All Commentary
Thursday, May 20, 2010

Financial Fiasco: How America’s Infatuation with Homeownership and Easy Money Created the Economic Crisis

Free-market greed stands accused of undermining the world financial system, but that is a mistaken analysis, writes Johan Norberg. The Swedish author made famous by his book In Defence of Global Capitalism is back to provide an explanation for the current financial crisis.

Many factors led to the global financial fiasco, Norberg writes, including a naive policy that privatized profits and socialized losses, risk-taking based on blind faith in computer models’ ability to predict the market, and a false sense of security bred by government assurances that the taxpayers would back up bad loans. This brought an unsustainable growth of assets and liabilities.

The title of the Swedish original (which I read) is A Perfect Storm, an expression describing an event where a rare combination of circumstances drastically aggravates a bad situation. That certainly describes the financial implosion that began in 2007. Norberg explains the events leading to the credit crunch through one chilling example after the other. The conscious actions of financial, political, and bureaucratic decision-makers and consumers might not have been too dangerous in themselves, but in combination they proved utterly disastrous.

According to Norberg, after the dot-com bubble and 9/11, Federal Reserve Chairman Alan Greenspan acted to avoid a recession by stimulating the economy with record-low interest rates in a sort of “pre-emptive Keynesianism.” But the Fed misjudged the state of the economy and kept the interest rates down far too long. Effective interest rates actually turned negative, building the momentum for another bubble.

The low rates encouraged even greater risk-taking, not to mention a mountain of debt passed on to the future. Instead of going into a recession, the global economy saw an artificial, temporary rise in prosperity. China’s policy of keeping its currency undervalued to stimulate its exports while pumping its surplus of capital into U.S. bonds supported the process and hid the imbalances created by the Fed.

Predictably, artificially low interest rates inflated the real estate market. No sector of the economy is more sensitive to interest rates than real estate, and American politicians put massive pressure on two government-sponsored enterprises, Fannie Mae and Freddie Mac, to lower their standards to enable vast numbers of unsound mortgages. The resulting foreclosures will leave a terrible mark in the minds and on the credit reports of millions.

Norberg is no less critical of the actions of the Wall Street capitalists. Weak oversight of money placed in investment and pension funds, coupled with huge bonus systems, encouraged shortsighted gambling with other people’s money. Lurking behind all that was the assumption that there was little risk because the mortgage-backed securities were implicitly guaranteed by the federal government.

In the public debate following the credit crunch, many argued as if the financial markets were ruled by laissez faire, but the credit-rating agencies had an oligopoly due to regulations. Such regulations break down the barriers between the government and the market. The problem was not too little regulation. Rather, it was faulty regulation upheld by a multitude of national and international agencies. Tough international bank regulations punished traditional banking, while pushing bad loans into a shadow banking system to avoid transparency.

Financial Fiasco ends on a pessimistic note, predicting that we will see extensive, long-term government involvement in the financial sector for years to come. “Create a crisis, and people will give you more power to fight it,” Norberg writes. He points to the risk that politically well-connected corporations and interest groups will not only further distort competition (as in the case of TARP), but also cause new losses and crashes. Politicians in many European countries have already subtly begun to require that banks concentrate lending in their national economies. A growing financial protectionism would throw more gravel in the financial machinery. We might also see a new wave of trade protectionism.

The book’s most important lesson is that the problem isn’t the current recession, but the previous boom. It was during the boom that poor investments were made based on hidden inflation and far too optimistic forecasts. The recession is the cure, when labor and capital are reallocated to better uses and productivity improves.

In its brevity, the book provides an interesting, accessible explanation of the reasons for and consequences of the financial crisis. It would have benefited, however, from specific recommendations on how to get to a freer economy. What must we do—or undo—to prevent politicians from repeating the boom and bust cycle? There is a dire need for a sound policy, but unfortunately hasty and simplistic “solutions” based on populist slogans have prevailed. Norberg says that people must realize that government has its limitations, but he doesn’t tell us just where we should draw the line.