Ghosts of 1929

By Joseph Beaudoin

President Barack Obama is ignoring the causes of the economic crisis.  He is looking for solutions in the Keynesian economic myth that government interventions got America out of the Great Depression.  Yet, the foundation of this economic crisis was laid out in 1938 by the very policies he espouses.

Contrary to the popular myth, the Great Depression was not a failure of markets.  It was the direct consequence of Federal Reserve monetary policies.  Throughout the 1920s, the Fed pursued an “easy-money” policy that caused credit expansion and unsustainable economic growth.  Eventually the expansion ended and America entered a recession in 1929.  That recession became the Great Depression because the Fed allowed the money supply to fall by 33 percent from 1929 to 1932.  As economists Milton Friedman and Anna Schwartz demonstrated, the Great Depression was a failure of government.

Contrary to the current liberal myth, this economic crisis is not a failure of markets nor was it caused by Wall Street greed.  This economic crisis results from massive and sustained government interventions in the mortgage and credit markets and from the easy-money policy of the Fed.  Just like the Great Depression this economic crisis is a failure of government.

A government-sponsored mortgage industry

Government intervention in the mortgage markets began in 1938 with Fannie Mae.  It increased in 1970 with Freddie Mac.  As the federal government implicitly guarantees their debts, Fannie and Freddie took risks that normal lenders would have avoided.  Not surprisingly, they are at the center of the current economic crisis.  But government intervention did not end with Fannie and Freddie.

In 1970, the Community Reinvestment Act forced banks to finance home purchases in all geographic areas regardless of risk assessment.  Beginning in 1977, the Congress of the United States pressured mortgage lenders, including Fannie and Freddie, to increase subprime loans.  In the early 1990s, the Clinton administration designed the National Homeownership Strategy to increase home ownership above the 65 percent mark.  Even the Fed joined in the homeownership frenzy.  In 1992, a Boston Fed study called for looser credit standards in order to enable more low-income Americans to buy homes.  Gradually, banks abandoned prudent lending criteria and loosened lending standards to accommodate the government homeownership policy.

Repeated government interventions in the mortgage business caused a dramatic erosion of mortgage lending standards.  Government, de facto, re-defined mortgage lending rules.  And homeownership became a government-sponsored venture.  So massive is government involvement in the mortgage market that Fannie and Freddie hold 50 percent of outstanding residential mortgages and accounted for 75 percent of new ones in 2007.  America’s residential mortgage business is on its way to becoming a government monopoly.

Subprime lending is a policy tool designed and implemented to further homeownership with “easy-mortgages.”  Subprime lending exists and reached the scale it did because of massive and repeated government interventions in credit markets.  Subprime lending is neither the by-product of a market economy nor is it a consequence of Wall Street greed.

A government-sponsored rating oligopoly

The toxic securities that have wrecked the U.S. and world financial markets were issued with the blessing of the Securities and Exchange Commission (SEC), an agency of the U.S. government.   That ought to be a sobering fact for those who argue for more regulations to protect investors. 

The U.S. credit rating industry is a government-regulated oligopoly consisting of Moody’s, S&P and Fitch.  There are no market forces at work here; no real competition; just three firms that owe the SEC a debt of gratitude for the substantial revenues they earn from their membership in the credit rating cartel.

The highest and most coveted credit rating is AAA.  It is supposed to be very difficult to achieve and to retain.  Buyers of AAA rated securities assume that these securities are the safest investments because that is what AAA rating means.  Unfortunately, the rating club engaged in hyperinflation.  In January 2008, while only 12 companies in the entire world had AAA ratings, there were 64,000 AAA ratings for issues of structured finance instruments, including mortgage-backed securities.  That constitutes a staggering perversion of credit rating standards.  The SEC, however, did not find these numbers disconcerting. 

Members of regulated oligopolies have a natural tendency to, first and foremost, please their regulators.  That is how they remain prosperous members of the cartel.  It is inconceivable that 64,000 security issues deserved the top rating when only 12 companies did.  Were the rating firms grossly incompetent? Were they grossly negligent?  Or were they grossly subservient to the U.S. government's easy-mortgage policy?  Did the rating firms feel they had to loosen rating standards to help create more funding for easy-mortgages?  Likewise, did the SEC allow the proliferation of AAA ratings because it too wanted to assist the government’s easy-mortgage policy?

