3. Money, Credit, and Crisis

I Introduction THE MOST OBVIOUS CULPRIT in the recent economic quagmire is the errors in judgment made by the managers of banks and other financial institutions. (1) As a result of these errors, a number of them have gone into receivership or been merged with better capitalized banks. According to the U.S. Federal Deposit Insurance Corporation (2008), an average of 5.4 banks failed per year from 2000 through 2007, followed by 25 bank failures in 2008, and another 25 failures by April 17, 2009. The failure of Washington Mutual Bank (WaMu) in 2008 was the largest bank failure in U.S. history. It held nearly $307 billion in assets when it was declared insolvent. IndyMac Federal Bank, with $32 billion in assets when it went into receivership in July 2008, was the largest savings and loan in the Los Angeles area. Its failure was the fourth largest in U.S. history. To provide a bit of perspective, the deposits of suspended banks in 1931 and 1933 amounted to around 0.6 percent and 2.9 percent of GNP in those two years, respectively (U.S. Bureau of the Census 1960: Series X-173, F-1). The combined failures of WaMu and IndyMac alone amounted to 2.4 percent of GDP in 2008. This does not include (a) the failure of many smaller banks; (b) the more than $500 billion of write-downs and credit losses as of September 2008 (before the bankruptcy of Lehman Brothers, valued at $639 billion in May 2008) (CNBC.com 2008); or (c) the billions in additional asset losses around the world after the Lehman bankruptcy led to liquidation of commercial real estate holdings at fire-sale prices. Surpassing all of the above liquidations, however, was the decline of asset values sustained by the Federal National Mortgage Association, Fannie Mae, and the Federal Home Loan Mortgage Corporation, Freddie Mac, which owned or guaranteed over $5 trillion of the $12 trillion mortgage market before they were placed under the conservatorship of the Federal Housing Finance Agency (FHFA) on September 7, 2008. By that time, their share prices were down about 90 percent from their high in 2007 (Goldfarb, Cho, and Appelbaum 2008: A1). Crises involving large numbers of bank failures have occurred with some degree of regularity in the United States and other countries, although the current crisis would appear to be on a larger scale than previous contractions. In each case, the pundits have attributed the most sensational cases to personal fraud and malfeasance. Certainly, there are individuals who manipulate markets, gamble with invested funds instead of acting prudently, or extend loans to people or institutions with bad credit histories. There are also regulators who look the other way rather than enforcing the rules strictly. So it is easy to view the debacle entirely through the lens of personal morality. The more important question, however, is who or what creates the conditions under which imprudent and fraudulent behavior by banks and regulators take place. To find out the answer to that question, we have to go behind the headlines to understand the fundamental nature of banking and what kinds of regulation are appropriate to prevent crises of the sort we currently find ourselves in. As we shall soon see, the fundamental problem lies in bank lending in which real estate serves as the collateral. By lending for housing and nonresidential land and buildings, banks risk losing their capacity to remain liquid, which thereby puts the entire financial system in jeopardy. A. The Trap of Conventional Wisdom In our effort to learn about the underlying causes of financial crises, we cannot simply turn to standard textbooks on money and banking. Of course, they are useful for explaining some of the basic mechanisms, such as fractional reserve banking. But a subtle bias enters into all conventional writing about the financial system, which creates the illusion that banks can be either healthy or insolvent independent of the real economy, as if finance operated in a different universe than the world of work and production. …