The Big Bean Bubble

By Polly Cleveland

In my last post, I wrote how, in A Brief History of Doom, Richard Vague shows how the boom-and-bust cycle originates in episodes of reckless and outright fraudulent private-sector lending. By the time a central bank tries to put on the brakes by raising interest rates, much of the damage is already done. The extent of further damage after the crash depends on how well the central bank maintains the banking system and helps the victims.

Let me now give a simple example to illustrate just how the boom-and-bust cycle does its damage and how the central bank’s response can worsen or mitigate that damage.

Imagine a country whose citizens primarily produce and eat beans. Here are the economic players: a number of bean farmers and their workers, a bean warehouse, a few banks, and a central bank. Every fall after harvest, the banks lend money to the farmers to cover their expenses over the next year. At the next harvest, the farmers sell their beans to the warehouse, pay off their loans to the banks with interest, and take out new loans. As in any but the most primitive economy, the farmers live in permanent debt, as do other small businesses.

Consider a typical bank, the First National Bean Bank, or FNBB. FNBB’s assets consist of a little bit of cash (created by the central bank), plus loans to bean farmers. Its liabilities are checking accounts belonging to bean farmers and to the bean warehouse. FNBB’s assets minus liabilities equals owners’ equity, that is, the owners’ stake in the bank. Liabilities are typically several times the amount of owners’ equity. In making loans, FNBB actually creates money—the money in the checking accounts. When it gives Farmer Brown a loan for $100,000, it simultaneously puts $100,000 in Brown’s checking account. FNBB requires collateral for the loan: Farmer Brown’s land, which must be worth more than the loan, say $120,000. If Brown defaults, FNBB can seize and sell his land.

Like all banks, FNBB faces two existential constraints. First, it must keep enough cash on hand to meet ordinary day-to-day withdrawals from checking accounts. Running out of cash means instant bankruptcy. If FNBB faces unexpected demands for cash, it may “call” some of its loans, that is, demand that the farmers pay early, or get an emergency loan from the central bank. Second, the FNBB must limit the ratio of liabilities—checking account money—to the owners’ equity. If some of the farmers default and their collateral doesn’t cover the loss, then owners’ equity can become zero or negative, making the bank insolvent or “under water.” If heavy defaults threaten to put FNBB under water, it will hide that fact as long as possible, lest panicky customers—the farmers and the warehouse—start demanding immediate cash, causing a “run” on the bank.

As for the warehouse, to play it safe it keeps a stock of beans greater than a normal year’s consumption. Before harvest, it still has half a year’s supply. After harvest, it has a year and a half’s supply.

In ordinary times, the money supply—cash plus checking accounts—remains stable. Over the course of the year, the farmers and their workers buy beans from the warehouse for consumption. The bank simply transfers money from their checking accounts to the warehouse’s checking account, but the total remains the same. The price of beans remains stable too. It’s just the monthly amount of money transferred divided by the number of beans purchased. At harvest time, the warehouse empties its checking account to buy the new beans, the farmers turn the money over to the bank to repay their loans with interest, the bank reissues their loans, and the cycle repeats, year in and out. (Note that the bank owners spend their interest income buying beans, keeping the money supply constant.)

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Then something exciting happens. A scientist announces he’s developed a new GMO bean that will double the yield of beans. The more progressive half of the farmers rush to plant the new beans. Not only that, but they start buying land from other kinds of farmers, such as corn farmers, to plant the new beans. How can they do that? They get additional loans from the banks, simultaneously increasing the money supply. Land values start to rise as the bean farmers bid for additional land. That increases the value of the collateral they provide to the banks. The bank owners get excited about all the interest they expect to earn and offer even more loans. Some banks become careless about checking the quality of land offered as collateral, which may be too rocky or swampy for beans. Both farmers and bank owners, already anticipating how much richer they will soon become, also buy and eat more beans than usual, raising not only the price of land, but the price of beans, and reducing the bean inventory below normal.

You can guess what happens. Come harvest time, the GMO beans have done poorly even on high-quality bean land, and failed altogether on the additional land some farmers purchased. The bean warehouse is almost empty. The progressive farmers can’t repay their loans. The land they provided as collateral now isn’t worth nearly as much as the loans made against it. Obviously, the banks cannot make new loans to these farmers. The large volume of failed loans puts many banks under water. Their liabilities, that is, their checking accounts, now exceed their assets, that is, good loans plus cash. (The banks will of course try to hide this reality as long as possible.)

