Serious economic lessons from the past and now

By Taxpayer Foundation of Oregon

12-15-08

 

Only 8 years after our last big financial boom ended in a bust we have an even bigger bust in the housing and debt markets that has brought us to the edge an entire collapse of the financial system. Millions have lost houses, jobs and Retirement savings and the carnage has only just begun.

 

Well what the hell happened? You’d think with that with our ever growing financial sophistication that we’d know better by now.   Every time this happens we think it will be the last.  But it never will be.   The 1979-80 oil and commodity spike offered many lessons about commodity bubbles.   Those who were victimized by it learned to be skeptical of “peak oil” quacks, and other forms of Malthusian analysis.   The 80’s saw the Junk Bond bubble. 

 

The 1998-2000 bubble was a more recent major bubble. For many the good times were rolling.   By 2002 the hangover was palpable. Investors learned a lot but it seemed like this was unlikely to happen again anytime soon.

 

Now we have our current housing and debt bubble. I think the lessons from the 1980’s Junk Bond bubble would have made what was coming obvious. The crash of 1987 and the ensuing Savings and Loan collapses are a bit too similar for comfort.   Enough history, let’s get to the causes:

 

Cause #1 cheap money.   Cheap money was going too long and then not so cheap money for too long. In 1997 and 1998 when the Asian currency crisis hit and then the hedge fund Longterm Capital Management blew up the fed responded the same way, by lowering domestic interest rates to very low levels. For this Alan Greenspan earned his title of Maestro.   He could keep the music playing no matter what the problem. Y2K presented a similar problem and the fed pumped liquidity at a massive rate into the system to alleviate any fears of Y2K problems. In early 2000 with Y2k past, and inflation starting to rear its head, Greenspan withdrew liquidity and raised the short term Fed Funds Rate to a level above the 10 year note rate.   Economists know this is a highly contractionary move for the economy, because banks won’t lend when short rates, their cost of money, is higher than long rates, what they lend at. POP goes the bubble.

 

How did Greenspan respond to the tech wreck?   Record low interest rates starting the cycle all over again, except this time the money was flowing to housing instead.  Poor Ben Bernanke inherited this from the Maestro, in addition to rapidly increasing commodity prices.  Ben did what central bankers do when they see inflation he raised the Fed Funds rate.   Again, short rates were increased above the long rates, and by the summer of 2007 no one was lending anymore for subprime housing. POP! The bubble burst.

 

Cause #2 Regulation. Where have you gone Glass-Steagal?  When congress effectively repealed the Glass-Steagal Act in the late 1990’s it of course seemed like a good idea the time. The idea that there should be an artificial wall between investment banking, banking, and insurance seemed an archaic relic of the 1930’s. Why should we restrict competition? No other country in the world does it this way? The problem with the deregulation is that it looked over to the other side of the river and said to everyone that it’s better on the other side. Unfortunately, you’ve got to figure out how to get over the treacherous river without a bridge.

 

The investment banks did what they do best. Figure out new ways to build boats and sell to them to those suckers at the banks and insurance companies. For the Banks they created Mortgage Backed securities and other collateralized debt securities. With these securities, garbage debt could be bound up with really good debt and no one could smell the trash. Banks could lend to otherwise unworthy people and make the almighty politicians happy for expanding the number of homeowners. On top of that they could get it off of their books and do it again and get paid a fee again.  

 

Now somebody had to buy this mixed garbage. What if the packager of this stuff went belly up? Step right up Mr. insurance company. This is your business isn’t it?  Insuring risk?   But if we really insure defaults on this contraption we’d have to have it regulated and put up reserves to guard against possible losses. No problem.  The credit default swap was born.  They called it a swap and not insurance and all those expensive reserves suddenly became unnecessary. Everything makes money and you can’t lose unless everyone goes broke….and people said that will never happen.

 

With The investment banks all broke and being bought by banks who are still standing due to large federally insured deposit bases, we are seeing the combined operations that you see overseas. Through this violent turmoil we are righting our business models to match the post Glass-Steagal world where investment banks are safely sat on by big slow moving banks where they can’t cause any more trouble.

 

Causes #1 and #2 can be blamed on the government whereas cause #3 and #4 can only be blamed on human nature.  

 

Cause #3 is human psychology.  “It’s different this time” is said to be the most expensive words in the English language. Human psychology almost guarantees that when matched with capitalism that bubbles will form. We are hard wired to return to what is safe and what works.

 

What could be safer than buying a house? The myth that houses never go down added to collective psychology.  You can hear how people reasoned themselves out of reason itself with conversations like “I heard that houses did decline once in Oregon way back in the stone age of 1980-82.   But we didn’t even have high tech here then. Back then the economy ran on Timber. Can you imagine that? Besides who lived in Oregon way back then, it’s hard to find anyone is actually from here. It’s way different this time. It can’t happen here.”  Well of course it did. And  a similar thought process reproduced itself all over the country.

 

If you asked someone who got killed in the California housing crunch in 1990-91 or in Oregon in 1980-82, they probably didn’t get too overextended, but too much of the population hadn’t had that experience and it was going to be “different this time”.

 

Cause # 4 — the bubble was in our interest (or at least it seemed to be at the time).  Was the real estate agent crooked for telling us that houses rarely go down? It was true.  He or she was just doing their job and making some money.   How about the mortgage broker who got us financed at low teaser rates? Again, it was his job to give us what we wanted and make money for himself. We wanted a bigger house than we could afford and we wanted a way to make that work, he gave it to us. What about the lenders? They had investors who wanted to buy mortgage back debt. Give the people what they want was the policy.   The investors just wanted to make a nice safe leveraged return and we have insurance this portfolio anyway.

 

I am sure all the participating parties all had a good time while it lasted. So what happens now? Most likely to occur is what always happens. We’re having a recession to pay for our sins. This isn’t new, but it will probably be more on the order of the nasty ’80-82 recession than the relatively light 2000 to 2002 recession.

 

The Fed has already dropped interest rates and is expanding the money supply. The Obama Administration and Congress will pass Regulations to make sure this doesn’t happen again. But mostly they will borrow a lot of money and spend it. This is the part that I fear the most. I don’t fear it for the fact that it won’t work, but that it will work. You see borrowing a lot of money is the right thing to do right now. Reagan did it with his tax cuts and defense build up in 1981. George W. Bush did when he passed his 2003 tax cut. Obama’s spending won’t be as efficient as tax cuts, but the affects are likely to similar when combined with Fed actions.   Government spending and deficit spending is not the best and most comprehensive way to fix the economy, it is instead consumer and business spending driven by tax cuts and a better business climate. 

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