The following comments by Mike Polioudakis are also available on the family website at http://www.polioudakis.com/ Feel free to download from there. It was originally part of an econ book that I wrote, so it has the number from that book of "10.15.01". Thanks.
10.15.01 Housing Crisis and Financial Meltdown of 2008
Wednesday 8 October 2008
The crisis is changing so fast that I have to date comments.
This appendix is not a full analysis. It was written to give a brief blend of facts and theory for people that don’t want to be barraged by either. I can support the assertions with data but not in a short piece like this. If you really want data, e-mail me and I will send you references.
It is easy to blame greed by house buyers, greed by financial officers, or lack of oversight by government institutions. Still, in addition, the crisis results from a history of bad government policies including lack of oversight. The oversight suggested during the crisis is another case of using the state to fix a problem largely created by the state. I would like to just let greedy investors and short-sided house buyers take a loss, let some banks fail, and expose the bad federal policies; but we are in too bad a situation now to do that. We have to use a bad bailout to make up for even worse previous policies. I only hope that we learn from this situation but I do not have high hopes.
(1) DEREGULATION. After the Great Depression of 1929-1941, the government regulated banks and other financial institutions so that they did not give out bad loans, and so that they stuck to the primary business typical of the institution. Savings and Loans, personal banks, commercial banks, investment banks, and insurance companies are different, and do different jobs; so the state watched to prevent any dangerous overlap. Banks took in deposits and they gave out some kinds of loans, including standard mortgages. Banks did not buy and sell mortgages wholesale and did not accept “shaky” credit. Other institutions carried out those kinds of transactions. With the rise of computers and large transactions in the 1970s, banks and financial institutions called for the end of regulations. Starting with Reagan, the state loosened regulations and continued to loosen them. The lines between types blurred, so we found local banks issuing credit cards and found large financial institutions carrying checking accounts for people in other states. Insurance companies went directly into investment. All institutions began to carry “shaky” credit credit, and to buy and sell mortgages to each other.
Beginning in the Reagan administration, the government loosened requirements for getting an insured loan through the quasi-federal agencies “Fanny Mae” and “Freddie Mac”. The loosening was not based on ability to pay but on giving favors to get votes. The Clinton administration carried this policy too far, up to the current loose standards, for the same reason.
(2) LIMITED MANUFACTURING, LIMITED INVESTMENT, WITH A TURN TO FINANCES. Since the 1980s, the United States has steadily lost manufacturing ability and manufacturing jobs. Commentators say that the United States switched from a manufacturing economy to a general services and financial services economy. An increase in general services and financial services would be tolerable as long as other sectors of the economy remained healthy enough to absorb investment, but they did not. Funds for investment from private people were channeled into large institutions for investment such as banks, mutual funds, and insurance companies. Because large investment institutions could not invest as much in manufacturing as in the past, they turned to alternatives. They turned especially to housing. For reasons, see below.
Because now there is not enough difference between kinds of institutions, all institutions interlocked, so, if anything bad happened to one institution, it was likely to happen to all.
(3) IRAQ WAR and INFLATION. Because the Iraq war was funded by deficits and by selling bonds to foreign nations, it caused the worst inflation in the United States since the 1970s, and it coupled inflation with very low interest rates, often below 2%. To counter inflation, investors sought alternatives other than manufacturing and the traditional kinds of investment.
(4) IRAQ WAR and LACK OF INVESTMENT. At the same time, because the war in Iraq was funded almost entirely by deficits and by bonds, the Iraq war did not bring many investment opportunities. It channeled money out of the American economy except for the financial sector. It probably inhibited normal recovery from recession and normal growth.
Housing was about the only real investment that was still available. Investors turned to finances and housing. The war fueled over-investment in housing and bad investment in housing.
(5) HOUSING INVESTMENT. Housing prices in the United States have been rising ahead of other investment opportunities at least since the early 1970s. Housing definitely brought a greater return than manufacturing. I cannot go into all the reasons here why this might be so. Usually the amount that can be invested into housing depends on the number of people that want housing and the kind of housing they want, which in turn depends on the number of steady jobs, especially in manufacturing. But, as manufacturing dwindled while finances boomed, affluent people changed their image of the ideal house and banks changed their criteria for who could get a mortgage for how much. More people wanted houses, and more people wanted much bigger houses. People bought “starter houses” with the intent to sell later for a profit so as to invest in a larger house later. With financial institutions not as careful as before, more people got what they wanted.
