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:
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.
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.
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.
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.