Wednesday, March 24, 2010

Tea Party Protest Signs

Repeal The New Deal

End Fiat Money, inflation without representation

Abolish the regulatory agencies, legislation without representation

End government manipulation of housing and healthcare

Abolish the Welfare State

Reject the statism of the right and left

Reject self-sacrifice

Restore the Constitutional Republic

Restore Gold as Money

Appoint Justices that believe the constitution has a content

Restore LIMITED government

Privatize Finance, Healthcare, Education, Transportation

Recognize the right to the pursuit of happiness
, i.e. individual self-interest

Demand political principles, not expedient pandering

Wednesday, March 3, 2010

The housing bubble

My cousin recently had an argument with his banking professor over the bank bailouts. Apparently the professor is a big fan of the bailouts and says that if we hadn't bailed out the banks unemployment would have risen to 30%. In order to address this, you first have to ask how we came to be faced with such a dilemma.

Keep in mind to distinguish between factors freely arising from voluntary trade amongst individuals (like an individual foolishly purchasing a house beyond his means), and government forced factors (like the Federal Reserve setting interest rates by fiat).

The center of the financial crisis was and probably still is the bursting of the housing bubble. What caused the bubble in the first place? A myriad of factors contributed. For 7 decades the federal government, operating on the principle of altruism, has been using the power of the printing press, the tax code and regulation to get more families into their own homes.

The government programs with the biggest effects have been the following:

  1. Suppression of interest rates. The federal reserve (est. 1913) sets interest rates at which it will lend credit to banks, 'printed' without restriction or oversight. (These dollars, consumers must by law accept in payment, despite no value backing the dollar since FDR.) Banks then lend ten times this money out adding a bit to the interest rate. The FDIC (est. 1933) guarantees their fractional reserve banking scheme. The artificially low interest and consequent credit inflation shows up in various asset bubbles (e.g. tech stocks, housing, general stock market rallies).
  2. The government created/bolstered secondary mortgage market. Through Fannie Mae (est. 1938) and later Ginnie Mae (est. 1968) and Freddie Mac (est. 1970), the government essentially created the secondary mortgage market, which transfers mortgages from the originating banks and then packages them into securities (MBS). Banks are payed a processing fee and absolved of all further responsibilities. The issued securities carry an explicit or implicit guarantee from the government (backed ultimately by every citizen). The whole scheme is a poster child for 'moral hazard'. The various home pages of these agencies used to proudly proclaim their role in creating Mortgage Backed Securities and Collaterallized Debt Obligations (the more complicated securities cut into tranches), but it looks like they've removed these.
  3. 'Too big to fail' government supports. Since at least the bailouts of the S&Ls in the late '80s there has been a general understanding in the market (proven correct in spades recently) that the government would step in to save any big actors that are in trouble. Part of this was the 'Greenspan Put', i.e. the known proclivity of Greenspan's to drop interest rates at any whiff of trouble.

Many other factors contributed, like mortgage interest deductions, various presidential encouragements to increase low income home and business loans, persecution of banks for 'redlining', the protected status of the ratings agencies, taking housing out of the CPI and replacing it with 'equivalent' rent, etc.

The one private factor at work is widely accepted economic principle that wealth can be created by printing money. Very few economists, financial advisers, columnists, citizens question the benefits of government manipulation of money and credit. Nor do they wonder at their right as recipients of unearned money. If this were otherwise, if more people questioned government manipulation of money or government involvement in the economy period, then the bubbles would never have had a chance, the government programs either wouldn't exist or people wouldn't participate in the resulting distorted economies. (There's mounting evidence that the general public, besides being opposed to the bailouts, is also not participating in the currently re-inflating stock market bubble. Perhaps they're learning.)

Did deregulation play a role? The aspect of the bubble that National Public Radio focused exclusively on in the year after the collapse, was credit default swaps. These are essentially insurance policies issued by one institution and purchased by another so that if the securities they are interested in lose value, the CDSs will help them minimize their losses. The derivatives market is said to be largely unregulated, though I doubt it. This lack of regulation has been cited as the main cause of the crisis.

The derivatives markets often play a larger role in the life of financial companies because the size of that market is much larger (by something like 10-fold) than the primary assets that are being derivatized. I remember hearing at one point that all the mortgages in the U.S. amounted to some low trillion figure but the derivatives on the mortgage securities was in the low tens of trillions. So while the derivatives market acts in many cases to smooth out gains and losses, in catastrophic situations it can magnify the effects.

The problem with blaming the derivatives and the supposed lack of regulation, is that the bubble was not created by that market, it was created by the factors outlined above in the primary housing market. The derivatives just made things worse for institutions either stupid enough to believe in the bubble, or 'smart' enough to know they'd be bailed out when things exploded.

So, what happened? The government created a housing bubble, in the name of 'affordability' which actually meant unaffordability, and a large part of our economy, i.e. our time, went into making houses, remodeling them, brokering the sales, etc. The prices went through the roof. Banks lent to anyone breathing, cause they had no skin in the game. GSEs packaged those loans because that was their mandate. Fund managers bought them because they're guaranteed and have AAA ratings. The ratings agencies never downgraded, because they (the agencies) would cease to be government sanctioned. And everyone felt safe because they knew big brother would come to the rescue if there was trouble.

Then the bubble burst. It doesn't matter why, it was inevitable. And what did we do? Congress and the Fed repeated and magnified all the policies that created the bubble in the first place, and bailed out most of the most reckless companies involved in creating the bubble.

What should have happened? We should have let the bubble burst, let the banks fail, let underwater owners become renters, let housing prices drop, let the smaller more conservative banks take over the business of the larger, irresponsible banks. Ultimately we should have used it as a lesson and started dismantling all the housing supports, the tax credits, the GSEs, the implicit and explicit guarantees, the Federal reserve and fiat money/credit.

Would unemployment have been worse? Undoubtedly, but only for a brief period while people shifted from making houses that no one needs and packaging mortgages that have no value to making stuff that's wanted (wanted without government incentives and support) and lending to people that deserve loans. There have been crises before and when the market is free, readjustment usually takes less than a couple years. I.e. it would have been over by now.

Instead we still have a situation where a huge part of the economy is devoted to making stuff we don't need (in housing, in the financial industry, in the new 'green' industries). They are getting paid by Fed created credit and are using that money to go out and buy stuff that's being created by the actually productive part of the economy, the farmers, engineers, etc. A smaller and smaller proportion of the population is being asked to feed and support a larger and larger fraction that produces nothing, or works for government trying to hamper their production. The fact that so many developers, bankers, construction workers, and financiers were employed in the housing bubble, should not be cause for joy, but for concern.

In sum, don't ask whether there would have been 30% unemployment. Ask rather what they are employed doing, and if they are gov't credit (read 'welfare') recipients that need to find employment in something actually productive.