This week I’d like to respond to two inquiries from VoR readers concerning the economic problems we face, and the role of the housing market in the larger economic picture.
To begin, there’s now general agreement that the housing bubble precipitated the financial meltdown. The bubble reached approximately $8 trillion, and when it burst it was going to have serious consequences for the economy even under the best of circumstances. The failure to recognize the bubble and act appropriately may go down as one of the biggest economic derelictions of duty in the history of the Federal Reserve. Alan Greenspan, the Fed chairman during most of the time the bubble was inflating, bears the largest share of the blame—but his successor Ben Bernanke, and other notable economists, were equally oblivious.
I have a Ph.D. in environmental economics, and I am no expert on macroeconomics or the housing market, but even I saw clearly that real estate was hugely overvalued and ready for a fall by 2005. I suspected the consequences would be severe, but I had no idea that so many different financial products had been created out of mortgages. It was these derivative products which would multiply the impact of the crash by orders of magnitude. (If I’d known, I could have made a lot of money and retired early.)
What occurred in 2008-09 was a perfect storm—a huge asset bubble, a huge class of highly complex financial products based on bubble prices, and so little capital required to back up losses that banks were leveraged at ratios of more than 30:1. When housing prices fell, the derivatives crashed as well; with so many hundreds of billions on their balance sheets, many banks became insolvent almost overnight. Added to this, the derivative products were so complex and their trail so convoluted that no one really knew how much the losses at any particular bank really amounted to, or how much any of this stuff would be worth once the dust settled (and it’s still settling, long afterward).
From a public policy perspective, the first question to ask is what caused the housing bubble in the first place; absent the bubble, there wouldn’t have been any crash. There are many reasons, but the biggest is the unprecedented low interest rates that persisted for so long. These kept mortgage payments low, continually drove up home prices, and encouraged home buyers to keep paying ever-higher prices (remember, it’s the monthly mortgage that people care about most). The thinking was that home prices would go up by double digits forever, so everybody and everything would be just fine.
Tax breaks and incentives that the government provides to make home ownership more affordable only exacerbated the problem. Government mortgage giants Fannie Mae and Freddie Mac backed many of the subprime mortgages, and had to be bailed out when everything crashed. Ironically, while so much public anger focused on the TARP bank bailouts and the stimulus bill, both were effective and virtually all of the TARP money is being paid back. In contrast, the rescue of Fannie Mae and Freddie Mac has already cost taxpayers $135 billion and the losses keep mounting—likely another $19 billion, possibly even another $124 billion.
Bottom line: an unprecedented era of cheap money, driven by loose monetary policy, created a supposed new norm—and then animal spirits and a poor housing policy did the rest.
To be fair, it’s not completely that simple. Low interest rates were necessary after the recession of 2000-1 to get the economy growing again. There’s no doubt that keeping rates low at that time was the right policy. In addition, part of the reason they could be so low was China’s appetite for U.S.-backed debt.
But once the housing bubble appeared, the Federal Reserve could have warned that the rise in prices was unsustainable. It could have put teeth in that warning by raising interest rates. Alan Greenspan did the opposite: he said there was no way there could even be a housing bubble, and he kept rates low well beyond the time the economy was growing again. When it mattered most, he blew it.
The Securities and Exchange Commission also fell down spectacularly. The commission is tasked with spotting systemic risks to the economy, precisely what derivatives and other fancy financial products posed. A couple of members made the connection, but they were ignored. Overall, this was a catastrophic failure by the nation’s main financial regulatory body.
The good part of the story is the government’s strong response, both during the Bush Administration and under Obama. Their actions—TARP, the bank and AIG bailouts, the stimulus bill—prevented a second Great Depression.
The fact that things could be a lot worse provides little solace to the millions of Americans who have lost their jobs, their homes, or both; still, it’s the truth.
Obama’s biggest mistake was under-estimating how bad things would get, and not giving himself the political room to adapt to new circumstances. In the report that accompanied the economic stimulus bill, the Administration estimated that unemployment would decrease to 8% by the end of 2009. That estimate doomed much of their policy going forward. All they needed to say was that the stimulus was critical to stabilize the economy, and that the prudent course would be to examine economic conditions at the end of 2009 and decide whether any additional stimulus was needed. Instead, they locked themselves into a position that left no room for error. And that was their biggest error of all.
Next week: How we get out of this mess and whether we’re up to the challenge.
Jason Scorse