Thursday, January 21, 2010

Fama on the financial crisis and "credit bubbles"

Eugene Fama, father of the efficient markets hypothesis, makes some good points in this interview in The New Yorker Magazine. Questioned as to whether the credit market could be considered efficient if "people were getting loans, especially home loans, which they shouldn't have been getting," he replied:

That was government policy; that was not a failure of the market. The government decided that it wanted to expand home ownership. Fannie Mae and Freddie Mac were instructed to buy lower grade mortgages.

In other words, it wasn't inefficient markets that led to the financial crisis, it was government intervention in markets that caused the crisis.

Questioned as to whether the credit market bubble that inflated and then burst could be considered an inefficiency that led to the 2008 financial crisis, he replied:

I don’t even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people saved too much during that period?
I like this response because I have argued along the same lines before. To say that a credit bubble (commonly viewed as a significant rise in the ratio of household debt to GDP) caused our problems is to ignore some important facts. In the absence of any evidence that the money supply grew by an unusual amount relative to the size of the economy (on average, M2 grew only 1% per year faster than GDP from 1997-2008), then the large increase in credit outstanding that we observed over those same years was the result of voluntary private sector activity.

Credit can be created by one person lending money to another, but that does not result in any increase in money outstanding, nor does it create any new demand. (New money is created only when banks extend credit via the fractional reserve system; when they do so, then the money supply expands.) If I take money out of my pocket and lend it to John, I have created credit, and the money I don't spend he now has to spend. Perhaps he turns around and lends it to George; that adds further to the amount of credit outstanding, but again it doesn't increase the amount of money in the system, nor does it create any new demand—it only shifts demand from one party to another.

From this it follows that, as Fama notes, if you argue that there was "too much credit" in the system, then you are also saying there was perhaps too much saving. Yet many of those who worry about too much credit also argue that another big problem in the U.S. economy in the past several decades has been profligate consumption and a very low savings rate. Someone is very wrong here, and it is the misunderstanding of how credit works that explains it.

Those who point to a credit bubble as the culprit in this crisis fail to understand that the growth in credit is not the same as an inflationary expansion in the amount of money. Credit can grow very rapidly or very slowly without creating any necessary implications for inflation. In a low and stable inflation world, it is entirely possible for credit to experience rapid growth. Indeed, rapid growth in credit is most likely to occur when conditions are stable and confidence is high.

When inflation is high and volatile, lending money becomes a very risky business and credit dries up. I know, because when I lived in Argentina during the triple-digit inflation of the late 1970s, I discovered that the average maturity of loans was measured in months, not years. To buy a house, for example, the best terms I could find were 30-60-90: one third of the price in 30 days, the next third in 60 days, and the final third in 90 days. When inflation and risk are high, no one wants to lend. Lending flourishes, in contrast, during periods of stability and confidence.

If you're looking for a guilty party to blame for the financial crisis, blame the federal government for mandating inefficiencies in the way FNMA and FHLMC operated, and blame the Fed for keeping interest rates too low for too long. The Fed's easy money policy caused the demand for money to decline. As a result of easy money, people came to want less money and more things, and that's one reason why housing, commodity and gold prices rose so strongly in the years leading up to the crisis. The price of the dollar fell and the price of things rose, and the rise in housing prices greatly exceeded the rise in incomes. This was the "bubble" that eventually popped: prices that got out of line with the ability to pay.

Moral: don't confuse "credit" with inflationary monetary policy. They are two very different things.


Public Library said...

Very good post. The blame squarely lands on the shoulders of government and in particular the Fed.

The irony is the complete denial by Bernanke, Greenspan, and Geithner of their part in the calamity.

The reality is, even if congress mandates more households should own property via FHA, FNMA, or GNMA, there isn't a problem until rates get so low that every Tom, Dick, and Harry can afford the illusory low payments.

Congress can mandate it, but people still need to be able to make the payments and that is where the Fed obliged with the 400-500 bps drop in rates early in the decade.

That was enough to make payments affordable for everyone. The proverbial punch bowl was full to the brim.

Benjamin Cole said...

Not sure about Fama's statement to the very good New Yorker writer.
After all, two-thirds of home loans were re-purchased as MBS by private buyers--after getting ace ratings from Moodys, Fitch, S&P et al. The private buyers bought purely of their own volition. It was a free market. Lenders knew they could re-sell loans, so they kept lending.
The credit rating agencies are paid by the issuers--no nice rating, no next job.
In theory, the free market should sort this out. Buyers will no longer trust ratings agencies.
But, we have a limited number of rating agencies. This will freeze up capital.
I think a solution is to require issuers who want ratings to put money into a pool, and then the rating agency is selected at random. Maybe this would work, though I dislike any more rules.

