The Party is Over

(I wrote this article in February, 2009. It appears on my Facebook)

We hear a lot of politicians and talking heads telling us what they are going to do to fix the problems we are having right now or giving us their view on how it all has happened. Many say it is the failure of the free market, that we have to regulate now more than ever to fix our problems. We are told that banks have been far too greedy and that now the government has to fix it. Indeed, the banks have made a lot of bad loans. However, the conditions in which this crisis has come about are a direct result of the interference of the government. After speaking with a couple of professors and reviewing some class material, I feel as though I can put my thoughts on this on paper.
Over the past eight years or so, loans were made that clearly should not have been made. The banks were loaning a lot of money to many people who should not have received a loan. Some banks made very risky loans to people who could not make their payments.
What happened here? Why did so many banks make these loans? Was it pure greed? In a way, yes, that is partly to blame. However, normal incentives for banks to turn a profit had been perverted. How is this?
Firstly, the Federal Funds rate (and discount rate as well) had been held too low for too long a time after the bursting of the NASDAQ bubble (sometimes called the “tech” bubble) in '00. These rates were held low to stimulate growth in the economy and to prevent a recession. ( http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=FF&s[1][range]=10yrs ) The result of these low rates was the creation of a lot of false credit. I say false because the savings rate was so low that this credit could not have been real ( http://www.bea.gov/briefrm/saving.htm ). Credit comes from savings; this is a fundamental characteristic of our economy. However, the credit had come from abroad and from our money printing press. It had come from countries like Japan and Saudi Arabia. These people sold us their goods and lent us the money to buy them. This is evidenced by the national debt being sky high ( http://www.treasurydirect.gov/NP/NPGateway ). The Fed lowered the rates in order to create more money in the hopes that demand would increase, causing an increase in productivity.
The FDIC also contributed to this problem. The insurance provided to banks as guarantees of deposit is effectively a guarantee of capital to banks. This makes the banks more able to lend money to risky borrowers. A few other sources of perverse incentives are Fannie Mae, Freddie Mac (both government sponsored entities), and FHA (another government entity) which enabled banks to make loans to people who could not afford the loans. The loans were made on the assumption that housing values would always appreciate. People were given loans that were as much or more than the price of the home that they were used to purchase. As one can imagine, this ease of obtaining credit spurred a lot of home building. This was an increase in demand, but it was artificial. Once people began to default on the ARMS and other loans made to them (which, clearly, should not have been made), this false demand was shattered. The over-filled housing market began to lose value rapidly. What people should have been doing was to rent apartments and duplexes. However, no one wanted to rent because, they thought, buying a house was the only way to go! To them, housing values would always increase, so there was no risk in obtaining a loan that was above it's current value. All of this is what was called the “Mortgage Crisis”.
As a result of housing values (and the asset-backed securities that were written on them) falling, banks which had made these loans suffered massive write-downs on their balance sheets and many failed. The banks which survived tightened up their lending standards on the fear that their capital would be further written down and they would fall deeper into insolvency (insolvency meaning that they were unable to pay their debts). As this credit tightened, the American economy, which was so used to near-unlimited amounts of credit, began to fall apart. The demand that was created by this credit, not only in housing, but in consumer goods and other things we had consumed, shifted negatively. This meant that prices would fall and we would be in a deflationary stage of the economic cycle. However, the government felt the need to step in again. Thus, we have the 750 billion dollar bailout. This bailout was created to influence banks to begin their lending again and to stabilize prices. We see here that the M1 Multiplier (a measure of the ability of banks to create money through lending) has plummeted. ( http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=MULT&s[1][range]=10yrs ) This means that the ability of the banking system to create money is restricted. In spite of this, the amount of money in the economy has skyrocketed. M1 and M2 are measures of the amount of money in the economy. M1 is, basically, cash, coin, and checking accounts. M2 is all of M1 plus certificates of deposit, savings accounts, and non-institutional money market funds. ( http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=M1&s[1][range]=10yrs ) ( http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=M2&s[1][range]=10yrs ) The creation of all this money has, effectively, kept prices up. Both the Consumer Price Index and Producer Price Index have remained fairly stable, considering the magnitude of the shift in aggregate demand. ( http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=CPIAUCNS&s[1][range]=10yrs ) ( http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=PPIFGS&s[1][range]=10yrs ) These are measures of the prices paid on goods by both consumers and companies who produce the goods we consume.
One of two things is always happening in a managed economy which uses monetary policy to effect the money supply and interest rates. Either the currency is deflating, causing an increase in purchasing power and an incentive to save, or the currency is inflating, causing a decrease in purchasing power and an incentive to borrow. Currently, our government is attempting to fix prices. This is inherently inflationary because the prices should fall. The demand was false and should be corrected. However, the government is not letting this happen. They seem to think that inflating the currency and keeping the prices high will make this whole problem pass.
Truly, if prices are allowed to fall, things will be hard. The Federal Funds Rate will be raised and people will have a new incentive to save their money. Prices will plummet and many companies which are poorly managed will fail. However, as the asset prices drop to their fair value, people will be able to afford them and we can return to a real economy where some save and others borrow. Businesses will be bought up by those who can effectively operate them (take, for instance, the auto makers who are afraid of smaller auto companies cropping up) and the increased supply will further drive down prices until consumers are able to afford them. Then, as demand rises, the quantity of goods will increase and all will be better off.
Our government, in spite of this, is bent on working its “magic”. The fixing of prices may, in the short run, keep us from harsh pain, but it will only make it worse in the long run. Eventually, the dollar will become so worthless from inflation, that it will not be able to buy anything. The dollar will be so worthless that we will not be able to pay our debts. Even if this does not happen, the inflation will only create yet another bubble and the government will have to, yet again, bail out our economy.
Inflation begets inflation, government intervention begets government intervention. I liken it to a story of cookies and milk. If I (the government) make a big batch of sugar cookies and pour a tall glass of milk for little Jimmy and Suzy (the private sector and consumers), they will probably eat it. If they get stomach aches, it is certainly their fault for eating all the cookies, but if I had not baked the cookies, they would not be in such pain! As I keep baking cookies and Jimmy and Suzy keep eating them, they eventually develop diabetes. To whom will they turn for medication for their ills? Why, to the one who gave them the cookies in the first place, of course!
This managed economy has only made it harder for the poor and the middle class. As prices of the goods we consume increase, it is harder and harder for those on fixed or low incomes to afford to live. Also, the poverty line is effectively raised and those who were considered middle class become poor. The government creates artificial conditions that make the poor get poorer and the rich get richer.

