Samuelson: The Tyranny of the Capital Markets

It's no secret that the housing industry is in a deep downturn. In its heyday, the real estate boom added 30,000 housing-related jobs a month (construction workers, mortgage brokers, real estate agents). Now, the bust is subtracting 15,000 a month, says Moody's In 2005, housing starts reached almost 2.1 million; expects starts of 1.4 million this year. By mid-2008, it forecasts, median prices for existing homes will be down almost 9 percent from their peak.

But the housing bust is really a small part of a larger story. Call it the tyranny of capital markets—global markets for stocks, bonds and other financial instruments. Our economy is increasingly under their sway. These markets are, of course, huge. At last count, the U.S. stock and bond markets alone were worth roughly $18 trillion and $24 trillion, respectively. Consider the impact on the "real" economy of jobs and production:

All this revises standard economics. The basic college course I took in the 1960s barely mentioned capital markets. Finance (the borrowing, investing and lending of money) was considered a sideshow. If the economy did well, the stock market rose. If companies needed money to invest—and were good credit risks—they could borrow from banks or sell bonds. Finance was passive. Its importance paled in comparison with technology, management or government policy. Based on some recent textbooks I've examined, that presumption still dominates.

Housing is its latest refutation. The boom stemmed partly from new "subprime" mortgages, which enabled people with lower incomes or weak credit histories to become home buyers. Credit standards were relaxed, down-payment requirements lowered. The packaging of these mortgages into "collateralized debt obligations" (CDOs) also encouraged lending. CDOs resemble bonds, with homeowners' monthly payments funneled to investors. CDOs are complex securities. Payments are split among investors, with the highest returns going to those accepting most of the default risk. The result: Credit flowed freely because a (relatively) small number of investors assumed big risks.

It was a bad gamble. Many subprime mortgages have gone into default. CDO investors are suffering losses. The credit cycle has reversed: Investors have retreated; credit standards have tightened; home buyers are scarcer; housing prices are dropping; it's harder to borrow against home values; consumer spending is weakening. Whether this will cause a recession is unclear.

But it captures a larger dilemma. Capital markets are not just incidental to economic growth. They're a force for both good and ill. The recent financial innovations have made it easier for countries, companies and individuals to borrow and tap investment capital. Many types of credit (auto loans, business loans) have been "securitized," unlocking new sources of money. New financial institutions have flourished: "hedge funds," pools of capital provided by pension funds and wealthy investors; "private equity" funds, with money from similar sources.

The peril is that so much has changed so quickly that no one knows how the system operates. It's often roulette. Monday's defensible investment may become Tuesday's silly speculation. Global markets are interconnected, and financial conditions are tightening. Some hedge funds—including foreign funds—have suffered huge losses on U.S. subprime mortgages. These could harm banks that lent to hedge funds. Up to a point, losses are inevitable and desirable. They remind investors of risk. But too many losses—too much fear of the unknown—can trigger a chain reaction of selling and credit contraction. This must worry the Federal Reserve and other government central banks.