Financial Fiasco

How America's Infatuation With Homeownership and Easy Money Created the Financial Crisis

Johan Norbeg

• Publisher: Cato Institute
• Year: 2012
• ISBN:
  9781937184087
• Topic: Politics & International Relations
• Subtopic: Public Policy
• Index: Politics & International Relations

Now newly expanded, with a with a new chapter on the spreading global economic crisis, Financial Fiasco guides readers through a world of irresponsible behavior by consumers, decisionmakers in companies, government agencies, and political institutions.

1. Preemptive Keynesianism

The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise.

—Alan Greenspan, “Gold and Economic Freedom”

Like so many other stories about our time, this one begins on the morning of September 11, 2001, with 19 terrorists and four passenger planes. Their attack, which cost almost 3,000 people their lives, shook our known universe. All U.S. aircraft were ordered to land immediately, and North American airspace was closed down. Routes of trade and communication were blocked as fear of additional attacks paralyzed the entire world, and speculation arose about long wars. The U.S. stock exchanges were closed; when they reopened, the New York Stock Exchange fell by more than 14 percent in one week. The United States was in a crisis, and the global economy was therefore under threat.

But there was one man on whom the world could pin its hopes. A New York economist of Hungarian-Jewish extraction with a bad back, who prefers to read and write lying down in his bathtub. A former jazz-band saxophone player who used to move in the laissez faire circles around writer Ayn Rand. A man whose dark clothes and reserved demeanor had caused his friends to nickname him “the undertaker.” After a career in the financial sector and a few stints as a presidential adviser, however, Alan Greenspan had become a pillar of the U.S. establishment.

Even so, few had predicted the next step in the career of this man, who had advocated both in speech and in writing that the Federal Reserve, or “Fed,” the U.S. central bank, should be closed down and that the market should instead determine the price of money, which should preferably be backed up by gold. In 1987, Greenspan was appointed chairman of the Fed at the age of 61. He soon acquired a reputation for expressing himself unintelligibly. This is probably a personality trait, but many believe he consciously adopted it to avoid scaring market players by using excessively strong words. In fact, this belief is symbolic of how commentators would always read into Greenspan’s behavior an element of careful thinking and cleverness. Indeed, he was soon declared a genius in his new role.

Less than two months after starting his new job, Greenspan had his baptism of fire. There is still disagreement on exactly what triggered it all, but an international dispute about exchange rates and an unexpectedly weak figure for the U.S. balance of trade gave rise to concern, and computer models with preset sell prices for stocks caused the decline in prices to spread quickly. In a single day— October 19, 1987—the New York Stock Exchange fell by almost 23 percent. It was Greenspan’s reaction to this “Black Monday” that laid the foundation of his fame. His response was to make an historically large cut in the benchmark interest rate and to offer freer credit. The market stabilized very quickly, and the ink of the magazines warning of a repeat of the Great Depression had hardly dried before the economy had shaken off the stock market crash and was back on track. A hero had been born.

With Greenspan at the helm, the Fed used the same modus operandi whenever crisis loomed: quickly cut the benchmark rate and pump liquidity into the economy. That is what it did at the time of the Gulf War, the Mexican peso crisis, the Asian crisis, the collapse of the Long-Term Capital Management hedge fund, the worries about the millennium bug, and the dot-com crash—and on each occasion, commentators were surprised by the mildness of the subsequent downturn. In someone with Greenspan’s clear-cut opinions about the importance of free markets, this readiness to throw money at all problems was surprising. However, to a direct question in Congress about his old laissez-faire views of monetary policy, Greenspan replied, “That’s a long time ago, and I no longer subscribe to those views.”¹ And even though he hung onto most of his other market-friendly views, he no longer felt bound by ideological principles. As an economist told the New York Times when Greenspan was appointed Fed chairman:

He isn’t a Keynesian. He isn’t a monetarist. He isn’t a supply-sider. If he’s anything, he’s a pragmatist, and as such, he is somewhat unpredictable.²

But regardless of what theory Greenspan’s actions built on, they caused him to be declared a genius in some circles, where he was viewed as a magician who had lifted growth and tamed the business cycle. Journalist Bob Woodward, of Watergate fame, chose the title Maestro for his book about Greenspan, who is there credited with orchestrating the 1990s boom in the United States. During the 2000 presidential election, the Republican primary candidate John McCain joked that he would reappoint the then 76-year-old Fed chairman—even if he were to die: “I’d prop him up and put a pair of dark glasses on him and keep him as long as we could.”³

