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The unregulated market caused the recession

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Wheylous posted on Thu, Oct 27 2011 4:59 PM

I hear this argument all the time, yet the events that would lead to the recession happened while I was politically inattentive. Could someone help point me to how government, not the free market, caused the problems we have? How it wasn't "greed" that the free market would have allowed but poor government policies?

I have begun my journey with this:

http://online.wsj.com/article/SB10001424052970203633104576623083437396142.html?mod=WSJ_Opinion_LEADTop

And I hope to find good arguments to use in discussion.

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The market is highly regulated.

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Yes, but the argument claims that there was much deregulation that caused the current recession.

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In a way, that's true. For example, the Glass-Steagall Act allowed banks and other financial companies to become even more leveraged.

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leveraged

Sorry, but what does this mean?

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Leverage: http://en.wikipedia.org/wiki/Leverage_(finance)

Also, I believe Autolykos meant to say the repeal of Glass-Steagall allowed banks to become more leveraged.

It is certainly possible for any given act of deregulation to cause problems, but the source is always previous regulations. Glass-Steagall is a great example. The government enacts regulations or policies that screw something up. They then pass Glass-Steagall to cover their screwups. Decades later, they repeal Glass-Steagall and the original problems surface again. But the free market isn't causing those problems, it's the original regulations and policies.

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Can you explain what those original problems were?

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Peter Schiff explained some of it briefly when he talked to the "99%" in the streets of New York. He also offered a great background in his Hazlitt memorial lecture. Other great lectures include this one in which he speaks to a group of students who just went through Bernanke's four-part college lecture series, and Schiff rebuts many of the Federal Reserve Chairman's claims about the cause of the housing crisis, the role of the Federal Reserve, the value of the gold standard, and more.

Here he lectures in a Congressional setting and explains "What About Money Causes Economic Crises?".  And of course there's also the now-famous lecture he gave to a conference of mortgage bankers in 2006, in which he predicted largely everything that was going to happen: [full lecture], [highlights].

In text form, he of course went into great detail in Crash Proof

If you want a really good explanation, Meltdown is the definitive Austrian text so far, and Financial Fiasco is actually a bit more detailed since it was written later, when more data became available.  (Of course there's been debate.)  The film Overdose [backup link] is based on the latter, and is actually narrated by Norberg himself.  It's the best overview of the boom/bust I've seen so far (but that may change [new, working link] soon enough).

But here's a breakdown:

 

Typical day at a bank in early to mid 2000s:
A bank makes a loan to a shitty customer with a 600 FICO who paid nothing down. It doesn't matter to them if the guy isn't able to make good on his payments because the bank that made the loan gets to turn around and sell it to Government-Sponsored Enterprises Fannie Mae and Freddy Mac, who basically pay the bank back more than what it just lent out. So the bank gets to keep making loans.

The fact that the bank essentially doesn't have to worry about the quality of the borrower to pay back the loan is what is referred to as "moral hazard." The person (or company, as it were) who originally decided the borrower was good enough to make the loan to doesn't have anything to lose if the borrower defaults...so there is really no incentive to originate loans with good quality borrowers.

Now normally, even though banks were able to sell off their notes on the secondary market before, they maintained higher standards because the buyers of the notes demanded higher standards (i.e. Freddy and Fannie wouldn't buy notes in which the borrower was below a certain standard of quality). With the government intervention and the push of people like Barney Frank, those two Government Sponsored Enterprises lowered their standards on the types of notes they would buy...which allowed the banks to then make loans to shittier customers.

Then of course the government can push banks in other ways too, as economist Walter Williams said "I challenge anyone to come up with one thing banks can do that's not covered by a regulation." So if everything you do is regulated by the government, the government then therefore has a lot of power to influence what you do.

So what happened?:

  • Government convinces the public that the "American Dream" is home ownership. Politicians want to tell all the poor people of America they too deserve a house (even though they don't want to work for it).
     
