As with all financial bubbles, there was a positive feedback process at work between house prices, mortgages, and credit creation. The subsidized low interest rates promoted by the Fed, combined with the world glut in savings, distorted incentives for both borrowers and lenders. Exotic mortgage products and cheap credit encouraged people to buy houses or refinance existing homes. The loans were then pooled and repackaged to be sold off to investors around the world. The proceeds of these sales were then channeled back into new credit creation with more loans. Easy credit meant more unmet demand for new homes, driving home prices higher. Higher home prices increased the value of the underlying collateral for the entire mortgage derivatives market, generating new credit for more loans. The positive feedback between new credit creation driving home prices higher, along with their collateral loan values, promoted more credit creation to satisfy housing demand. The end result was a bubble in the values of all collateralized financial assets. Home owners, for instance, were borrowing based on home values that were unrealistically priced. The financial derivatives were also overpriced according to these overvalued homes. The bubble fever soon spread to the shopping malls and auto dealers as homeowners borrowed against home equity to buy, buy, buy.
The banks’ frantic search for new borrowers to keep this business going eventually led down a slippery slope until the only prospects left were borrowers who really couldn’t afford a loan for an overpriced house or car. These were the subprime borrowers who applied for the infamous ‘liar’ and ‘NINJA’ loans: no job, no income, and no assets. All that was required by the lenders was the ability to fog a mirror and the "American Dream" of owning a home. That dream also became a clarion call for politicians seeking voter support by encouraging subsidized mortgage lending through the government home mortgage agencies known as Fannie Mae and Freddie Mac.[45]
Unfortunately, while all this debt-driven buying was going on, nobody was watching the store. The risks of mortgage loans were sold off to unsuspecting investors in the form of securitized debt instruments. These poor innocents put their trust in these securities because they were rated AAA by credit agencies such as Moody's, Fitch, and Standard and Poor's. As quasi-government agencies with strong political support, Fannie and Freddie were seen as guaranteed by the Federal government. Nobody had incentives to monitor the risks at the source of all this financial alchemy: the inherent creditworthiness of the borrowers or the intrinsic value of the underlying collateral.
If we refer back to our model, we can see exactly what was happening. Economic growth was being funded by massive amounts of subsidized credit and debt. The recapitalization of the housing market did not create newfound wealth; it merely raised the valuation of existing assets.[46] In other words, we mostly lived in the same houses that we always did, they were now just worth much more in nominal dollar terms. Enough to finance a new Mercedes and a luxury cruise. Money for nothing? This is a neat trick if you can pull it off.
Alas, what goes up must come down. Or in the case of interest rates, what goes down must come back up. When interest rates finally did begin to rise in 2005 and 2006, home prices started to weaken and the positive feedback cycle quickly reversed. Regrettably, this is what happens with credit and debt cycles, and the down cycles can be far more brutal. Subprime home owners began to default, causing securitized mortgage investments to plunge in value. This depressed the collateral values that backed up home loans and the derivatives of those loans. Soon the interdependent derivatives markets created by the vast expansion of securitized debt began to crash like cascading dominoes. All collateral values went into a free-fall, creating confusion and uncertainty throughout the financial industry over the values of all its complex credit instruments. The meltdown caused a credit crunch in corporate overnight lending, as all trust in valuations was shattered and nobody was willing to extend any credit. This is what occurred in late summer of 2007. But the debt spiral continued to feed on itself.
In a credit downturn, loan assets, like houses and stocks, must be sold to cover debts and loan recalls, depressing the prices of these assets further. This sets off a chain reaction of more defaults throughout the economy as prices, investment, and production contract. A collapse in the general price level is what we call deflation. Deflation is the opposite of inflation. In periods of deflation, prices drop. This sounds delightful for consumers, but it creates a serious problem when expectations of falling prices cause buyers to delay purchases to wait for prices to drop further. This causes businesses to fail if they either do not sell their goods and services or do so at a loss. Unemployment rises as workers are laid off, driving consumption demand even lower.
Deflation in a debt-driven economy is even more catastrophic. As economic activity declines, debts must still be paid in full or go into default. Most homeowners understand this. If both their incomes and house values fall, they still have to repay the full amount of their mortgage loan. As people default on their debts, available credit shrinks as banks rebuild their capital reserves instead of making new loans. The money supply is effectively contracting, causing the purchasing power of the currency to rise. If goods are cheaper, each dollar buys more goods. Debts previously incurred, however, must now be paid with dearer dollars. At the same time, incomes and wages that service these debts are shrinking, causing more defaults. Forced asset sales to pay debts drive prices ever lower. We’ve seen this in the housing meltdown. Incomes and house values have fallen, but mortgage debts remain the same, meaning more homeowners slip into insolvency and banks foreclose on their homes, driving house prices even lower. This further depresses economic activity, which pushes more homeowners to the brink.
