How Did This Happen? (The economic mess)

American Thinker ^ | March 01, 2009 | Randall Hoven

[neverdem]

We are in financial and economic trouble.  And by "we", I mean just about everybody, from the US to Iceland  and Latvia.  Isn't it worth, say, ten minutes to try to figure out how this happened?  That is, while we throw virgins into volcanoes and go into debt at a rate of about one trillion dollars every two months in frantic attempts to save ourselves, shouldn't we also try to figure out what's really going on?

Since I don't have a PhD in economics, I won't convince Rep. Pete Stark (D-CA) of anything .  But I think it worth a try to employ something called "critical thinking" to the situation.

We are often told this whole thing started with US housing.  US house prices dropped and default rates rose.  Now who would this hurt?  It would hurt institutions that lend money to people who buy houses.

But funny thing: for the most part, the direct lenders were not the institutions that got into trouble.  Savings and loans, except for IndyMac, have been surviving.  So have most commercial banks.  Who had all the trouble?  AIG and Lehman Brothers were investment firms.  They didn't lend money for homes directly; they invested in mortgage-backed derivatives - things like Credit Default Swaps.  The most troubled banks were investment banks with global reach, not your local savings & loan.

Without my PhD in economics, I don't know how CDSs or other mortgage-backed derivatives work, at least in the sense of knowing what they are worth.  But apparently, no one else did either, including PhD's in economics throughout the globe.

Everyone bought them.  The big US investment firms like AIG did.  European investment banks did.  Too much of Iceland's and Latvia's money was in mortgage-backed derivatives, apparently.  And the whole time, these institutions were getting just great bond ratings.  So the banks themselves didn't know their investments were close to worthless.  Neither did the people who rate the risks on those banks.  Nor the investors in those banks.  Nor the regulators of those banks in any country.

You might want to blame George W. Bush for this.  I might want to blame Bill Clinton or Barney Frank.  But how did anyone in the US cause a global financial meltdown, Iceland to go bankrupt and Latvia's government to resign?  There is a limit to even Barney Frank's ability to do evil.

Not to mention, housing prices didn't drop that much.  Look at the Office of Federal Housing Enterprise Oversight's quarterly index.  Housing prices peaked in the 3^rd quarter of 2007.  When IndyMac went bust in March 2008, OFHEO's housing index was down just 0.35% from that peak.  When Lehman Brothers went bust in September 2008, the index was down 1.94%.  Just how fragile are these mortgage-backed derivatives?  Housing prices edge down 2%, and your whole institution goes broke?

Even by the end of 2008, well after recessions began around the globe, the index had come down just 4.63% from its 2007 peak.

How did a drop of a percent or two in US home prices cause whole countries in Europe to go bankrupt?

Actually, how do we know the bad thing spread from the US to the rest of the world, and not vice versa?  I invite you to look at the data.  If you do, you will find that Europe's economic decline started before, and is deeper than, the US's.

Look at the 2^nd quarter of 2008, for example.  In that quarter, the US economy grew 0.7%.  Yet the economies of France, Germany, Italy and Japan all shrank by 0.3% to 0.9%.  In fact, the average for the Euro area was an economic shrinkage of 0.2%.

Those European economies that shrank in the 2^nd quarter also shrank in the 3^rd.  By that time, so did the US's economy - but by just 0.1%.  The Euro area's average shrinkage was twice that.  The economies of Germany, Italy, Japan and the United Kingdom shrank five to six times as fast.

By the 4^th quarter, the US economy was unambiguously shrinking.  (You might recall that the 4^th quarter of 2008, starting October 1, was kicked off with the $850B bailout, passed by the Senate on October 1 and signed into law October 3.)  But still, the US shrinkage was 1.0%.  The shrinkage in Europe was 1.5%.

(Update: The 4^th quarter GDP growth in the US was revised Friday, Feb. 27, to a shrinkage of 6.2% annualized, or 1.5% for the quarter -- up from the previous estimate of 1.0%.   So this latest revision puts the US on par with Europe, assuming Europe's data was not revised recently as well.)

Over all of 2008, the US GDP shrank 0.2% (0.7% with latest revised data).  But Europe's shrank 1.1%.

Now let's say you have two people sick with fever, and you are trying to figure out which one spread the virus to the other.  I would look for the one who got sicker sooner.  In this case, Europe got sicker sooner.  Not conclusive, but if you seek merely a keen grasp of the obvious, it sure doesn't look like the global economic decline was due to the US.

