The Financial Crisis: Lessons Not Learned

The financial crisis of 2008-9 — accompanied by the Great Recession, a doubling of the U.S. jobless rate (to 10 percent), and a plunge in major stock-price indexes (−53 percent, peak to trough) — was caused by government intervention, mainly in mortgage finance and the housing sector. Unfortunately, that’s not the conventional interpretation, so no subsequent policy change has been adopted to correct the problem; in fact, still more intervention has occurred, via the Dodd-Frank Act (2010) and Federal Reserve capital policies and controls on bank dividends.

Since the lesson of 2008-9 has not been learned, further crises are likely, but with still more severe consequences, given the accumulation of still more powers of state intervention.

For most of the past century, this has been the tragic pattern of U.S. financial crises and policy responses; instead of identifying the offending interventions that cause crises and repealing them, the crises have been blamed on greed, free markets, and capitalism. The alleged cure has been less financial freedom and more socialistic policies. The financial sector has been victimized and weakened by this. Finance being a complex phenomenon, most people don’t understand it, and what’s not understood is usually feared and blamed when things go wrong.

The Federal Reserve itself was proposed in 1910 (and adopted in 1913) to provide a more “elastic currency.” Prior decades had seen repeated, disruptive liquidity shortages (“money panics”), the worst in 1907; they were caused not by free banking but by legal restrictions on banks’ ability to issue currency to displace checkable deposits when, for seasonal reasons, customers preferred it.

Legal restrictions also required currency issuance to be backed and tied to the national debt, the supply of which was dwindling (as the volume and needs of commercial trade were expanding). A repeal of those non-economic restrictions would have solved the problem; instead the Federal Reserve was concocted, nationalizing the currency.

The stock-price crash of 1929 and subsequent Great Depression (1930s) were triggered by the protectionist Smoot-Hawley Tariff Act (1930), but even before that by the Fed’s punitive interest rate policy of “inverting the yield curve” (lifting shorter-term rates above longer-term rates, making lending unprofitable because financial institutions “borrow short and lend long”).

In 1932, as the federal budget deficit widened, Congress and President Herbert Hoover raised the top tax rate from 25 to 62 percent, making the economy (and deficit) even worse. Candidate Franklin D. Roosevelt, that same year, hinted that if elected (to replace Hoover), he might copy Britain’s prior (1931) policy of abandoning the gold standard; that hint triggered bank runs because Americans feared not an unstable, illiquid banking system but FDR’s confiscation of their property. That’s just what happened, in 1933, as FDR and critics blamed greed, Wall Street, and capitalism. Instead of reversing the offending interventions, legislators gave the Fed still more power, then added government deposit insurance (the FDIC), which put a premium on unsafe banking, causing a subsequent, steady, decades-long dwindling of bank capital ratios.

The subsequent expansion of deposit-insurance coverage and adoption in 1984 of the “too big to fail” doctrine (bailing out large, illiquid, and insolvent banks) further fostered excessively large banks and reckless financial practices, as did massive federal bailouts of the artificially contrived, inherently frail savings and loan associations in 1989-91. Once again, the interventions weren’t repealed. The lesson wasn’t learned. More power flowed to the Fed, the FDIC, and the federal mortgage agencies, Fannie Mae and Freddie Mac.

For almost two decades, the Clinton and Bush administrations (1992-2008) adopted a formal, national policy that everyone should be able to afford and occupy a house, regardless of their financial wherewithal, creditworthiness, or preference for alternatives (renting). The homeownership rate of 65 percent was allegedly too low and had to be raised, if necessary by artificial means. The un-housed were supposedly victims of racist, greedy bankers.

The FHA, HUD, Fannie Mae, and Freddie Mac would promote subprime loans. If the shaky loans went bad, as they likely would (and did), blame would be placed not on White House goal setters, subsidies, or deadbeat borrowers who sought something for nothing, but on “predatory lenders.” When lenders went bust, they’d get public bailouts, then public derision, then still more strings attached. That’s been the pattern: more subsidies, moral hazard, and rules.

When Washington adopted the $700 billion Troubled Asset Relief Program (TARP) in fall of 2008, most economists, policy makers, and journalists believed it made things better; in fact, it made things worse. TARP didn’t prevent the crisis but contributed to it.

The root cause of the bearishness in 2008 was the recession that had begun in late 2007, long before TARP, caused by the Fed’s deliberate and prior inversion of the Treasury yield curve. But instead of shuttering the handful of insolvent banks (like Citigroup) and encouraging private purchases of bad mortgage assets from others, the Treasury forced hundreds of safe banks to take overly expensive public capital and face business-line rules, dividend restrictions, and “pay czars.”

