It was this time ten years ago that people started to catch on that something was going wrong. Home prices stopped rising, many were falling, the flipping schemes were dying out, and default notices were being posted for smaller banking houses.
Could it be that the entire glory days of the spectacular increases in home prices were coming to an end? Denial was still in the air. The Fed was responding to the very prospect with the same-old strategy: driving interest rates ever lower. Minutes of meetings released years later made the point: the Fed was very slow to catch on.
Denial didn’t change reality. Six months later, the full financial panic was unleashed, complete with public fear, investor meltdowns, bailouts, expanded guarantees of all sorts, and massive money printing. The bubble in home prices exploded with a vengeance and threatened to take down large swaths of the heavily-invested financial and banking industry with it.
What was only recently said to be unthinkable suddenly seemed inevitable. Before the reality hit, the experts were thinking that that market frenzy could be softlanded, that real estate was too localized to become a national boom-bust, that perhaps a bit of house cleaning was in order but no real crisis was in the offing. All would be well, surely.
Cause of the Cycle
What had gone wrong? There was no consensus then and, sadly, there is no consensus now. A major reason concerns what you see as the problem to begin with.
Was it the bust itself? If all prices could have gone up forever, if all mortgage-backed securities had maintained their value, if lenders had never faced a liquidity crisis, there would be no problem to solve. If that is true, the solution suggests itself: restore the status quo ante. The only job of policymakers – whether regulators, the Fed, or Congress – is to get prices back up again. This was the New Deal’s theory of economic recovery, and roughly the same one pursued after 2008. It was all about reflation. If you look at housing prices today, it seems to have worked.
On the other hand, you could look at the bust as the solution to the real problem of the boom. How could the prices of financial assets have come to be so misaligned with underlying reality? How could such high demand for housing have so completely outstripped the capacity of borrowers to service the debt? And how did it come to be that financial institutions had so thoroughly misjudged the quality of the debt they traded as an asset?
What about Greed?
This is the more foundational way to look at the problem. It also happens to be the least popular way. The Big Short (2015) was a wonderfully entertaining movie, and it contained some technically competent explanations of some of the complex assets that brought down whole financial empires. On the other hand, it contained not a single word about the Federal Reserve, credit policies, or loan guarantees that created the perfect storm that generated the boom-bust.
The movie didn’t quite say the average viewer could come away with a sense that the underlying problem in 2008 was essentially moral. Greed had taken over in financial markets and this affected real estate most profoundly. The answer was more regulation to rein in the materialist spirit. Markets had broken; government would fix them. Such an explanation had no more a scientific foundation that the belief that witches caused the plague.
A more sophisticated version of this same theory says, very simply, the crisis was caused by deregulation (at the mention of which you are supposed to shudder in fear!). If you google the cause right now, this is the first result. The idea is that once government lifted its hand from regulating financials, the result was hell unleashed. In fact, this is wholly incorrect. Blaming the genuine financial innovations of the 2000s is entirely misplaced. For a demolition of that position, see Ed Stringham’s “The Functioning of Wall Street During the 2008 Economic Downturn.”
Plus, if you want to talk about greed, how about the stunning behavior of the president and Congress? Just as the crisis had fully hit public awareness, they pushed through a $700 billion spending bill called the Troubled Asset Relief Program or TARP. It was the biggest bailout of Wall Street in history but it was only the beginning. The full powers of the Federal Reserve were deployed to pump up the markets and save banks, insurers, mortgage companies, developers, and owners.
It seems incredible that in hundreds of years of business cycles, nearly all stemming from the same main source, that we still don’t know. Greed is hardly an explanation at all. To be sure, greed like gravity will be with us always, but what needs to be explained is why economic activity swings in cyclical ways with investors and consumers acting in concert, moving from wild speculation to panic selling and back again.
The answer has been known for a very long time but somehow continues to elude pundits and policy makers. It comes down to two words: bank credit, or what used to be called credit inflation. E.C. Harwood, in a 1932 book-length expansion of a 1928 essay, provides the classic definition: “the condition arising when the banks of the country have originated purchasing power in excess of that required to represent goods produced which are currently coming to market.”
