The Real
Issues: Economics
The Financial Crisis:
Causes, Solutions, and Future Adjustments
By
Charles Kirchofer, October 18th, 2008
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It's impossible to turn on the TV these days without hearing more about
how the financial world as we know it is coming to an end. What is
going on, how did it happen, how can we fix it, and what can we do to
prevent another one?
What's going on
The answer to what's going on is easily said and harder described.
Banks currently either do not have enough money to loan to each other
and to private customers (businesses and consumers) or are too nervous
to do so because so many banks, business, and consumers have been
defaulting (not paying back) on their loans in the past 12 to 18
months. If you've read my economics section, including the part on
central banks and interest rates, you know that not being able to
borrow money slows an economy down. Business cannot expand. In
addition, fear tends to make people save money. This is also bad news
during an economic downturn. Less money changing hands as fewer goods
are
purchased means slower (or negative) economic growth. So how can we get
money flowing again?
How we can fix it
The Federal Reserve, led by Ben Bernanke, and the federal government
(led by Treasury Secretary Henry Paulson), along with the central banks
and governments of Europe, Japan, and other parts of the world, are
attempting to fix the crisis by solving the illiquidity problem. If
markets are illiquid,
money
is not flowing around, which is essential if business are to get the
money they need to expand. Governments are propping up banks (by
injecting them with capital or nationalizing them if necessary) and
central banks are lowering interest rates and providing nearly
no-strings-attached loans to banks. What will this do? It ensures the
banks can pay their bills, will loan to one another, and carry on
business as usual. One other big point is to keep people and investors
from panicking. Panic means everyone holds on to their money and the
economy comes to a grinding halt - leading to a recession or, worse, a
full-scale depression.
But why is the government bailing out banks and not the little guy?
This is the question we hear most often these days, and it is based
upon a false idea. The underlying idea is that the government could
choose to bail out homeowners instead of banks. This is false. Even
though the credit crisis started with some people unable to pay their
mortgages, it has gone far beyond that now. Even if they had the money,
there's no guarantee that many of the people would stay in undervalued
homes with overvalued mortgages. Even if they did, this would not solve
the problem of illiquidity. It must be understood that if the banks
were allowed to fail, the result could be another Great Depression.
This was the mistake governments made back then (along with a gold
standard that didn't allow the Fed to drop interest rates when it
needed to) that largely led to the Great Depression being as bad as it
was. The government is not choosing banks over the little people, the
government is doing what is absolutely necessary to save everyone from
economic doom! Help for the little people will never be enough if they
all lose their jobs and the economy dives. However, the government is
discussing plans to push banks to refinance mortgages and work to
prevent further foreclosures. The banks may also have to use some of
the
bailout money to accept mortgage losses, meaning the homeowners would
have to pay back a smaller amount on their mortgages. So the government
is working to try to help homeowners, but it is first working to save
essentially the entire world, and that has priority.
How it happened
Experts are likely to argue about the precise causes of
and
their respective influences on the financial crisis for years to come.
There is already some agreement, however. For me, it comes down to six
factors:
- Innovation ahead of regulation. Financial markets have done
some
innovative things in the past few years, some of them designed to get
around regulations in place. Even if regulators had recognized what was
going and improved regulation, it is likely investors, who are
better paid (i.e. have better incentives), often more talented, and
certainly more numerous than regulators, would probably have found new
ways to cut corners and outfox the regulators.
- Bad government policies. The government's implicit support
of
Fannie Mae and Freddie Mac, as well as its directives to boost home
ownership with tax exemption schemes and government funding, caused
some of the problem on the housing market.
Since everyone believed Fannie Mae and Freddie Mac could never fail
because the government wouldn't let them, many invested in the
companies as a safe bet. This meant the twins had a steady flow of
cheap cash that they then invested in housing. At the same time, the
government did not exercise direct control over the two. In this way,
the two are private when they're turning profits, and become public
when there're problems. This led to a lower perception of risk (moral
hazard) and big imbalances.
- Money was too cheap. It is now generally accepted that
money was
too cheap. This has two causes. One: The Fed kept interest rates too
low for too long and did not raise them quickly and high enough. Two:
Asian countries saved too much money and invested it in dollar assets.
This made money cheap in the US, regardless of Fed policies, meaning
the Fed did not have complete control over the price of money. Also,
cheap imports from China, partially held cheap by the purchasing of
dollar assets, led to disinflationary pressures.
