What Caused the Great Recession?

Steven Horwitz, Charles A. Dana Professor of Economics at St. Louis University, has an excellent presentation on what caused (and what didn’t cause) our current economic woes.

Before talking about how we did get here, let me say a quick word about what didn’t cause this mess. Those who wish to blame greed for the crisis need to explain how and why it is that greed seems to causes crises only at specific times, despite the fact that it is omnipresent as a feature of human nature and market economies. As the economist Larry White has noted, if we saw a bunch of planes crash all on the same day, we wouldn’t blame gravity. It’s always there. Something else must be at work. I would argue that the key is the set of institutions through which greed or self-interest is channeled. That is, good institutions can cause self-interest to generate desirable unintended consequences, and bad ones can cause undesirable ones. So perhaps we should be looking at institutions and policy.

Those who wish to blame deregulation or the supposed “laissez-faire” philosophy of the Bush Administration are going to have to identify the deregulation in question, which will be a challenge given that the last deregulatory legislation in the financial industry was in 1999 under Clinton. These folks will also have to explain how the enormous growth in the Federal Register and domestic spending over Bush’s two terms reconciles with his supposed belief in laissez-faire. Answer: it doesn’t.

The two key causes of this crisis are expansionary monetary policy on the part of the Fed and a series of regulatory and institutional interventions that channeled that excess credit into the housing market, creating a bubble that eventually had to burst. In other words, the boom (and the inevitable bust) are the product of misguided government policy, not unbridled capitalism.

The Fed drove up the money supply and drove down interest rates very consistently since 9/11. When central banks do so, they make long-term investments relatively cheaper than short-term ones, thus the excess funds flow toward such goods. Historically, these were producer goods in capital industries, but in this particular case, a set of other government interventions and policies pushed those funds toward housing.

A state-sponsored push for more affordable housing has been a staple of several prior administrations. Fannie Mae and Freddie Mac are key players here. Although they did not originate the questionable mortgages, they did develop a number of the low down-payment instruments that came into vogue during the boom. More important, they were primarily responsible for the secondary mortgage market as they promoted the mortgage-backed securities that became the investment vehicle du jour during the boom. Both Fannie and Freddie are, we must remember, not “free-market” firms. They are “government-sponsored entities,” at one time nominally privately owned, but granted a number of government privileges, in addition to carrying an implicit promise of government support should they ever get into trouble. With such a promise in place, the market for mortgage-backed securities was able to tolerate a level of risk that truly free markets would not. As we now know, that turned out to be a big problem.

Other regulatory elements played into this story. Fannie and Freddie were under significant political pressure to keep housing increasingly affordable (while at the same time promoting instruments that depending on the constantly rising price of housing) and extending opportunities to historically “under-served” minority groups. Many of the new no/low down-payment mortgages (especially those associated with Countrywide) were designed as responses to this pressure. Throw in the marginal effects of the Community Investment Act and zoning laws that crowded residential development into less and less space in many large cities, not to mention the bully pulpit arguing for more affordable housing of at least the last two presidents, and you have the ingredients of a credit-fueled and regulatory-directed housing boom and bust. And all of this was happening with the enthusiastic support of much of the private sector, who benefitted from the wealth generated by the government-induced boom.

Full article here.

People who rely on the mainstream media for their “news” tend to assume they know with 100% certainty the cause(s) of the current economic crisis. They toss around the names of the usual suspects with aplomb: “deregulation”, “the failure of capitalism”, “Wall Street greed” or “George W. Bush’s mismanagement of the economy” (a meaningless phrase which under cross-examination rarely gets more specific than “tax policies that benefitted the rich at the expense of the poor and middle class”). Horwitz’s presentation debunks these common myths.

Ironically, for all their smug self-assurance, the same folks who parrot these media shibboleths tend to have little understanding or curiosity about subjects like credit default swaps, mortgage-backed securities, mark-to-market regulations, the roles of the Federal Reserve Bank, Fannie Mae and Freddie Mac, the Community Reinvestment Act, “redlining”, sub-prime mortgage loans, NINJA loans, etc.

They never ask themselves: “What if we’re wrong?” If their unexamined assumptions about the causes of the Great Recession are fundamentally flawed, then their clichéd prescriptions (“stimulus spending”, “higher taxes on the rich”, “more stringent regulations” are likely to make things worse. But they remain blithe to the idea that they might be wrong about subjects they do not understand and rarely think about.

These people also seem to believe, when it comes to monumental decisions involving trillions in new spending whose ramifications will impact the country for better or worse for decades, that less debate is better than more. And if you disagree, then you need to be reminded that Obama won, in case you didn’t get the memo.

Because, as 2007 Nobel prize® recipient Al Gore continually reminds us: “The science is settled so the time for debate [and thinking] is over.”

Because ending discussion and debate and stifling dissent are the hallmarks of “Science.”

Galileo would be proud.

Hat tip: Jonah Goldberg


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