  • Government creates legislation (like the Community Reinvestment Act of 1977) to "reduce discrimination against low-income individuals and neighborhoods." Government officials like Attorney General Janet Reno threatened legal action against lenders whose racial statistics raised her suspicions. Politicians want to appeal to voters and be able to say things like "home ownership is at an all time high", like President George W. Bush does in this laughable speech.
     
  • Government then essentially has government-sponsored enterprises (Fannie Mae and Freddy Mac) and the Federal Housing Administration (FHA, a government agency) lower their standards on the types of loans that they will buy and insure.
     
  • Banks now have financial incentive (as well as governmental pressure) to make loans to lesser qualified people that the banks would otherwise not want to lend to, for fear of not getting paid back.
     
  • More and more unqualified people are able to get loans. They are able to pay less and less of a down payment, and many times make NO down payment...and even sometimes get to borrow more than the amount needed (as in 115% financing).
  • The money to finance all these new loans came from the Federal Reserve, which engaged in inflationary policies throughout the early 2000s—something actually not covered by Thomas Sowell in his book on the housing boom. Keynesian economist and Nobel Laureate Paul Krugman wrote in his New York Times column in 2002: "Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble." With a brand new president in the White House, not wanting his first years to be presiding over a depression, large federal deficits were run and, as recommended, Greenspan lowered interest rates to an incredible, unprecedented 1%, for an entire year.
     
  • This artificial manipulation of rates essentially provided a false sense of profitable investment as well as easy access to credit for investors, who in turn were more likely to take greater risk, as money was not as expensive to borrow. (This helps explain not only the housing boom but also the unsustainable rise in long-term production in general.) (In his book Meltdown for example, historian Thomas Woods utilizes this fact to explain not only the wild rise in housing prices in certain markets, but also the causal forces behind the rise of commodities futures speculation, the upward surge in oil prices which preceded the bust, and the heavy losses recently sustained by capital goods and input producers whose products are only tangentially related to housing prices, such as US Steel.)
     
  • All the meanwhile, Congressmen like Chris Dodd and Barney Frank, who was a ranking member (and later Chair) of the House Financial Services Committee vehemently pushed against transparency and government regulation of the government-sponsored enterprises Fannie Mae and Freddy Mac, while at the same time pushing for more "home ownership" (and of course lying about it later.) They argued that screwing with such organizations would essentially hurt the economy and continuously assured Congress and the White House and the public that those institutions were healthy and sound. Basically they lied.  (And then lied about lying.)
     
  • So with more and more people able to buy homes when they shouldn't have, an unrealistic artificial demand (i.e. a bubble) was created. With an artificial demand, comes artificially high prices. More and more people buying houses meant higher and higher prices...which meant more and more people buying, into a big cycle. The reason people were able to keep buying despite the high prices was, again, the ease of getting credit, which was a combination of cheap money (courtesy of the Federal Reserve) and lax lending standards (courtesy of the GSEs and FHA and other governmental factors). And the fact that prices shot up so high helped buyers and lenders alike feel like they were both safe...because everyone assumed prices would keep going up. So the borrower felt like it didn't matter he couldn't afford his payments because his home was always going to grow to be worth more. The lender didn't worry either because if the borrower defaulted they could take back the house, which of course was going to continue to be worth more.
  • Greenspan was lauded as a modern hero, avoiding the expected meltdown after the dot-com bust and living up to his now-famous Time Magazine cover which called him and then-Secretary and Deputy Secretary of the Treasury Robert Rubin and Larry Summers "the committee to save the world." 
  • A lot of people made a shitload of money buying and selling houses and originating loans.
     
  • Investment banks and other firms bundled up all the sub-prime mortgages into big securities (financial instruments that represent some sort of ownership of something of financial value), which they could then sell to other investors.

    These securities, which got their value from mortgages ("mortgage-backed securities"), were bought, sold and traded between companies in the financial markets, as well as in private deals. The value of such securities was increasing (just like the houses) because of increased demand (just like the houses).
     
  • A lot of people made a shitload of money creating, buying, selling and trading mortgage backed securities. Many large companies heavily invested in these securities.  They were also quite popular with foreign investors, like the Chinese.
     
