Vernon L. Smith: Insolvency, Policy, and Economic Stress

Fresno California
Fresno, California Alec Soth / Magnum Photos

Whether or not America is facing a double-dip recession, the country has already entered a double-dip growth recession as measured against the past century's 3 percent rate of expansion. U.S. securities markets, nearly always behind the curve, have gone into a state of panicky volatility. The deficit-stimulus policies of presidents Bush and Obama have failed: the costs have far exceeded the benefits. And ordinary Americans have grown suspicious of economic experts—as well they should be.

Why is the economy stuck? The only empirical model we have for the current crisis is the Great Depression, whose severity has long been attributed to the Federal Reserve's failure to provide desperately needed liquidity to the banks. With that conventional explanation in mind, Fed chairman Ben Bernanke set out in August 2007 to remedy the current financial crisis by injecting temporary cash into the banking system.

It didn't work: the banks, laden with bad loans, faced outsize insolvency problems, not just a shortage of liquid funds. When Bernanke figured out the real problem, he lifted more than $1 trillion in overvalued loans from the balance sheets of U.S. banks, a move that may have saved us from a second Great Depression. Between 1930 and 1933, the unemployment rate reached as high as 25 percent, where from 2008 until now the rate has held at 9 or 10 percent. All the same, we still can't know the full consequences of Bernanke's unprecedented intervention—it may have just stretched the pain further into the future. In that case, Bernanke has only moved us to a different circle of hell.

In my opinion, the onset of the Great Recession in 2007 and 2008 was a twin of the 1929–30 balance-sheet crisis that ushered in the Great Depression. In both cases the problem was insolvency, not just a shortage of liquidity. The credit-fueled housing boom of the 1920s explains the bank crisis that followed. Back then, 85 percent of commercial-bank mortgages were for terms of only three or four years and were not fully amortized, ending instead with balloon payments that usually required refinancing. That financial juggling act ended in 1929, resulting in the crash, and household insolvency immediately spilled into the banking system. The deleveraging process and its economic consequences dragged on for the entire decade of the 1930s.

How long will it take to climb out of the hole this time? The trouble is that Bernanke's stimulus spending was a blunderbuss. It didn't address the need to restore the damaged balance sheets of banks and households, and without such repairs, businesses and consumers will be obliged to keep paying down debt rather than hiring and spending, while banks will concentrate on piling up cash reserves in order to cover bad loans instead of making new loans to get the economy up and running again. Troubled assets were removed from the banks' books at face value, to be replaced by reserves on which the Fed pays interest to the banks, rewarding them for not making loans. Meanwhile, many struggling homeowners had their mortgage payments reduced by lengthening their loans or reducing interest rates—not by reducing principal to realign their debt with home values.

But without balance-sheet restructuring, such adjustments only extend America's bullet-biting into the indefinite future. The painfully slow process of deleveraging continues to handicap the prospect of recovery. The Fed rescue may have boosted spirits at financial institutions, but it's now clear that the seemingly miraculous rebound of bank profits was an accounting artifact that took insufficient notice of sour loans. And now the window for raising private bank capital to reboot damaged balance sheets has slammed shut.