The current financial crisis was caused by a mix of market failures which were prompted by government failures:In reaction to the dot-com implosion and the collapse in business investment, Alan Greenspan rapidly cut interest rates to spur housing and consumer spending. In June 2003, even as the tax cuts were passing and the economy took off, he cut the fed funds rate to 1% and kept it there for a year.Read the whole thing.
His stimulus worked -- far too well. The money boom created a commodity price spike as well as a subsidy for credit across the economy. Economist John Taylor of Stanford has analyzed the magnitude of this monetary mistake in a new paper that assesses government's contribution to the financial panic. The second chart compares the actual fed funds rate this decade with what it would have been had the Fed stayed within the policy lanes of the previous 20 years.
"This extra easy policy was responsible for accelerating the housing boom and thereby ultimately leading to the housing bust," writes Mr. Taylor, who worked in the first-term Bush Treasury, though not on monetary affairs, and is known for the "Taylor rule" for determining how central banks should adjust interest rates.
By pushing all of this excess credit into the economy, the Fed created a housing and mortgage mania that Wall Street was only too happy to be part of. Yes, many on the Street abandoned their normal risk standards. But they were goaded by an enormous subsidy for debt. Wall Street did get "drunk" but Washington had set up the open bar.
For that matter, most everyone else was also drinking the free booze: from homebuyers who put nothing down for a loan, to a White House that bragged about record home ownership, to the Democrats who promoted and protected Fannie Mae and Freddie Mac. (Those two companies helped turbocharge the mania by using a taxpayer subsidy to attract trillions of dollars of foreign capital into U.S. housing.) No one wanted the party to end, though sooner or later it had to.
Here is more on the Taylor Rule.
(HT Dad)
3 comments:
There's no doubt that Greenspan's legacy is very tainted by his handling of interest rates during this period.
One problem interrelated to this was the Bush administration insistence that their tax cuts were a cure all for the economy. The tax cuts, which were tilted towards the upper end, ended up not working very well, as critics suggested.
So the real job of stimulating the economy was left to the Fed, and the war in Iraq made matters worse, since the Fed felt an even greater imperative to keep the economy pumped up.
However, let's not let these the mortgage lenders and Wall Street firms off so easily. These people are supposed to know better, and they ran wild.
It would be like blaming a store for encouraging shoplifting because it lessened its security guards, rather than blame the shoplifters.
Also, Greenspan and the govt failed in other ways, in not regulating either the lending market or the new markets for all types of new securities.
As for Fannie and Freddie, they too had their problems, but it's a conservative myth to keep blaming them.
The majority of subprime lending came through independent mortgage lenders and were sold, not to Fannie or Freddie, but to the investment houses for securitization. In fact, Fannie and Freddie complained they were missing out on the party.
The reality is that any economy is a complex interplay between govt and private industry. Both failed us ... govt in allowing private industry to run wild, and private industry in not having the sense to moderate themselves.
Markets were best where there is the proper framework to function.
Just like a society needs a rule of law to allow for true freedom, so does a market need its own regulations and boundaries.
Greenspan and the Feds neglected to do that, and the motivation for short term profit ran wild. The result is what we see today.
There's a great article by Nobel Laureate Joseph Stiglitz titled "Capitalist Fools."
He makes several great points, among them (using mostly direct quotes from the article):
1)The repeal of Glass-Steagall led to a change in the culture.
Commercial banks are not supposed to be high-risk ventures; they are supposed to manage other people’s money very conservatively. It is with this understanding that the government agrees to pick up the tab should they fail. Investment banks, on the other hand, have traditionally managed rich people’s money—people who can take bigger risks in order to get bigger returns. When repeal of Glass-Steagall brought investment and commercial banks together, the investment-bank culture came out on top.
2) Another mistake was the decision in April 2004 by the Securities and Exchange Commission, at a meeting attended by virtually no one and largely overlooked at the time, to allow big investment banks to increase their debt-to-capital ratio (from 12:1 to 30:1, or higher) so that they could buy more mortgage-backed securities, inflating the housing bubble in the process.
3) Another mistake: The cut in the tax rate on capital gains contributed to the crisis in another way. It was a decision that turned on values: those who speculated (read: gambled) and won were taxed more lightly than wage earners who simply worked hard. But more than that, the decision encouraged leveraging, because interest was tax-deductible. If, for instance, you borrowed a million to buy a home or took a $100,000 home-equity loan to buy stock, the interest would be fully deductible every year. Any capital gains you made were taxed lightly—and at some possibly remote day in the future. The Bush administration was providing an open invitation to excessive borrowing and lending—not that American consumers needed any more encouragement.
Stiglitz concludes:
The truth is most of the individual mistakes boil down to just one: a belief that markets are self-adjusting and that the role of government should be minimal.
mmmm....open bar.
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