A deflationary spiral is a vicious downward cycle. The psychological effect is a complete loss of confidence, with a desire to hoard real assets as protection against an uncertain, frightening future. Productive activity comes to a halt. This is akin to the economy being slowly dragged off a cliff as businesses and banks are forced into insolvency. This is somewhat what happened in the 1930s with the Great Depression. It was not a pretty picture.
The financial crisis that began to roil the markets in 2007 came to a head in fall of 2008 when the credit markets froze. The financial market meltdown and contagion risked a full-blown deflationary spiral and a potential world-wide depression. All the central banks and world governments were forced to step in and provide trillions of dollars/euros/yuan/yen in support of an imploding financial system.
Imagine the economy is a hot air balloon that is constantly rising as we overheat the credit burners. When leaks develop and the hot air of financial euphoria finally begins to cool, the credit begins to contract. As the cooler air compresses, or leaks out, the balloon begins to collapse at an alarming rate. This was the state of the world economy when governments began to pump more hot air (i.e. bailouts and credit, now funded by taxpayers), into the balloon to keep it from crashing to earth. The result of these government actions is the replacement of shrinking private credits with public credits backed by an unprecedented expansion of public debt. The goal was to save the banks and the financial system from a catastrophic meltdown that would threaten the non-financial world economy. However, public debt is a liability that must be paid off from future government revenues, so the servicing of this debt must be paid from increased direct or indirect taxes on the population.[47] In effect, we now find ourselves having traded a private debt bubble for a public one.
We are not yet out of the woods, by any estimate. If government tax receipts cannot cover the increase in debt service, the government, through the U.S. Treasury, will have to issue more public debt. Debt service by borrowing always explodes exponentially as one must continually borrow to service rising debt levels. It is the ultimate Ponzi scheme, with only one possible outcome: a massive, deflationary crash.[48] Without sound corrective policies, this is the place we may all soon find ourselves.
The housing boom and bust was a typical case of financial euphoria, similar to many in histo
ry, such as the 17th century’s tulip bulb mania in Holland and the South Sea Bubble in 1720. It was surprising because it came so closely on the heels of the dot-com bubble. The trillion dollar question that nobody asked the policymakers was: If all housing prices were booming around the world because of low interest rates, what would happen when interest rates began to rise? What would happen when the value of collateral fell? We know from our model that interest rates rise and fall in order to keep the economy on a stable path. Interest rates are the principal 'governor' that regulates economic decisions over time. If rates stay permanently low, investment in the future will dry up as present consumption dominates. (This is just another way of saying there’s no tomorrow, or “the world is ending!”) How did we miss this fundamental truth?
Over the past two-plus decades we have experienced economic growth funded by an expanding credit and debt bubble. Our simple economic model shows that credit borrowing that is invested in order to increase future production can add to our stock of wealth. If the investment is productive, future consumption will not have to be reduced in order for the debt to be paid off. But credit that is used to increase present consumption rather than present investment will require a reduction in future consumption in order to repay the debt. From 2002 to 2008, we did not defer our consumption to save and invest. Instead, we borrowed heavily so that we could keep consuming and speculating on assets. Had we chosen instead to invest our borrowing in profitable investments, our GDP and incomes would have grown and we wouldn’t be in this mess. But a housing asset bubble is not profitable for society; it is mostly illusory wealth.
It should be apparent that the policies of the past 30-40 years will be inappropriate policies for the future. It is also unlikely that the economic choices we have all made over this period will be the same going forward. Over the next decade or two we will discover just how wisely or unwisely we have spent our bailout and stimulus money. As many pundits have said, we cannot borrow and spend our way to prosperity. With an aging population, we also face some major demographic changes that will have a profound impact on all our policy choices and decisions.
From a policy perspective, this is the crux of the matter. As our economy slowly recovers, we will discover how much damage has been inflicted on our economic well-being. Savings rates have already increased significantly. But increased saving behavior is fighting against policies that are trying to induce more borrowing and spending.
And lest we forget, all this credit is fiat money, backed by the full faith and credit of governments that seem wholly incapable of applying prudent economic policies in the long-term interests of their citizens. This frightening reality now circles the globe, from Japan to China to India to Europe to the U.S.A.
4.2 The Policy Agenda
At this point one might be tempted to ask, incredulously, what were the so-called policy experts thinking?! As we discussed earlier, our leaders focus primarily on economic growth and employment as solutions to every problem. So they seek every way to stoke the engine of GDP growth with the tools they have—loose credit promoted by Federal Reserve policy, government spending authorized by Congress, and tax cuts. But, to reiterate, we cannot borrow and spend our way to prosperity. Instead, we must invest our scarce resources efficiently and profitably. One does not need an economics degree to understand this (apparently, having one doesn't necessarily mean one understands it either). As policy critics, we can be generous and concede that to err is human. We do, however, need a way to correct our errors before they become catastrophic. And we need to learn from our mistakes. Though the rescue of the financial system from the crisis of 2008 was necessary, the danger is that we may not have learned the prudent policy lessons from this disaster.