(6) HOUSING BUBBLE. With not much alternative investment, with people wanting larger houses, with the people who had jobs in finance and law able to afford larger houses for now, and with many people able to get financing on a house due to the lax regulations under Fanny Mae and Freddie Mac, a housing bubble began. Investors realized they could “flip” houses. Many more people began to buy houses just for investment, or just to flip them. Bigger investors realized they could finance the smaller investors that did the real work on flipping houses. All investors realized they could finance starter houses and finance suburban sub-mansions. Even if house buyers had trouble making payments, they could sell their present commitment, make a profit, and then move on closer to what they wanted. As long as housing prices kept climbing, there was hardly any way to make a loss. The housing bubble was on. I do not go into details of what enabled the bubble such as Adjustable Rate Mortgages and Sub-Prime mortgages. I do not explain how the interest rate for mortgages does not only depend on the U.S. prime rate. If anybody is really interested in the details, he-she can email me.
(7) COLLAPSE. I also do not go into details of the collapse. When bubbles go, they “reverse feed” on themselves. Suppose two things had supported each other so that both got increasingly bigger. Now, as the first gets smaller, it also drags down the second, and the second drags down the first, and the first drags down the second again, and so on. As houses could not be sold, and as housing prices fell, financial institutions could not buy-and-sell mortgages to each other. Financial institutions were not even sure how much a piece of real property cost. In case the price of a house might fall, institutions were no longer willing to buy from each other or to give credit. Because so much of investment had gone into housing instead of into manufacturing or other real alternatives, financial institutions did not have enough reserves to do business at all.
(8) CONTINUING RECESSION. The economy never really recovered from the recession of 2000. By 2008, another recession was due. The recession of 2008 coincided with the housing collapse and made the collapse worse. The collapse would have been bad on its own, so the recession is not responsible for the collapse. The two made each other worse, and it is hard to say how bad each would have been in the absence of the other, and how much worse each made the other.
(9) WEAKENING DOLLAR. A weakening dollar has both good and bad effects, and I cannot sort them out here. Induced inflation caused the dollar to weaken against other currencies, so that the value of the dollar fell continuously against the Euro and the Chinese Yuan. In some cases, this weakening would have helped because it would have led foreigners to buy American goods and to invest in America. In this case, it did not help much because America is not making as much to sell as it could have and because investment here is not as attractive as it should be. At the same time, because of the weak dollar, America has no leverage in international financial markets. On the whole, the weakening dollar worsened the problem.
(A) APPRECIATE THE FED AND TREASURY. The Federal Reserve Board (Fed) and the Treasury Department were caught between a rock and a hard place. To lessen the recession and the housing crisis, the Fed needed to lower interest rates. At about 4% to begin the crisis, interest rates were about as low as they could go, and so the Fed had little leeway by which to lessen rates and help. At 2% in middle 2008, there was nothing more the Fed could do with interest rates. Lowering rates below 2% makes little difference. On the other hand, to stop inflation, to preserve house values, and to end the bubble, the Fed should raise interest rates sharply. The Fed could not do both. It has to walk a tightrope. This was too much to ask of a state agency. I believe the Fed did a good job given the impossible situation it was in.
(B) STRONG MANUFACTURING AND DIVERSE INVESTMENT. If we want to avoid over-investment in housing and finances, we have to make sure other sectors of the economy are strong enough to attract investment. We have to make sure we do not lose manufacturing ability. We have to develop alternative manufacturing such as bio-technology, computers and other kinds of artificial intelligence, new materials such as new kinds of concrete and plastics, green energy, self-sufficiency in energy, and new foods technology such as genetically modified organisms. We can lose some manufacturing to the Chinese and Indians but we have to develop new kinds to take the place of what we lose. We have to educate our citizens to work in the new kinds of manufacturing, and not just to sweep up in the financial offices and law offices.
(C) STOP DEFICIT SPENDING AND INDUCED INFLATION. If we really need a war, then pay for it as we go. If we pay for the war as we go, and if the President mismanages the war, then we can force Congress to adjust spending and policy accordingly. When we pay through deficits, we no longer control policy. Deficit spending creates inflation, stops investment in some areas of the economy, and distorts all investment. I do not even dwell on other problems from inflation such as the impact on salaries and retirement checks. Inflation and deficit spending really have to stop.
