Tag Archives: Austrian Business Cycle

The crash of 08 from an Austrian’s perspective

The roots of the 2008 collapse can be summed up in two words: Government intervention. These include, Fannie Mae and Freddie Mac, The Community Reinvestment Act, a pro-ownership tax code, the Federal Reserve, and lastly, the too big to fail mentality. These interventions incentivized the economy in such a way that capital inefficiently flowed to sectors whose investments didn’t match consumer demand. Furthermore, the behavior of firms and consumers was riskier than it would otherwise have been under a free market as a result of these interventions. Fortunately, according to Thomas Woods Jr. in his book Meltdown, there are multiple actions that can be taken by government which will allow the markets to readjust and get back on the path to growth.

Fannie and Freddie are two entities that played a crucial role in orchestrating the current mess the economy is enduring. The function they performed was buying mortgages from banks, which they typically bundled into mortgage backed securities, and then sold to investors. The big three ratings agencies, S&P, Fitch, and Moody’s, in turn recklessly gave these securities high credit ratings, despite even the New York Times commenting on the high degree of risk forming in the mortgage industry. The ratings agency’s behavior was the result of the government regulations in the ratings market which allowed these firms to be shielded from competition, and their profits were therefore guaranteed. By any one agency rating the securities as anything other than AAA, they would have opened themselves up to SEC investigations, and most likely a revoking of their special privileges due to the political winds favoring the easy loans, and the instruments that made them possible.

The role that Fannie and Freddie played, allowed the banks to have more capital to loan out than they otherwise would have been able to in a free market, and subsequently, riskier and riskier loans were made because their risk was artificially diminished. Consequentially, less credit worthy individuals were able to get cheaper loans. This most fortuitous series of events pleased the banks because they were able to loan to minorities, and therefore protect themselves from the lawsuits the Community Reinvestment Act opened them up to. The Community Reinvestment Act was brought back to life after the Boston Fed published a flawed report showing that banks were lending less to minorities than they were lending to whites and Asians, even after adjusting for creditworthiness. This law basically allowed banks to be held liable for insufficient numbers of loans to minorities if those loans didn’t satisfy authorities.

Although Congress gladly welcomed the GSE’s actions which resulted in more political contributions, and lending to minorities, it was not Congress which originally encouraged this activity. As a matter of fact, this behavior was started by the Fed under Alan Greenspan who desired to reignite the economy after the Dot com bust and the 9/11 attacks which triggered a recession. Greenspan’s response to this recession was to lower the federal funds rate, eventually down to just 1 percent, and over the period of time from 2000 to 2007, more money was created than the previous years of the nation’s existence combined. This money and cheap credit found its way into the housing sector because the Fed encouraged the GSE’s as well as the FHA to borrow and lend more than they previously had. Some observers of the crash will try to draw attention to the sub-prime mortgage market, but in 2007, the percent increase in the rate of foreclosures happened simultaneously within both the prime and the sub-prime mortgage market. In addition, the nominal amount of prime mortgages that were foreclosed upon was greater than the nominal amount of sub-prime mortgages that were foreclosed upon, and this is due to the fact that 75 percent of the US mortgage market was comprised of prime mortgages. What the commonality between the prime and sub-prime mortgages that were foreclosed upon seems to be is the adjustable rate mortgages or ARMs as they are more commonly called. These ARMs were encouraged by Greenspan, but the problem with these is the speculators they attract. The ARMs include a very low teaser rate for a specified period of time before the rate changes according to various economic indices. The speculators would buy a house with these adjustable rate mortgages and either fix them up, or sit on them until they appreciated and then sell them for a profit. The adjustable rate mortgages and their teaser rates were a dream come true for speculators because before the teaser rate period was over, they would have sold the house and made a profit. In 2006, the price of houses began to fall because the high supply was pushing prices down, and during this period of decreasing prices, the foreclosure rate was already high. Once the prices fell by 1.4 percent over 6 months, the foreclosure rate skyrocketed by 43 percent. This would lead to the conclusion that the speculators seeing the home prices fall realized that their opportunity for profiting off the homes was decreasing, and because they had to have no money down, they could simply walk away from the homes without losing any equity.

