UNINTENDED CONSEQUENCES 9781591845508_Unintended_FM_pi-x.indd iii9781591845508_Unintended_FM_pi-x.indd iii 04/04/12 10:38 PM04/04/12 10:38 PM 9781591845508_Unintended_FM_pi-x.indd iv9781591845508_Unintended_FM_pi-x.indd iv 04/04/12 10:38 PM04/04/12 10:38 PM UNINTENDED CONSEQUENCES WHY EVERYTHING YOU’VE BEEN TOLD ABOUT THE ECONOMY IS WRONG EDWARD CONARD PORTFOLIO / PENGUIN 9781591845508_Unintended_FM_pi-x.indd v9781591845508_Unintended_FM_pi-x.indd v 04/04/12 10:38 PM04/04/12 10:38 PM PORTFOLIO / PENGUIN Published by the Penguin Group Penguin Group (USA) Inc., 375 Hudson Street, New York, New York 10014, U.S.A. Penguin Group (Canada), 90 Eglinton Avenue East, Suite 700, Toronto, Ontario, Canada M4P 2Y3 (a division of Pearson Penguin Canada Inc.) Penguin Books Ltd, 80 Strand, London WC2R 0RL, England Penguin Ireland, 25 St. Stephen’s Green, Dublin 2, Ireland (a division of Penguin Books Ltd) Penguin Books Australia Ltd, 250 Camberwell Road, Camberwell, Victoria 3124, Australia (a division of Pearson Australia Group Pty Ltd) Penguin Books India Pvt Ltd, 11 Community Centre, Panchsheel Park, New Delhi—110 017, India Penguin Group (NZ), 67 Apollo Drive, Rosedale, Auckland 0632, New Zealand (a division of Pearson New Zealand Ltd) Penguin Books (South Africa) (Pty) Ltd, 24 Sturdee Avenue, Rosebank, Johannesburg 2196, South Africa Penguin Books Ltd, Registered Of ces: 80 Strand, London WC2R 0RL, England First published in 2012 by Portfolio / Penguin, a member of Penguin Group (USA) Inc. 10 9 8 7 6 5 4 3 2 1 Copyright © Edward Conard, 2012 All rights reserved Library of Congress Cataloging-in-Publication Data Conard, Ed. Unintended consequences : why everything you’ve been told about the economy is wrong / Ed Conard. p. cm. Includes bibliographical references and index. ISBN 978-1-59184-550-8 1. United States—Economic conditions. 2. United States—Economic policy. 3. Finance—United States. I. Title. HC103.C7348 2012 330.973—dc23 2012006013 Printed in the United States of America Set in ITC New Baskerville Std Designed by Pauline Neuwirth No part of this book may be reproduced, scanned, or distributed in any printed or electronic form without permission. Please do not participate in or encourage piracy of copyrighted materials in violation of the author’s rights. Purchase only authorized editions. 9781591845508_Unintended_FM_pi-x.indd vi9781591845508_Unintended_FM_pi-x.indd vi 04/04/12 10:38 PM04/04/12 10:38 PM For my wife and daughter 9781591845508_Unintended_FM_pi-x.indd vii9781591845508_Unintended_FM_pi-x.indd vii 04/04/12 10:38 PM04/04/12 10:38 PM 9781591845508_Unintended_FM_pi-x.indd viii9781591845508_Unintended_FM_pi-x.indd viii 04/04/12 10:38 PM04/04/12 10:38 PM CONTENTS INTRODUCTION 1 PART I: WHAT WENT RIGHT ONE: A Brief History of the U. S. Economy 11 TWO: The Role of Investment 30 THREE: The Role of the Trade De cit 52 FOUR: The Role of Incentives 72 PART II: WHAT WENT WRONG FIVE: The Role of Banks, Credit Rating Agencies, and Regulators 113 SIX: The Role of Short- Term Debt and Government Policy 158 PART III: WHAT COMES NEXT SEVEN: Preventing Another Bank Run 195 EIGHT: Reducing Unemployment 219 NINE: Redistributing Income 254 CONCLUSION 275 Acknowledgments 287 Notes 289 Illustration Sources 301 Index 305 9781591845508_Unintended_FM_pi-x.indd ix9781591845508_Unintended_FM_pi-x.indd ix 04/04/12 10:38 PM04/04/12 10:38 PM 9781591845508_Unintended_FM_pi-x.indd x9781591845508_Unintended_FM_pi-x.indd x 04/04/12 10:38 PM04/04/12 10:38 PM 1 INTRODUCTION WAS OUR COUNTRY’S economic success over the last twenty- ve years built on false pretenses? Did we simply borrow and spend too much money? Are we now paying the price for that unsustainable spending spree? In the aftermath of the Financial Crisis in late 2008 and early 2009, many commonly held beliefs have emerged to explain its causes. Wall Street bankers* stand accused of using low down pay- ments, teaser rates, and other predatory tactics to seduce home own- ers into buying homes they couldn’t afford. Critics charge that bankers