(D) BETTER POLICIES. We need to think through wars before we get into them. We need legislators that can say “no” and “yes”, and can understand why. We need legislators that can say “no” to the President and to their fellow legislators. We need legislators that are not afraid of Karl Rove or Dick Cheney.
(E) REGULATE AGAIN. Contrary to the ideals of my Libertarian and Austrian friends, we really do need some regulation. It is a bit crazy to have bad policies and then to use regulation to make up for bad policies, but that is what we do. We might have gotten by with little regulation if we did not have bad policies to begin with such as deficit spending, wars that were not well thought out, and impeded manufacturing. But we do have these initial bad policies, and we have to be prepared for their repercussions. We have to regulate. We have to regulate more than we might want. We have to define distinct kinds of financial institutions. We have to make sure people that want a mortgage can pay for it. We have to make sure that financial institutions actually supervise the people to whom they loan money. We have to be careful about how financial institutions loan to each other. We have to limit the terms of borrowing even for houses. We can probably do this kind of regulation by using the agencies that we already have and by returning to the ideals of the 1950s and 1960s. I hope we do not need more agencies.
(F) TAX REFORM. Along with proper regulation, we really need proper tax reform. We probably cannot have one without the other. We have to stop government programs that subsidize house buying. Government programs that supposedly helped house buying actually enabled flipping, balloon payments, sub-prime rates, and adjustable rates. They did not help working people to buy modest houses nearly as much as they should have helped. We have to stop allowing people to take interest for house payments off their taxes. We have to stop all kinds of tax credits. We have to simplify taxes. When done properly, tax reform is a kind of mild deregulation and a kind of tolerable return to the market.
(1) NON-SMITHIAN MARKET. A “Smithian” market is an idealized free market without any significant distortion due to imperfect competition or externalities. A Smithian market comes to fairly well defined, fairly stable prices. It clears. It returns to the well-defined stable prices after fluctuations. We can foresee trends up or down. The housing market is not too prone to bubbles. A change in the price causes about a proportional change in selling (demand) and vice versa. For example, a 10% decrease in price would cause about a 10% increase in demand. For more on the ideas of a Smithian or non-Smithian market, see Chapter Two of the little book or Part Two of the big book, and see early chapters of Part Ten of the big book.
Since the middle 1960s, the housing market has usually been Smithian but has not always been Smithian. Sometimes the conditions above do not always hold. Many readers can remember the real estate boom of the late 1970s and early 1980s. The reason for not being Smithian usually lies not in the market itself but in other markets and in bad state policies, as with the inflationary polices and oil shocks of the 1970s. Even so, disturbances usually are not too bad and do not last too long. I do not explain past problems here.
Since the second war in Iraq, the housing market has been more un-Smithian. It has acted in all the strange ways described above. It is not stable, and it is prone to bubbles. Changes in price and demand are not roughly proportional. It does not clear. Rather than the details, here it is important to see that non-Smithian tendencies in the housing market recently are probably not part of the market itself but result mostly from bad government policies. Bad policies pushed a generally good free market to not be a free market. Recently, most of the bad distorting policies lie outside the market itself, although the policy of allowing buyers to write off their interest on taxes did distort the market from within the market. We can act directly on the housing market to make it more Smithian but we will have a hard time keeping it that way unless we also change the bad state policies that make the housing market not like a good free market. If we change the bad state policies, then the housing market will revert to acting more like a good free market pretty much on its own with only minimal oversight needed. Unfortunately, now, that is not likely to happen.
(2) LIKE FRACTIONAL RESERVES. To maintain the housing market and the bubble, financial institutions had to buy-and-sell houses, other property, and mortgages to each other. They did this in many ways, including bonds, credit, and direct sales. This buying-and-selling-back-and-forth is another version of fractional reserves even if it does not look like fractional reserves on the surface (if you do not remember fractional reserves, go to the chapter on money in the little book or the part on money in the big book, or see the brief account below). The banks actually owned only a portion of the real estate on the market. That is like the fraction of deposits that serves as the basis for the fractional reserve system. They used the portion that they actually owned to get credit to buy more. As real estate became over-valued, the ratio of value-based-on-speculative-credit to secure-value-based-on-solid-real-estate-market-value got higher and higher. The speculative “more” above the solid base value of old market value is the same as the fraction of money that is not backed by a solid reserve of wealth such as silver or gold on hand. It was as if the banks had a smaller and smaller fractional reserve requirement. The smaller the fractional reserve requirement, the greater is the danger of collapse. The state regulates the ratio of fractional reserves based on deposits in savings and checking but it does not really regulate the ratio of real property kept as a reserve against speculation on real estate.