I notice no one ever, ever, ever challenges the home mortgage interest tax deduction in the housing bubble. Surely, that plays a huge role. Canada has no home mortgage interest tax deduction, and did have a lesser bubble-plunge.
The home mortgage interest tax deduction is a type of state nannyism, along with health insurance accounts, college etc.
Just keep my tax rates as low as possible, and let me do what I want with my money. Don't distort markets with tax breaks. Milton F. would agree.
But, of course, once you make enough money, you are all but forced to buy property for the tax benefits, as everyone's accountant advises--thus overfunneling trillions into property markets.

Fat chance we get rid of the home mortgage interest tax deduction. That will end with farmer subsidy-give-aways.

Bill said...


I agree that the govt. was a big culprit in the financial crisis, but as another of these posts points out, no one forced the private banks to leverage the MBSs 30:1. When housing prices started to fall, there were runs on these banks because of the perception that they didn't have enough capital to pay back their debt. I suppose from a free-market perspective it would have been better to let these institutions to fail, but that's what Mellon advised in '29 and look what happened.

Scott Grannis said...

The whole subprime mortgage story is very complex. When I was at Wamco back in 2005-2007 we talked a lot about the risk to mortgages of a decline in home prices. I even asserted at the time that prices could fall 30-35%. We were aware of the risks, and so we didn't buy mortgages that weren't AAA+, and that we thought could withstand a 30% price decline. What we didn't know or realize was that with that kind of price decline all hell would break loose and there would be panic selling of just about everything that wasn't a T-bill or a Treasury.

The panic was so bad that prices ended up falling way below where they should have for a 30% home price decline. It was a total wipeout for nearly everyone. The panic fed on itself.

I truly believe that the vast majority of banks and institutional investors that ended up losing tons of money on MBS never imagined that things would ever get as bad as they did. It was a perfect storm. Those are almost impossible to predict.

Yes, a lot of things contributed to the crisis, from the Fed to the ratings agencies to Fannie and Freddie etc. But only a handful of people were able to connect the dots and see a Perfect Storm/total wipeout coming.

I keep thinking however that without Fannie and Freddie buying a trillion or more of subprime securities, the situation would never have gotten as bad as it did. With F&F buying the vast majority of these securities, the banks were making loans as fast as they could. Everyone lost sight of the magnitude of the potential problem.

W.E. Heasley said...

Mr. Grannis:

John B. Taylor’s book Getting Off Track explains it nicely. In 100 pages Taylor clearly spells it out. Taylor makes a good point that cheap money set the stage for all the other activities that followed. That is, all the financial activities that occurred that are referred to as the components of “the financial crisis” can be traced back to 2002-2004 creation of cheap money.

Ralf Graute said...

Dear Scott,

thank you very much for your daily economics lectures! They are great fun to study and it is a big honor that you share your knowledge with us. Please keep up the good work.

Could please let me know where you got the M2 data from which you calculated the 1% figure?

Many thanks in advance and have a great weekend!

Ralf from Germany

Scott Grannis said...

WEH: John Taylor would be my choice to replace Bernanke.

Scott Grannis said...

rgraute: M2 data is available from the Federal Reserve:

GDP data is available here:

lb100 said...


Thanks for the post and the link to the Fama interview. The reference to the efficient market hypothesis, however, raised a question I've had for some time about your investing philosophy and approach. Perhaps I've misunderstood, but it seems that your approach is to use cues from the various bond, money, and commodity markets as guides to the strength and direction of the financial markets. I certainly don't get the impression you follow a "passive" approach. Am I wrong? I'm very curious. Thanks.

Scott Grannis said...

lb100: I use a combination of active and passive investment strategies. I hold some major positions in index funds, and I hold outsized positions in companies that I follow very closely and feel very strongly about.

I'm always looking for situations in which the market tells me that the outlook for the future is very different from my own outlook. I believe the market can and does make mistakes from time to time, and that I can have an edge.

One example: I took a position in AAPL some 7 or 8 years ago. At the time the market thought there was a high probability that AAPL would go out of business. I thought that AAPL had some great new products that had fantastic potential, and that AAPL could gain significant market share from MSFT. In hindsight this sounds like a layup but at the time the negative sentiment regarding AAPL was intense.

Another example: At the end of 2008 the market was priced to a severe depression and deflation. I looked at a number of key indicators and saw instead that the fundamentals were improving and that the market was way too pessimistic. I thought that equities were therefore very attractive.

Adele said...
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