An Inflationary Boom of Some Sort

After September 11, 2001, the world once more looked to Alan Greenspan, the Fed chairman who, like Archimedes, got his best ideas in his bath. And he did not hold his fire. The Fed started to increase the amount of money in the economy. All of a sudden, the annual rate of increase of “M2”—one of the most common measures of the money supply—soared to 10 percent. In mid-2003, it remained as high as 8 percent. In other words, the metaphorical printing press in the Fed’s basement was running red-hot. This was part of an effort to force down the Fed funds rate—the benchmark interest rate at which banks can borrow money in the short term, which is one of the Fed’s tools to control the economy. In fact, Greenspan had already been lowering this rate rapidly throughout 2001 to prepare for a looming economic downturn, and after 9/11 he pushed it down aggressively. At the beginning of 2001, banks had to pay 6.25 percent interest on the money they borrowed; at the end of the year, they could get away with 1.75 percent—and they would not have to pay more until almost three years later. But this was not enough for the Fed, and the market players were clamoring for more to cope with the downturn.

Basically, this desire to help the economy squares well with the task that the Fed has been given by Congress. Unlike most other central banks in the world, the Fed has a duty not only to maintain price stability but also to ensure that the unemployment rate is as low as possible and that long-term interest rates are low. This has made many European politicians view the Fed as a model. What’s more, there was concern at the Fed that prices would start falling. One Fed governor who was an expert on the Great Depression, Ben Bernanke, convinced Greenspan and their colleagues that the country was at risk of entering a deflationary spiral as it had in the 1930s and as Japan had done in the 1990s.

But there was in fact no collapsing economy in need of being propped up. Only two months after 9/11, the stock exchange was back at a higher level; in 2002, the United States saw economic growth of 1.6 percent. Even so, the Fed worried that higher interest rates could halt the rise and thus continued making cuts. Alan Greenspan himself has admitted that at least the last rate cut, down to 1 percent in June 2003, was not necessary:

We agreed on the reduction despite our consensus that the economy probably did not need yet another rate cut. The stock market had finally begun to revive, and our forecasts called for much stronger GDP [gross domestic product] growth in the year’s second half. Yet we went ahead on the basis of a balancing of risk. We wanted to shut down the possibility of corrosive deflation; we were willing to chance that by cutting rates we might foster a bubble, an inflationary boom of some sort, which we would subsequently have to address.⁴

One percent was the lowest the rate had been in half a century, and in August the Fed promised it would remain at that level “for a considerable period.” In December, promises were again made about very low interest rates for a long time to come.⁵ The most ardent defender of the record-low rates was Bernanke. The Fed ended up keeping its benchmark rate as low as 1 percent for a full year; once it finally began edging it upward, it did so in tiny, cautious steps even though the wheels of the economy were by then turning very fast. Only in June 2004 did the Fed funds rate reach 1.25 percent, and it took almost two more years to attain 5 percent. The overall effect of this for borrowers was that, over a period of two and a half years, inflation reduced the value of their loans by more than the total cost of interest. In other words, borrowing was not just free— you were actually paid to borrow.⁶ And while short-term rates thus stayed low, long-term rates were affected by other factors as well and never came down any further than to just under 3.5 percent. That made it a particularly profitable proposition to take out short-term loans and then lend the money long term, but doing so always involves large risks because the people you have borrowed from short-term may suddenly decide that they want their money back (or that they will not renew your short-term loan) while you have passed on that money to others and promised them they will not have to repay you for a long time.

As Greenspan admitted, the Fed took a conscious risk, and the result did indeed turn out to be an inflationary bubble of some sort. It is true that people were not keen on general consumption, as unemployment was rising at the time and they had just gotten their fingers burned on the stock market—but if you pump new money into the economy, it will always end up somewhere or other. This time it went into real estate.

The U.S. political establishment had actually paved the way for a real-estate boom long before this. Homeownership is viewed as part of the American dream, as a route from poverty and social exclusion to independence and responsibility. For this reason, ever since the United States introduced an income tax its government has been helping out its citizens by allowing them to deduct mortgage-interest payments from that tax—similarly to some other countries, including Sweden. This support for homeownership was reinforced by President Ronald Reagan and Congress in 1986, when the tax deduction for home mortgage interest was retained, while tax incentives favoring rental development and ownership were removed. In addition, the deduction for other consumer loans, such as car and credit card loans, was abolished, which had the effect of steering more and more lending toward the housing market. In 1994, 68 percent of home loans were in fact used to pay down debts for other consumption, for example, car purchases.⁷ Some people therefore see the mortgage deduction as an annual $80 billion subsidy for the house as an investment object.

“Clearly, we’ve gotten some bang for all these bucks,” as the economics writer Daniel Gross explained in Slate in 2005:

The United States has an enviably high rate of homeownership and a highly developed infrastructure—secondary markets in mortgage-backed securities, online mortgage companies, etc.—that supports the construction and purchase of homes.

