What went wrong?

By Stephen Bowen | May 03, 2009

So, how did we get into the economic mess we’re in today?

The conventional wisdom seems to be that there simply was not enough government oversight and regulation of the financial markets. A few people on Wall Street got greedy with other people’s money, we are told, and we just didn’t have enough government around to stop them from dragging down the entire global economy.

The problem was not enough government, and the solution, therefore, is more government.

Peter Schiff disagrees. In a remarkable speech delivered at the Ludwig Von Mises Institute last month, Schiff, an author and stock broker, described how government, not the private sector, was overwhelmingly responsible for the financial mess which now threatens economic prosperity both here and abroad. Worse still, says Schiff, the Obama administration’s preferred cure, which is still more government, will only make matters worse.

To Schiff’s way of seeing it, what went wrong is relatively simple. Too many Americans, lured by mortgage rates that were too low, borrowed too much money to buy too many homes at prices that were too high. They did this because the federal government slashed interest rates a few years back in an attempt to bolster an economy reeling from September 11 and the burst of the dot-com bubble. The federal funds rate, set by the Federal Reserve, dropped to 1 percent from the 5 percent or so it had been for years. Mortgage rates plunged as well, and the real estate boom was on.

Home prices soared, and if the free market been allowed to operate as it should, mortgage rates would have begun creeping upward as buyers who could ill-afford to do so borrowed more and more money. Instead, the Federal Reserve kept rates artificially low, borrowers kept borrowing, and the bubble continued to grow.

Wasn’t there a risk in having so many people with such poor credit borrowing so much money? Sure, but the government stepped in yet again, this time to insure mortgages it had no business insuring. The federally-chartered Freddie Mac and Fannie Mae were happy to buy up and securitize high-risk mortgages, making them largely risk-free for creditors, or so it was thought.

So government meddling with interest rates made borrowing more affordable, and government-backed mortgage guarantees made borrowing less risky. How can it be that nobody saw what would happen next?

A crash was clearly on its way, but not before fundamental damage was done to the U.S. economy. Billions of dollars that should have been invested in job-creating businesses were poured into real estate instead and subsequently vanished. Consumers, buoyed by rising home prices, went on a spending spree. Savings rates dropped to zero. Wealth was created on paper, but disappeared in real life.

At the same time, the federal budget deficit skyrocketed, as out-of-control government spending sucked up the few investment dollars that were not being spent on ill-advised real estate ventures of one kind or another. The only jobs any of this created were in housing, finance, and the service sector. The manufacturing and the natural resources sectors of the economy plunged. Instead of an economy where we made things and created wealth, we became an economy where we sold overvalued real estate and depreciating consumer goods to each other, and used money that we borrowed from overseas to do it.

What would have happened if government policies hadn’t made things worse? We probably would have had a longer, larger recession back in 2001, says Schiff, but nothing on the scale we face today. The recession would likely have resulted in a drop in real estate prices, rather than an explosive increase, as demand for housing would have declined in the face of an economic downturn. Interest rates, had they remained unmolested by government meddling, would have remained at a reasonable level, which would have encouraged savings, rather than borrowing and spending. The lack of government mortgage guarantees would have meant fewer Americans qualifying for mortgages, but would also mean fewer mortgages in default for the rest of us to pay back today with money borrowed from our grandchildren.

And what about all that money? What about the billions that were invested in housing developments which today stand empty and worthless? Or the billions borrowed by Americans to buy depreciating consumer goods made overseas? Or the billions, and now trillions, borrowed by the federal government in a vain attempt to spend our way out of this catastrophe?

Perhaps it would have been invested in job creation. Perhaps we would have built high tech factories to make cars for China, Korea, and Japan, instead of having them build cars for us. We certainly don’t need any more cars, argues Schiff, but we need to start building things for the rest of the world to buy from us if we ever hope to get out from underneath the mountain of foreign debt we now owe.