Meanwhile, the conservative farmers sell their crops as usual to the warehouse, and as usual repay their loans to the banks. But then what? Because many of the banks are under water, they can’t issue new loans to the conservative farmers either. This is key. Because many of the banks engaged in reckless lending to progressive farmers and outright speculators, they now must cut off lending to the conservative farmers, the ones who didn’t take part in the GMO bean frenzy. The farmers lay off their workers, creating massive unemployment. All of a sudden, hardly anybody has money to buy beans. Even though the bean warehouse is only half full, the price of beans plummets. To naïve observers it looks like there’s a surplus of beans. In reality, there’s a deficit in demand for beans.

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Enter the Beanland Central Bank, or BCB. BCB has some limited control over the banks, because it can lend them money at an interest rate it sets. It also can regulate the banks’ lending standards. During the GMO excitement, the BCB kept its interest rate low and mostly ignored the growing level of fraudulent lending. Come the crisis, what can and should the BCB do?

Option A. In an effort to stop the madness, the BCB can suddenly hike interest rates and cut its lending to the banks. That’s slamming the barn door after the horse has escaped. It’s the very worst thing to do. Option A guarantees that the weakest banks will shut down, wiping out the remaining checking accounts of the warehouse and surviving bean farmers, and further shrinking the money supply. It will set off a long deep depression as the farmers struggle to survive and recover with much reduced banking services.

Option B. The BCB can bail out the failing banks, that is, the worst offenders during the boom, by buying their bad loans at face value, and lending them new money at zero interest rate, in the hope that they will relend it to the bean farmers. This is a better solution than Option A. There will only be a long recession. However, the BCB has essentially rewarded worst offenders’ reckless behavior and left many farmers hopelessly in debt and still dependent for money on the very banks that screwed them. Remember that bean prices have collapsed due to the drop in demand. The miscreant banks might just sit tight for a while without bothering to lend, or they might use their new free money on something unproductive, like speculating in gold futures.

Option C. The BCB can bail out the bad banks, fire or jail the crooked management, and install new managers. The BCB will require these managers first to renew the loans to the conservative farmers, to keep them in business as usual. The new managers will also renegotiate or forgive the overpriced loans to the failed progressive farmers, to get them back into business. However, things won’t return to normal for some time. Bean inventory is still dangerously low. As the reconstituted failed banks resume lending to farmers, and their starving workers begin to consume beans again, bean prices may actually rise well above pre-bubble normal. Meanwhile, as taxpayers, the farmers and workers will foot most of the bill. There will still be a recession until the bean inventory recovers, but that recovery will happen faster than under Option B.

There you have it. During the boom phase of a bubble, damage accumulates invisibly in the form of dubious investments, undertaken at the expense of vital ones. Beanland farmers planted dicey GMO beans not only on good bean land, but on land normally planted to other crops, as well as on rocky or swampy soil. Speculators even borrowed money just to live lavishly, helping drive down bean inventory. Land, labor, and capital all went to waste. Come the inevitable bust phase of a bubble, the BCB can either make things worse by allowing the bad banks to fail (Option A), mitigate the damage by bailing out the bad banks (Option B), or actively promote recovery by bailing out the farmers (Option C). In real life, of course, central banks typically muddle through with some combination of all three options.

I didn’t mention inequality, but it also plays a role. First, the more unequal the economy, the higher on average the debt load of individuals and small businesses, and therefore the more they suffer from a cut off of credit. Second, the more unequal the economy, the greater the political power of the biggest banks. These can induce the central bank to ignore their misconduct during a boom, and then to preferentially bail them out come the inevitable bust. That’s clearly what happened in the boom before the 2008 crash, causing the Great Recession, from which we haven’t yet recovered.

 

 

 

Review: A Brief History of Doom

By Polly Cleveland

Review of A Brief History of Doom: Two Hundred Years of Financial Crises,
by Richard Vague

A Brief History of Doom is the most important economics publication to come along in years. This short, well-documented, and engrossing book wasn’t written by an economist, but by a banker.

Richard Vague made a fortune as a conservative Texas banker. On retiring, he decided to investigate the cause of boom and bust cycles. His results shocked him. As he told us at a recent Institute for New Economic Thinking presentation, he had always assumed markets were perfectly efficient and that government incompetence or malfeasance caused the problem. Instead, here’s what he found:

A necessary and sufficient explanation [his italics] for a boom and bust cycle is an episode over several years of excessive private sector lending, typically triggered by an exciting innovation. That lending inflates values of land or stocks, and sets off a vicious circle of increasingly reckless and often egregiously fraudulent behavior, with lending driving rising values and rising values justifying more lending. When the bubble eventually bursts, the damage has already been done. The only difference from one bubble to the next is the size, and the degree of competence with which the government contains the aftereffects.

