Without a question we can all remember the
financial crisis of 2007–2008.
Perhaps you learned of its effects the hard
way.
The media told us that greed and excessive
risk were responsible.
Some economists, however, point out that blaming
greed for the crisis is like blaming gravity
for aircraft crashes.
The real cause runs deeper.
Both Republican and Democratic politicians,
joined by mainstream media all at once picked
free markets as the usual suspect, claiming
that the only solution was more regulation,
more government intervention, and more debt.
To use Tom Woods’ parallel, everyone seemed
to be looking for whomever was breaking all
the furniture, pretending not to notice an
elephant in the center of the living room.
The Fed and the government intervention were
the elephant.
The causes of the crisis:
To some extent we are all aware that the immediate
cause of the crisis was the bursting property
bubble in the US.
However, people seldom look for the origins
of the bubble itself.
What prompted consumers to suddenly start
speculating excessively in the real estate
market?
What caused this massive tide of new real
property?
In order to explain this, once again we need
to draw from the Austrian business cycle theory.
A short reminder: Austrian economists consider
interest rate to be meaningful just as any
other price.
When the interest rate is determined freely
on the market, it conveys information about
the quantity of savings necessary to realize
investment plans made by entrepreneurs.
However, once the central bank floods the
market with new money that is disconnected
from real resources, the result is an artificial
reduction of interest rates.
The entrepreneurs mistake these artificially
low interest rates as a sign of higher amount
of saved resources than there actually are.
Based on this misinformation the entrepreneurs
make long-term investments wrongly assuming
their future profitability.
This is how the artificial boom begins.
But in reality the economy wildly differs
from this view.
There is actually less resources than what
is required to complete all investments at
assumed costs, and to make them sufficiently
profitable upon completion.
When this reality becomes apparent, the bad
investments go bust.
The best possible course after the crash is
to allow liquidation of the bad investments
as quickly as possible, freeing misallocated
resources such as raw materials, capital goods
and labor, thus paving way for the reallocation
of these resources into viable projects.
Let us illustrate this point by using a story
by Peter Schiff: Imagine that you run a small
town restaurant.
The town is briefly visited by a circus.
Suddenly, you see a large influx of customers.
But you fail to see the connection between
the circus and a sudden spike in demand.
To you, it is just a beginning of a permanent
prosperity.
You start to invest in your business.
You hire more workers, add a new wing, and
some tables.
All seems to be working, until finally the
circus takes off to another town.
It turned out that your decisions were based
on false stimuli.
When it turns out that you have made a mistake,
then you should immediately dismiss additional
staff, try to recover and liquidate at least
some of the materials used in expansion, and
sell the new furniture.
So much for the theory.
Let us see how it looked in practice.
After the dot-com bubble burst in 2000 and
after the 9/11 attack, Alan Greenspan, the
Chairman of the Federal Reserve at the time,
decided to revive the economy by lowering
interest rates from 6.5 percent at the end
of 2000 to 1 percent in June 2003.
The rates remained at this then historic low
throughout the entire year.
The M2 money supply rose by 51 percent, from
around 4.9 trillion dollars at the end of
2000 to around 7.4 trillion dollars at the
end of 2007.
In this way, the Fed by, in quotes, “saving”
the economy from one bubble going bust, has
inflated an even bigger one.
We can, however, wonder what caused the real
estate market to be most affected.
Why did the new money end up there?
To find out, we need to consider government’s
actions during the boom.
We should start with a thorough examination
of two huge, government-sponsored enterprises
(GSEs): Fannie Mae and Freddie Mac.
Both of them were granted special privileges
by the government, such as tax exemptions,
favorable regulatory treatment, and an unlimited
line of credit from the Treasury.
What were their supposed functions?
Usually a mortgage loan taken in a bank is
repaid by its client to the same lending bank.
However, the lender may sell such a loan on
the secondary market to an institution such
as Fannie Mae or Freddie Mac.
In this way the bank reclaims its lent capital
and frees itself from the loan default risk.