  • After a year of keeping interest rates at a ridiculous 1%, the Fed then steadily ratcheted them back up in quarter-point increments to 5.25% by June 2006. This made borrowing less attractive to investors as well as home buyers. It became less and less profitable to buy many of the homes at the prices at which they were currently selling, because the borrowed money was too expensive in comparison. With less buyers, there was less demand. With less demand, prices stopped climbing. With home values not increasing as fast as they did before, people could no longer bank on a Home Equity Line of Credit (HELOC, essentially a way to take cash out of the value of the home like an ATM). With no more ATM, no way to refinance, and no one to buy their extremely overpriced home, the people who bought homes they couldn't afford to make the payments on in the first place started missing payments...and eventually went into foreclosure...

    ...The bubble was popped.
     
  • The ball kept rolling as more and more people who bought homes they couldn't afford foreclosed and prices continued to drop as there was more and more supply (houses trying to be sold) and less and less demand (people wanting to buy a house). For a short while the average was estimated by some to be 250,000 foreclosures per month across the country.
     
  • As more and more people foreclosed (i.e. defaulted on their loans) the true value of the mortgage-backed securities began to fall. (Basically, a promissory note (i.e. an IOU) is only worth anything if the borrower makes good on the payment. If he doesn't pay, then the IOU isn't worth anything.) So there was essentially billions of dollars worth of these securities that were getting to a point at which they were not worth near what they were bought for...yet there were many large companies who had invested heavily in these instruments. This meant those assets that the company held had no real value and therefore the company itself had less value. Of course, a company that held such assets that weren't worth anything had a difficult time selling them. No one wants assets like that. They were toxic assets.
     
  • Here is a large part of where and why the Wall Street meltdown occurred. It, however is a complicated quagmire in itself that was magnified and exacerbated by risky practices by the companies engaging in deals involving complex financial instruments like "derivatives"...including "credit default swaps (CDS's)".  (For more info on this, Frontline produced a comprehensive series of documentaries (viewable for free, click "watch the full program"): Inside the Meltdown, 10 Trillion and Counting, Breaking the Bank)
     
  • Suffice to say, when those companies were not allowed to fail as they otherwise would have without government intervention, the government and Federal Reserve essentially did not allow the bubble to fully deflate. This is why the recession is not over...because it hasn't found a true bottom, and has only continued to be artificially propped, by the spending programs, bailout programs, and borrowing incentives of both the Bush and Obama administrations.

    Eventually the government will run out of toothpicks to keep the structure (i.e. the economy) from crashing. There are only so many ways to prop up something so unstable before, by law of physics, there is no way to keep it from falling.


For a great visual representation of most of this, see here.  And this was an animation that used Bush's speech as the audio and mixes in some facts...but if you click the link you'll see what happened to it.

 

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Glass-Steagall is nothing more than a beloved buzz word that people like to throw around to sound like they know what they're talking about.  They don't know what it is, they don't know what it says, they don't know when it was enacted and they don't even know what president signed the (partial) repeal...(not Bush...and I guarantee you more than 99 times out of 100, they won't be able to tell you it was a partial repeal).  All they know is it was a financial regulation repeal that took place at some point in history close enough to be able to blame the crisis on it...and the only reason they know that is because they heard someone else say it.  And of course this is perpetuated by useless films like Inside Job.

As Golden State Liberty blog notes:

The best they can do is to cite the partial repeal of the Glass-Steagall Act in 1999, and even this argument weakens on examination. The repeal (known as Gramm-Leach-Bliley) merely eliminated a provision that prohibited commercial banks and investment banks from existing under the same corporate umbrella, a provision that exists nowhere else in the world; other elements of Glass-Steagall, including those prohibiting commercial banks from underwriting or trading in securities and those prohibiting securities firms from taking deposits, were left intact, and other laws exist to prevent investment banks from unloading toxic securities onto commercial affiliates. Are we really supposed to believe that this repeal created some new sort of trading activity whose effects brought the world's financial system to its knees?

