How The Government Created A Financial Crisis
This column by ACRU General Counsel and Policy Director for the Carleson Center for Public Policy (CCPP) Peter Ferrara was published May 19, 2011 on Forbes.com.
Facing double digit inflation, double digit interest rates and soon to be double digit unemployment, President Reagan came into office with a four point economic program on which he had explicitly campaigned, fundamentally changing the course of American economic policy. As discussed in my recent op-ed, “Reaganomics vs. Obamanomics: Facts and Figures,” those four points were:
- Reduce tax rates sharply to improve incentives for savings, investment, job creation, business start-ups and expansion, entrepreneurship and work.
- Cut unnecessary government spending.
- Pursue anti-inflationary monetary policy to maintain a stable dollar.
- Deregulation to reduce costs for business and consumers and to increase efficiency.
As I discussed in that article, this was the most successful economic experiment in world history. Inflation was tamed by 1983, never to be heard from again — until recently. The economy took off on a 25-year boom, “the greatest period of wealth creation in the history of the planet,” as recounted by Art Laffer and Steve Moore, and “an economic Golden Age,” as rightly labeled by Steve Forbes.
Why did it end with the 2008-2009 financial crisis, from which we have not yet fully recovered? By 2008, as shown below, American economic policy had departed from every one of the four planks of Reaganomics. Two of those blunders were especially salient: 1. the Bush cheap dollar monetary policy and 2. the Clinton re-regulation to force the financial community into the subprime mortgage fiasco.
Federal Reserve Board Chairman Alan Greenspan and other governors at the Fed eventually departed from Reagan’s injunction that monetary policy focus on maintaining stable prices, and started trying to stimulate the economy through old Keynesian policies of easy money. The Bush Treasury supported that, favoring a cheap dollar in response to ubiquitous business lobbyists in Washington more than willing to sacrifice the long term economy to their short term export goals. The central role of the resulting Fed policies in causing the financial crisis was most authoritatively explained by Stanford Economics Professor and monetary policy guru John Taylor in his timely book, Getting Off Track. Taylor begins:
The classic explanation of financial crises, going back hundreds of years, is that they are caused by excesses — frequently monetary excesses — that lead to a boom and an inevitable bust. In the recent crisis we had a housing boom and bust, which in turn led to financial turmoil in the United States and other countries. I begin by showing that monetary excesses were the main cause of the boom and the resulting bust.
Economics Professor Lawrence H. White now of George Mason University elaborates:
In the recession of 2001, the Federal Reserve System…began aggressively expanding the U.S. money supply. Year-over-year growth in the M-2 monetary aggregate rose briefly above 10 percent, and remained above 8 percent entering the second half of 2003. The expansion was accompanied by the Fed repeatedly lowering its target for the federal funds (interbank short term) interest rate. The federal funds rate began 2001 at 6.25 percent and ended the year at 1.75 percent. It was reduced further in 2002 and 2003, in mid-2003 reaching a record low of 1 percent, where it stayed for a year. The real Fed funds rate was negative…for two and a half years. In purchasing power terms, during that period a borrower was not paying but rather gaining in proportion to what he borrowed. Economist Steve Hanke has summarized the result: This set off the mother of all liquidity cycles and yet another massive demand bubble.
From early 2001 until late 2006, as White further explains, “the Fed pushed the actual federal funds rate below the estimated rate that would have been consistent with targeting a 2% inflation.” That estimated rate is determined by what is known in economics as the Taylor Rule. Steve Forbes adds, “In 2004, the Federal Reserve made a fateful miscalculation. It thought the U.S. economy was much weaker than it was and therefore pumped out excess liquidity and kept interest rates artificially low.”
The demand bubble thus created went heavily into real estate. From mid-2003 to mid-2007, while the dollar volume of final sales of goods and services was growing at 5 percent to 7 percent, real estate loans at commercial banks were growing at 10-17 percent. Credit fueled demand pushed up the sale prices of existing houses and encouraged the construction of new housing on undeveloped land, in both cases absorbing the increased dollar volume of mortgages. Because real estate is an especially long-lived asset, its market value is especially boosted by low interest rates.
Sustained below-market interest rates distort huge flows of investment into housing in particular because the lower rates most favor the longest term investments.
But low interest rates by themselves do not mean monetary policy is excessively loose. That depends on what market prices are saying, as reflected by the dollar, gold and inflation. The Fed’s loose monetary policies during the Bush Administration, however, also generated sharp declines in the dollar. The dollar was worth 1.15 euros near the start of 2002, but it declined by close to 50% near to 0.6 Euros by the start of 2008. The price of gold soared from $350 near the end of 2002 to almost $1,000 by the start of 2008. Even inflation, defeated 25 years previously, started to come back, increasing from 1.55% at the end of 2001, to as high as 5.6% in July 2008.
