The Financial Crisis: Causes, Solutions, and Future Adjustment

By Charles Kirchofer, October 18th, 2008

It's impossible to turn on the TV these days without hearing more about how the financial world as we know it is coming to an end. What is going on, how did it happen, how can we fix it, and what can we do to prevent another one?

What's going on
The answer to what's going on is easily said and harder described. Banks currently either do not have enough money to loan to each other and to private customers (businesses and consumers) or are too nervous to do so because so many banks, business, and consumers have been defaulting (not paying back) on their loans in the past 12 to 18 months. If you've read my economics posts, including the one on central banks and interest rates (forthcoming), you know that not being able to borrow money slows an economy down. Business cannot expand. In addition, fear tends to make people save money. This is also bad news during an economic downturn. Less money changing hands as fewer goods are purchased means slower (or negative) economic growth. So how can we get money flowing again?

How we can fix it
The Federal Reserve, led by Ben Bernanke, and the federal government (led by Treasury Secretary Henry Paulson), along with the central banks and governments of Europe, Japan, and other parts of the world, are attempting to fix the crisis by solving the illiquidity problem. If markets are illiquid, money is not flowing around, which is essential if businesses are to get the money they need to expand. Governments are propping up banks (by injecting them with capital or nationalizing them if necessary) and central banks are lowering interest rates and providing nearly no-strings-attached loans to banks. What will this do? It ensures the banks can pay their bills, and hopefully will loan to one another, carrying on business as usual. One other big point is to keep people and investors from panicking. Panic means everyone holds on to their money and the economy comes to a grinding halt - leading to a recession or, worse, a full-scale depression.

But why is the government bailing out banks and not the little guy? This is the question we hear most often these days, and it is based upon a false idea. The underlying idea is that the government could choose to bail out homeowners instead of banks. This is false. Even though the credit crisis started with some people unable to pay their mortgages, it has gone far beyond that now. Even if they had the money, there's no guarantee that many of the people would stay in undervalued homes with overvalued mortgages. Even if they did, this would not solve the problem of illiquidity. It must be understood that if the banks were allowed to fail, the result could be another Great Depression. This was the mistake governments made back then (along with a gold standard that didn't allow the Fed to drop interest rates when it needed to) that largely led to the Great Depression being as bad as it was. The government is not choosing banks over the little people, the government is doing what is absolutely necessary to save everyone from economic doom! Help for the little people will never be enough if they all lose their jobs and the economy dives. However, the government is discussing plans to push banks to refinance mortgages and work to prevent further foreclosures. The banks may also have to use some of the bailout money to accept mortgage losses, meaning the homeowners would have to pay back a smaller amount on their mortgages. So the government is working to try to help homeowners, but it is first working to save essentially the entire world, and that has priority.

How it happened
Experts are likely to argue about the precise causes of, and their respective influences on, the financial crisis for years to come. There is already some agreement, however. For me, it comes down to six factors:

