The Cause and Solution of Our Recession

The financial crisis and subsequent, still lingering, economic recession has fascinated me from its beginning. It is by far one of the most complex issues I have faced. Since I am a student of political science, I have found it necessary to understand economics – because the two subjects are symbiotic. After much reading, many observations, and quality conversation, I have drafted a mental interpretation of this economic event and find it necessary to transcribe my thoughts here.

In the effort of full disclosure, I approached this topic from a classical liberal perspective. Thus my policy prescriptions respect and adhere to principles such as free markets, individual rights, and private property. Consequently, if one adopts these basic principles one must then hold that the only moral social organization of society is capitalism. I make mention of this because it has become the case among political commentators and politicians where possible solutions conflict simply because the authors’ ultimate aims are diametrically different. One seeks to preserve the welfare state and a socialized economy, while the other seeks to relinquish government intervention and uphold the principles of capitalism. With that said, I come from the latter camp and would now like to seek your confidence in my logic.

The altruistic goal of increasing home ownership among the needy and undeserved has been a common policy within both dominant political parties for decades. Often, home ownership is wrapped nicely in the phrase “the American dream” somehow defining the two as mutually dependent. In 1995, President Bill Clinton, addressing his administrations push for home ownership, said:

This is a big deal. This is about more than money and sticks and boards and windows. This is about the way we live as a people and what kind of society we’re going to have.[…] It’s 100 specific actions that address the practical needs of people who are trying to build their own personal version of the American dream, to help moderate income families who pay high rents but haven’t been able to save enough for a downpayment, to help lower income working families who are ready to assume the responsibilities of home ownership but held back by mortgage costs that are just out of reach, to help families who have historically been excluded from home ownership.

In 2006, President Bush echoed the same ethic in his comments after signing the American Dream Downpayment Act:

One of the biggest hurdles to homeownership is getting money for a downpayment. This administration has recognized that, and so today I’m honored to be here to sign a law that will help many low-income buyers to overcome that hurdle and to achieve an important part of the American Dream.

But that law was not the first of its kind. The push to expand home ownership began in 1992 when Congress passed the Housing and Community Development Act of 1992. The law forced the two largest government-sponsored mortgage companies Fannie Mae and Freddie Mac to expand the percentage of mortgages issued to low- and moderate-income borrowers to 42%. Fannie and Freddie complied, and by 2005, that percentage was expanded by the government to 52%. Objective restructions were cast aside as well. The percentage of money needed for a downpayment became smaller and smaller. By 2005, 43% of first time homeowners were borrowing the entire cost of their home and 68% were putting down less than 10%. The government even order Fannie and Freddie to issue mortgages to even lower income brackets, accounting for 22% of total mortgages in 2005.

It was clear to the sober observer that the issuing of these mortgages amounted to a serious assumption of risk by Fannie Mae and Freddie Mac that had already controlled an astounding 42% share of residential mortgages in the United States by the year 2000. However, these government-sponsored enterprises (GSEs) by nature had the implicit backing of the U.S. treasury and immunity to strict accounting standards. Fannie and Freddie were not subject to the same Securities and Exchange Commission regulations, nor to state and local income taxes. They were not required to hold the same amount of capital as private firms either. It was a textbook illustration of a moral hazard. Imprudent behavior brought on by altruistic government intervention into the housing market was divorced from the prospects of failure because there existed a lender of last resort – the U.S. government.

To close the home ownership gap that existed between Caucasian and minorities, the Federal Reserve sought to stimulate demand by lowering interest rates to historic lows, which made lending money much cheaper. All the ingredients for the crisis were in order. Government meddling of market forces inflated growth in the housing market, historically low interest rates manipulated demand, and the extended period in which those interest rates remained all fed the creation of a housing bubble. When the Fed began to raise interest rates in 2006 to tighten the money supply, housing prices fell quickly and soon, many Americans found themselves “underwater” where the mortgages they had assumed were now worth much more than their actual home. As mortgage payments slowed, the value of such mortgages dropped precipitously and the balance sheets of lending institutions went into financial shock. As those institutions that created the housing bubble began to melted down, so too did Americans’ savings. The destruction of wealth led to a liquidity trap – in which consumers hoard money in the face of uncertainty – and caused a slowdown of the entire economy and today’s recession.

This narrative omits complex financial products trading such as credit default swaps which destabilized A.I.G., the largest insurance company in the United States. The omission is intentional as it does not lend context to the policy prescriptions that rise from my understanding of the crisis.

