THE CRISIS (Graphs not included).
THE STATE OF IDEAS: PRECRISIS
It was foolish to think we, as a nation and as an interconnected global economy, would no longer experience any recessions. What could have led us to believe that we were invulnerable to drastic market fluctuations and instability? Those beliefs, in my opinion, were both arrogant and naïve to say the least. Perhaps, it was the overall failure of commonly held ideas and beliefs that led to the economic collapse of 2007 and beyond.
However, given the current state of ideas, there were still moments in history where a little cautiousness could’ve gone a long way. “While the vulnerabilities that created the potential for crisis were years in the making, it was the collapse of the housing bubble–fueled by low interest rates, easy and available credit, scant regulation, and toxic mortgages – that was the spark that ignited a string of events, which led to a full-blown crisis in the fall of 2008.” (Financial Crisis Inquiry Report, xvi).
HOUSES FOR EVERYONE
It is important to question why it was so desired that we should provide as many Americans as possible, regardless of the long-term risks, with a fair chance of owning home. I understand that the study of economics as a social science is geared towards increasing the standard of living and overall welfare, but obviously the way in which we have most recently gone about doing so has been completely wrong. Why lower interest rates and make money so cheap that we lose sight of what it means to have a value on something? Why make loans available to bad prospects unlikely to repay? It seems irresponsible of the government to assume that we could endure such growth without it eventually leading to a significant contraction. Empirical evidence can support that whenever there is a boom, a bust will most likely follow, the extent and degree of which is most likely left in shroud until after the fact.
Notice the immediate busts that occur after each significant spike in housing prices – one during the 1980s, the 90s, and again in 2007.
DEREGULATION
Encouraged by government deregulation during the Clinton and Bush administration, banks effectively painted a golden picture for the consumers in America – owning a home is easy and affordable. Simply take out a loan you think you can afford so we can reap the benefits of a variable interest rate, or adjustable-rate mortgage, that will begin to increase without you knowing. The banks certainly tricked what are called ‘Ninjas’ – borrowers that had no income, no job, and no assets, and themselves. There is certainly a line of fault here. What kind of credit agency would allow a ‘Ninja’ to take out a loan on a home? Why were these banks allowed to participate in such shady behavior?
According to Skidelsky, there were three major deregulating policies that set the stage for, but did not necessarily cause the economic collapse of 2007. First, in 1999, the Clinton administration passed the Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act. This act effectively repealed the Banking Act of 1933, more commonly known as the Glass-Steagall Act. It certainly seems strange, after repealing an act that had been in place for nearly 70 years after the great depression, within the decade, we have another major economic collapse. The original Glass-Steagall Act was imposed to separate investment banking from commercial banking operations, the reason being that commercial, or retail, banks took on too much risk when they participated in selling securities, a now dangerous financial innovation. For lack of a better definition, and to preserve context with the most recent recession, Skidelsky explains securitization, “Securitization is the process of bundling up individual mortgages into tranches of different risk which can be sold on by the originating bank. Because the tranches most at risk were a small proportion of the whole, the risks attached to lending money to sub-prime borrowers could be widely spread” (Skidelsky, 7). The problem is, the ability to appropriately assign a risk value to these securities became more and more difficult as bundling continued and as uncertainty rose. But can we blame the banks for trying to be profit-maximizers? Do we blame the culture of the financial system in which these events transpired or do we blame each and every individual American consumer that was fooled by the system?
Our economic state was furthered endangered when the Clinton administration chose not to monitor and regulate these high-risk, credit-default swaps. It appears the administration assumed that the financial sector was invulnerable to a macroeconomic failure due to microeconomic decisions, a naïve assumption at that.