In turn, the two GSEs aggregated hundreds
of such loans from various geographic regions
into packages, called mortgage-backed securities
(MBS), and sold these to other investors.
The bank that sold the loan to one of the
GSEs now had idle money available for another
loan.
Obviously, such practice allowed for much
greater credit creation and justified taking
more risk when granting loans than would be
possible without the two GSEs.
Having the law of supply and demand in mind,
it is not difficult to conclude that the result
of very easy access to mortgage loans would
be an increase in real estate demand and,
consequently, in real estate prices.
Both Fannie Mae and Freddie Mac had no problems
with raising capital for their activities,
because the market was convinced that the
government would not let its GSEs fail.
Their bonds and government bonds were treated
as equal.
The result was that by 2008 both GSEs owned
more than half of all US mortgage loans.
Senator Ron Paul rightly warned in 2003:
“This is because the special privileges
granted to Fannie and Freddie have distorted
the housing market by allowing them to attract
capital they could not attract under pure
market conditions.
As a result, capital is diverted from its
most productive use into housing.”
His warnings, however, were ignored.
Loose credit policy
Fannie Mae was pressured by government to
allow people with low and medium incomes to
get mortgage loans that they would not otherwise
receive.
The result was lowered requirements for borrowers.
All in the name of the American dream of everyone
having their own house.
The problem was that the banks assess creditworthiness
not out of pure malice, but because it is
actually useful.
The purpose is to reduce credit risk.
The creditworthiness assessment is beneficial
for all parties involved: for the bank and
its depositors (because their funds are safer),
and for the borrower (because it is better
for him not to take a loan he will fail to
repay).
Granting risky loans, however, was insisted
upon for political reasons.
One of said reasons was that the American
establishment wanted to solve a problem of
“racial inequality”.
Thus, various government agencies pressed
lenders to grant more risky loans to ethnic
minorities.
Lenders obeyed, fearing accusations of racial
discrimination that would have cost them large
compensations if they did not.
The legal justification was the Community
Reinvestment Act (CRA) that exposed banks
to indictments for discrimination if they
did not grant sufficient amounts of loans
to minorities.
The goal was simple: force banks to lower
credit standards, making mortgages available
to people who did not qualify before.
Nobody seemed to care that there were specific
reasons behind the ineligibility of these
clients, and their skin color was not among
them.
It is true that banks granted risky loans,
but one must not forget that these institutions
did exactly what the authorities demanded
of them.
Whoever blames lack of regulation for the
crisis, should note that it was precisely
the regulations that forced banks to take
on much greater risks than they otherwise
would.
Artificially stimulated speculation
Due to the fact that the Fed was flooding
banks with reserves, new financial engineering
inventions appeared on the credit market,
such as loans with no down payment.
Loosening loan requirements did not stop with
low- and middle-income people.
No wonder: by loosening requirements for everyone,
banks could earn even more.
Prices rising constantly due to rising demand
and loose credit standards were a breeding
ground for speculation.
People bought houses not only to live in them,
but also to sell them profitably in the future.
When the boom was nearly at its end, around
25 percent of the houses were bought for speculation.
Many people bought the property, made some
improvements and resold it or simply waited
for its price to go up.
Just before the crisis some said that the
more risky subprime loans were the only cause
for concern.
It turned out later that the problem was much
more than that.
The additional problem was that many people
took variable rate loans.
Alan Greenspan himself encouraged taking them.
With variable rate loans, the main risk for
borrowers was having to repay more in the
event of an increase in interest rates.
This type of loan suited people who bought
property for speculation, because they did
not plan keeping it for long.
It turned out that variable interest was more
commonly employed in average-risk loans than
in subprime loans.
When prices peaked, and then began to fall
slightly, the number of real estate foreclosures
skyrocketed.
No wonder.
Imagine that you bought a house by taking
a loan that originally had a low interest
rate and no down payment needed.
You hoped that the prices would go up, but
it turned out that the bonanza was over and
the prices began to fall.
A reasonable solution was to stop repaying
the loan and let the bank take the property back.