Schiff concludes his speech, which can be found on YouTube, with some dire predictions about the future of our economy. Real estate and the stock market remain overpriced, he suggests, which means they’ll continue to decline. The U.S. government is not only borrowing with abandon but is printing money as fast as it can. Schiff expects massive inflation as a result, a series of long overdue bankruptcies for companies like General Motors, and rising unemployment.

The Obama administration, Schiff says, is only making the situation worse with its ongoing borrow and spend policies.

Government, you see, is the problem. When we needed a recession back in 2001, it was cut short by government monetary policies. When we needed to save and invest, we were encouraged by the government to borrow and spend. When we needed failing businesses that were wasting capital to go bankrupt, the government prevented that from happening.

Government, not the private sector, is almost entirely to blame for the mess we’re in. Now, when we need less government meddling in the economy than ever, we’re getting more than we’ve ever had.
Comments (2)
Posted by: Ronald Horvath | May 04, 2009 18:40

"Government, you see, is the problem."

More of that tired old Republican white noise, eh. Of course the government that Bowen refuses to name was the bush administration. And how come no mention of an unnecessary war that no one needed, or wanted, and that will cost upwards of three trillion dollars when all is said and done.

No, the "problem" with the bush government was purely a lack of oversight, or as they like to put it, self-regulation. And now we all know how that worked out don't we. The Republicans wanted a hands-off kind of government and the bankers went wild since no one was allowed to question their methods. They pushed loans as though they were drugs, paid off their accomplices, the mortgage brokers, and then sold the debt.

"One other thing I've done, is I've called on private sector mortgage banks and banks to be more aggressive about lending money to first-time home buyers. And the response has been really good. There's a lot of people in this -- our communities around the country that deeply care about the issue of homeownership, and they've been responsive."
-George W. Bush, U.S. President, March 26, 2004.

“And there is probably no greater missed opportunity than the reform of Fannie Mae and Freddie Mac passed by the House in 2005. If the law had been enacted, the takeover of those companies may have been avoided. It failed in large part because President Bush wanted to fully privatize them and feared that if they were adequately reformed, privatization would lose steam.

Indeed, it was in the Bush years that antiregulation and deregulation found full expression, fueled by an ideology that markets know best, government hampers markets, and problems will magically fix themselves.

The nation is now painfully relearning that the opposite is true. Christopher Cox, chairman of the Securities and Exchange Commission, admitted on Friday that his agency’s “voluntary regulation” of investment banks was a failure that contributed to the current crisis.


“But for much of Mr. Bush’s tenure, government statistics show, incomes for most families remained relatively stagnant while housing prices skyrocketed. That put homeownership increasingly out of reach for first-time buyers like Mr. West.

So Mr. Bush had to, in his words, “use the mighty muscle of the federal government” to meet his goal. He proposed affordable housing tax incentives. He insisted that Fannie Mae and Freddie Mac meet ambitious new goals for low-income lending.

Concerned that down payments were a barrier, Mr. Bush persuaded Congress to spend up to $200 million a year to help first-time buyers with down payments and closing costs.

And he pushed to allow first-time buyers to qualify for federally insured mortgages with no money down. Republican Congressional leaders and some housing advocates balked, arguing that homeowners with no stake in their investments would be more prone to walk away, as Mr. West did. Many economic experts, including some in the White House, now share that view.

The president also leaned on mortgage brokers and lenders to devise their own innovations. “Corporate America,” he said, “has a responsibility to work to make America a compassionate place.”

And corporate America, eyeing a lucrative market, delivered in ways Mr. Bush might not have expected, with a proliferation of too-good-to-be-true teaser rates and interest-only loans that were sold to investors in a loosely regulated environment.

“This administration made decisions that allowed the free market to operate as a barroom brawl instead of a prize fight,” said L. William Seidman, who advised Republican presidents and led the savings and loan bailout in the 1990s. “To make the market work well, you have to have a lot of rules.”