Meanwhile, Washington bolstered the same policies that had encouraged excessive leverage and reckless lending: FDIC coverage, the “too big to fail” doctrine, cheap Fed loans, and the mortgage government-sponsored enterprises (Fannie Mae and Freddie Mac).

In March 2008, only a half year before TARP’s enactment, the Fed had made a huge policy mistake by bailing out Bear Stearns and buying $30 billion of its bad assets while forcing J.P. Morgan to pay $10/share for the remainder. Nearly everyone at the time applauded the bailout, but it sent the message to other over-leveraged banks (Lehman Brothers and Merrill Lynch) that they needn’t raise capital (although it was possible to do so in summer 2008) and instead could gamble: if heads they’d win, but if tails U.S. taxpayers would lose.

Many attributed the 2008 panic to the failure of Lehman Brothers (mid-September) and the “unexpected” decision by the Treasury and Fed not to bail it out. Yet Merrill Lynch, although a much bigger and more retail-oriented brokerage house, also failed in the fall of 2008, and was safely absorbed into Bank of America. The same could have been done with Lehman Brothers, but it waited too long, counting on political help. That fatal expectation was the real problem: not the failure itself, but the way Washington misled markets. Eventually Lehman’s remaining value was bought by Barclays Bank; it could have been done earlier, calmly.

If TARP had truly helped, markets would have performed worse before it was enacted (October 3) and better afterward. U.S. bank stocks had plunged 49 percent from early February to mid-July 2008, then rebounded sharply (+52 percent) in the two months through September 6, retracing 76 percent of the prior peak. That could have marked the end of the banks’ bearish run; but before long, markets had to consider not that Washington would “rescue” failed banks but that it would nationalize and operate them (as it did, for a while).

The proximate trigger for the panic occurred in early September, when the Treasury declared Fannie Mae and Freddie Mac to be insolvent, then nationalized them to live another day. Bank stocks peaked yet again, then plunged. Without the failures of Washington’s mortgage agencies, there wouldn’t have been a TARP, and no bearish threat of further political interference in banks.

It was only in that context — a politically stoked financial crisis — that the Treasury ran in panic to Congress, seeking $700 billion for TARP, and only then did bank stocks begin a five-month slide. The system soon depended on government “capital,” not on private capital. The long history of political ownership and control of banks had always been a bearish history.

Most U.S. banks were healthy in 2008-9 and should have been left free of TARP. Instead, they were exploited by Washington (and unwittingly by U.S. taxpayers). TARP’s inherent bearishness had both an anticipatory aspect and a trailing effect; in the five months before it was adopted (October 3), the S&P 500 fell by 22 percent, while U.S. bank stocks dropped by 21 percent. In contrast, in the five months after TARP was enacted, the S&P 500 declined by a large 38 percent while bank stock prices plunged by an even larger 72 percent. Obviously, markets were much worse off in the five months after TARP’s adoption than in the previous five months, and they performed worst of all in the sector (banking) that TARP was supposed to help.

A decade after 2008-9 should be enough time to gain perspective, gather facts, apply logic, make valid conclusions, and enact relevant policy reforms to prevent recurring crises. But after thousands of misguided articles and dozens of poorly researched books, most people today still attribute the crisis to greed, Wall Street, and capitalism. All culpable government agencies still exist. Indeed, they’ve been given still more funding and power than they wielded before 2008, mostly in the Dodd-Frank Act (2010), legislation that was cosponsored by the two politicians who most favored Washington’s promotion of unaffordable housing

Valid policy reforms would restrict or phase out the Fed, FDIC, FHA, HUD, Fannie Mae, and Freddie Mac. Despite all the damage these interventionist agencies have inflicted, and regardless of the ease with which free market alternatives can be fashioned to replace them, they’re still viewed as sacrosanct and untouchable. Thus, future financial crises are inevitable.

 

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Richard M. Salsman

AIER Senior Fellow Richard M. Salsman is president of InterMarket Forecasting, Inc. and a visiting assistant professor of political economy at Duke University. Previously he was an economist at Wainwright Economics, Inc. and a banker at the Bank of New York and Citibank. Dr. Salsman has authored the books Gold and Liberty (1995), The Collapse of Deposit Insurance and the Case for Abolition (1993) and Breaking the Banks: Central Banking Problems and Free Banking Solutions (1990), all published by AIER, and, most recently, The Political Economy of Public Debt: Three Centuries of Theory and Evidence (2017).

Dr. Salsman earned a B.A. in economics from Bowdoin College (1981), an M.A. in economics from New York University (1988), and a PhD in political economy from Duke University (2012).