How The Government

Created A Financial Crisis

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Facing double digit inflation, double digit
interest rates and soon to be double digit
unemployment, President Reagan came into
office with a four point economic program on
which he had eplicitly campaigned,
fundamentally changing the course of American
economic policy! As discussed in my recent op"
ed, #Reaganomics vs! $bamanomics% Facts and
Figures,& those four points were%
'! Reduce ta rates sharply to improve incentives for
savings, investment, (ob creation, business start"ups and
epansion, entrepreneurship and wor)!
*! Cut unnecessary government spending!
+! Pursue anti"inflationary monetary policy to maintain a
stable dollar!
,! -eregulation to reduce costs for business and
consumers and to increase efficiency!
As . discussed in that article, this was the most
successful economic eperiment in world
history! .nflation was tamed by '/0+, never to
be heard from again 1 until recently! The
economy too) off on a *2"year boom, #the
greatest period of wealth creation in the history
of the planet,& as recounted by Art 3affer and
4teve 5oore, and &an economic Golden Age,& as
rightly labeled by 4teve Forbes!
6hy did it end with the *770"*77/ financial
crisis, from which we have not yet fully
recovered8 9y *770, as shown below, American
economic policy had departed from every one of
the four plan)s of Reaganomics! Two of those
blunders were especially salient% '! the 9ush
cheap dollar monetary policy and *! the Clinton
re"regulation to force the financial community
into the subprime mortgage fiasco!
Federal Reserve 9oard Chairman Alan
Greenspan and other governors at the Fed
eventually departed from Reagan:s in(unction
that monetary policy focus on maintaining
stable prices, and started trying to stimulate the
economy through old ;eynesian policies of easy
money! The 9ush Treasury supported that,
favoring a cheap dollar in response to
ubi<uitous business lobbyists in 6ashington
more than willing to sacrifice the long term
economy to their short term eport goals! The
central role of the resulting Fed policies in
causing the financial crisis was most
authoritatively eplained by 4tanford =conomics
Professor and monetary policy guru >ohn Taylor
in his timely boo), Getting Off Track! Taylor
begins%
The classic eplanation of financial crises, going
bac) hundreds of years, is that they are caused by
ecesses 1 fre<uently monetary ecesses 1 that
lead to a boom and an inevitable bust! .n the
recent crisis we had a housing boom and bust,
which in turn led to financial turmoil in the
?nited 4tates and other countries! . begin by
showing that monetary ecesses were the main
cause of the boom and the resulting bust!
=conomics Professor 3awrence H! 6hite now of
George 5ason ?niversity elaborates%
.n the recession of *77', the Federal Reserve
4ystem@began aggressively epanding the ?!4!
money supply! Aear"over"year growth in the 5"*
monetary aggregate rose briefly above '7
percent, and remained above 0 percent entering
the second half of *77+! The epansion was
accompanied by the Fed repeatedly lowering its
target for the federal funds Binterban) short
termC interest rate! The federal funds rate began
*77' at D!*2 percent and ended the year at '!E2
percent! .t was reduced further in *77* and
*77+, in mid"*77+ reaching a record low of '
percent, where it stayed for a year! The real Fed
funds rate was negative@for two and a half
years! .n purchasing power terms, during that
period a borrower was not paying but rather
gaining in proportion to what he borrowed!
=conomist 4teve Han)e has summariFed the
result% This set off the mother of all li<uidity
cycles and yet another massive demand bubble!
From early *77' until late *77D, as 6hite
further eplains, #the Fed pushed the actual
federal funds rate below the estimated rate that
would have been consistent with targeting a *G
inflation!& That estimated rate is determined by
what is )nown in economics as the Taylor Rule!
4teve Forbes adds, #.n *77,, the Federal
Reserve made a fateful miscalculation! .t
thought the ?!4! economy was much wea)er
than it was and therefore pumped out ecess
li<uidity and )ept interest rates artificially low!&
6hite continues%
The demand bubble thus created went heavily
into real estate! From mid"*77+ to mid"*77E,
while the dollar volume of final sales of goods
and services was growing at 2 percent to E
percent, real estate loans at commercial ban)s
were growing at '7"'E percent! Credit fueled
demand pushed up the sale prices of eisting
houses and encouraged the construction of new
housing on undeveloped land, in both cases
absorbing the increased dollar volume of
mortgages! 9ecause real estate is an especially
long"lived asset, its mar)et value is especially
boosted by low interest rates!
4ustained below"mar)et interest rates distort
huge flows of investment into housing in
particular because the lower rates most favor the
longest term investments!
9ut low interest rates by themselves do not
mean monetary policy is ecessively loose! That
depends on what mar)et prices are saying, as
reflected by the dollar, gold and inflation! The
Fed:s loose monetary policies during the 9ush
Administration, however, also generated sharp
declines in the dollar! The dollar was worth '!'2
euros near the start of *77*, but it declined by
close to 27G near to 7!D =uros by the start of
*770! The price of gold soared from H+27 near
the end of *77* to almost H',777 by the start of
*770! =ven inflation, defeated *2 years
previously, started to come bac), increasing
from '!22G at the end of *77', to as high as
2!DG in >uly *770!
The cheap dollar monetary policy further
inflated the housing bubble because it generated
flight into real assets to escape the depreciating
greenbac)! This also eplains why the housing
crisis showed up virtually worldwide! The Fed
managing the world:s reserve currency
effectively eported its wea) currency policy
globally! $ther countries loosen their monetary
policies to avoid the negative short term trade
implications of appreciating currencies relative
to the dollar! 5oreover, the dollar:s wea)ness
mas)s the looseness of their monetary policies,
misleading them into even looser policies!
