Of Houses and Hamburgers
Smith, Vernon L., Newsweek
Byline: Vernon L. Smith
Some markets are ugly. Others work miracles.
The Great Recession began in the fourth quarter of 2007. Measured in Depression clock time, 2012 was 1934, when the U.S. economy expanded 7.7 percent. Today such expansion seems remote. Rather, the economy is still stuck in a low-growth rut, the second such severe downturn in the United States since 1929.
We suffer from a balance-sheet crisis, the consequence of a collapse of property values plunging many households--now 21.5 percent--into negative equity. These households owe more on their mortgages than their houses are worth; even more households hover near the edge of that black hole. Equally serious for the resumption of economic growth is that the banks holding these mortgages were simultaneously plunged into negative equity.
Why were economic policymakers blindsided by these events? It's simple: balance-sheet effects are not included in policy thinking. When balance sheets are widely damaged, the normal flows of consumption and lending are disrupted, as households gradually pay down debt to climb back to positive net wealth and banks severely limit new mortgage lending.
There is strong evidence from the experience of economies as diverse as Japan, Sweden, and the U.S. that the least painful solution to balance-sheet crises is to allow defaults and bankruptcies to run their course, so that bloated debt obligations are realigned with realistic market-asset values. It is now 20 years since Japan suffered a real-estate collapse and--foreshadowing U.S. policy of protecting large banks from failure--became mired in anemic growth. The political process tends strongly to favor a policy of "too big to fail" for the banks. Why? Because it protects incumbent investors who are highly visible, contribute to election campaigns, and naturally do not want to lose their investments, however much based on an unsustainable housing-price bubble. Sweden suffered a balance-sheet crisis in the early 1990s, but mounted a swift, decisive response in which failing banks were required to recognize losses and recapitalize. Similarly, in the U.S. over 400 smaller banks failed, their mortgage assets sold at market worth, and were recapitalized. This process is salutary: it heals balance sheets, enabling capital to flow into new investments earning a return undiluted by the rescue of old investors that had failed but were not required to take their hit.
Fundamental insights have come from experimental economics that explain why some markets produce episodes of instability and economic suffering. My own first experiments were published 50 years ago, the results having surprised me as much as the economics profession. They demonstrated that markets governed by ordinary repetitive supply and demand converged quickly to prices and outcomes that maximized the gains from specialization and trade. But these markets had features distinct from the housing-mortgage markets so prominent in the Great Recession and Depression: the items were immediately paid for and consumed. Participants were always either buyers or sellers, and all sales were final, as items could not be retraded. …