Economic crisis part 1: the causes
I'm a huge news junkie these days - my addiction started with politics, since for the first time in eight years we have a presidential candidate who I'm really interested in. Then the housing market tanked, the stock market followed, and we were faced with the possibility of Great Depression II: This Time YOU'RE History. I started studying up on economic issues, trying to figure out how we got into this mess and what to do about it, and now I have lots and lots of links to share.
Bushonomics (PDF) - A very basic issue at the heart of all this is that prices for just about everything have gone up, but most people's wages have not. The market's "solution" has been to substitute credit for income, to give people more and more credit so that they can continue to buy all the stuff that companies produce. This of course was unsustainable - eventually a lot of people got so far into debt that their incomes were not sufficient to make payments to their creditors.
BTW, the same thing happened the last time around.
There's a lot more to this problem than average folks getting in debt, though. Wall Street firms built securities and derivatives worth trillions of dollars (on paper at least) on top of all that debt - the "value" of these pieces of paper ended up being orders of magnitude larger than the mortgages they were based on. Once borrowers started defaulting on their loans, the whole house of cards came tumbling down. And this part is the kicker: Wall Street pushed for those bad loans to be made in the first place. Huge firms were demanding more and more mortgage-backed securities, so mid-sized firms that bundled loans demanded more and more mortgages to make securities out of. Smaller firms sprang up all over the country making mortgages to sell to the bundlers. Eventually the smaller firms ran out of truly qualified buyers, but the firms above them all the way up the chain gradually relaxed their standards about the kinds of loans and securities they would buy, finally getting to the point where they accepted "NINA" loans ("No Income No Assets", meaning that nothing about the borrower's finances was verified). The largest firms and investors had convinced themselves that they could make a good investment out of a bunch of bad loans by turning them into securities. They had convinced themselves that it was safe to sell credit default swaps, which are basically insurance policies, on these securities even though they didn't have the capital to pay out if that insurance was ever called upon. After all, property values always go up, right?
60 Minutes summarized the situation in in this video, and NPR did an hour-long audio piece about it here.
After the Great Depression, which was caused in part by a great big speculatory bubble, the government put some regulations in place to rein in the excesses of the market. In the last decade or so there's been an emphasis on deregulation. The Gramm-Leach-Bliley Act, passed in 1999, allowed commercial banks to get into the investment business and vice versa for the first time since 1933. The Commodity Futures Modernization Act of 2000 expressly forbid any government regulation of credit default swaps. In 2004 the SEC decided to grant five firms an exemption from the normal leverage-to-capital requirements and let them get into debt up to 40 times greater than their actual assets - those five firms were Bear Stearns (dead), Lehman Brothers (dead), Merrill Lynch (bought out), Morgan Stanley (in very bad shape), and Goldman Sachs (bailed out by Warren Buffett just recently). The Federal Reserve dropped its interest rate to under 2% - lower than the rate of inflation - and left it that low from late 2001 to mid-2004. Dropping the rate temporarily to stimulate the market after 9/11 made sense, but leaving it so low for so long created an incentive for firms to make risky investments. And in the absence of government oversight, Wall Street's own ratings agencies "became the de facto watchdog over the mortgage industry" - a job at which they failed miserably.
Here's a great summary of the government's role in creating this crisis. Here's another, much more detailed analysis by the same economist examining all the bad actors.
There were many, many self-deluded and irrationally optimistic people who had a role in creating this crisis. There were probably also some intentional bad actors - CEOs who drove up profits in the short term knowing that there would be a crash in the long term, who now, with their "performance" bonuses and golden parachutes, are laughing all the way to the bank. Over time some of that latter group will be caught and prosecuted. But I want to give some attention to one bad actor in particular, one man who used his influence to help create the conditions that have now destablized the entire US economy: former Texas senator Phil Gramm. Gramm backed both the Gramm-Leach-Bliley Act and the Commodity Futures Modernization Act. After leaving the Senate, he became a lobbyist for a Swiss bank called UBS that profited from mergers allowed by Gramm-Leach-Bliley - UBS became heavily involved in the subprime mortgage market. In July of this year, Gramm said that America was in a "mental recession" and that we are a "nation of whiners".