The cheap dollar monetary policy further inflated the housing bubble because it generated flight into real assets to escape the depreciating greenback. This also explains why the housing crisis showed up virtually worldwide. The Fed managing the world’s reserve currency effectively exported its weak currency policy globally. Other countries loosen their monetary policies to avoid the negative short term trade implications of appreciating currencies relative to the dollar. Moreover, the dollar’s weakness masks the looseness of their monetary policies, misleading them into even looser policies.
When the Fed finally realized it had to rein in its loose monetary policy, soaring housing prices slowed, flattened out and then tipped into declines. The steep decline in housing prices produced chaos throughout the financial industry in the U.S., and ultimately the world, as widespread financial assets based on housing collapsed in value. As Taylor concluded, “[The] extra-easy [Fed monetary] policy accelerated the housing boom and thereby ultimately led to the housing bust.”
But that is not the whole story. Chapter 2 of the story is the “affordable housing” policies going back many years, spawned by liberals and progressives. These increasingly extreme and unbalanced policies began the housing bubble even before the Fed’s miscalculations starting in 2001. Moreover, because of these affordable housing policies, when the bubble burst, and housing prices stopped rising and started deep declines, the resulting damage was far worse.
In the early 1990s, these liberal/left activists began using the Community Reinvestment Act and anti-discrimination housing laws to allege discrimination against housing lenders who maintained traditional lending standards that excluded borrowers who were not creditworthy. Their demands reached the point of insisting that lenders discount bad credit history, no credit history, no savings, lack of steady employment, a high ratio of mortgage obligations to income, undocumented income and inability to finance downpayment and closing costs, while counting welfare and even unemployment benefits as income in qualifying for a mortgage. These unreasoned demands were imposed on financial institutions through overregulation, as HUD and Justice began threatening and even following through on discrimination suits, and bank regulators began downgrading institutions that refused to knuckle under.
But the big breakthrough came when President Clinton got on board with what was effectively an official national policy of looting the banks. As Stanley Kurtz explained for National Review:
“Finally, in June of 1995, President Clinton, Vice-President Gore and Secretary Cisneros announced the administration’s comprehensive new strategy for raising home-ownership in America to an all-time home high. Representatives from ACORN were guests of honor at the ceremony. In his remarks, Clinton emphasized that: ‘Our homeownership strategy will not cost the taxpayers one extra cent. It will not require legislation.’ Clinton meant that informal partnerships between Fannie and Freddie and groups like ACORN would make mortgages available to customers ‘who have historically been excluded from homeownership.’ In the end, of course, Clinton’s plan cost taxpayers an almost unbelievable amount of money.”
Clinton expanded the looting to Fannie Mae and Freddie Mac, forcing them through regulatory fiat to massively increase funds for subprime mortgages through their securitization practices. That securitization further spread severe damage once the housing bubble popped throughout the entire U.S. financial community, and beyond to financial institutions globally
The big problem wasn’t caused just by loans to low income borrowers. The problem was that once lending standards were trashed for these borrowers, they couldn’t be maintained for more creditworthy borrowers. This let more well-heeled speculators in on the scam, now able to qualify for highly speculative mortgages they could not have qualified for previously. That vastly expanded the resulting credit risk vulnerabilities for the financial system, and vastly pumped up the housing bubble far more.
Other regulatory blunders further contributed to the damage caused by the ultimately inevitable collapse of the artificial housing bubble. These included ill-considered “mark-to-market” accounting requirements, and regulatory favoritism for an oligopoly of corrupted credit rating agencies. The panicky, incoherent bailout policies led by Bush Treasury Secretary Henry Paulson only further contributed to the crisis, further panicking the U.S. and world economies.
Consequently, the real cause of the financial crisis is that by 2008, President Clinton, President Bush and Republicans and Democrats in Congress had departed from every one of the four planks of Reaganomics that produced the 25-year economic boom. Bush’s Fed had trashed Reagan’s monetary policy. Clinton’s overregulation produced the subprime mortgage fiasco. Moreover, during Bush’s presidency Congress lost control of spending, with federal spending rising by one seventh as a percent of GDP, reversing the gains that had been made under the Gingrich Republican majorities in the 1990s.
Then, as the recession gained steam in 2008, instead of responding with Reagan style supply side rate cuts to restart growth, President Bush cut a deal with the Democratic Congress in February, 2008 for a thoroughly forgettable Keynesian stimulus package, which predictably failed to produce any positive effect. Worse, it provided the foundation for President Obama’s far more egregious Keynesian travesties, which have also thoroughly failed yet again.
How then to restore booming growth should be obvious. Restore each of the four planks of Reaganomics. How to do that will be discussed in my column for next week.