The last of the causes of the 2008 collapse include the too big to fail mentality and the pro-ownership tax code. What is meant by this tax code is the tax incentives that government uses to try and steer people towards owning a home. Partaking in the housing market comes with several perks, including exemption from capital gains tax and the home mortgage interest deduction for homeowners, as well as, free land and subsidies for developers. These incentives steer capital away from other ventures and instead gets directed into housing because homeowners will benefit from the tax breaks and developers get the most return on their capital when they get all the goodies from the government. An implicit guarantee that the government gave banks, was the too big to fail mentality. The FDIC insured depositors’ money up to $100,000 and this allows the banks to take greater risks with this money because if they lose it then they know that the government will come in and cover their obligations, and this is known as moral hazard. Another example is if banks loaned out too much money, and customers got worried about the solvency of the bank to the extent that bank runs occurred, the Fed could bail them out by loaning them money through the discount window, and in essence saving them from the harm their dishonesty would have caused them. Perhaps the biggest too big to fail idea was the implicit guarantee that the Fed would bail out its major actors in the case where they were in danger of going bankrupt, according to economist Anthony Mueller. This too big to fail notion allowed banks to become highly leveraged, and take great risks, all while the FDIC, the SEC, and the Fed lulled customers and investors into an undeserved relaxed state, and thus letting the banks stay profitable in the good times, and get bailed out in the bad times. With this knowledge, who would ever engage in safe practices that earn you smaller returns when surely your competitors will take those artificially diminished risks?

The time is now to decide how we will recover from this hardship, and fortunately we have history as our ever faithful ally leading us in the right direction if we ever stopped to understand it. The methodology that was employed to free us from the much more severe downturn of 1920 to 1921 was a reduction in government spending, the national debt and taxes. This allowed the market to naturally do what it has an innate tendency to do, which is to adjust asset prices downward towards their true value, reduce credit consumption and indebtedness, and allow only the most resource efficient businesses to stay open while resource wasters go bankrupt. The action that is needed to be taken by government is to, let the failing businesses fail, abolish the GSEs, stop the bailouts and stimulus, and get government out of the money supply. The most important step of all is for the government to get out of the money supply. The Federal Reserve has caused this mess by manipulating interest rates, and has caused people to invest in projects that are not supported by the resources needed to complete them. Getting government out of the money supply and returning to a voluntary commodity standard will allow for confidence in the value of money which would be a much more desirable alternative to our debased dollar of today. The too big to fail mentality needs to be forever abolished as well. When a firm goes bankrupt its capital and assets don’t disappear, they are just transferred from an incapable steward of them to one who is more efficient. The idea that jobs are dependent on a failing firm’s existence is a tragic mistake indeed. The firm, by its very existence, is wasting wealth, and therefore more capable firms are forced to compete with this failing firm which raises prices and drags down the standard of living for everyone. The employees of this firm will be able to bring their talents to some other employment because the economy has limitless wants, and there will always be jobs needed to be done. Furthermore, Fannie and Freddie have to be dismantled so they cannot further distort the economy, and provide artificial funds for banks to loan. Harvard’s Jeffery Miron states that because of this mess’ occurrence being the government’s fault, any solution to this mess would logically include eliminating government’s presence not by attempting to fix bad government with more government. Finally, government bailouts and spending has to be eliminated. The government spending siphons resources away from the economy, and in a bust time when resources have already been misallocated, government spending will serve no other purpose than to further misallocate resources, and make our situation worse off.

If these suggestions Thomas Woods Jr provides in his book Meltdown are followed we can begin our return to prosperity, and if we don’t learn from our mistakes we are doomed to repeat them, and the next bust will be waiting around the corner.

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