Now, I'm not saying the government is all bad; we do need regulations. The effective enforcement of transparency laws and loan limits would probably go a long way to help curb this problem. However, the government, in its quest to make everyone happy, has created perverse incentives and artificial demand. The right regulations need to be in place. I do fear, though, that only the wrong regulations and policies will be used (as we are seeing now with all of this reckless spending) and we will have this same problem yet again, if we are lucky enough that our currency lives. The only solution is to raise the Fed rates and allow people to save so that we can have real domestic credit. The government is dedicated to not allowing this to happen and will continue to destabilize our fragile economy.
In my opinion, this whole mess makes a very good case for smallness. It is, in my mind, the mammoth size of the government's power and of the companies that cause these problems. A larger company requires more regulation, in my mind, because the process is dehumanized. There are alternatives to bigness. Take, for example, credit unions. These are “banks” of a sort, but they are owned by those who make their deposits there. They are local entities that enjoy freedom from many government regulations and taxes. As a result of this, they typically can make loans at much lower rates. This, quite obviously, helps the local economy by providing a source of cheaper funding for business ventures that provide products and create jobs. I believe that these credit unions do not need the regulation of larger banks because those who borrow are putting at risk the very livelihoods of their neighbors and friends, not some rich fat cat in a suit in New York. These local credit unions could ideally be regulated by the local governments, which have a much better grasp on the specific issues at hand in their community.
Perhaps a bit more far-fetched is the idea of bank-produced currencies. The government has no incentive to keep from inflating the currency. Politicians have a very short time horizon; they don't care much for the economy past their term in office. They can finance any war and give money to any lobbyist they wish if they have the power to print money. If banks are allowed to print their own currency (denominated in dollars), they have an incentive to keep from inflating. We can, even now, move from dollars to euros to rubles to yen at the click of a mouse. It is not so unreasonable that we could move from Bank A's dollars to Bank B's dollars. This ease of movement tells the banks that they had better not inflate their currency by printing too much money, or the people will trade the inflating bank's currency for another bank who is not artificially inflating their currency. All in all, though, the ideal currency is that which is based on a commodity, as it has real value and its value cannot be manipulated by the government.
So, what's the point? The point is that our current system is flawed. We have created perverse incentives and have allowed our own greed to create a “spend, spend, spend” mentality. My suggestion would be to reject the idea that houses always appreciate, that your dollar is always a store of value, that you can live on credit and not have to pay for it. We must understand that if we live outside our means, we will eventually live beneath our means. The party, it seems, is over.