But the once-modest deduction has evolved into a very large and highly inefficient rent subsidy. The deduction plainly causes distortions. People are willing to pay more for houses and buy bigger houses than they otherwise would because they can deduct the interest from their taxes.⁸

Homeownership was favored even more after 1997, when President Clinton abolished the capital gains tax on real estate (up to $500,000 for a couple) but kept it for other types of investment, such as stocks, bonds, and people’s own businesses. “Why insist in effect that they put it in housing to get that benefit? Why not let them invest in other things that might be more productive, like stocks and bonds?” asked the then head of the Internal Revenue Service, but to no avail. The money was going to the housing sector and that was that. A Fed study showed that the number of home deals during the decade starting in 1997 was 17 percent higher than it would have been without this selective tax cut.⁹

As far back as August 2001, James Grant, publisher of the financial newsletter Grant’s Interest Rate Observer, noted with concern that U.S. home prices had increased by 8.8 percent over the past year even though the dot-com bubble had burst and the economy was virtually in recession. “What could explain a bull market in a non-earning asset in a non-inflationary era?” he wondered—replying himself that the reason was simply that credit was too easily available at too-low an interest rate, and that we did not realize there was hidden inflation in the background.¹⁰

It is hardly surprising, then, that further rate cuts stoked the fire. The economic columnist Robert Samuelson suddenly discovered that his wife understood the housing market vastly better than he did. Houses in their neighborhood were being sold for one-fourth more than he thought they were worth, but his wife was not in the least surprised. Americans had started exploiting the low interest rates to take out new and bigger loans. My home was no longer my castle, but my ATM. Since homes were suddenly worth more, their owners could go back to the bank and borrow even more money against the same collateral. In the past, most people used to take out loans that they would actually pay off, but now more and more borrowers were obtaining loan agreements under which they would only have to pay interest or at least would not have to pay back any of the principal until after a decade or so.

In 2002 alone, U.S. households borrowed $269 billion more on their homes, usually for consumption or home improvement. In Samuelson’s words: “Fed up with the stock market, Americans went on a real-estate orgy. We traded up, tore down and added on. Builders started almost 1.7 million new homes, up 5 percent from 2001. Existing home sales were a record 5.5 million.”¹¹

In a speech to a number of credit institutions in February 2004, Alan Greenspan effectively reprimanded borrowers for taking out costly fixed-rate mortgages. The Fed’s research showed that many homeowners could have gained tens of thousands of dollars in the past decade if they had let the interest rates on their mortgages move freely instead of locking them at a certain level. Greenspan called for new, freer types of loans: “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.”¹² More and more Americans took this lesson to heart and obtained adjustable-rate mortgages instead. In January 2004, the Washington Mutual bank stated that the proportion of its customers who chose adjustable rates had increased from 5 to 40 percent in a single year.¹³

Between 2000 and 2005, the value of U.S. single-family homes increased by $8 trillion.¹⁴ More than 40 percent of all new jobs were related to the housing sector, and new mortgages were financing record consumption. The American people could finally draw a sigh of relief. The crisis was over; money was flowing. Happy days were here again. The Fed had saved the economy once more, this time from the dot-com bubble—but it had done so by inflating a new bubble.

A financial worker living outside Atlanta, Georgia, was pleasantly surprised to realize that he could buy his dream home even though he was unable to sell his old home, as it was being renovated. He simply took out an interest-only mortgage at the end of 2001 and became the owner of two homes. One year earlier, he would have had to pay around 7 percent interest, but now the loan cost him only 2.8 percent. And that was before tax deductions. He felt as though he “was getting a house for free.”¹⁵

It is important here to note that the bubble manifested itself very differently in the various parts of the United States, depending on how hard it was to build new homes there. The economist Paul Krugman, who is usually no enemy of economic regulation, wrote in August 2005 that from the perspective of housing policy, the United States consists of two different countries: one in the middle and the other along either side. In the inland region, or “Flatland,” building is fairly simple and cheap, and no housing bubbles ever arise. Along the west and east coasts, however, stretches “the Zoned Zone,” where land-use regulations place a series of obstacles in the way of new developers. If people grow enthusiastic about real estate there, for example because of low interest rates, that causes the prices of existing homes to explode.¹⁶

Statistics prove Krugman right. The real-estate bubble proper actually occurred in only about a dozen states. The environmental economist Randal O’Toole identifies their common denominator in that they were almost the exact same ...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Dedication
• Contents
• Preface to the Paperback Edition
• Preface to the First Edition
• 1. Preemptive Keynesianism
• 2. Castles in the Air
• 3. How to Build Financial Weapons of Mass Destruction
• 4. Hurricane Season
• 5. Madly in All Directions
• 6. Tomorrow Capitalism?
• 7. Oops, We Did It Again
• My Debts
• Notes
• References
• Index