All Commentary
Thursday, December 31, 2015

The Big Short, the Fed, and the Market

The film's dangerous lack of clarity

 The Big Short — based on Michael Lewis’s bestselling book on the 2008 financial crisis — is both great and terrible. It’s wonderful as a narrative of a financial mania. It’s terrible if seen as a complete treatment of that mania’s underlying causes or a path to future solutions.

There’s no question that the movie is significant and is being pushed as the go-to film for the key economic event of our times. Two New York Times film critics think the film ought to be considered for a Best Picture Oscar. Paul Krugman agrees, writing: “I think it does a terrific job of making Wall Street skulduggery entertaining… the movie gets the essentials of the financial crisis right.”

Why Market-Haters Cheer

Krugman and friends like the film because it leaves out any discussion of the main culprit behind the financial crisis, which was not Wall Street “greed” but bad monetary and credit policies from the Federal Reserve and the federal government. The movie barely hints at any exogenous factors behind the boom or bust. (This FEE report by Peter Boettke and Steven Horwitz fills in the missing information.)

So the pro-regulation crowd is cheering. Viewers are given no understanding of the real causal factors and hence fill in the missing data with a feeling that banks just love ripping people off.

To be sure, if you approach this movie with some knowledge of economics and monetary policy, the rest of the narrative makes sense. Of course Wall Street got it wrong, given Washington’s policies on mortgage lending!

However, if this were your one and only exposure to the history of the crisis, and knew nothing beyond it, it is easy to see how a person could walk away thinking: “Wow, Wall Street and the capitalist system are rackets that desperately need controlling by a powerful government.”

But it’s an odd message to read into the story, since the movie also nicely shows how the large banking firms, investment houses, rating agencies, and regulators all worked together, riding the boom as high as possible and delaying the correction until the last possible moment.

How new regulations would fix this is not entirely clear — who regulates the regulators?

The Merit of the Movie

The Big Short’s biggest virtue is explaining the weird financial products that made such a splash before the bust. It does a terrific job in explaining how a mortgage-backed security (MBS) works, and how it mutated into a collateralized debt obligation (CDO) and then into a “synthetic CDO,” fobbed off on the markets as a quality investment.

As a pure piece of expository journalism, it performs a great service of stripping away the then-fashionable flimflam to reveal the underlying unsoundness of the housing bubble and financial boom of the 2000s.

Plus, any movie that can make financial markets and business cycles interesting and compelling is worthy of honorable mention at least. Such movies remind us how central economics is to the story of our lives. Economics is the theoretical template for understanding how human beings are faring in the struggle against poverty, insecurity, disease, and early death, which is why the subject is worthy of study by everyone.

There’s another thing to love about The Big Short. It subtly turns short sellers — the pessimists who bet against ever-rising financial valuations — into heroes. It’s about time. They have been demonized since the New Deal as enemies of the people. This movie shows that they are people willing to stick their necks out based on a contrarian opinion, and thereby perform the valuable service of tempering exuberance when it is unwarranted.

Strangely, the film rails against the greed and wealth of most of Wall Street, but ends up celebrating a handful of expert speculators who made billions betting against millions of unqualified homebuyers. Perhaps unintentionally, The Big Short defies decades of lefty rhetoric about short sellers, turning them into geniuses that deserved every bit of their earnings.

Krugman asks whether the movie gets the story right. His answer is yes, though he cautions that the causal links are not always made explicit. He is right about that. The Big Short is a great story without a coherent theory. Whatever theory you bring to the movie is the theory you will find reinforced by the narrative.

Krugman’s left-wing Keynesian perspective can be read into the movie, but so can the market-based story of how the crash of an artificially inflated housing sector brought down some of the most powerful players on Wall Street. The Big Short is a kind of Rorschach test for one’s underlying theoretical presuppositions.

The Missing Narrative

Without a robust theory, The Big Short treats most of the trading activity before the crash as little more than malicious scamery. The traders thought they had found some magic pathway to infinite wealth and became horribly cynical about it all, pushing worthless securities on unsuspecting buyers. It’s this perception that has been behind the calls for criminal prosecution for the heads of banks and brokerage houses.

For a more realistic look, and a more humane understanding of the way financial markets work, the 2011 film Margin Call provides an excellent inside look at one dramatic day from the inside of a money-management firm.

These firms were not, on the whole, driven by criminal malfeasance. Instead, they were obeying the market signals they had on hand, as is their job. They had cobbled together a model that presumed that past behavior would persist into the future. This model worked — until it did not.

At this point, it was a matter of life and death of the business. The rush to get out before the crash led to vast selling of soon-to-be worthless securities at current market prices. When the securities fell to zero price, heads rolled — and then the most powerful players in the industry were bailed out by politicians driving truckloads of taxpayer cash.

Margin Call showed that the financial market was working as it should, following the profit and loss signals where they were pointing at the time. The movie is also just as interesting, if not more so, than The Big Short. The drama is intense and thrilling for anyone with the slightest interest in finance.

The question that neither The Big Short nor Margin Call address is the one everyone should be asking: how did so many smart people get it so wrong for so long? Here is where we must deal with the delicate signaling system of interest rates and the way they came to be so distorted through 1) Fed policy, 2) subsidized lending, and 3) the recklessness of traders in the face of too-big-to-fail policies.

The Money Machine

To understand this, we must leave the realm of fun “based on a true story” movies and point to a more serious documentary. The best one available is Money for Nothing: Inside the Federal Reserve (2013). This documentary interviews top Fed officials in Washington, D.C., and the regional banks. It follows the career of Alan Greenspan and Ben Bernanke and their shifting views on the proper role of monetary policy.

Here we find the proof of the real source of the problem. Following the terror attacks on September 11, 2001, and the wars that followed, the Fed embarked on its first round of stimulus as a matter of funding the spending spree and demonstrating national resilience.

The Fed started dropping rates, further and further, subsidizing lending and promoting a wild anything-goes atmosphere. Government-backed lending agencies were pushed to become buyers for any and every new mortgage. Home ownership itself had become a doctrine of the civic religion, and the whole of the regulatory, monetary, and bureaucratic state was there to enforce it.

The result was a mass cluster of errors going up and another cluster of errors coming down. And this is precisely what cries out to be explained. Of course, market traders can be wrong. But why was most everyone wrong? Why were their errors centered on housing and not some other sector? And why were they wrong on housing in this period and not previously? Any explanation that does not deal with these questions directly is not really getting to the core of the problem that needs to be explained.

Depending on the knowledge you bring to it, The Big Short — as entertaining as it is — can be extremely misleading. Not wrong. Just incomplete. Anyone who tries to sell an explanation of the 2008 financial crisis that does not mention the Fed is no more trustworthy than a trader who offered to sell you an MBS at top dollar in 2007.

Why should we care about how the 2008 crisis is interpreted? As with the 1929 crash, the story we tell has much to do with the policies that are created later. If 2008 was the failure of capitalism, massive new regulations, controls, and taxes might make sense. If 2008 traces to centralized mismanagement of money and banking, a very different policy follows.