 

When people mention the words "glass steagall", ask them what it is.  Just ask "what is that?"  See what happens.  Same thing when they have any policy recommendation.

 

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z1235 replied on Thu, Oct 27 2011 8:36 PM

The Fed -- a government mandated monopoly on money creation, and (Soviet-style) central planning for the price of the asset at one side of ALL transactions in the economy: money. Easy to guess, the distortions to the economy and the abuses by the entities closest to the wellspring of easy money would be epic. Unregulated, you say? The free market, the poor thing, never even got a chance to crawl from being smothered like this, much less to get up and do any damage to anyone.

 

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Market regulations were destroyed by government intervention, for example by guaranteeing firms against possible losses.

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Fed gave so much cheap money through low interest rates that people had great incentive to invest into housing. Even with high regulation, that incentive would have stayed. And there actualy was much regulation, but it was build to help everyone to get a chep house. And what happened? Meltdown by Tom Woods is best book about it.

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John James:
Glass-Steagall is nothing more than a beloved buzz word that people like to throw out to sound like they know what they're talking about.  They don't know what it is, they don't know what it says, they don't know when it was enacted and they don't even know what president signed the repeal (not Bush).  All they know is it was a financial regulation that was repealed at some point in history close enough to be able to blame the crisis on it...and the only reason they know that is because they heard someone else say it.  And of course this is perpetuated by useless films like Inside Job.

As Golden State Liberty blog notes:

The best they can do is to cite the partial repeal of the Glass-Steagall Act in 1999, and even this argument weakens on examination. The repeal (known as Gramm-Leach-Bliley) merely eliminated a provision that prohibited commercial banks and investment banks from existing under the same corporate umbrella, a provision that exists nowhere else in the world; other elements of Glass-Steagall, including those prohibiting commercial banks from underwriting or trading in securities and those prohibiting securities firms from taking deposits, were left intact, and other laws exist to prevent investment banks from unloading toxic securities onto commercial affiliates. Are we really supposed to believe that this repeal created some new sort of trading activity whose effects brought the world's financial system to its knees?

 

When people mention the words "glass steagall", ask them what it is.  Just ask "what is that?"  See what happens.  Same thing when they have a policy recommendation.

Thanks John. I admit to being fuzzy on the details of the Glass-Steagall Act and its partial repeal. What I had read - I believe it was an article on this site - was that, in the absence of any (significant) restraint on fiat currency and fractional-reserve banking, capital would gain the appearance of being super-abundant instead of scarce. The partial repeal of the Glass-Steagall Act led to fewer restraints on those things.

However, I found a gem in the Wikipedia article on the Gramm-Leach-Bliley Act:

Crucial to the passing of this Act was an amendment made to the GLB, stating that no merger [of a commercial bank and an investment bank] may go ahead if any of the financial holding institutions, or affiliates thereof, received a "less than satisfactory [sic] rating at its most recent CRA exam", essentially meaning that any merger may only go ahead with the strict approval of the regulatory bodies responsible for the Community Reinvestment Act (CRA).[16] This was an issue of hot contention, and the Clinton Administration stressed that it "would veto any legislation that would scale back minority-lending requirements." [17]

Essentially, then, the people who blame the (partial) repeal of Glass-Steagall for the ongoing financial crisis have only a small piece of the overall picture. Commercial banks and investment banks could merge only if they kept feeding into the subprime-mortgage behemoth. This behemoth, of course, was entirely the product of government legislation and regulation. Combine that with the highly loose monetary policy from the Fed and you get a financial crisis just waiting to happen.

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Autolykos:
Essentially, then, the people who blame the (partial) repeal of Glass-Steagall for the ongoing financial crisis have only a small piece of the overall picture.

I say you're giving them way too much credit.

 

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"It doesn't matter to them if the guy isn't able to make good on his payments because the bank that made the loan gets to turn around and sell it to Government-Sponsored Enterprises Fannie Mae and Freddy Mac, who basically pay the bank back more than what it just lent out."

 

That right there, that is the piece of information missing from the Occupy Wallstreet folks. 

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