Let us step back and use our model to think about how the economy departs from, and then returns, to equilibrium. We humans make mistakes: we open restaurants that fail in short order; we open boutiques for pets that fizzle; our investment ideas are not always brilliant. But what happens if the financiers of our bad ideas keep giving us more credit? A deep hole becomes a chasm that can swallow us whole. It is the same case with loose credit subsidized by the entire banking system. The situation only worsens when bad ideas that fail get bailed out just so they can fail again, but even bigger, another day. This is merely postponing the day of reckoning.
The super credit cycle that we experienced from 1982 to 2008 has distorted many prices and induced many inefficiencies across the economy. A price crash, or a recession, is the market's way of realigning prices to where goods once again become attractive for an exchange between buyers and sellers. When our economic policies cause, or allow, the economy to outrace itself at a rate that is unsustainable, eventually the prices of financial assets, as well as real assets, collapse as the economy contracts. After a bubble, stock prices, housing prices, energy prices, and retail goods prices all collapse. As wage rates fall, labor must be reallocated to more productive uses, which entails unemployment. When the dust settles, we pick ourselves up off the floor and rebuild.
Of course, a good policy agenda would insure that price distortions never percolate into a bubble. Once the pot has begun to boil, however, the quickest remedy is a price reset.[49] The architects of our recent economic policies have done their best to resist an asset price reset, in the hopes that we can draw out the adjustment process over time without a complete financial market failure. This strategy is prudent policy management given that the financial system was broken, but the sooner we get back to prices that reflect economic fundamentals, the sooner the economy can get back to a balanced growth equilibrium.
We know that the valuation of capital is heavily dependent on some ephemeral feeling of confidence; when pessimism reigns, capital can be devalued in an instant. Our policymakers surely want to avoid price declines that overshoot fundamental values because of pessimism or perceptions of unchecked price deflation. This is politically understandable but doesn’t make the current policies ideal. We can see their results—stock and commodities prices boom ahead, while unemployment stays unchanged or increases. This cannot last; capital must be redeployed into productive uses, or the price collapse will be even steeper next time. The policymakers are fighting Mr. Market but, in the end, Mr. Market always wins.[50]
At this point we should turn the discussion away from past mistakes toward a more winning formula for the future. For a comprehensive and consistent policy approach, we should first articulate a guiding philosophy that will help orient our analysis. Without this guiding philosophy we may only discover after the fact that many policies are contradictory and counterproductive. I will take our constitutional principles as a starting point. With these in hand, I will offer appropriate guiding principles given what we know about the economy and the policy tools we have at our disposal. There is much room for debate and disagreement over the political and social goals of policy and what trade-offs are acceptable or preferred. We will not get bogged down in those subjective differences, but, suffice to say, this is where the political divide fractures and the heated debate begins.
A conventional approach to formulating policy is to identify a problem, consider several solutions with rudimentary cost-benefit analyses, choose the best solution that is politically viable, and then move on to the next problem. It should be apparent to anyone paying attention that this method is wholly inadequate. First, cost-benefit analysis assumes we can predict how behavior will change, or not change, after the policy is enacted. Our behavioral models in the social sciences are inadequate to this task, the upshot being that we cannot assess the necessary trade-offs in choosing one policy over another.[51]
Second, existing policy programs are rarely revisited and re-evaluated. If the policy solution was successful, and the problem solved, shouldn't the program end? And if the program was unsuccessful, shouldn't we scrap it and start over? What actually happens is that the new problems created by applying the wrong policies demand more policy solutions, and so we layer bad policies u
pon bad policies and wonder why the problem is never solved. (This is somewhat how we distorted the healthcare market beyond all rational recognition, and now propose to fix it with a bureaucratically controlled, Rube Goldberg solution.)
Third, one of the most serious mistakes we make in designing and evaluating economic and social policies is to focus on the observable consequences and not the hidden ones. This is referred to as the law of unintended consequences, best illustrated by the broken window fallacy.[52] If a child breaks a window, we might think that this creates work for the glazier, whose wife then spends the money at the market and so on, stimulating demand across the economy. But this ignores the fact that the owner of the window will now not spend that money he had to pay the glazier for something else, like a new suit, thereby hurting the tailor, etc. Now, this common-sense analogy does not apply so well to government spending under a fiat currency, since the monetary authorities can create new deficit spending out of thin air and not crowd out private sector spending. However, that doesn’t mean there are not unintended consequences.
Public goods markets do not create accurate price signals since the government creates the supply by mandate and often subsidizes the price and thus the demand. There are no price signals that indicate whether the public goods provision is optimal or efficient. For instance, we never know if the U.S. Postal Service is efficient or not and what the true price of delivering a letter is. This suggests that the public sector will be less efficient than private markets but through government subsidies will be able to out-compete private companies and drive them out of business, thereby creating a government monopoly. If we are merely substituting public spending for private spending, we may be gaining less and paying more.[53] This is an important point to consider when we increase public spending and confirms our intuition that we cannot borrow and spend our way to prosperity. Economic policies must always consider what Sherlock Holmes referred to as “the dog that didn’t bark.”
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