In the continuing aftermath of the recent financial crisis, it is natural to try and find the causes of the problem. Many are pointing toward the free market and capitalism as the failure. However, many do not realize that we have not enjoyed the freedom and productivity of a free market for nearly 100 years.
Capitalism is an economic system characterized by private or corporate ownership of capital goods, by investments that are determined by private decision, and by prices, production, and the distribution of goods that are determined mainly by competition in a free market [1].
What we have in America is a centrally planned economy. Many do not want to think about the American economy in that way, because it conjures up visions of the USSR or even China. However, our economy is in fact centrally planned and it has been responsible for the “boom and bust” cycle since the inception of the Federal Reserve, which is the main source of economic planning in the American economy. These cycles are made worse by further intervention from the Federal Government in the form of restrictive legislation and forceful mandates.
We have examined the current system and its responsibility for the recent crisis with a question and answer format.
Where does capital come from?
Some comes from the market; or the existing capital in the system. The rest comes from the Federal Reserve and is brought to market on the backs of US tax payers via debt and/or an increased money supply (leading to inflation). When the Federal Reserve want to pump money into the system, they can either buy a bond from a major banking institution, from where the money is disseminated into the system through standard banking transactions such as lending to individuals or companies; or they can buy a US Treasury bill or bond, where the Federal government distributes the money via “stimulus checks”, “bailouts”, entitlement programs or other types of government spending. When the US treasury sells a bond to the Federal Reserve, this is called monetizing debt. The money that comes from the Federal Reserve does not come from a vault somewhere, the Federal Reserve simply prints the money.
Who controls the flow of capital?
The Federal Reserve controls the flow of capital in our economy through the manipulation of the monetary base and interest rates. The monetary base (M3: true account of the real money supply) is controlled by the purchase and sale of debt instruments by the Federal Reserve. The purchase of debt instruments was mentioned above as a way to expand the money supply. However, when the Federal Reserve wants to decrease the monetary base, they will sell bonds back to the private institutions. The trend is however, that the monetary base has been growing since the inception of the Federal Reserve, which has resulted in the devaluation of the dollar.
The Federal Reserve has another magic wand with the interest rates. This mechanism is supposed to make the economy more stable, because in theory, it allows the central bank to hit the brakes or the throttle depending on the current state of the economy without changing the monetary base. Increasing the interest rates encourages savings in banks, bonds and other interest bearing assets. This reduces the amount of money available to purchase goods and services (the brake). Reducing the interest rate decreases incentives to save and increases the amount of money available in the market (the throttle).
What happens if the Federal Reserve prices money incorrectly?
Artificially manipulating the price of money can be a disaster if it is done incorrectly. It can cause capital to flow to otherwise unprofitable uses. This can lead to bubbles, which then lead to busts as the market corrects and capital flows again to its best and highest use. To correctly price money so that imbalances do not occur, timing and price are the two key factors. In order for a central bank to effectively and efficiently plan an economy this way, it would be necessary for them to have perfect information on the economy as a whole. So, it is not enough for the interest rates to be set at precisely the right price, but also at precisely the right time. Any variation can cause capital to flow inappropriately and cause huge imbalances, which is what we see in the boom bust cycle.
What would happen if there were no Federal Reserve?
Interest rates would be determined by supply and demand. The free market should determine the price of money like it determines the prices of any other commodity. If the economy starts to heat up, more money will be needed for capital investment and the demand for loanable funds will increase. This will increase the price of money and encourage savings, which will in turn cool the markets. As the amount of loanable funds increases as a result of the new savings, the price for money will begin to drop and discourage savings and once again begin to drive spending. The key is that this cycle would have much less volatility, because the ‘corrections’ will result in smaller peaks and troughs. Where the free market would perform these functions automatically and continuously, the Federal Reserve relies on decision makers with often times flawed information and assumptions. In addition, the decisions intervals by the Fed are much longer than a free market system, which only exacerbates errors.
Why did the real estate bubble occur?
Malinvestment caused by the Federal Reserve and government intervention via GSE’s and the CRA (long answer below).
Why was there so much sub-prime borrowing?