6hen the Fed finally realiFed it had to rein in its
loose monetary policy, soaring housing prices
slowed, flattened out and then tipped into
declines! The steep decline in housing prices
produced chaos throughout the financial
industry in the ?!4!, and ultimately the world, as
widespread financial assets based on housing
collapsed in value! As Taylor concluded, #ITheJ
etra"easy IFed monetaryJ policy accelerated the
housing boom and thereby ultimately led to the
housing bust!&
9ut that is not the whole story! Chapter * of the
story is the #affordable housing& policies going
bac) many years, spawned by liberals and
progressives! These increasingly etreme and
unbalanced policies began the housing bubble
even before the Fed:s miscalculations starting in
*77'! 5oreover, because of these affordable
housing policies, when the bubble burst, and
housing prices stopped rising and started deep
declines, the resulting damage was far worse!
.n the early '//7s, these liberalKleft activists
began using the Community Reinvestment Act
and anti"discrimination housing laws to allege
discrimination against housing lenders who
maintained traditional lending standards that
ecluded borrowers who were not creditworthy!
Their demands reached the point of insisting
that lenders discount bad credit history, no
credit history, no savings, lac) of steady
employment, a high ratio of mortgage
obligations to income, undocumented income
and inability to finance downpayment and
closing costs, while counting welfare and even
unemployment benefits as income in <ualifying
for a mortgage! These unreasoned demands
were imposed on financial institutions through
overregulation, as H?- and >ustice began
threatening and even following through on
discrimination suits, and ban) regulators began
downgrading institutions that refused to
)nuc)le under!
9ut the big brea)through came when President
Clinton got on board with what was effectively
an official national policy of looting the ban)s!
As 4tanley ;urtF eplained for National Review%
#Finally, in >une of '//2, President Clinton,
Lice"President Gore and 4ecretary Cisneros
announced the administration:s comprehensive
new strategy for raising home"ownership in
America to an all"time home high!
Representatives from AC$RM were guests of
honor at the ceremony! .n his remar)s, Clinton
emphasiFed that% #$ur homeownership strategy
will not cost the tapayers one etra cent! .t will
not re<uire legislation!& Clinton meant that
informal partnerships between Fannie and
Freddie and groups li)e AC$RM would ma)e
mortgages available to customers #who have
historically been ecluded from
homeownership!& .n the end, of course,
Clinton:s plan cost tapayers an almost
unbelievable amount of money!&
Clinton epanded the looting to Fannie
5ae and Freddie 5ac, forcing them
through regulatory fiat to massively increase
funds for subprime mortgages through their
securitiFation practices! That securitiFation
further spread severe damage once the housing
bubble popped throughout the entire ?!4!
financial community, and beyond to financial
institutions globally
The big problem wasn:t caused (ust by loans to
low income borrowers! The problem was that
once lending standards were trashed for these
borrowers, they couldn:t be maintained for more
creditworthy borrowers! This let more well"
heeled speculators in on the scam, now able to
<ualify for highly speculative mortgages they
could not have <ualified for previously! That
vastly epanded the resulting credit ris)
vulnerabilities for the financial system, and
vastly pumped up the housing bubble far more!
$ther regulatory blunders further contributed to
the damage caused by the ultimately inevitable
collapse of the artificial housing bubble! These
included ill"considered #mar)"to"mar)et&
accounting re<uirements, and regulatory
favoritism for an oligopoly of corrupted credit
rating agencies! The panic)y, incoherent bailout
policies led by 9ush Treasury 4ecretary Henry
Paulson only further contributed to the crisis,
further panic)ing the ?!4! and world economies!
Conse<uently, the real cause of the financial
crisis is that by *770, President Clinton,
President 9ush and Republicans and -emocrats
in Congress had departed from every one of the
four plan)s of Reaganomics that produced the
*2"year economic boom! 9ush:s Fed had
trashed Reagan:s monetary policy! Clinton:s
overregulation produced the subprime mortgage
fiasco! 5oreover, during 9ush:s presidency
Congress lost control of spending, with federal
spending rising by one seventh as a percent of
G-P, reversing the gains that had been made
under the Gingrich Republican ma(orities in the
'//7s!
Then, as the recession gained steam in *770,
instead of responding with Reagan style supply
side rate cuts to restart growth, President 9ush
cut a deal with the -emocratic Congress in
February, *770 for a thoroughly forgettable
;eynesian stimulus pac)age, which predictably
failed to produce any positive effect! 6orse,
it provided the foundation for President
$bama:s far more egregious ;eynesian
travesties, which have also thoroughly failed yet
again!
How then to restore booming growth should be
obvious! Restore each of the four plan)s of
Reaganomics! How to do that will be discussed
in my column for net wee)!
Peter Ferrara is Director of Policy for the
Carleson Center for Public Policy and Senior
Fellow for ntitle!ent and "udget Policy at the
#eartland $nstitute% #e served in the &hite
#ouse Office of Policy Develo'!ent under
President Reagan( and as )ssociate De'uty
)ttorney General of the *nited States under the
first President "ush% #e is the author
of America:s Tic)ing 9an)ruptcy 9omb(
forthco!ing fro! #ar'erCollins( which
discusses the causes of the financial crisis and
how to restore boo!ing growth in !ore detail%