Thirdly, deregulation in 2004 by the SEC (US Securities and Exchange Commission) allowed select firms to more than double their leverage ratios, effectively taking on more than double the risk. Some believe it was the specific deregulation by the SEC that led to the failure of Lehman Brothers, what once was the fourth largest investment bank in the United States (Satow). The Financial Crisis Inquiry Commission, commissioned by Obama following the recession, sums up the lack of regulation, “To give just three examples: the Securities and Exchange Commission could have required more capital and halted risky practices at the big investment banks. It did not. The Federal Reserve Bank of New York and other regulators could have clamped down on Citigroup’s excesses in the run-up to the crisis. They did not. Policy makers and regulators could have stopped the runaway mortgage securitization train. They did not. In case after case after case, regulators continued to rate the institutions they oversaw as safe and sound even in the face of mounting troubles, often downgrading them just before their collapse. And where regulators lacked authority, they could have sought it. Too often, they lacked the political will—in a political and ideological environment that constrained it—as well as the fortitude to critically challenge the institutions and the entire system they were entrusted to oversee” (Financial Crisis Inquiry Commission Report, xvii).
Ultimately, the Federal Reserve Board will always be a major target for placing blame whenever there is an economic collapse. “The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not” (Financial Crisis Inquiry Commission Report, xvii). As to whether we would have been better off without the FED in the first place, it is impossible to say. However, it is beyond arguing nowadays. We, as a government, have established this institution with the responsibility to effectively monitor our economic condition and keep it in control. We must use this institution for the better, and during the 2000s, we certainly would’ve been better off had the FED regulated banking activity more thoroughly.
We have developed a system where what’s good for the individual can be inevitably bad for the whole. We have developed a system where individuals acting to maximize profits through legal means can have detrimental effects in the lives of countless others. An intense desire to increase the standard of living resulted in the exact opposite – joblessness.
FINANCIAL INNOVATION & IMPERFECT KNOWLEDGE
Throughout the past 20 years it seems our financial system has evolved beyond our control and understanding. Through securitization based on sub-prime mortgages, debt ran rampant and risk ran immeasurable. Following the years of deregulation, the percentage of sub-prime mortgages shot up. The graph below shows lending to sub-prime customers as a percentage of total originations doubling.
As soon as housing prices began to fall in 2006, banks finally realized they weren’t aware of the true value of the homes these securities were based on. All of a sudden, banks were scared into a ‘credit crunch’ – they were no longer loaning other banks nor the American consumer any money – and feared insolvency. We effectively experienced a risk shock within the housing market.
CLOSING
It seems we’ve had just the right culmination of failing ideas throughout the past 20 years to breed a disaster. It would be foolish to simply blame one agent or another. We as a nation made these decisions, and although one could say there was no way of predicting the collapse, that kind of thinking is anti-intellectual. There is no hope for future generations if our top economists just say, ‘Well this terrible thing happened, another terrible thing will probably happen ten years from now, its just unfortunate.’
However, I do believe the majority of the blame must be placed on the deregulating policies as of past. If we go beyond problems with deregulation, I believe we begin to loose sight of cause and effect relationships. If we regulated the market more effectively, true, we probably wouldn’t have experienced the same amount of economic growth, that’s okay with me because we also wouldn’t have had such a downturn. Messing with interest rates and the money supply might have had unknown repercussions.
In analyzing the causes of the Great Recession, it is evident – the premises of New Classical economic thinking breakdown. Throughout the past decade, firms, and more specifically banks, did not behave rationally when they continued to sell and bundle these low interest rate mortgages. They did not act on perfect information, as they assumed borrowers would pay them back and they would remain solvent. They did not expect housing prices to fall and Lehman Brothers to fail.
It is safe to say we should evolve into the future, economically at least, with great trepidation. As times goes on, it seems we have ability say fewer and fewer things with absolute certainty. We should be together wary, as consumers and investors, as firms, and as a government, as we should have been wary of unsustainable increasing house prices.
SOURCES
“A History of Home Values.” Classic Case Shiller Housing Price Chart, Update. Web. 21 Feb 2011. .
Satow, Julie. “Ex-SEC Official Blames Agency for Blow-Up of Broker-Dealers.” The New York Sun. 18 Sept. 2008. Web. 21 Feb. 2011. .
Skidelsky, Robert. “Keynes: The Return of the Master”. New York: PublicAffairs, 2010. Print.
“Sub-prime Mortgage Volume and Percentage of Total Origination.” Value Securities. Web. 21 Feb 2011. .
United States. Financial Crisis Inquiry Commission. “The Financial Crisis Inquiry Report”. Washington: GPO, 2011.