The administration encouraged speculation
and boosted demand in other ways, for example
by introducing capital gains tax exemption
upon the sale of real estate, or tax deductions
for taxpayers with a mortgage loan.
Curiously, a taxpayer was not eligible for
the deductions if she paid for her house in
cash or rented it.
Developers were offered free land and tax
privileges just so they would build new houses.
As you can see, speculative mania was to be
expected, as the government did everything
in its power to make it happen.
Moral hazard
Economist Anthony Mueller said:
“Since Alan Greenspan took office, financial
markets in the U.S. have operated under a
quasi-official charter, which says that the
central bank will protect its major actors
from the risk of bankruptcy.”
Greenspan proved time and again during his
term the validity of this view.
Now, let’s think what would happen if a
financial institution were to be released
from the burden of risk.
Imagine having 1000 dollars and taking it
to a casino, while your rich relative tells
you: “You know what?
Try your best to win, but if you lose, do
not fret.
I will cover your losses.”
Do you think that given such an offer you
would be more or less careful with the money?
Surely, less.
This is what is called “moral hazard”.
It means that institutions with a safety net
from the Fed act less sensibly than they normally
would.
Summarizing the boom period: The Fed provided
fuel for an artificial bubble, and the government
poured it all over the real estate market.
In some ways, every speculative bubble resembles
a financial pyramid.
When prices are disconnected from the economic
fundamentals, there must be an even bigger
sucker who will buy at an even greater price.
But at some point even all the suckers in
the world were not enough.
All speculative bubbles in history had one
thing in common.
They all burst.
This one was no different.
Fearing the rise of inflation the Fed began
to raise interest rates.
Borrowers with variable interest loans began
having problems with repayment.
By 2006, the real estate prices had already
stopped growing and banks began to take real
estates back.
The bubble had burst.
At first, some claimed that it was only a
minor problem with subprime loans.
But it was much more than that.
Soon the real estate prices collapsed.
MBSs that were previously treated as safe
investment started to turn up worthless.
In addition, credit default swaps or CDSs
began to be a problem for companies that insured
lenders against the risk of mortgage loan
defaults.
One of these companies was AIG.
Some investors who bore no debt at all also
bought CDSs for speculation.
Big financial institutions that were heavily
loaded with these toxic assets got in trouble.
Unemployment spiked.
Many people working in the real estate market
simply ceased to be needed.
Interbank lending plummeted because no one
knew which bank is loaded with toxic assets
and to what extent.
By 2009, the Dow Jones fell from its peak
in 2007 by 53 percent.
Then, in 2008, the bailouts began.
The Fed and the government handed out hundreds
of billions of dollars to rescue and recapitalize
large financial institutions and other companies.
Fannie and Freddie have been nationalized.
As the purpose of this video is not to teach
history, but economics, we shall discuss the
economic effects of the government’s most
visible actions after the crisis.
Bailouts
The foremost reason behind the stipulation
that the government should not financially
support companies that make unwise investment
decisions is that the government uses someone
else’s money to do that.
In this case, the money came mainly at the
expense of the future of the American economy.
In other words, the government became more
indebted.
Instead, the best course would be to let the
losers lose.
The banks should bear the responsibility for
their investments, as they knew (or should
know) all too well the risks associated with
investing.
Propping up bad investments only wastes resources
and harms the economy.
It forces taxpayers to finance and exercise
in futility.
The same resources could be used in so many
better ways.
Consider Lehman Brothers.
It was a huge bank that was allowed to fail.
Amazingly, the world still goes around, and
the sun rises every morning.
Lehman’s good assets were taken over by
other institutions.
When five or ten bad banks fail, there are
five or ten better and more prudent ones ready
to take over.
If there are none, the only conclusion possible
is that they are not needed.
The market hates vacuum.
Some may claim that these institutions were
duped by the government to make errors (that
was actually the case), but it does not warrant
trying to fix a bad situation by making it
even worse.
Of course bailouts did nothing to help and
the recession came anyway.
Moreover, the existing moral hazard was only
made worse after the crisis, because now big
banks could be sure that they will always
be too big to fail.