Since the rate of inflation remained low up until the crisis, the Fed
saw little reason to dramatically raise interest rates. Another
disinflationary effect was the steady stream of low-wage workers from
Mexico, which may have helped prevent a wage-price spiral in food and
low-end goods.
- There was an underestimation of the effect of financial
innovation on house prices and of the odds of a national house price
decline. Previously, people bought their houses to live in them. That
meant house prices generally remained stable, at least on the national
average. If a person's house lost value, it didn't mean they'd turn
around and try to sell it. This time around though, there was an
increase in the number of
investors buying houses, holding on to them and/or fixing them up, and
then selling them at a higher price. Historically, the number of
housing being bought by investors was rarely higher than 10% (mostly
with the intention of renting the properties, not flipping them). By
2005, however, this number had risen to 28% (Greenspan 231). This meant
there were more people
who would be unable to pay mortgages over the long term and who were
relying on rising house prices. These people also were less wedded to
the homes, since they weren't living in them. The phenomenon was common
enough to have TV shows about "flipping" houses. This was a sign the
game had changed. As investors looked for the next place they could get
high returns after the dotcom crash, needing to stay away from low
interest rate bonds and bank accounts, they began investing in housing,
housing securities, etc.
- The Anglo-Saxon investment banking system is more
pro-cyclical.
Since assets (like stocks or homes) are used to back borrowing, higher
asset prices mean more borrowing power. More borrowed assets mean more
assets and more borrowing power again if assets rise. The opposite is
true, however, when things fall. The system means Anglo-Saxon countries
recover from crises and expand very quickly, but they can also fall
into crises quicker, harder, and farther than countries that rely on
more traditional banking systems. It is important to point out that in
sum, since central banks and regulators had previously been able to
maintain stability with this system, that the Anglo financial sectors
have expanded
much more quickly than their tradtional counterparts.
- Governments often subsidize debt and punish savings with
their
tax structures. Consumers get tax breaks on mortgage debt, for example.
This effectively encourages people to go into debt, as that might be
cheaper for them in the long run. This means the government is
essentially paying part of the bill for houses. No wonder the
government is then also on the line when prices fall! This is also
related to the implicit Fannie and Freddie guarantees, as the twins
were given the explicit mission of increasing home ownership.
How we can prevent the next one
This is the most difficult and crucial question of all.
There
are a few things we can do. For one, the lending practices must be
looked at, and tighter financial requirements for people taking out
mortgages are in order. New capital reserve requirements for investment
banks and other investment organizations should probably be looked at,
too. Central banks, the Fed in particular, that have previously
essentially ignored asset price inflation are going to need to pay
better attention to it in the future. In their defense, they seemed to
be right to ignore it for a long time. After all, the stockmarket and
asset crashes of 1987, 2000 (the dotcom crash) and 2001 (9/11) all
resulted in very little negative inpact for the real economy at large.
In my view, this was only because the size and depth of the debt hadn't
yet reached critical levels and because there was always a new bubble
to invest in, brought about by low interest rates and cheap money from
Asia. The procyclical nature of the Anglo banking system needs to be
steered against more aggressively in the future, which means more
attention paid to asset prices, particularly in Anglo-Saxon economies
like the US and Britain.
In addition to better (not necessarily more) regulation and closer
attention to
asset price inflation, Fannie Mae and Freddie Mac need to be completely
privatized with no implicit government support. Even so, tighter
regulation will be needed everywhere due to the moral hazard caused by
the knowledge that the government would be forced to bail the banks out
if it ever happened again. One proposal is to penalize banks fiscally
(through taxation) for becoming "too big to fail." Whether this would
be feasible economically or politically (as it would require worldwide
cooperation if the US were not to be unduly disadvantaged as a result)
is another (difficult) question entirely. If the next time were to come
in the
too-near future, governments might already be too indebted to do so.
The result would be an unavoidable depression. There is no question
then, that regulations need to be modified to keep up, and possible
risks must be foreseen earlier.
One problem could come from over-regulation, though. A return to the
over-regulated old days could lead us back to times of stagflation. For
this reason, regulators need to be sure to control things effectively,
create the right types of incentives (possibly by not incentivizing
debt), and not get involved in areas where it makes no sense.
Protectionism and stops on trade and finance would hurt everyone and
would do nothing to prevent a future crisis. Such measures would
therefore
be highly counterproductive.