used fraudulent credit ratings to sell these risky mortgages to unsuspecting investors, bundling pools of risky mortgages into securities in which 80 percent of the cash ows received the lowest- risk, AAA rat ings— ratings that agencies have long since down- graded. These risky loans and their subsequent defaults, they claim, would have bankrupted our nancial infrastructure had it not been for taxpayers’ bailouts. If taxpayers must provide guarantees to lend- ers, shouldn’t they demand fair compensation for their guarantees? Many of the same people assert that bankers put our nancial * The book uses the terms “banking,” “bankers,” and “Wall Street” loosely to encompass both commercial banks that accept deposits and investment banks that do not. My usage of the terms aligns most closely with common usage. Where differences are relevant, the text delineates different types of nancial institutions. N 9781591845508_Unintended_TX_p1-310.indd 19781591845508_Unintended_TX_p1-310.indd 1 05/04/12 3:16 AM05/04/12 3:16 AM 2 UNINTENDED CONSEQUENCES infrastructure at risk for their own gain by allegedly funding loans with too much short- term debt and engineering their way around prudent banking regulations while the Bush administration looked the other way. All the while, Wall Street raked in unprece- dented pay. Critics blame misaligned incentives and sheer incom- petence for this recklessness. Don’t we need extensive regulations to protect us from a repeat of this behavior? Meanwhile, American households stand accused of borrowing recklessly to increase consumption. Over the last twenty years, debt* as a percent of gross domestic product (GDP) rose from 250 percent to 350 percent. Personal saving rates declined from a his- torical average of 10 percent in the 1970s and early 1980s to essen- tially zero prior to the Crisis. We seem addicted to nancing increased consumption, while the trade and scal de cits sky- rocket. Have we mortgaged our children’s future as a result? Others believe the Federal Reserve spurred this borrowing by holding interest rates too low after the 2001 recession. They blame cheap credit for arti cially driving up real estate prices, which lulled borrowers and lenders into a false sense of con dence and increasingly reckless behavior. At the same time, the trade de cit exploded as income inequal- ity grew dramatically. Some economists claim that low household saving rates and a corresponding lack of investment eroded U. S. competitiveness. Overheated consumption supposedly tightened our industrial capacity utilization, which drove valuable manufac- turing jobs offshore. Critics claim Americans have become a nation of hamburger ippers and that open trade borders and cheap offshore labor have held down the wages of domestic work- ers. According to the New York Times, 99 percent of the U. S. popu- lation went without pay raises for decades as their standards of living declined. Meanwhile, the incomes of the top 1 percent grew 300 percent. 1 Income inequality increased substantially. The evi- dence seems mighty damning. To add insult to injury, the tax policies of the Bush administration * The sum of government, business, and nancial debt. N 9781591845508_Unintended_TX_p1-310.indd 29781591845508_Unintended_TX_p1-310.indd 2 05/04/12 3:16 AM05/04/12 3:16 AM [...]... on their own, or can private investors put our economy at risk for their own gains? Nothing less than the credibility of capitalism is at stake Science judges hypotheses, not by what they explain, but by what they fail to explain When anomalies pile up, experts reject the hypothesis that engender them The various hypotheses explaining the Financial Crisis are riddled with anomalies For instance, if the. .. 9781591845508 _Unintended_ TX_p 1-3 10.indd 20 05/04/12 3:16 AM A BRIEF HISTORY OF THE U.S ECONOMY 21 temporarily exit the workforce in mid- career to raise children As a group, these workers have below-average productivity Also, a large share of the forty million new American workers employed since the mid-1980s have been low- skilled, younger-than- average Hispanic immigrants, largely lacking high- school... 