Robert Shiller Calls for More Encompassing Solutions to Credit Market Woes

In today’s New York Times, Yale economist and author of Irrational Exuberance Robert Shiller says, in effect, that the problems in the financial system are large enough to call for large scale, possibly even radical remedies. Shiller admits to not having a notion of what those measures should be. He does call for some changes he deems obvious, helpful, but only partial solutions, such as raising the amount of bank deposits subject to FDIC insurance and the brokerage firm balances covered by SIPC.

What is interesting is that the list of problems that Shiller lists as most pressing all go back to the breakdown of the securitization model. In fact, the simpler form of securitization, such as mortgage pass-throughs, have not, to my knowledge, led to any serious problems; it’s the more complex variants, particularly structured finance, which is what has gone awry. Yet one of the points of structured finance was to create higher-rated tranches that had more predictable payment characteristics than simple pass-throughs did. Thus, if structured credits are sufficiently tarnished that the market shrinks, say to 20% of its former volume, that would have serious implications for many lending markets. Would investors be willing to consume more of the same underlying credits in less packaged form, or will banks wind up keeping a higher proportion of the loans they originate on their balance sheets?

That is a long-winded way of saying that reformers need to look long and hard at the structured credit mess, because that is the epicenter of this earthquake.

From the New York Times:

The key to maintaining economic stability is well-placed confidence in the markets. Bubbles, by contrast, result from misplaced confidence.

We are living in a post-bubble world, following the stock market bubble of the 1990s and the real estate bubble of the 2000s. That is the backdrop for the current crisis. We need to restore confidence in the markets’ basic ability to function, not in their presumed tendency to make us all rich by always going up.

Some short-term remedies are under way. President Bush has said that fiscal policy is urgently needed to address the current situation and has reached tentative agreement with Congress on a temporary tax cut of $150 billion. This might increase the official federal deficit from about 1 percent of gross domestic product to something like 2 percent, about where it was a couple of years ago. And on Tuesday, the Federal Reserve under its chairman, Ben S. Bernanke, made an emergency between-meetings cut of three-quarters of a percentage point in the federal funds rate. The move brought that benchmark rate down to its level midway into the 2001 recession, and the Fed has signaled that it stands ready to make further cuts.

While a temporary tax cut and interest rate cuts are good ideas, they don’t address the underlying crisis of confidence. If these measures succeed merely in making people consume more, running to the malls and making the already-negative personal saving rate even more negative, they won’t restore faith in the financial markets.

One main response to the Depression that helped prevent another from occurring was a set of tools that improved confidence by truly improving market security. One of these was the Federal Deposit Insurance Corporation, in 1933, but there were also a large number of others, especially the Securities and Exchange Commission the next year.

These were not obvious innovations and, in fact, were highly controversial at the time. Indeed, it is never obvious how the government should foster well-functioning markets. The fundamental role of governments in promoting markets is clear, but the design of their instruments must make creative use of a great deal of information about financial theory, human psychology and existing institutions and practices. The successful markets we have are a result of considerable inventive effort.

The F.D.I.C. was controversial because it was established amid the ruins of various state-level deposit insurance plans that had just gone bankrupt. Critics at the time also argued that federal deposit insurance would encourage unsound banking. But it turns out that the F.D.I.C. was a very good idea. It restored confidence in the banking system during the Depression, and with hardly any cost.

The S.E.C. was similarly controversial. Critics said it would hamstring or straitjacket the markets. But it is now the model for securities regulation around the world.

We need such inventive effort today. It won’t be easy, but the first step would be to set up a national study commission and to pay for serious creative research on how to adapt important ideas, like deposit insurance and securities regulation, to a modern financial world.

Mr. Bernanke certainly knows the importance of well-functioning markets. In his 2000 book, “Essays on the Great Depression,” he wrote persuasively that runs on the banks and extensive defaults on loans reduced the efficiency of the financial sector, prevented it from doing its normal job in allocating resources, and contributed to the Depression’s severity.

The Depression-era problems he studied are mirrored by similar issues today, and they need urgent attention. The very fact that many people feel they can no longer rely on some of our financial institutions may bring a self-fulfilling prophecy, which could then fundamentally harm economic activity.

The mortgage market is suffering. People are having a hard time getting mortgages, and mortgage originators are finding it harder to sell their mortgages to those who would repackage them in mortgage securities.

The commercial paper market is suffering, too. The amount of outstanding asset-backed commercial paper, which has become a main element of an unregulated, uninsured, shadow banking system, has fallen 30 percent since August.

Other credit markets are also having problems. For example, some municipal borrowers have already had the credit ratings of their debt lowered because of the downgrading of Ambac, a municipal bond insurer, by Fitch Ratings. Problems in the bond market are likely to multiply if there are further downgradings of Ambac, or downgradings of other insurers like MBIA.

CONFIDENCE in our brokerage firms is suffering. With every announcement of major losses, some people start to wonder whether they can rely on these companies.

The Bank of England’s bailout of the mortgage lender Northern Rock in September was truly urgent. The bank was experiencing a run, the first in Britain since 1866. The newspaper photographs of long lines of people waiting on the street to withdraw their money probably rekindled dormant fears. People tend to remember such dramatic stories because they remember when their own confidence has been shaken.

The Northern Rock bailout was needed because ordinary depositors had begun to worry about their saving accounts. It was necessary to show them that they didn’t have to be worried. Improvements in the deposit insurance system in Britain began immediately after this crisis.

