Under Discussion The Anatomy of the Banking Crisis

Edited and condensed by David Hollander MFA ’97

In a 2009 interview, former Vice President Dick Cheney insisted that the 2007 collapse of the US financial markets was completely unavoidable.

“Nobody anywhere was smart enough to figure [it] out,” Cheney said. Of course, those who could have figured it out were making big money on dubious investments and repackaged debt, and weren’t about to call off the party. “As long as the music is playing,” Citigroup CEO Chuck Prince said just weeks before the crash, “you’ve got to get up and dance.”

But economics faculty member Jamee Moudud’s class, “Money and Financial Crises: Theory, History, and Policy,” has been probing the anatomy of the banking crisis without the irrational exuberance of people making boatloads of money. It seems the market inherently encourages a boom-to-bust cycle ad infinitum. Upswings are financed by private debt—from mortgages, car loans, and credit cards—which the banking system reinvests wherever returns are highest. But when people start going bankrupt, this so-called money—which has become enmeshed with the entire economy—dissipates like pixie dust. The whole system crashes in a hurry.

What follows is a partial transcript of the class conversation, as Moudud’s students explore the relationship between the imaginary riches of a debt-fueled boom and the national “current account balance,” which measures real, production-based income. The US was running huge current account deficits for years preceding the crash, as exports dipped, debt piled up, and the bankers—drunk on capital and blind to tomorrow—danced on. It’s not that no one was “smart enough” to foresee disaster; it’s that this time, like all the other times, we thought we were smarter than we actually are.

Jamee Moudud: Today we’re going to look at the anatomy of a banking crisis. Let’s say you have a country that is running a current account deficit. More money is leaving this country than coming into it. Essentially, it has to attract short-term foreign capital. You do that by raising interest rates on bonds, right?

(Lots of nodding)

Let’s follow that through. Suppose that you have a bank in this country and the interest rates on bonds go up. Now there are two interest rates. One is the interest rate of deposits at this bank, and the other is the interest rate on bonds. ... What will happen to deposits in this bank? Are they going to go up or down?

Aman Banerji ’14: They’re going to go down.

Moudud: Why?

Aman Banerji: Because money will automatically be channeled into the buying of bonds.

Moudud: Right. People have the choice of putting their money in this bank or putting it into bonds. Bonds have a higher rate of interest, so the money will flow from the bank to the bond market. How is the bank going to respond?

Several Voices: Raise interest rates on deposits.

Moudud: Right. Now follow with me here. If the bank raises the rates on deposits, what will it do to the bank’s profits?

John Murdock ’12: Profits will go down and the bank will get involved in speculation.

Moudud: (nodding) As the interest rate in deposits goes up, the bank will be incentivized to invest in activities that offer higher rates of interest. So there will be a push toward more and more speculative activity by this bank. Does everybody see this? (Nodding. Sounds of assent.)

Moudud: So next what happens? Now you’ve got cash coming in and increased speculation. The roller coaster is on, right? … More and more money is being loaned out to borrowers. You are fueling a boom, but it’s a fragile boom. On the other side, the debt level is rising. Now as the debt level rises … some folks go bankrupt. The government reacts, says we need to lower interest rates to lessen the pressure on private finances. … What will happen as the interest rates go back down?

Aman Banerji: Capital moves out at the worst possible time.

Moudud: Right. The currency is dumped. … This could trigger a series of bankruptcies across the economy, like a cobweb unraveling.…

Moudud: Okay, let’s look at it this way. Suppose you end up with $500,000 in your bank account. Where did it come from? Is it money that you borrowed or money that you earned? You could get your credit card company to deposit $20,000 into your bank account. You could say, “Hey, I’m rich!”

Believe it or not, this is oftentimes the way political discourses go. Countries run a current account deficit, but money is coming in on the capital account, which is borrowed money. It adds to the foreign exchange reserve, and the country is made out to be some kind of poster child of development. This capital flow bonanza often creates the impression that it’s party time. Maybe someone could work out the argument for us.

Selena Skorman ’12: Well, because all the capital inflow causes more credit to be given out, asset prices start to rise.

Moudud: Exactly. So you’ve got this huge current account deficit, and there’s also a huge amount of money coming in. The liquidity of the financial sector is increasing, but it’s all based on debt. Now, in terms of our current crisis, did anybody bother to worry about any of this as it was happening?

Aman Banerji: (smiling) This time is different.

Moudud: (nodding) This time is different. There you go. People downplay the seriousness of current account deficits.…

Moudud: The argument was that the US didn’t need to worry about running a huge current account deficit. Why weren’t people worried when there was all this money coming in?

Priscilla Liu ’14: Well, as of now the international banking system still readily absorbs the dollar. You can keep printing out money and monetize debt.

Preksha Krishna Kumar ’14: (nodding) As long as your currency remains the world’s reserve currency, as long as it’s accepted universally, you can afford to run a current account deficit.

Moudud: Right. This was the claim. What about the International Monetary Fund? What did it have to say in 2007?

Sean Scanlan ’12: That there was no risk.

Moudud: It’s right here. Page 214. Reinhart and Rogoff say that the IMF concluded in April of 2007 that (reading) “risks to the global economy had become extremely low, and for the moment, there were no great worries.”

Several Voices: Whoa. (Laughter)