9781591845508 _Unintended_ TX_p 1-3 10.indd 8 05/04/12 3:16 AM PART I WHAT WENT RIGHT N 9 9781591845508 _Unintended_ TX_p 1-3 10.indd 9 05/04/12 3:16 AM 9781591845508 _Unintended_ TX_p 1-3 10.indd 10 05/04/12 3:16 AM CHAPTER ONE A BRIEF HISTORY OF THE U S ECONOMY THE PERFORMANCE OF the U.S economy over the two decades prior to the Financial Crisis was much stronger than commonly perceived Over the last two decades, the. .. 1990s Even with the European sovereign debt crisis looming over world markets, household net worth rebounded soon after the Financial Crisis to the same level it had reached at the peak of the Internet boom in 2000 (see Figure 1-1 0) To exaggerate the case that there is too much debt, proponents of this argument often add financial debt to the sum of household, N 9781591845508 _Unintended_ TX_p 1-3 10.indd 25... economic history helps to put these comparisons into perspective 1950S AND 1960S: THE HALCYON DAYS A unique set of circumstances accelerated the growth of the U.S economy in the 1950s and 1960s The world economy suffered N 11 9781591845508 _Unintended_ TX_p 1-3 10.indd 11 05/04/12 3:16 AM 12 N UNINTENDED CONSEQUENCES a decade- long depression in the 1930s that stifled capital investment Following the Great... ended the halcyon days of the 1950s and 1960s After the postwar catch-up, advance economies saw their growth slow and their unemployment rise Productivity growth— the 9781591845508 _Unintended_ TX_p 1-3 10.indd 13 N 05/04/12 3:16 AM 14 UNINTENDED CONSEQUENCES relevant measure of an economy s growth— stalled (see Figure 1-1 ) The most talented U.S workers were fully educated Europe and Japan caught up to the. .. the 1970s and 1980s took on the slow- growth characteristics of large companies In the face of an influx of forty million new full- and parttime workers since the 1980s, the U.S economy gradually shifted to a more entrepreneurial mode It’s hardly surprising to find that these turbulent developments have taken their toll on employees As Robert H Frank and Phillip J Cook’s 1995 book, The Winner-Take-All... recognize the consequences this shift would entail for employment In the 1970s and 1980s, when equity bore these risks, growth slowed and unemployment rose 1990S TO 2008: THE RISE OF INNOVATION As the world grew increasingly competitive, one might have expected growth to slow, wage growth to flatten, and the risk of unemployment to rise But the opposite happened in the 1990s and beyond The U.S economy. .. Freddie Mac? Why was it slow to transition the United States to international banking standards, which loosened capital adequacy requirements? If loose monetary policy is the primary cause of the Crisis, why are loan defaults predominantly confined to subprime mortgages† and not spread more broadly? A full explanation of the workings of the economy and the Financial Crisis must account for these apparent... 9781591845508 _Unintended_ TX_p 1-3 10.indd 22 05/04/12 3:16 AM A BRIEF HISTORY OF THE U.S ECONOMY 23 in pay has been significantly higher Half the jobs created by the United States between 1983 and 2005 were created at the highest end of the wage scale— doctors, lawyers, managers, scientists, etc Prior to 1983, these jobs represented only 23 percent of the workforce This surge in productivity has had an astonishing . Data Conard, Ed. Unintended consequences : why everything you’ve been told about the economy is wrong / Ed Conard. p. cm. Includes bibliographical references and index. ISBN 97 8-1 -5 918 4-5 5 0-8 1 PM 9781591845508 _Unintended_ FM_pi-x.indd iv9781591845508 _Unintended_ FM_pi-x.indd iv 04/04/12 10:38 PM04/04/12 10:38 PM UNINTENDED CONSEQUENCES WHY EVERYTHING YOU’VE BEEN TOLD ABOUT THE ECONOMY IS WRONG EDWARD CONARD PORTFOLIO /. HISTORY OF THE U. S. ECONOMY THE PERFORMANCE OF the U. S. economy over the two decades prior to the Financial Crisis was much stronger than commonly per- ceived. Over the last two decades, the