Financial Crisis 101
Bojojoti comments: "I thought the problem with the banks was that they had lent too much money poorly, and that brought about a great deal of the mess we are in at present."
Basically, you are correct. Here is my account of what happened to create the financial crisis. Let me explain the theory, and recite the historical events wherein the theory is played out. Unfortunately, I am simplifying complex phenomena, and telling it from a partisan point of view, so take everything here with a grain of skepticism. Nonetheless, the general outline is clear.
First, theory: depressions in general are caused by state meddling in the credit market. This can take many forms, from price supports to direct mandates, but the upshot is, that the cost of borrowing money (interest rates) are artificially lowered below the natural rate for one segment of the economy, one good, that the state wishes to make more abundant.
There is a certain amount of money in society to lend and spend. When work is done efficiently, this amount of money is high, and, since prices tend down when supply is high, the interest rate tends down. When interest rates are low, speculators borrow money from the bank, and buy stock, building factories, hiring workers, and making goods. Because the amount of money to lend and spend is high, the workers have extra money on hand to buy the manufactured goods.
When work is inefficient, the amount of money to lend and spend is low, and interest rates are high, and speculators restrict their borrowing, and do not build factories. It is a time of thrift.
When the government interferes, the amount of money to lend and spend is low, but the interest rates are artificially low, so the speculators borrow money from the bank, buy stock, build factories, hire workers, and make goods. Because amount of money to lend and spend is low, the goods cannot be sold and rot on the shelves. The factories make no profit and cannot repay the loan from the bank, and cannot pay the hands their wages. The workers are fired, and go to the bank to draw out their savings, but in the bank vault is nothing but an IOU from the factory, because this is where the speculators borrowed their money from. Everyone tries to withdraw their money from their bank at once, which is called a run on the bank, an everyone tries to sell off bad stock at once, driving down the price of the stock. The result is high unemployment, his interest rates, and liquidation of bad investments.
You see, in an unhindered market, the interest rate and the price of goods and the level of wages act as signals to the speculators and wage-earners, debtors and creditors, tell each man what the aggregate demands and needs of his fellow man might be. Low interest rates are a signal than the workers do not have much savings in the bank to spend, and the bank has not much money to lend, which is the market place "telling" the investors not to build factories. State interference forces the market to "tell" lies to the investors. It is called malinvestment because the false price signal "tells" the investors to borrow and invest in one area of the economy, such as the housing market, when the needs and desires of the people are not asking for houses. To build a house a man cannot buy is not doing him a favor: it is merely a waste of money, the same as if you took your banknotes, threw them in a pit, and burned them. The only way out is to sell off (at a loss) the bad investments, and reinvest the money and energy of society where the needs and desires of the people actually rest. This is called a market correction.
If left alone, malinvestments cause a market correction. What happens is called a ‘bust’ : the interest rates go up, bad investment are liquidated, the banks lend money more carefully, the return on investment is lower, and the workingmen find jobs at lower wages. A season of hard work allows the economy to recover. If the government attempts to extend the boom, by artificially lowering interest rates again, or micromanaging wages or returns on investment, in order to encourage more bad loans and more imprudent investments. This is sort of like paying your credit card bill with another credit card.
This is what Hoover and FDR did in the 1930’s to create and then massively extend the Great Depression. In other nations, that period of economic down turn is known as a depression, and it was over in a few months. In America, it was a Great Depression, and lasted ten years. What we had that England and France did not have was FDR. He was the one who made the depression Great.
In the 1990’s, the Federal Reserve Board monkeying with interest rates created the so-called Dot-Com bust, by mandating interest rates at first below, and then above, the natural rate. That time, it was internet company stock rather than factory work, but the principle is the same.
This is exactly what is happening again. This time, it is the housing market rather than factory work, but the principle is the same. This time, we have a leader who thinks FDR’s only flaw was that FDR did not meddle enough.
Next, history:
1. The Carter Administration passes, and the Clinton Administration expands, the Community Reinvestment Act, which gives any minority denied a homeowners loan at a bank the right to sue as if a violation of a civil right occurred.
2. The banks were under constant threat of lawsuit and federal investigation if they did not make loans and mortgages to minorities who could not possibly repay. (The Realty agents, it should be noted, were paid by commission, not by profit: that is, they got money if they make a bad loan, and did not lose money when the loan was not repaid.)
This means the government forced the banks to accumulate loads and loads of bad debt.
3. Fannie Mae and Freddie Mac, which are government-subsidized entities, allow any loses to be underwritten by the taxpayers, but any gains to be private, hence are in a position to take imprudent risks with money. If they lose the money, it is taxpayer money, you pay. If they win money, it is their money, they keep it.
The banks sold the loans accounts to Fannie Mae and Freddie Mac, who (because the risk was socialized and the gain was privatized) were encouraged to buy up these bad loan accounts.
4. Fannie Mae and Freddie Mac, oddly enough, did not follow the same accounting procedures that are routinely imposed on non-government-sponsored banks. Indeed, by 2005, they were both enmeshed in scandal, as some of their practices — to be blunt, theywere cooking the books — became public.
5. In 2005 Alan Greenspan told Congress how urgent it was for it to act in the clearest possible terms: If Fannie and Freddie “continue to grow, continue to have the low capital that they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest rate risk aversion, they potentially create ever-growing potential systemic risk down the road,” he said. “We are placing the total financial system of the future at a substantial risk." (emphasis added).
6. Reform efforts in Congress were proposed (By John McCain, among others) and opposed on the grounds that forcing Freddie and Fannie to keep honest books was ‘racist’. It was a straight party line vote in the Senate banking committee.
