Samuelson: The Catch-22 of Economics

We are now in the "blame phase" of the economic cycle. As the housing slump deepens and swings in financial markets widen, we've embarked on the usual search for culprits. Our investigations will doubtlessly reveal much wishful thinking and miscalculation. They will also find incompetence, predatory behavior and some criminality. Though inevitable and necessary, this exercise is also simplistic and deceptive.

It assumes that, absent mistakes and misdeeds, we might remain in a permanent paradise of powerful income and wealth growth. The reality, I think, is that the economy follows its own Catch-22: by taking prosperity for granted, people perversely subvert prosperity. The more we—business managers, investors, consumers—think that economic growth is guaranteed and that risk and uncertainty are receding, the more we act in ways that raise risk, magnify un-certainty and threaten economic growth. Prosperity destabilizes itself.

This is not a new idea. Indeed, it explains why terms like "the business cycle" and "boom and bust" survive. But it gets overlooked in periods of finger-pointing: now, for instance. The housing-collapse and credit fears are undeniable. Someone or something must be held responsible. Here's a rundown of popular suspects:

The Federal Reserve. It allegedly held short-term interest rates too low for too long. From late 2001 to late 2004, the overnight Fed funds rate was 2 percent or less. Credit was supposedly "too easy."

The Chinese. They funneled their huge export surpluses (mostly in dollars) into U.S. Treasury bonds. That kept long-term interest rates low even after the Fed began raising short-term rates in 2004. China's foreign-exchange reserves now exceed $1.3 trillion.

Mortgage bankers. They relaxed lending standards for weak borrowers, leading to high defaults. In 2006, about 90 percent of new "subprime" mortgages had adjustable interest rates. That exposed borrowers to future rate increas-es—which many now can't afford.

Wall Street. The mortgage bankers got giddy only because they could sell the loans to pension funds, hedge funds and others as mortgage-backed securities (bonds created by bundling loans).

Credit rating agencies. Moody's and Standard & Poor's—which rate the credit-worthiness of bonds—allegedly weren't tough enough on subprime mortgages. That fanned investor appetite.

Lending standards were clearly too lax and rating agencies too uncritical. Still, the rating agencies have downgraded less than 5 percent of 2006 subprime mortgage-backed securities (by dollar volume). This suggests that many investors knowingly bought risky mortgage bonds, thereby inflating the housing bubble. Just why they did this is less clear. Did the Fed foster easy credit for too long? Maybe. But economist Mark Gertler of New York University argues that if this were so, inflation would have exploded. It didn't. From 2003 to 2005, it rose modestly, from 1.9 percent to 3.4 percent.

What seems to have happened was a broad and mistaken reappraisal of risk. Once highly risky bonds were considered much less so. China's appetite for Treasury bonds may account for some of this. It may have lowered interest rates on Treasuries and sent investors scurrying into riskier bonds with higher rates (corporate "junk" bonds, mortgage bonds, and bonds of "emerging market" countries like Brazil). But that can't fully explain the extraordinary drop of interest-rate "spreads"—the gap between rates on riskier bonds and safer Treasuries. In early 2003, junk bonds carried rates eight percentage points above Treasuries; early this year, the gap was less than three percentage points. Somehow, junk bonds were no longer so risky; therefore, it was OK to accept lower rates.

Paradoxically, the fact that the U.S. economy grew in spite of so many daunting obstacles—corporate scandals, 9/11, higher oil prices—may have created a false sense of confidence that it could overcome almost anything. Sophisticated investors and ordinary consumers alike seem to have fallen under the spell of this logic. Believing risks had declined, the first group actually adopted ever-riskier investment strategies—and unknowingly increased financial risk. The second, believing in continuing economic growth and rising home prices, assumed ever-heavier debt burdens—and created potential obstacles to future spending. In 2000, household debt was 103 percent of disposable income; in 2007, it's 136 percent.

Mistakes and misdeeds do not occur in a vacuum. The ultimate culprit may be irrational exuberance. As economic expansions lengthen, people become careless. The fact that the economy has done well creates conditions in which it may—at least temporarily—do less well. Prosperity inevitably interrupts itself. This produces recriminations and promises to do better, but there is always a next time.