The Man Who Called the Financial Crisis—70 Years Early

何鸿燊

By JASON ZWEIG

Decades before anybody had ever heard of a mortgage derivative, an economist named Melchior Palyi predicted key causes of the 2008-2009 financial crisis with precision that makes a modern reader's hair stand on end.

His warnings help explain why investors insist on trusting market gatekeepers they know to be fallible—such as policy makers, regulators and credit-ratings firms.

The seeds of today's problem were planted long ago, and its forgotten history holds important lessons. In 1936, as part of reforms under the new Banking Act, the U.S. government mandated that federally regulated banks could no longer hold securities that weren't rated investment-grade by at least two ratings firms.

To determine how to implement the new policy, the government launched a massive project—with experts from the Federal Deposit Insurance Corp., the National Bureau of Economic Research and the Works Progress Administration—to study how credit ratings should be used.

Mr. Palyi, then teaching at the University of Chicago, was a vocal skeptic from the outset. Looking back into the 1920s, he found that investment-grade bonds went bust with alarming frequency, often in the same year they were rated. On average, he showed, a bank that followed the new rules would end up with a third of its bond portfolio going into default.

The record was so unreliable that it would be "still more responsible," Mr. Palyi growled, to "stop the publication of ratings altogether." He was especially troubled that the new banking rules switched the responsibility for credit safety from bankers—and even bank regulators—to ratings firms. "From there," he warned, it "will have to be shifted again—to someone else," presumably taxpayers. Liquidity, Mr. Palyi argued, was being replaced by what he scornfully called "shiftability," a new kind of risk that could someday "be magnified into catastrophic dimensions." In response to his criticism, government researchers studying how to apply bond ratings changed their method for calculating the performance of investment-grade bonds. By 1943 they had come up with an oddly contorted median that magically improved the track record of the ratings providers.

This switcheroo, recently documented for the first time by economists David Levy of George Mason University and Sandra Peart of the University of Richmond, legitimized the new regulatory model and flushed Mr. Palyi's criticism down the memory-hole of history. Credit ratings, in the words of economist Lawrence White at New York University, acquired "the force of law."

Since the 1930s, more than 150 laws and regulations sprang up requiring banks, brokerage firms, insurance companies, pension plans and money-market funds to hold securities regarded as investment-grade by rating agencies. A study released in 2007, on the eve of the financial crisis, found that 76% of fund managers wouldn't invest in bonds below certain credit ratings, even though fewer than a third of them thought that was "a good investment strategy."

In the wake of the crisis, Fitch, Moody's and Standard & Poor's, today's major ratings companies, have all said they have taken steps to improve the transparency and reliability of their ratings and that no one should use credit ratings as the main basis for an investment decision. This year's financial-reform law scales back, but doesn't eliminate, the role of credit ratings in regulation.

Who was Melchior Palyi? Born in Hungary in 1892, he became chief economist at Deutsche Bank. Fluent in at least four languages and endowed with a wicked sense of humor, Mr. Palyi was the chief economic adviser to the German central bank during the financial reconstruction of Germany after the hyperinflation of the early 1920s. In 1933, as Hitler came to power, Mr. Palyi fled to the U.S. He nursed a wariness of centralized power and inflation until he died in 1970.

Mr. Palyi warned in 1938 that a push toward universal home ownership would "make the population fixed to the ground" by "overburdening them with housing costs." That, he foresaw, would limit the mobility of American workers—helping explain why unemployment is so stubbornly high today.

He also derided what is now called "quantitative easing," characterizing it as "a sort of Santa Claus to the economic system" that can lead to "runaway inflation" and a concentration of too much power in too few hands. Investors piling into stocks today based on the Federal Reserve's latest bond-buying binge shouldn't get too cocky.

Mr. Palyi was fond of saying that sooner or later, too much credit always turns into a giant debit as borrowers crumple under the burden of escalating interest payments. That's a warning this entire country would do well to heed. — intelligentinvestor@wsj.com; twitter.com/jasonzweigwsj