Say that a house was valued at $100,000 to begin with. The bank acquires a 25% share of the house, or $25,000. It uses that as the basis to buy more real property. How much more depends on what other institutions are willing to accept. If other institutions require only 5% down, then the bank can use the $25,000 to buy 5 more houses at $100,000 apiece. Now suppose the market value of the house doubles to $200,000. The bank now owns $50,000 instead of $25,000, and can now buy 10 new houses at $100,000 apiece. As long as the market value stays steady or goes up, and as long as there are more new houses continually, this whole system can keep going. Instead, suppose the bank has bought 10 new houses, and the value of the original house goes down from $100,000 to $50,000. Now the value that the bank owns in the original house no longer serves as a solid basis for owning the 10 new houses. The bank should sell the additional houses, but it probably does not want to. If the value of the original house went down, then the value of the new houses likely went down to. If the bank is forced to sell, then it will lose a lot of the money it had invested in the 10 new houses. Suppose no bank knows how much the value is of the original $100,000 house, so no bank knows how much of the original invested $25,000 the bank really owns now. Then no other bank or institution can lend to the original bank. The bank cannot buy any more houses, and it cannot even sell the 10 new houses it bought in addition to the original house. Lending back and forth, and buying and selling, stop. The whole system collapses. This is typical of what happens when fractional reserves collapse.
Fractional Reserves in Brief. You do not need to read this sub-section if you know about fracitonal reserves. Banks do not keep all their deposits from savings in the vaults. They loan out most of them at interest. That is how banks make their profits and are able to serve depositors and lenders. What percentage banks keep on reserve in case somebody wants his-her money today is called the “fractional reserve”. If the banks keep too much in reserve, the miss out on chances to give loans and make money. If they keep too little in reserve, and a customer cannot get his-her money right away, then customers get nervous and take out all their deposits at once; the system crashes. Over the years, banks have learned that about 10% in reserve is more than enough.
Banks actually do not keep 10% of their deposits in reserve and loan out 90%. Instead, the banking system acts as if all the money in deposits is in reserve, and uses that as the basis to loan out money. If the banking system got $100,000 in deposits to begin with, and kept reserves of 10%, then it would loan out another $900,000. The total amount of money and credit (as loans) would then be not $100,000 but $1,000,000.
By keeping only some deposits in reserve, banks essentially create money and credit. The less they keep in reserve, the more money and credit they create. The amount of money and credit can expand quite a bit from the original amount on deposit. On the flip side, if for some reason the system begins to fail, then it can contract immediately, like a burst balloon.
For these reasons, the government regulates normal fractional reserves and credit. But oversight did not apply to credit based on mortgages and on real property. The banks were able to use those as the basis for fractional reserves, on which they built the big balloon of credit.
(3) SOCIALIST NON-PRICES. In the 1920 and 1930s, Ludwig von Mises and other Austrian economists showed that an economy cannot come to a stable and useful set of prices except through free enterprise. A socialist command system cannot come up with a set of prices to make an economy work well (there are some exceptions but they are not found in the real world, and so I do not deal with them here). When the normal price system is upset, the market does not clear. People cannot tell how much something costs. People cannot tell how much something will cost in the future. People are afraid to buy or sell because they do not know if they will lose in the future. The market grinds to a halt.
That is what happened to the housing market and the financial market. The housing market and financial markets lost the mechanisms that made them part of the public price system process. They lost the ability to price. Nobody knows how much a mortgage is worth for sure. Nobody knows how much a mortgage will be worth in the future. Nobody wants to buy or sell the mortgage. So the housing market freezes, and then financial markets freeze. In effect, the housing and financial markets showed the signs of failed socialist markets.
Only if the ability of the housing market to create public prices is restored can the housing market unfreeze and can the financial markets unfreeze.
Because the problem is so severe, for now the state can step in to re-start the public price mechanism by guaranteeing some value to a mortgage both now and in the future. Hopefully, eventually that government-guaranteed price can serve as the basis for a normal price in a semi-normal market. Hopefully, eventually the state can stop serving as the foundation for a price system and can let the housing market find its own prices again. But the price system can only re-establish and stay healthy if the state also stops the distortion that caused the price system to lock up in the first place.