Vague and his research team collected massive amounts of data on financial crises from 1819 to the present, in the US and elsewhere. He begins with the Roaring Twenties and the ensuing Great Depression. Contrary to the assertions of former Federal Reserve Chair Ben Bernanke, not to mention conventional Keynesian wisdom, the boom and bust was not a monetary phenomenon. Rather, as I have written, when the new horseless carriage appeared to open up vast tracts of suburban land to housing, banks engaged in a frenzy of reckless lending to sketchy real estate developments, such as underwater lots in Florida. Two or three years before the stock market crash of 1929, the developments began to fail, stopping interest payments, and sticking banks with worthless collateral. The banks in turn had no money to lend to legitimate businesses, causing these to fail, setting off a downward cascade of failures. Following the market crash, panicky customers began runs on all banks, crooked and sound. The brand-new inexperienced Federal Reserve dithered, allowing the damage to accumulate.

Vague continues by examining the “Decade of Greed” in the 1980s, with the exploits and crash of the Savings and Loan banks, as well as of Michael Milken, the junk bond king. Again—a story well told by Bill Black in The Best Way to Rob a Bank is to Own One—the S&L’s engaged blatant self-dealing and fraudulent real estate investments at the expense of their customers. After the inevitable collapse, the US rescued the customers at the cost of some $480 billion dollars and sent over a thousand bankers to jail

From here, Vague moves to the mind-boggling Japanese real estate bubble of the 1990s, whose collapse together with Japanese mismanagement has left Japan with close to zero economic growth since then. The Chinese have handled their bubbles more effectively, though Vague wonders how long they can continue. Then he backtracks to famous historical bubbles. In the US, these include the canal boom of the 1830’s and the later railroad booms of the 1840s, 1870s and 1890s, which also affected British investors in US railroad companies. Finally, he tackles the giant mortgage boom, crash in 2008, and subsequent Great Recession that we all recently lived through. In this case he retells a story of reckless lending and fraud in the mortgage industry, a story already familiar from such books as Michael Lewis’s The Big Short.

Vague says it’s vital and feasible to identify budding bubbles: When the private loan volume in a particular sector rises faster than GDP, there’s usually a bubble. Inexplicably, the federal government does not separate data on loan volume by economic sector. Yet one has to be blind—or blinded by conventional economic theory—to miss big real estate bubbles. Without knowing anything about the crazy lending behind the last bubble, I personally saw it coming by 2005 in the exploding Case-Shiller home price index. There’s an unmistakable boomlet going on right now in the flipping of single-family houses for rental.

Vague is skeptical of remedies. Should the Fed “take away the punch bowl just as the party gets going” by raising interest rates? By the time the bubble is obvious, the damage is done and the frenzied fraudsters will ignore the signal, as they did in the months before October 29, 1929. Should Congress pass more laws like Dodd-Frank to rein in egregious bank misconduct? Trouble is, when the punch bowl starts to bubble, regulators come under enormous pressure to look the other way and politicians often have accepted huge campaign contributions from malefactors. Remember the “Keating Five” –the five Senators, including John McCain, who had received favors from the notorious S&L king, Charles Keating? Moreover, innovative banksters will find ways around the rules. The mortgage lenders, like Angelo Mozila’s Countrywide Financial, formed part of a “shadow banking” system not subject to bank regulation. Influential bank lobbyists prevented efforts to regulate the “securitization” innovation that powered the bubble leading to the 2008 crash.

I have one quibble with Vague: He says bubbles do their damage by creating “overcapacity.” Well, not exactly. A housing bubble does create a moonscape of vacant lots and even half-built houses, mostly in locations that weren’t suitable to begin with, which is how the developers got the land cheaply. That’s just waste. There’s a more insidious form of waste: the productive investment that didn’t happen, such as the older buildings that weren’t maintained while their owners waited to make a killing in a rising land market. Bubbles are man-made disasters, equivalent to the 2010 BP oil spill in the Gulf of Mexico. They call for the same remedy: first contain the damage then aid the victims and punish the corporate malefactors.

From that angle, the US response in 2008 was a travesty. Yes, bailouts of $700 billion and still counting prevented the collapse of the banking system. But the bankers responsible for the calamity proved “too big to jail,” and the tens of millions of homebuyer victims were not allowed to write down their inflated mortgages to the post-bubble value of their homes. Vague says that such debt restructuring, like the Biblical debt-forgiveness “jubilee,” would indeed have stimulated a rapid economic recovery.

Finally, what about preventing bubbles? I asked Vague about his native Texas, which suffered relatively little in 2008. That was possibly due, I suggested, to relatively high property taxes that kept down land values, and a well-enforced loan to value limit of 80% of equity. Yes, laughed Vague, and Texas also has a constitutional prohibition on second mortgages—we bankers lobbied furiously to get that undone, to no avail. I trust that as he and his team will further pursue the prevention possibilities of combining high property taxes with stiff regulation.