The toxic securities were rated AAA by a cartel created, maintained and regulated by the U.S. government.  Easy-rating was condoned by the SEC.

A government-sponsored easy-money policy

Milton Friedman once compared easy-money to alcohol: at first it makes you feel good, then it makes you sick and it can even kill you.  This analogy was lost on the Fed.

From 2001 to 2005, the Fed tinkered with the money supply.  It drastically reduced the Fed Fund Rate from 6.5 percent in January 2001 to 1.75 percent in January 2002.  That is a staggering drop of 73 percent in the cost of money over 12 months.   Further reductions brought the Fed Fund Rate to 1 percent for a year.  And for three years the Fed Fund Rate was at or below 2 percent.  There is no precedent for such easy-money interest rate policy in Federal Reserve history.   

Predictably easy-money produced a huge credit expansion enhanced by easy-ratings and, together with easy-mortgages, fueled the demand for homes; dramatically pushed up home prices; and created a false “wealth effect” that fueled more demand.  Home prices increased so much and so rapidly that they destroyed the very concept of fair market value.  Worse, housing inflation persuaded lenders that asset appreciation would cover whatever credit deficiencies borrowers might have.  That encouraged them to make riskier loans.  Eventually, everyone got caught into the housing trap, including Wall Street. 

Now former Fed Chairman Alan Greenspan tells us that this economic crisis is a “one in a century event” as if it were a random phenomenon.  That is disingenuous.  Bad monetary policies and their consequences, unlike natural disasters, are man-made—in this case, Greenspan-made—and, therefore, completely avoidable.

The Fed's easy-money inflated the real estate bubble that is at the root of the current crisis.

The U.S. government made it its business to increase homeownership.   It pushed for looser credit standards and encouraged subprime lending.  Through the SEC, the U.S. government presided over the debasement of rating standards and the hyper-proliferation of AAA ratings, ostensibly to fund more lending.  Through the Fed's easy-money policy, it presided over a massive credit expansion that fueled the housing bubble.  

Each one of these policies was a violation of free market principles and would have had a negative impact on the economy.  Taken together they were catastrophic.  But they were not isolated random events.  They were all willful government interventions in the economy. 

Sadly, when the subprime house of cards Uncle Sam built came crashing down on everyone’s head, Uncle Sam pointed the finger at market failures and Wall Street greed.  Yet, neither markets nor Wall Street were protagonists in this government-made tragedy.

Enter the stimulus bill

The U.S. has a $14 trillion Gross Domestic Product (GDP).  Housing losses may reach $6 trillion and the value of U.S. equities may drop by over $7 trillion.  This crisis could cause losses that exceed the U.S. GDP.  The consequences can only be severe and long lasting. 

In response to this unprecedented wealth destruction sponsored by U.S. government policies, the White House and Congress want to spend even more taxpayer money.  Somehow, they convinced themselves that spending $800 billion will offset $13 trillion in losses.  The stimulus bill is nothing more than a haphazardly concocted hodgepodge of spending and tax cuts with little or no focus.  Those who believe in government spending think the bill does not have enough government spending.  And those who believe in tax cuts think the bill does not have enough tax cuts. 

Washington hopes the stimulus bill will re-start consumer spending which represents 70 percent of U.S. economic activity.  But Americans do not have any more money to spend.  They are deeply in debt.  As a percentage of disposable income, debt increased from 70 percent in 1992, to 100 percent in 2000, to 140 percent in 2008.  In addition, with home prices still declining, the much touted “wealth effect” is now working in reverse.  The home equity ATM has become a cash sinkhole that will continue to gobble up more wealth. 

Consequently, the stimulus bill will not work; but that is not what is really wrong with it.

The bill’s most profound and nefarious impact will be a dramatic expansion of federal government activities, in the economy and in the financial markets.  That can only be done at the expense of the private sector.  History shows that when government power expands, it does so at the expense of individual freedom.  History also shows that governments do not relinquish their power easily.  It is, therefore, likely that Mr. Obama’s interventionist policies will impact America for decades to come. 

Remember, Fannie Mae was set up in 1938 to help Americans buy homes.  By 2008, the Fannie Mae philosophy of government interventions had wrecked the housing market, the banking system, the stock market and the real economy. 

- Joseph Beaudoin holds degrees in economics and finance, and worked in the banking and investment industries for 20 years. He is a regular contributor to Reflections.