current and future elderly starve to

82Ibid83https://fred.stlouisfed.org/series/M1SL84SeeCohan(2010)

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death.85Theindeterminacyisactuallyevenworse.TheSamuelsonmodeladmitsacontinuumofequilibriabasedondifferentassumptionsaboutthepathof futureratesatwhichmoneywillswapforchocolates.86Ofcourse, it’shardtoproveopacity -- thatnoonereallyunderstoodBear’sbookofbusinessexcept,perhaps,JimmyCayne.Cohan’s(2010)“proof”comesfrominterviewinginsidersatBear,buttheymayhaveborngrudges.Forwhateverit’sworth,letmerelatemyowninterview,whichIconductedin2008withmythenbrother-in-law,Jim.JimwasatopbankerwithJPMorganatthetimeandwasoneofsometwohundredJPMorganbankerswhoweretaskedtospendwhatturnedouttobeBear’sfinalweekendvaluingBear’sassets.AfterBearsoldforlessthanthevalueof itsheadquartersbuilding, I asked Jimhowmuchheandhis colleagues knewaboutBear’sassetsbeforetheybeganlookingatitsbooks.Hisanswerwas“nothing.”IthenaskedJimhowmuchheandhiscolleaguesknewaboutBear’sassetsaftertheyspent24-7foralmostthreedayslookingatBear’sbooks.Hisanswerwas“nothing.”Bear’scollapseshowedthemarketthattherewaspotentiallynotherethereinanyofthebanks.If Bear’s mysterious “rock solid” assets were worth a fortune yesterday, but nothing today,maybethesamewastrueofotherbank’sassets.Andasthenextmost“trustworthy”bankfell,because,again,itbecameclearthatnoonecouldreallyunderstanditsassetseither,thebeliefthatyetmore“trustworthy”bank’sassetswererocksoliddeclined.Theserialfailureofthebanks,thus,appearstoaccordwithwhatopacityandfaith-basedassetvaluationswoulddeliver.Byanalogy,ifIslandA’skidsstopswappingchocolateformoneybecausetheythinktheirownkidswon’t swapwith them, the failure of the self-fulfilling prophecy in Island A can flip thebehaviorofkidsinislandBwhoweremodelingthemselvesafterIslandA’skids.Next,IslandC’skids,whoweremodelingthemselvesafterIslandB’skids,canflipandsoforth.Intheevent,oncethemightyCountrywideFinancialandthe85-year-oldBearStearnsfell,otherbanks began to collapse. First IndyMac, then Fannie Mae and Freddie Mac (the massivegovernment-sponsoredmortgagecompanies)followedbyMerrillLynchonthesameweekendasLehman.87NextcameAIG,WashingtonMutual,Citigroup,andWachovia.Theserialfailures,over a year, of one huge financial corporation after another, has the feel of an informationcascade.EliminatingtheTwinPillarsofFinancialCollapse–LeverageandOpacityBanksthathavezeroleverage--don’toweanythingtoanyone--can’tgobankrupt.Hence,theobvious way to prevent future banking crises is to preclude all financial corporations fromborrowing.Moreover, if opacity is amajor problem, the answer is to have the governmentoverseedisclosure.Whythegovernment?First,privatepartiescan’t,aswe’veseen,betrusted

85AsdiscussedinKotlikoff,PerssonandSwensson(1986),eachgenerationofyoungcanconsiderprintingitsownmoney.Thattoo,withoutsomeotherfeatures,candestroySamuelson’sgoodequilibrium.86SeeKotlikoff(2006)87IndyMacandMerrillLynchsoldthemselves.FannieandFreddiewerenationalized.

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to provide truthful disclosure. Second, they can be mistrusted even if they are acting in atrustworthymanner.Third,informationisapublicgood,makingitsdisclosureapublicgood.TheDoddFrankreformdoesverylittletoalterfinancialcompanyleverageorlimitthefinancialsystem’sopacity.Asindicated,today’sbankingsystemhasessentiallythesamecapitalratioasLehmanhadthedayitdied.Asformakingfinancialcompaniestransparent,it’sbusinessasusualonWallStreet.ThepassonopacitywasimplicitlyendorsedbytheFCICreport.Thatreportruns633pages.Thewordopacityappearsonce.Thewordopaqueappearsseventimes.ConclusionStandardexplanationsofthe2008financialcrisisanditsassociatedGreatRecessionrepresentthebigcon.LikethemovieTheBigShort,theymakebadactors,notintrinsicproblemswiththefinancial system and the economy, namely multiple equilibrium, facilitated by leverage andopacity,theculprits.Bad/greedy/lazy/irresponsibleactors,we’retold,engagedinallmanneroffinancialmalfeasance,risktaking,negligence,theftandgreed.Andwhatwe’retoldistrue.Therewereplentyofbadactors–enoughtofilluphundredsofbooksandmoviescripts.Butthestoryofthesebadactorsisnot the real storyof theGreatRecession.Thereal story is thatboth theeconomyandthebankingsystemareinherentlyunstable.Theyareunstableduetoexpectations-drivenmultipleequilibria.Ifenoughpeoplethinkenoughpeoplethinkabankisgoingdown,thatbankwillgodownregardlessof itstruecondition.Ifenoughpeoplethinktheeconomyisgoingdown,theeconomywillgodown,alsoregardlessofitstruecondition.Oneapproachtoaddressingtheproblemof financialmultipleequilibriumistoreplaceDodd-Frank with more fundamental financial reform, such as Kotlikoff (2010)’s Limited PurposeBanking(LPB).LPBwouldtransformallfinancialcorporationsinto100percentequity-financedmutual fund holding companies subject to full and real-time disclosure supervised by thegovernment.

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