1. Innovation ahead of regulation. Financial markets have done some innovative things in the past few years, some of them designed to get around regulations in place. Even if regulators had recognized what was going and improved regulation, it is likely investors, who are better paid (i.e. have better incentives), often more talented, and certainly more numerous than regulators, would probably have found new ways to cut corners and outfox the regulators.
2. Bad government policies. The government's implicit support of Fannie Mae and Freddie Mac, as well as its directives to boost home ownership with tax exemption schemes and government funding, caused some of the problem on the housing market. Since everyone believed Fannie Mae and Freddie Mac could never fail because the government wouldn't let them, many invested in the companies (and companies they guaranteed) as a safe bet. This meant the twins had a steady flow of cheap cash that they then invested in housing. At the same time, the government did not exercise direct control over the two. In this way, the two are private when they're turning profits, and become public when there're problems. This led to a lower perception of risk (moral hazard) and big imbalances.
3. Money was too cheap. It is now generally accepted that money was too cheap. This has two causes. One: The Fed kept interest rates too low for too long and did not raise them quickly and high enough. Two: other countries (like Japan, China, Germany, Saudi Arabia, Norway, and others) saved too much money and invested it in dollar assets. This made money cheap in the US, regardless of Fed policies, meaning the Fed did not have complete control over the price of money (especially in the form of long-term bond rates, which Alan Greenspan tried unsuccessfully to raise in 2004). Also, cheap imports from China, partially held cheap by the purchasing of dollar assets, led to disinflationary pressures. Since the rate of inflation (exluding housing, in hindsight a rather foolish exclusion) remained low up until the crisis, the Fed saw little reason to dramatically raise interest rates. Another disinflationary effect was the steady stream of low-wage workers from Mexico, which may have helped prevent a wage-price spiral in food and low-end goods.
4. There was an underestimation of the effect of financial innovation on house prices and of the odds of a national house price decline. Previously, people bought their houses to live in them. That meant house prices generally remained stable (generally only rising in the last 2-3 decades), at least on the national average. If a person's house lost value, it didn't mean they'd turn around and try to sell it. This time around though, there was an increase in the number of investors buying houses, holding on to them and/or fixing them up, and then selling them at a higher price. Historically, the number of housing being bought by investors was rarely higher than 10% (mostly with the intention of renting the properties, not flipping them). By 2005, however, this number had risen to 28% (Greenspan 231). This meant there were more people who would be unable to pay mortgages over the long term and who were relying on rising house prices. These people also were less wedded to the homes, since they weren't living in them. The phenomenon was common enough to have TV shows about "flipping" houses. This was a sign the game had changed. As investors looked for the next place they could get high returns after the dotcom crash, needing to stay away from low interest rate bonds and bank accounts, they began investing in housing, housing securities, etc.
5. The Anglo-Saxon investment banking system is more pro-cyclical. Since assets (like stocks or homes) are used to back borrowing, higher asset prices mean more borrowing power. More borrowed assets mean more assets and more borrowing power again if assets rise. The opposite is true, however, when things fall. The system means Anglo-Saxon countries recover from crises and expand very quickly, but they can also fall into crises quicker, harder, and farther than countries that rely on more traditional banking systems. It is important to point out that in sum, since central banks and regulators had previously been able to maintain stability with this system, that the Anglo financial sectors have expanded much more quickly than their traditional counterparts.
6. Governments often subsidize debt and punish savings with their tax structures. Consumers get tax breaks on mortgage debt, for example. This effectively encourages people to go into debt, as that might be cheaper for them in the long run. This means the government is essentially paying part of the bill for houses. No wonder the government is then also on the line when prices fall! This is also related to the implicit Fannie and Freddie guarantees, as the twins were given the explicit mission of increasing home ownership.

How we can prevent the next one
This is the most difficult and crucial question of all. There are a few things we can do. For one, the lending practices must be looked at, and tighter financial requirements for people taking out mortgages are in order. New capital reserve requirements for investment banks and other investment organizations should probably be looked at, too. Central banks, the Fed in particular, that have previously essentially ignored asset price inflation (like house prices and stocks) are going to need to pay better attention to it in the future. In their defense, they seemed to be right to ignore it for a long time. After all, the stock market and asset crashes of 1987, 2000 (the dotcom crash) and 2001 (9/11) all resulted in very little negative impact for the real economy at large. In my view, this was only because the size and depth of the debt hadn't yet reached critical levels and because there was always a new bubble to invest in, brought about by low interest rates and cheap money from Asia. The pro-cyclical nature of the Anglo banking system needs to be steered against more aggressively in the future, which means more attention paid to asset prices, particularly in Anglo-Saxon economies like the US and Britain.

In addition to better (not necessarily more) regulation and closer attention to asset price inflation, Fannie Mae and Freddie Mac need to be completely privatized with no implicit government support (though how to do that exactly is a question in and of itself). Even so, tighter regulation will be needed everywhere due to the moral hazard caused by the knowledge that the government would be forced to bail the banks out if it ever happened again. One proposal is to penalize banks fiscally (through taxation) for becoming "too big to fail." Whether this would be feasible economically or politically (as it would require worldwide cooperation if the US were not to be unduly disadvantaged as a result) is another (difficult) question entirely. If the next time were to come in the too-near future, governments might already be too indebted to do so. The result would be an unavoidable depression. There is no question then, that regulations need to be modified to keep up, and possible risks must be foreseen earlier.

One problem could come from over-regulation, though. A return to the over-regulated old days could lead us back to times of stagflation. For this reason, regulators need to be sure to control things effectively, create the right types of incentives (possibly by not incentivizing debt), and not get involved in areas where it makes no sense. Protectionism and stops on trade and finance would hurt everyone and would do nothing to prevent a future crisis. Such measures would therefore be highly counterproductive.

Work Cited
Greenspan, Alan. The Age of Turbulence: Adventures in a New World. London, 2007.