I don't think this is Bush's fault.  I also don't think it's Barney Frank's fault.  I think even looking for the blame in some part of the US, whether its housing market, some mysterious lack of regulation or some politician, is a red herring.  If this situation is "inherited," I'd say we inherited it from Europe.

Given that no one involved, from the US to Iceland, Latvia or Europe generally, has been a bastion of "laissez-faire" capitalism, I think we can also dismiss blaming capitalism or free-markets for this one.

I wish I could answer what did cause the meltdown, but I can't.  But here is the key: nobody can.

It is facile for Democrats to blame Republicans (who have not been in control of Congress since 2006, when unemployment was 4.4%).  While this argument is facile, it is also flaccid.  If you'll notice, the Democrats never quite say exactly what Bush did to make this happen.

(There is a good case that Democrats, Barney Frank in particular, caused the housing bubble and burst, and the Fannie/Freddie failures in particular.  But I still fail to see how that relatively minor failure in one sector of the US economy led to a global financial meltdown.)

Did Bush spend too much?  Or too little?  If he spent too much, why are Democrats spending even more, by absurdly humungous amounts?  If he spent too little, why do they criticize his deficits, while quadrupling the deficit from 2008 to 2009 themselves?  And don't blame it on tax cuts.  Federal revenues were above the pre-Bush average as recently as 2006 and 2007.

If something wasn't regulated, what wasn't regulated?  Because Sarbanes-Oxley, the cure-all to financial shenanigans, was signed into law by President Bush, largely to prevent another Enron, which happened on Bill Clinton's watch.  Bush and McCain tried to get Fannie and Freddie more regulated, but were thwarted by Barney Frank, Chris Dodd and Barack Obama.  You want to blame Gramm-Leach-Bliley and what it did to Glass-Steagall?  That passed in the Senate by a vote of 90-8 and was signed into law by President Clinton .

Whatever this Dark Matter of missing regulation was, how did all of Europe and the entire planet also happen to miss it?

I don't think this is something we can analyze from home.  We need some real forensic accounting of Lehman Brothers' books, AIG's books, Iceland's books, etc..  How did hundreds of billions of dollars disappear overnight?  How did a 2% drop in houses impact mortgage-backed derivatives to the point of making them worthless?  How did bond raters so totally miss the risks in these investments?

While no one has the answers to any of these obvious questions, few are even asking them.  Yet almost everyone is ready to take some kind of action.  Action that involves absurdly huge amounts of other people's money.

One approach to handling total uncertainty is to start trying different things and see how they turn out.  So OK, let's try something different.  Then shouldn't that something be truly different?

It is a lie to act like what we had been trying up to now is laissez-faire capitalism or a free market.  If deficit spending stimulated an economy, President Bush stimulated our economy his last seven years straight.  If regulation fixed things, the 80,000 or so pages of regulations already on the books (30 times more than the middle of the New Deal), including Sarbanes-Oxley, should have worked.  If increased government spending, especially on education and health care helped, Bush helped a lot more than his predecessor.

Yet that lie is exactly President Obama's logic: Bush went overboard with a free market, and since that didn't work, we must try the opposite -- socialism, good and hard and quick.  Please tell me people don't really believe this Looking Glass logic.

What has really been happening is the equivalent of bleeding patients.  The best doctors in the country bled George Washington to death in 1799.  He started out with a cold or flu, so they bled him.  When he got worse, they bled him more.  The best doctors around turned a minor flu into a death sentence for the Father of Our Country by adamantly insisting they had a cure that was instead a curse.  If that isn't the metaphor for today's global political economy, I don't know what is.

President Obama is doing more of the same: bleeding us even faster than Bush did.

"What I won't do is return to the failed theories of the last eight years that got us into this fix in the first place."  President Obama as reported by the Kansas City Star.

If you want to try something truly different, try a free market.  That would be progressive.

Randall Hoven can be contacted at randall.hoven@gmail.com or  via his web site, kulak.worldbreak.com.

[UCANSEE2]

Now, will somebody please explain why I have to foot the bill for the other guy's severe lapse in judgment?

Because... the President stated that just because his daughter goes out and gets pregnant , she shouldn't have to be stuck with a baby (stuck with taking responsibility for her actions).

He sees the economic situation the same way.