He was John McCain's chief economic advisor and co-chair of the McCain campaign for a year.
Bushonomics (PDF) - A very basic issue at the heart of all this is that prices for just about everything have gone up, but most people's wages have not. The market's "solution" has been to substitute credit for income, to give people more and more credit so that they can continue to buy all the stuff that companies produce. This of course was unsustainable - eventually a lot of people got so far into debt that their incomes were not sufficient to make payments to their creditors.
BTW, the same thing happened the last time around.
There's a lot more to this problem than average folks getting in debt, though. Wall Street firms built securities and derivatives worth trillions of dollars (on paper at least) on top of all that debt - the "value" of these pieces of paper ended up being orders of magnitude larger than the mortgages they were based on. Once borrowers started defaulting on their loans, the whole house of cards came tumbling down. And this part is the kicker: Wall Street pushed for those bad loans to be made in the first place. Huge firms were demanding more and more mortgage-backed securities, so mid-sized firms that bundled loans demanded more and more mortgages to make securities out of. Smaller firms sprang up all over the country making mortgages to sell to the bundlers. Eventually the smaller firms ran out of truly qualified buyers, but the firms above them all the way up the chain gradually relaxed their standards about the kinds of loans and securities they would buy, finally getting to the point where they accepted "NINA" loans ("No Income No Assets", meaning that nothing about the borrower's finances was verified). The largest firms and investors had convinced themselves that they could make a good investment out of a bunch of bad loans by turning them into securities. They had convinced themselves that it was safe to sell credit default swaps, which are basically insurance policies, on these securities even though they didn't have the capital to pay out if that insurance was ever called upon. After all, property values always go up, right?
60 Minutes summarized the situation in in this video, and NPR did an hour-long audio piece about it here.
After the Great Depression, which was caused in part by a great big speculatory bubble, the government put some regulations in place to rein in the excesses of the market. In the last decade or so there's been an emphasis on deregulation. The Gramm-Leach-Bliley Act, passed in 1999, allowed commercial banks to get into the investment business and vice versa for the first time since 1933. The Commodity Futures Modernization Act of 2000 expressly forbid any government regulation of credit default swaps. In 2004 the SEC decided to grant five firms an exemption from the normal leverage-to-capital requirements and let them get into debt up to 40 times greater than their actual assets - those five firms were Bear Stearns (dead), Lehman Brothers (dead), Merrill Lynch (bought out), Morgan Stanley (in very bad shape), and Goldman Sachs (bailed out by Warren Buffett just recently). The Federal Reserve dropped its interest rate to under 2% - lower than the rate of inflation - and left it that low from late 2001 to mid-2004. Dropping the rate temporarily to stimulate the market after 9/11 made sense, but leaving it so low for so long created an incentive for firms to make risky investments. And in the absence of government oversight, Wall Street's own ratings agencies "became the de facto watchdog over the mortgage industry" - a job at which they failed miserably.
Here's a great summary of the government's role in creating this crisis. Here's another, much more detailed analysis by the same economist examining all the bad actors.
There were many, many self-deluded and irrationally optimistic people who had a role in creating this crisis. There were probably also some intentional bad actors - CEOs who drove up profits in the short term knowing that there would be a crash in the long term, who now, with their "performance" bonuses and golden parachutes, are laughing all the way to the bank. Over time some of that latter group will be caught and prosecuted. But I want to give some attention to one bad actor in particular, one man who used his influence to help create the conditions that have now destablized the entire US economy: former Texas senator Phil Gramm. Gramm backed both the Gramm-Leach-Bliley Act and the Commodity Futures Modernization Act. After leaving the Senate, he became a lobbyist for a Swiss bank called UBS that profited from mergers allowed by Gramm-Leach-Bliley - UBS became heavily involved in the subprime mortgage market. In July of this year, Gramm said that America was in a "mental recession" and that we are a "nation of whiners".
He was John McCain's chief economic advisor and co-chair of the McCain campaign for a year.