We now know that many of the senators who protected Fannie and Freddie, including Barack Obama, Hillary Clinton and Christopher Dodd, have received astronomical levels of financial support from Fannie and Freddie over the years.
Throughout his political career, Obama has gotten more than $125,000 in campaign contributions from employees and political action committees of Fannie Mae and Freddie Mac, second only to Dodd, the Senate Banking Committee chairman, who received more than $165,000.
(It should be noted that the current depression would have been caused anyway by the malinvestment in the housing market, but the political corruption accelerated the effects.)
7. With the reform killed, the banks continued to make bad loans, Freddie and Fanny continued to buy them up, and the housing market continued to build new houses for families that could not afford them.
8. Because the housing market was building houses, the price of houses suffered a boom. House prices, artificially inflated (by government interference in the market) became a valuable asset: speculators were buying houses merely to resell (flip) them at a profit. Because of speculation, the price of housing rose again, and contractors built more houses.
9. This led to a speculator’s bubble. (See EXTRAORDINARY POPULAR DELUSIONS AND THE MADNESS ES OF CROWDS for a description of the Dutch Tulip craze, a similar speculator’s bubble).
A speculator’s bubble is when prices rise due to increased demand, but some or all of the demand in caused by speculators buying more because prices are rising. It is a positive feedback loop. The moment the speculators begin to fear prices might fall, they sell off, and the prices do fall, and the market corrects to the natural value of the good.
In this case, the government interference caused malinvestment in the housing market. Too many houses were built that the market could not afford to buy. The homes stand empty: the money goes to waste.
10. Then the bills came due. The home loans make to families that could not possibly repay them were not repaid. The speculator’s bubble burst. There was, in effect, a run on the bank. Everyone acted as quickly as possible to withdraw their money from institutions that owed more money than they could pay back, or to sell off houses whose prices were falling.
11. At the worst possible time, Bush, in a fit of madness sent by the gods, decided the best thing to do was to borrow astronomical sums of money and/or inflate the currency in order to loan money to banks that had been run into the ground by a previous round of government interference in the market. This absorbed rediculous amonts of the money available for loans in the credit market.
This action was entirely unconstitutional and, from an economic point of view, irrational and counterproductive. You do not get out of debt by going deeper in debt.
The Treasury Department sovietized the banking industry, forcing sales and taking control of banks.
12. At aboutthis same time, Ford, GM, and other major American automotive manufacturers, who had been suffering what is basically government-backed extortion by labor unions for years, found that they could not compete with Japanese auto manufacturers. Unionization adds a lard-layer of expense to each car make in America that overseas sales do not suffer. The auto makers pay the pension of retired workers, and the Japanese workforce is younger on average, for example.
The auto industry turned to the banking industry for loans to tide them over until they could become productive again, but, lo and behold, the loan market had dried up, thanks to the Freddie and Fanny crises. So the car manufacturers turned to DC to beg for money.
13. President Obama, who knows even less about economics than President Bush, used the general panic of the populous to pass the most massive spending bill in world history, nearly a trillion dollars. This is enough money to paste a line of hundred dollar bills around the equator of the Earth some 30 times or so.
The spending bill has nothing whatsoever to do with helping the economy. It is a source of bitter amusement that the Democrats and their compliant media propaganda-machine continue to pretend this is the case. It will not and cannot create jobs or save jobs, and everyone involved knows this full well.
The money is to be used for things like condoms, studying swamp rats, building windmills, nationalizing health care, and hiring minorities or wetbacks who don’t know how to build roads and bridges (rather than native-born white guys who do) to build roads and bridges starting two or three years from now. There is also payola to the National Endowment for the Arts, and so on.
The money is being raised by loans and inflation, which dries up the credit market and robs creditors in favor of debtors. It is the worst possible thing to do during a depression, since the economic effect is to discourage trade, raise prices, raise interest rates, and lower wages, and lower the return on investment, which, in turn, kills jobs and strangles small businesses.
It is worthwhile noting that the same political party, the Democrat, and THE SAME INDIVIDUALS, Dodd, Frank, Obama and other members of the Senate Finance Committee, who bear the lion’s share of blame for causing this mess are now the ones being trusted to fix it. The foxes are guardin the henhouse and the inmates are running the asylum. These individuals made money from Freddie and Fanny, and received political support from the very quarters that taxpayer’s money is now being used to pay off.
The irony could not be more bitter. The Robin Hood Democrats decide to rob you, the taxpayer, in order to buy houses for the poor. But they did not actually buy the houses and give them to poor people; the lured poor people into loans the poor could not repay by threatening banks. The loans are made, houses are built, the poor cannot repay, the houses stand empty, and the bank loans default. The Democrats blame the banks for the bank-robbery, and, in order to cure the fact that the banks have been robbed, rob you again, this time for much, much more money. They use the money to bribe the constituencies which voted them into power. Meanwhile the housing market, the banking sector, and the auto manufacturors now take orders directly from the White House.
It is the most naked act of political hubris since the day when the Praetorian Guard auctioned the Roman Empire to Didius Julianus for 25,000 sesterces. Our nation and our freedoms are being sold for money before our very eyes, and we, and our children, and our grandchildren, will be paying the bill until the end of the Republic.
And they got away with it, too. No Severus is marching to throw our version of Didius out of office.
Welcome, wandering stranger, to this, our Earthly sphere; laws we have apleanty, but we have no justice, here.
About John C Wright
John C. Wright is a practicing philosopher, a retired attorney, newspaperman, and newspaper editor, and a published author of science fiction. Once a Houyhnhnm, he was expelled from the august ranks of purely rational beings when he fell in love; but retains an honorary title.