But Mr. Bush populated the financial system’s alphabet soup of oversight agencies with people who, like him, wanted fewer rules, not more.”

The president did push rules aimed at forcing lenders to more clearly explain loan terms. But the White House shelved them in 2004, after industry-friendly members of Congress threatened to block confirmation of his new housing secretary.

In the 2004 election cycle, mortgage bankers and brokers poured nearly $847,000 into Mr. Bush’s re-election campaign, more than triple their contributions in 2000, according to the nonpartisan Center for Responsive Politics. The administration did not finalize the new rules until last month.

- White House Philosophy Stoked Mortgage Bonfire, http://www.nytimes.com/2008/12/21/business/21admin.html?_r=1&hp

"In the 10-year period beginning in 1998, financial companies spent $1.7 billion on federal campaign contributions and another $3.4 billion on lobbyists. They quickly got what they paid for. In 1999, (Phil) Gramm co-sponsored a bill that repealed key aspects of the Glass-Steagall Act, smoothing the way for the creation of financial megafirms like Citigroup. The move did away with the built-in protections afforded by smaller banks. In the old days, a local banker knew the people whose loans were on his balance sheet: He wasn't going to give a million-dollar mortgage to a homeless meth addict, since he would have to keep that loan on his books. But a giant merged bank might write that loan and then sell it off to some fool in China, and who cared?

-MATT TAIBBI, The Big Takeover, http://www.rollingstone.com/politics/story/26793903/the_big_takeover/print

"The Republican side of the same tarnished coin is Phil Gramm, the former senator from Texas. Like Rubin, he helped push through banking deregulation when in government in the 1990s, then cashed in on the relaxed rules by joining the banking industry once he left Washington. Gramm is at UBS, which also binged on credit-default swaps and is now receiving a $60 billion bailout from the Swiss government.

-FRANK RICH http://www.nytimes.com/2008/12/14/opinion/14rich.html

“… a conservative campaign blames the global financial crisis on a government push to make housing more affordable to lower-class Americans has taken off on talk radio and e-mail.

Commentators say that's what triggered the stock market meltdown and the freeze on credit. They've specifically targeted the mortgage finance giants Fannie Mae and Freddie Mac, which the federal government seized on Sept. 6, contending that lending to poor and minority Americans caused Fannie's and Freddie's financial problems.

Federal housing data reveal that the charges aren't true, and that the private sector, not the government or government-backed companies, was behind the soaring subprime lending at the core of the crisis.

Between 2004 and 2006, when subprime lending was exploding, Fannie and Freddie went from holding a high of 48 percent of the subprime loans that were sold into the secondary market to holding about 24 percent, according to data from Inside Mortgage Finance, a specialty publication. One reason is that Fannie and Freddie were subject to tougher standards than many of the unregulated players in the private sector who weakened lending standards, most of whom have gone bankrupt or are now in deep trouble.

During those same explosive three years, private investment banks - not Fannie and Freddie - dominated the mortgage loans that were packaged and sold into the secondary mortgage market. In 2005 and 2006, the private sector securitized almost two thirds of all U.S. mortgages, supplanting Fannie and Freddie, according to a number of specialty publications that track this data.”


"At Washington Mutual, getting the job done meant lending money to nearly anyone who asked for it — the force behind the bank’s meteoric rise and its precipitous collapse this year in the biggest bank failure in American history.

On a financial landscape littered with wreckage, WaMu, a Seattle-based bank that opened branches at a clip worthy of a fast-food chain, stands out as a singularly brazen case of lax lending. By the first half of this year, the value of its bad loans had reached $11.5 billion, nearly tripling from $4.2 billion a year earlier.

According to these accounts, pressure to keep lending emanated from the top, where executives profited from the swift expansion — not least, Kerry K. Killinger, who was WaMu’s chief executive from 1990 until he was forced out in September.

Between 2001 and 2007, Mr. Killinger received compensation of $88 million, according to the Corporate Library, a research firm. He declined to respond to a list of questions, and his spokesman said he was unavailable for an interview.

WaMu pressed sales agents to pump out loans while disregarding borrowers’ incomes and assets, according to former employees. The bank set up what insiders described as a system of dubious legality that enabled real estate agents to collect fees of more than $10,000 for bringing in borrowers, sometimes making the agents more beholden to WaMu than they were to their clients.

WaMu gave mortgage brokers handsome commissions for selling the riskiest loans, which carried higher fees, bolstering profits and ultimately the compensation of the bank’s executives. WaMu pressured appraisers to provide inflated property values that made loans appear less risky, enabling Wall Street to bundle them more easily for sale to investors.

“It was the Wild West,” said Steven M. Knobel, a founder of an appraisal company, Mitchell, Maxwell & Jackson, that did business with WaMu until 2007. “If you were alive, they would give you a loan. Actually, I think if you were dead, they would still give you a loan.”


"And if the belief of many Americans that they could count on capital gains forever sounds naïve, it’s worth remembering just how many influential voices — notably in right-leaning publications like The Wall Street Journal, Forbes and National Review — promoted that belief, and ridiculed those who worried about low savings and high levels of debt.

Then reality struck, and it turned out that the worriers had been right all along. The surge in asset values had been an illusion — but the surge in debt had been all too real.

-Paul Krugman, Decade at Bernie’s, http://www.nytimes.com/2009/02/16/opinion/16krugman.html?_r=1

“Over the last 20 years American financial institutions have taken on more and more risk, with the blessing of regulators, with hardly a word from the rating agencies, which, incidentally, are paid by the issuers of the bonds they rate. Seldom if ever did Moody’s or Standard & Poor’s say, “If you put one more risky asset on your balance sheet, you will face a serious downgrade.”

"These oligopolies, which are actually sanctioned by the S.E.C., didn’t merely do their jobs badly. They didn’t simply miss a few calls here and there. In pursuit of their own short-term earnings, they did exactly the opposite of what they were meant to do: rather than expose financial risk they systematically disguised it.

- MICHAEL LEWIS, The End of the Financial World as We Know It, http://www.nytimes.com/2009/01/04/opinion/04lewiseinhorn.html?hp

"Tax cuts played a pivotal role in shaping the background conditions of the current crisis. Because they did very little to stimulate the economy, real stimulation was left to the Fed, which took up the task with unprecedented low-interest rates and liquidity… The flood of liquidity made money readily available in mortgage markets, even to those who would normally not be able to borrow. And, yes, this succeeded in forestalling an economic downturn; America's household saving rate plummeted to zero. But it should have been clear that we were living on borrowed money and borrowed time.

The cut in the tax rate on capital gains contributed to the crisis in another way. It was a decision that turned on values: those who speculated (read: gambled) and won were taxed more lightly than wage earners who simply worked hard. But more than that, the decision encouraged leveraging, because interest was tax-deductible. If, for instance, you borrowed a million to buy a home or took a $100,000 home-equity loan to buy stock, the interest would be fully deductible every year. Any capital gains you made were taxed lightly-and at some possibly remote day in the future. The Bush administration was providing an open invitation to excessive borrowing and lending-not that American consumers needed any more encouragement.

- Capitalist Fools by Joseph E. Stiglitz, http://www.commondreams.org/view/2008/12/10-1

Posted by: jenette leblang | May 03, 2009 18:58

Government, you see, is the problem. When we needed a recession back in 2001, it was cut short by government monetary policies. When we needed to save and invest, we were encouraged by the government to borrow and spend. When we needed failing businesses that were wasting capital to go bankrupt, the government prevented that from happening.

( A pity that Stephen Bowen no longer teaches! This is the most succinct analysis I have read ! )

If you wish to comment, please login.