[Cacique]

btt

[org.whodat]

It seems to me if the US Treasury had stepped forward early in the crisis and promised to purchase every bad mortgage at face value, the crisis would have ended instantly.

That would have still left about 14 million empty housing units on the market. The major cause of this whole mess was the changes in the law made by the republicans and the midnight credit default swaps. Total world derivatives are around 550 to 660 trillion.

The treasurer could have bought all the defaulted mortgages for about 10% of the tarp. But then the government would not have been able to say we are helping the people.

They are hiding behind mortgages for a rich banker wall street bailout.

[RED SOUTH]

On Obama & Pelosi’s Ipod.

Believe in all the good things
That money just can’t buy
Then you won’t get no belly ache
From eatin’ humble pie
I believe in rags to riches
Your inheritence won’t last
So take your Grey Poupon my friend
And shove it up your a$$!
[Chorus]

Eat the Rich: there’s only one thing they’re good for
Eat the Rich: take one bite now - come back for more
Eat the Rich: don’t stop me now I’m goin’ crazy
Eat the Rich: that’s my idea of a good time baby

Aerosmith.

[r-q-tek86]

ping

[Sequoyah101]

Kudos to you and ping this thread for future reference.

[Sequoyah101]

A bargan yes, but where did the money go?

Yes, the market value of assets (houses) has plunged but somebody got paid for the houses. Where did the money go?

In the equities, paper gains have become paper losses and lost opportunity to convert to cash....that is understandable but where did the money for the houses and “stuff” go? Somebody got paid.

As for financial markets...the value is never really value until converted to cash and even then, with fiat currency, the value is suspect.

[zeestephen]

org.whodat,

Re: 14 million empty houses

I was trying to keep my post relatively short.

Once the US Treasury acquires a bad mortgage, they should instantly sell it to the highest bidder.

At most, 10 million homes would foreclose at an average loss of $150,000, which is about a 40% price decline.

The market would clear instantly.

There might be millions of empty homes, but only because of massive overbuilding.

And, every empty home would be owned by a speculator who is actively searching for a long term buyer.

In exchange for taking on the bad loans, the US Treasury would demand to step in front of all stock and bond holders of the companies that now own these toxic mortgages.

The US Treasury would then instantly sell its (probably 100%) interest in AIG, Fannie, Freddie, Citi, etc. to the highest bidder.

Within 24 hours, each of these companies would be operating as usual, with new owners.

The original stock and bond holders would be wiped out, but the “new” companies would have perfect balance sheets.

Obviously, new regulations and transparency would be required for the “new” companies, but that's an essay for another time.

[DHerion]

I don’t think we are going back far enough on how this got started. The fact that most of the industrialized world is sucked into this points the finger at Central Banks (US, Europe, Japan). For the last fifteen+ years they kept telling us inflation was running at 1-3%, while real estate prices were going up 5-10+ percent every year...and they never added that into the inflation numbers. If they had inflation would have been much higher and the central banks would have been compelled to raise interest rates years ago...and this global real estate bubble would never have occured.

[WayneLusvardi]

None of the comments seem to directly address the author’s question: why did the world-wide collapse seem to start in Europe with a small proportion of mortgage defaults?

I would suggest reading Anthony Downs’ book Niagara of Capital: How Global Capital Has Transformed Housing and Real Estate Markets (2007). Downs explains how after 9/11, foreign investors were looking for a safe haven for their money from the threats of terrorism and America was looking to stimulate its ailing post 9/11 economy. U.S. investment banks concurrently invented collaterlized mortgage bonds and securitized real estate stocks (derivatives) to raise money for foreign investment in U.S. real estate. What could be safer than American real estate? This resulted in a Tsunami of money into U.S. real estate and a spike in the money supply which drove interest rates down, oil prices sky high, and inflation in good and services down but inflation in real estate and oil prices up. So it was essentially the influx of foreign capital that brought about the real estate bubble - hence it would be no surprise that Europe would be first to feel the pain of even a small amount of defaults. Also, positive loan leverage works great; but in reverse it has an exponential negative effect.

[Freedom_Is_Not_Free]

And now for all of your common sense and prudence, you get the privilege to pay for your neighbor’s stupidity and greed so he can stay in the luxurious home he swung with no money down and sucked all of the equity out of. Aren’t you lucky?

[SunkenCiv]

Thanks neverdem.

[petercooper]

bttt

[petercooper]

bttt

[zeestephen]

peter,

Which of my points were off topic?