President Obama and his administration approached the economy from a Keynesian perspective named after the famous economist John Maynard Keynes. I’ve spoken at length about the shortcomings of Keynesian economics but will constrain my comments on the applicability to this recession. Keynesianism holds that in recessionary times, when demand has fallen so low within the private sectors as to fail to sustain growth, deficit spending by the government can and should be used to stimulate the economy in the short-term and pay off the debt acquired by the inevitable long-term growth. Keynesian theory thus promotes and defends public works projects and massive stimulus programs which are designed to inject sufficient liquidity into the market. This is precisely what Obama has advocated.

The problem with the Keynesian solution in our current case is that its goal is to increase aggregate demand when the nature of this recession is not an unexplained dip in demand, but a balance sheet shock in which capital was destroyed by imprudent (and sometimes fraudulent) lending practices. Increasing demand among a population in which savings has been destroyed and financial institutions lack sufficient capital to make additional loans is an off-base solution which seeks to treat the symptoms rather than cure the disease. Extending opportunities to the unemployed to spend money they do not have is a fools errand. Temporarily employing the unemployed with infrastructure projects is an equally fruitless response. What prudent family will spend their precious income when they know such income is only temporary?

The Keynesian approach to recessions is a close-minded one with a distasteful interpretation of the economy. It paints an insulting picture of  consumers as irrational mattress stuffers hoarding their money in the face of bad economic times, yet it also assumes them to be manipulable enough by government stimuli to spend at the first sight of additional cash. It thus paints a simplistic picture of a homogeneous economy made up of ‘stuff’ that simply needs money to move it around. These assumptions necessitate implicit trust in the ‘wisdom’ of government spending which not only runs counter to the American spirit of distrust in the state, but ignores the government’s disgraceful track record in spending taxpayer dollars wisely. Ultimately, what it fails to understand is that the economy is in fact a complex web of markets with producers seeking to produce what they believe consumers will buy, and those consumers are mere human beings which pursue purposeful economic behavior.

Multiple problems arise with government spending initiatives. Far too often special interest groups and lobbyists maliciously influence our easily corruptible politicians to acquire the funds they need for pet projects. Pork-barrel spending plagued the American Recovery and Reinvestment Act and sent millions of taxpayer dollars to ridiculous spending programs. Stimulus programs tend to also misdirect national resources away from sustainable economic projects that are in market demand, in deference for short-term projects which the government chooses is best (best sometimes aligned to political reasons). Yet, the government is without the price signals private companies use to make economic decisions. This leads astray economic activity to unsustainable lines of production. Stimulus funding does not even accomplish its designed function: increase aggregate demand. In order to spend a trillion dollars in stimulus, the government must first take that money from somewhere else. Whether it prints money, sells bonds, or increases taxes, it drains money out of the economy damaging long-term growth in favor of short-term production. In our current case, the government sold billions of dollars in government bonds which placed that money into the ‘wise’ hands of the government.

Attempting to create demand where there is none is not only a misguided diagnosis of the problem, but also confuses the market where there otherwise would have been more accurate demand signals from individuals and businesses that kept more of their own money and spent it as they saw fit.

Generally speaking, the economy was herded into an unsustainable structure of production by altruistic federal government intervention of the market economy. In a truly free capitalist economy, structures of production are naturally configured in a way that responds to consumer preferences. With that configuration tampered with, investment moved towards unsustainable structures of production (i.e. more homes than would have been in market demand). The resolution to this recession is to allow those structures of production to readjust through layoffs and business closures. Private investment is needed to reinvigorate production that is in market demand, not public investment in what Washington D.C. politicians decide is in political-demand. Propping up and bailing out failing institutions creates a moral hazard and preserves those unsustainable structures. The reallocation of labor takes time also, but will only be prolonged by the expansion of the welfare state and unemployment benefits.

This economic recession was certainly avoidable. It was born in the halls of Washington D.C. by politicians who thought they were pursuing an honest end: increased minority home ownership. In reality, they were sacrificing objectivity (reasonable lending standards) for subjectivity (skin color). The creditworthiness of low-income borrowers, the looming insolvency of baking institutions, and the growing rate of defaults mattered little. Armed with an ethic that was widely accepted but hardly understood, and with unapologetic access to taxpayer wallets, the federal government sewed the seeds of our current condition.

The solution rests within the free market – an economic state of condition that the United States has not enjoyed since the Great Depression. Only until the surrendering of power and control by the federal government over the free interactions of free people can prosperity return. It requires freedom of thought, trade, and personal responsibility which must come from the private sector. Central planning is not the course laid by free societies. Government got us into this, it cannot get us out.

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One thought on “The Cause and Solution of Our Recession

  1. Matt says:

    So basically affirmative action and political choices based solely on public approval for re-election are the major causes of most fuck ups. Wow I’ve been saying that for how long?

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