Cheap money, GSE’s and the CRA (long answer below).
Where did all of that money come from to allow homebuyers to borrow in the first place?
90% came from Fannie Mae and Freddie Mac. (long answer below).
Long Answer:
Bubbles are created when too many resources are flowing to an area of the economy that is unwarranted due to misleading information. The market relies on information. The more information and the more reliable the information the better. In the case of our modern boom and bust cycle, the Federal Reserve creates them by manipulating what should otherwise be a free market determined price, which is the “risk free interest rate”. This manipulation of interest rates can send the wrong signals to the market and therefore, the wrong information. Again, interest rates are simply the price of money. Following 9/11 the Federal Reserve reacted to keep the stock market from continuing its decent and the economy from slipping into a recession. They began to lower interest rates in an effort to increase the flow of capital. As money fled the stock market, it began to spread into other sectors of the economy. Real estate became the natural choice, because of historically cheap money and government intervention that artificially increased the demand for housing.
There were two key factors on the side of government intervention that contributed to this recent bubble by artificially increasing the demand for housing, GSE’s and the CRA. GSE’s are otherwise known as ‘government sponsored enterprises’. We know them in the world of lending as Fannie Mae and Freddie Mac. These two ‘enterprises’ were backed by the federal government. That means that shareholders enjoyed the profits and the American tax payers would share in the losses (not a free market vehicle). These ‘companies’ also accounted for as much as 90% of the secondary mortgage market [2]. The secondary mortgage market is where mortgage brokers turn to sell loans that they are paid to originate, but they do not hold on their books. Which means the mortgage brokers can make a profit, but transfer the risk of the asset on to whoever buys the security. Since Fannie Mae and Freddie Mac were backed by the US tax payers, they were able to take on risks that other companies could not. Therefore, they were able to set loan standards extremely low with no need to adequetly price the loan for risk with a higher interest rate. This made homes dissasterously easy for many to ‘afford’ that otherwise could not.
Another piece of the government intervention puzzle is the CRA, which is also known as the Community Reinvestment Act. This began under Carter and was expanded under Clinton and Bush. The Community Reinvestment act was supposed to address lending discrimination. It was used by Clinton and Bush to artificially increase home ownership in America. The CRA simply turned into legislation mandating that banks begin lending to borrowers that did not have the ability to repay the loans. However, this program really found its home with Fannie Mae and Freddie Mac, who were more than willing to comply.
The predatory lenders that everyone was screaming about were originating mortgages based on guidelines from Fannie Mae and Freddie Mac. These guidelines in turn came from the CRA. That doesn’t make the mortgage brokers innocent, but they would have never been able to make those loans had it not been for the GSE’s. It was an absolute absurdity when a borrower with no money down, on a “no no loan” (no income, no asset verification) would be charged a risk premium of 1-2% over a prime borrower. A true free market would have priced those subprime loans much higher. In fact, a free market would more than likely have never touched those loans, because they are near impossible to price, given that the risks would be too difficult to determine.
The bubble was created by an orchestra of market intervention from the Federal Reserve, the manipulation of interest rates; and the Federal Government intervention via GSE’s and affordable housing initiatives. Artificially lower interest rates increased the demand for housing. It also allowed for housing prices to increase beyond a nominal level by making them more affordable at a higher price. The GSE’s created a market for the subprime and risky loans, which were then securitized and sold to Wall Street. The Community Reinvestment Act poured fuel on an already volatile situation. All of this activity created artificial demand for housing with cheap money and artificially low lending standards. All of this was made possible by the practices of the Federal Reserve and its ability to create money out of thin air and government interverntion.
Many try to blame the free market in the aftermath of this mess. The reality is that we haven’t seen a free market economy since the creation of the Federal Reserve (1913) and it has become even less of a free market ever since. If a true free market were at work, these malinvestments would not have been possible, because the capital required for them would not have been available to do so.
That leaves us with the last question:
What is the solution to our problems? The free market or more government intervention?
Recommended Books:
“Housing Boom and Bust”
Thomas Sowell
“Meltdown”
Thomas E. Woods Jr.
Recommended videos:
Money, Banking and the Federal Reserve
Direct References:
