The debate about the cause of the current crisis in our financial markets is important because the actions taken to deal with the crisis will affect us for many years.
If the cause was an unsustainable boom in house prices and irresponsible mortgage lending that corrupted the balance sheets of the world's financial institutions, reforming the housing credit system and correcting attendant problems in the financial system are called for. But if the fundamental structure of the financial system is flawed, a more profound restructuring is required.
The mainstream media has been quick to blame deregulation, ‘unrestricted’ capitalism, the ‘Tatcher/Reagan’ model, and the Bush administration for the crisis. However, some dissenting voices have begun to question such presumptive consensus. Phil Gramm, Peter Wallison, John Taylor, Robert Barro and the editorial board of the Wall Street Journal have all expressed different views on how we got where we are. Gramm focuses on the issue of ‘deregulation’ in the financial sector and whether it was indeed responsible for the crisis. Taylor and Barro looks to monetary excesses, whilst Wallison concetrate on the role of Fannie, Freddie and the regulator.
Admittedly, most of these authors write on the WSJ, the Hoover Institute, or the American Enterprise Institute – traditionally bastions of free-marketeers, capitalism apologists and er… Republicans (and Gramm himself has become a frequent scapegoat for the financial crisis – Paul Krugman, Time, the CNN have listed as one of the top two people responsible for the crisis, as if one person alone could be so influential to become ‘responsible’ for it!). However, these voices are not alone (occasionally such dissenting voices find space on the Financial Times as well) and also they are not lightweight – Barro is a Nobel Prize winner and Taylor is one of the most influential economists in the US.
The view expressed by what I would call this WSJ ‘gang’ is that there is a very strong case to be made that the financial crisis stemmed from a confluence of two factors: the unintended consequences of a monetary policy, developed to combat inventory cycle recessions in the last half of the 20th century, that was not well suited to the speculative bubble recession of 200; and the politicization of mortgage lending.
To understand this, let’s look at Bush’s economic record. Mr. Bush inherited a recession. The dot-com bubble had burst in 2000, and the economy was sinking even before the shock of 9/11, the corporate scandals and Sarbanes-Oxley. Then enters Bush’s tax cuts: Mr. Bush's original tax-cut proposal was designed in part as insurance against such a downturn.
However, to win over Senate Democrats, Mr. Bush both phased in the tax rate reductions and settled for politically popular but economically feckless tax rebate checks. Those checks provided a short-term lift to consumer spending but no real boost to risk-taking or business investment, which was still recovering from the tech implosion. By late 2002, the economy was struggling again -- which is when Mr. Bush proposed his second round of tax cuts.
This time the tax rate reductions were immediate, and they included cuts in capital gains and dividends designed to spur business incentives. As the tax cuts became law in late May 2003, the recovery began in earnest. Growth averaged nearly 4% over the next three years, the jobless rate fell from 6.3% in June 2003 to 4.4% in October 2006, and real wages began to grow despite rising food and energy prices. While his Administration was handling the fiscal levers, the Federal Reserve was pushing the monetary accelerator to the floor. In reaction to the dot-com implosion and the collapse in business investment, Alan Greenspan rapidly cut interest rates to spur housing and consumer spending. In June 2003, even as the tax cuts were passing and the economy took off, he cut the fed funds rate to 1% and kept it there for a year. His stimulus worked -- far too well. The money boom created a commodity price spike as well as a subsidy for credit across the economy.
Economist John Taylor of Stanford has then analyzed the magnitude of this monetary mistake in a new paper that assesses government's contribution to the financial panic. The second chart compares the actual fed funds rate this decade with what it would have been had the Fed stayed within the policy lanes of the previous 20 years.
"This extra easy policy was responsible for accelerating the housing boom and thereby ultimately leading to the housing bust," writes Mr. Taylor, who worked in the first-term Bush Treasury, though not on monetary affairs, and is known for the "Taylor rule" for determining how central banks should adjust interest rates.
By pushing all of this excess credit into the economy, the Fed created a housing and mortgage mania that Wall Street was only too happy to be part of.
The effects of the monetary excesses were then amplified by several complicating factors including the use of subprime and adjustable-rate mortgages, which led to excessive risk taking. There is also evidence the excessive risk taking was encouraged by the excessively low interest rates. Delinquency rates and foreclosure rates are inversely related to housing price inflation. These rates declined rapidly during the years housing prices rose rapidly, likely throwing mortgage underwriting programs off track and misleading many people.
Adjustable-rate, subprime and other mortgages were packed into mortgage-backed securities of great complexity. Rating agencies underestimated the risk of these securities, either because of a lack of competition, poor accountability, or most likely the inherent difficulty in assessing risk due to the complexity.
Therefore, it cannot be denied that banks and financial institutions admittedly abandoned their normal risk standards. But they were goaded by an enormous subsidy for debt.
For that matter, most everyone else was also drinking the free booze (or helping themselves to the ‘free lunch’): from homebuyers who put nothing down for a loan, to a White House that bragged about record home ownership, to the Democrats who promoted and protected Fannie Mae and Freddie Mac. The government-sponsored enterprises Fannie Mae and Freddie Mac were encouraged to expand and buy mortgage-backed securities, including those formed with the risky subprime mortgages. Those two companies thus helped turbocharge the mania by using a taxpayer subsidy to attract trillions of dollars of foreign capital into U.S. housing. No one wanted the party to end, though sooner or later it had to. And so it did. When the bust finally arrived with a vengeance in 2007, the political timing couldn't have been worse. Mr. Bush tried to rally with one more fiscal "stimulus," but he repeated his 2001 mistake and agreed to another round of tax rebates. They did little good. The Administration might have prevented the worst of the panic had it sought some sort of TARP-like financing for the banking system months or a year earlier than it did last autumn. But neither the Treasury nor the FDIC seemed to appreciate how big the banking system's problems were. Their financial rescue attempt was well meaning but came too late and in a frenzy that invited mistakes – and there were quite a few in the process (see John Taylor’s article, How Government Created the Financial Crisis, WSJ, 09 Feb 2009)
This history is crucial to understand. Mr. Bush and his team did many things right after inheriting one bubble. They were ruined by monetary excess that created a second, more dangerous credit mania. One of the main lessons of Reaganomics had by then been forgotten, which is the importance of stable money.