In the United States, the very least we can do is to raise the F.D.I.C.’s limits on insured deposits. The limit of $5,000 in 1934 was 12 years’ worth of per capita personal income at the time. The limit was last raised in 1980, to $100,000, which was then 10 years’ income. But because of inflation and economic growth, that limit is less than three years’ income today.

The Federal Deposit Insurance Reform Act of 2005 did not raise that ceiling, though it will start indexing the limit to inflation in 2010. We have allowed deposit insurance to go three-quarters of the way to extinction.

The insurance limits of the Securities Investor Protection Corporation, which protects customers when brokerage firms fail, were also last raised in 1980 — to $100,000 in cash accounts and $500,000 in securities — and thus have suffered an equally drastic erosion in real value. Such erosion could suddenly matter if the crisis, or even just the psychology of the crisis, were to worsen.

But far beyond this, at a time when so many problems have arisen outside the limits of existing federal insurance programs, we need to do more than update the programs for inflation. We need to consider the fundamental principles on which they were based, stress-test them for today’s environment and consider extending them in creative ways.

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  1. TS

    Strongly recommended reading in the most recent issue of ‘Harper’s’: Eric Janszen’s The Next Bubble: Priming the markets for tomorrow’s big crash.

    Janzen argues that America’s economy now depends upon Bubbles created by the Finance Insurance and Real Estate sectors of the economy (FIRE), where before the dot-com era they had been a relatively rare occurrence.

    His bet is that the alternative energy sector is the next Bubble-in-the-making.

  2. jo jo


    I would be interested in seeing your thoughts on Frederick Feldkamp’s November 5, 2007 public comment letter to the Federal Reserve criticizing a number of policy decisions by the Fed on mortgage and corporate securities and derivatives. Yesterday, Barrons highlighted a couple points from the letter, but didn’t print it.

    I’d also like to read the letter.

    Thank you. Sorry to be off topic.

  3. STS

    Thanks for this post. It is helping to direct attention away from the current DC stampede towards out-Keynesing Keynes with yet further fiscal stimulus. Much as I admire ol’ Maynard, even a good idea can be overdone.

    The housing implosion is freeing up resources which currency adjustment will draw towards tradables. There’s a good chance of a relatively mild recession which facilitates dramatic improvement in our international competitiveness IF we start weaning ourselves from our over-reliance on fiscal stimulus.

    The most serious risk at the moment is an accelerating debt-deflation process which idles productive resources in response to accounting standards which tell companies to start crying poverty because there has been a big drop in the market value of some of their securities holdings. That’s a bit like being forced by accounting rules to sell your fully paid off house simply because your neighbor lost 20% on his house sale last week.

    By all means lets get more realistic about credit standards and risk spreads,etc. but lets not stampede ourselves into a panic.

  4. Anonymous

    The losses in the stock market since the highs of October 2007 are about 14 percent. This predicts — very roughly — a fall in corporate profits of roughly 14 percent. Yet there has never been a decline of quite that size for even one year in the postwar United States, and never more than two years of declining profits before they regained their previous peak.

    What the hell is that moron saying there?

    When I hear people saying the stock market is crashing or wondering why The Fed was over-reactive it does seem in a word, retarded, where I think Gentle Ben’s eyes must have rolled into the back of his head and then popped some connective tissue that short circuited, because all you have to do is look at a chart:

    The index is down about 7% and The S&P500 is still at least 5% overvalued in terms of fair market value related to a 10 year Treasury.

    What the hell is the reason behind people thinking that the stock market is in a crash> Yup, housing bubble excess is helping to restore some sanity to a bubble that needs to be popped but the overvaluation of the asset bubble in regard to stocks, is just hype! I hate to quote Bush in any positive way, but the economy is not crashing (therefore I guess he thinks its doing great…Hmmm?). The simple final issue is that the housing bubble has at least another year to readjust down and probably values will go down another 15% in places, and stocks will go down maybe 10% and GDP will fall and it will be ugly, but its not the end of the world — unless we have The Fed and Bush add more chaos fuel to the credit fire and try to inject too much cash into the derivatives market…that where the retarded part comes in!

  5. Deborah

    When I think about it, I really disagree with this 100% insurance thing. Why should taxpayers be on the hook for 100%?

    Maybe 100% for first 10k, 95% for next $90k, 90% for next $100k and 80% for next $300k.

  6. Carlomagno


    Two words: Northern Rock. The scheme you propose is actually well known (it is known as co-insurance) and is applied in a number of countries, including the United Kingdom. The problem is that it has now been shown to encourage bank runs, since it makes it rational for depositors with deposits over the threshold for 100% insurance to pull their money out of the bank at the first sign of trouble.

    In your example, that would be all depositors with more than 10k, which are evidently more numerous that those with more than 100k (the current FDIC insurance limit).

    Check the posts and comments about Northern Rock on for more info.

    NB: I initially failed to understand the perverse incentives provided by the UK’s deposit insurance scheme and how it promoted the run on Northern Rock. Calculated Risk made me see the light!

  7. newsman

    Sometimes somebody needs to state the obvious to bring people back to reality. That’s what Shiller does in his second paragraph:

    “We need to restore confidence in the markets’ basic ability to function, not in their presumed tendency to make us all rich by always going up.”

    France’s Sarkozy provided a similarly elegant dose of adult thinking in his comments (from Times of London) on the SocGen troubles:

    “The point of a financial system is to lend money for economic activities which, in turn, generate profits. It is not to go and speculate on different activities which create enormous flows and profits in a few hours.”

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