“The effect of inflation is to place in the hands of individuals and businesses excess purchasing power which is naturally used to purchase goods of one kind or another. In the absence of goods to balance the excess, buyers bid up prices in general.” Or, “the resultant rise in prices is especially marked in some particular class of articles.” The new money flows to the flavor of the day: commodities in 1919, stocks in 1928-29, dot coms in 1998, and real estate in 2008.
A large portion of the excess purchasing power remains on duty in the principal field of speculation, rapidly changing from hand to hand as speculators for the rise successively buy and sell, bidding up prices to ever higher levels. However much of the excess finds its way into the channels of trade. Successful speculators buy new houses, automobiles, and other luxuries. Many businesses, deceived by the artificially stimulated demand, enlarge plant facilities with funds obtained, in part, from the flood of excess purchasing power.
Lending for long-term projects outstrips the savings and capital available to support it, but the investment boom nonetheless continues. “The rising prices, which at first may be in a limited field, invite speculation for the rise, which means further borrowing,” wrote Harwood. “Finally, the book is fully developed and sustained largely on the basis of pyramided extensions of credit. It is, therefore, a very vulnerable situation.”
The result is a deflationary phase of the cycle, “a constant drain of funds from the stream of money incomes. The banking system withdraws this credit by selling securities in the open market and by calling loans….Prices have to be reduced. Merchants and manufacturers thereby suffer losses and attempt to curtail production and cut costs.”
The very core of Harwood’s view – and the Austrian cycle theory generally – is that the instabilities revealed in the boom-bust cycle are not inherently to the market process itself but are rather the result of distortions generated out of bad policies. When the bust comes, the cure is not more bad policy but rather the rebalancing energy of the market itself. The market is the salve to repair the wounds inflicted by misleading signals.
Of course this reality is a tough one to teach. In the boom, writes Harwood, “the public loses all interest in the necessary adjustments of the social and economic scheme to changing conditions.” In the bust, “there is a general tendency to hysterical action which refuses consideration to all rational solutions of important problems.”
Here Harwood writes as if he is talking about TARP, regulation, QE 1,2, and 3, and so on: “One of the seemingly inevitable accompaniments of hard times is the series of panaceas or cure-alls proposed by numerous well-meaning individuals in the expectation that the readjustments incident to inflationary maladjustments can somehow be avoided.”
Zero Tolerance for Pain
It was one of the truly strange and tragic elements of the post-2008 world that the idea of riding out the recession was essentially seen as inceivable. This is in contrast to, for example, 1981-1983, when Ronald Reagan patiently explained to the American people that there would have to be some pain as the economy readjusted following an unsustainable boom. He cut taxes, avoided regulation, and rode it out, at which point the market worked to clear itself of errors and got on a course toward a very strong recovery.
It’s impossible to do counterfactuals but the ten years of slow growth in the US economy is surely related to the efforts to reflate, re-regulate, and restrict. For ten years, this has become the new normal.
Check out how sluggish this recovery has been, right in the midst of the great technological revolutions in history.
Other problems were revealed after 2008, such as the incredible failure of the bond-ratings agencies to realistically assess risk, the shakiness of the banking system that puts all private wealth at risk, the moral hazard created by implicit loan guarantees, and the sloppy aggregation of ownership claims over properties that was so opaque that it took several years to untangle before the Fed essentially bought securitized assets.
Nonetheless, the conventional wisdom today is that the Fed did it all the right way, even if it came at the expense of ten years of economic growth. And today? Housing prices are back, higher than ever. Is this another bubble ready to explode? Some say yes, but most say no. How can we know for sure? All the conditions that led to 2008 are still in place.
From this, there is a tragic conclusion: we’ve learned nothing from 2008 because we do not like the real lessons that the experience taught us. What are those lessons? Stop manipulating money and credit. End tax-backed guarantees of investments. Withdraw all promises that any institution is too big to fail. Stop using public policy to push investors and consumers in directions that the competitive market economy would otherwise not wish them to go. Finally, there is no substitute for letting the market work.