An attempt at propping up real estate prices
At the outset the government’s alleged plan
was only to make housing affordable for more
people.
But when are people able to afford houses?
Is it when houses are cheap or humongously
expensive?
True, people who bought expensive houses would
suffer.
They made their beds, however.
At least they would have learned an important
lesson not to listen to the bureaucrats and
their assurances of the better future.
Just because some people made bad decisions,
other people who acted reasonably should not
be impoverished by new money being created
and pumped into (the) real estate market.
Fannie and Freddie, now fully owned by the
government, announced emergency measures to
help the borrowers whose property was in danger
of being taken back.
Principals and interest rates were lowered,
and repayment terms were extended.
Needless to say, it was horribly unfair to
those who were able to afford houses, and
bought them without any mortgage loans.
Nobody helped them.
But once you bought a house that you could
not afford or took a mortgage loan for consumption,
then you could count on Fannie and Freddie.
This has encouraged people to stop repaying
their loans.
By doing that they got better deals.
In some families it was even more profitable
for a spouse to quit his or her job, because
lower income resulted in better repayment
conditions due to debt payments being limited
to 38 percent of household income.
Asking for a temporary salary reduction was
profitable as well.
The government did everything it could to
enable everyone to afford a house, except
for the most obvious solution: Let the property
prices fall, thus making the houses affordable
without the need to lend unbelievable sums
of money.
Credit stimulus
During the crisis, people who were afraid
of losing their jobs started saving, while
banks cared more about their liquidity and
refrained from risky lending.
The government considered this unacceptable.
The administration started to buy shares in
private banks to recapitalize them and stimulate
credit.
Banks were unwilling to lend money blindly,
and rightly so.
Since the source of the crisis was mindless
lending, then surely the cure could not be
more mindless lending.
On the contrary: strict credit standards were
the cure.
As the initial proposal that the government
should buy the toxic assets from banks was
abandoned, it was instead decided to tackle
the problem of insufficient consumer lending.
Secretary Henry Paulson said that “the illiquidity
in this sector is raising the cost and reducing
the availability of car loans, student loans
and credit cards.”
As if the gravely indebted Americans needed
that.
The Americans needed to rebuild their savings
so as to invest again in productive ventures.
Nobody, however, took this into account.
The official reasoning was: We eat a lot when
the fridge is full, but because of toxic food
we stopped filling up the fridge, so we started
to starve.
But if we throw away the toxic food we won't
have any food left!
So the only way to eat again is to use flavor
enhancers and eat up the toxic food.
Now that we are eating, we can start filling
up the fridge with good food again, and all
turns back to normal.
But in this convoluted reasoning a simple
truth was lost: the toxic food was actually
toxic, and as such it should be avoided, not
embraced.
True, the brief hunger would be difficult,
and people would have to work hard to recoup
their losses naturally.
But in effect the toxic food would end up
in a trashcan, and the fridge would be once
again filled with good, healthy food.
In essence, the government saw that people
consumed less during the crisis, and concluded
that low consumption was the problem, not
the solution.
Savings consist of limiting present consumption
in an effort to increase future consumption.
Savings are an essential part of investments,
which, in turn, enable greater future productivity
and consumption.
Lowering interest rates to zero and unprecedented
money printing
In response to the crisis, by the end of 2008
the Fed lowered interest rates to zero.
The Fed also started quantitative easing,
or QE.
There were several QE rounds, which is just
a nicer name for inflation.
The Fed managed to bounce off the bottom as
late as December 2015.
The financial crisis of 2007–2008 was caused
by keeping interest rates at 1 percent for
a year and by not allowing to liquidate erroneous
investments in 2001.
We can only guess the kind of turmoil looming
around the corner now that the interest rates
were kept at 0 percent for so many years,
while the market was not allowed to clear
itself completely after 2008.
Last time, the United States still had some
breathing space when it came to going into
debt.
Now this option is very limited.
On this topic we recommend reading “Meltdown”
by Tom Woods and “The Real Crash” by Peter
Schiff, which were useful in making this video.
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