Here is a question for you Wall Street protesters to ponder:

Why would any lender in their right mind lend to a potential home buyer who had a credit score of around 500, paid almost nothing as a down payment, and just told you what his or her income was without any proof (‘liar loans’)?

The answer to this question has a great deal of significance and it is the key to understanding why we had and are still having an economic crisis.

I bring this up because you folks are demonstrating your anger at “Wall Street” for our problems. The direction of your rage is misplaced. You blame “Wall Street” and the “corporations” and “greed” for the Great Recession. You are looking in the wrong place.

Start with “greed.” It isn’t the problem. “Greed” is a word which most folks associate with anyone who is successful and makes buckets of money. “You know they all stole it,” is a common idea. That is because most people don’t understand economics, entrepreneurship, and the fact that wealth is created, not stolen. How much did Steve Jobs ‘steal’?

“Greed” is a moral concept stemming from religious values («excessive desire to acquire or possess more (especially more material wealth) than one needs or deserves»). That definition assumes that someone gets to decide how much you need or deserve. I would say that it is the definition itself that is immoral, not the act, but that is beyond the scope of this article.

I am sure “greed” exists, but so what. It isn’t confined to Wall Street. Such behavior is part of human nature and it exists at all times everywhere. Why all of a sudden did greed take over Wall Street and ruin us? Answer: It didn’t. There has to be another explanation don’t you think (it isn’t “animal spirits”, a simplistic cop out by an economist who had no answer to this questions)? Look beyond the easy, conventional explanations.

The proper question to ask is: Why do we have these boom-bust cycles? Greed or no greed, they keep occurring.

This is something Austrian theory economists discovered a long time ago. In fact Ludwig von Mises first dealt with this in 1912 (Theory of Money and Credit). It is a monetary phenomenon caused in modern times by central banks. Even if you know nothing about monetary theory or care not to know anything about it, you might wonder if the Fed bailout of the last crisis with cheap (fiat) money had anything to do with today’s problems. You may wish to ask why such explosions of fiat money are usually followed by a boom and then a bust. It’s nothing new. It’s happened for millennia, by Caesars, kings, war lords, juntas, dictators, banks which issued money, and central banks. These tyrants conflated money with wealth and believed they could create wealth by counterfeiting (printing) money.

Our Fed does this. One of the ways it creates money out of thin air is by lowering the Fed Funds rate. It is not a coincidence that a boom phase followed the rush of new fiat money. By looking at these charts you can also see when it went boom and then bust:

You can see that in response to the Dot.bomb recession, the Fed took rates from 6.5% to 1% (May 2000 to June 2003). This artificially pumped up the money supply as measured by M2 and resulted in another boom, and then when they started raising the rate in 2004, it went bust:

The rule of thumb is that these kinds of booms cannot be sustained: there is always a crack-up bust. Always.

Think about the one first question I asked at the beginning of this article. What idiot would lend money to someone who is obviously financially unqualified?

That is an interesting question. First you need to know that in these boom phases money flows somewhere. Historically it usually goes into stocks or real estate. If it’s real estate it can be commercial or residential. This time is was mainly homes. And flow it did and we all know where home prices went with the pressure of all that fiat money.

The answer to the idiot lender question is this: the government approved those loan standards and guaranteed the loans. These guarantors, Fannie Mae, Freddie Mac, FHA, Ginnie Mae, were created by the government to promote home ownership and were subject to the laws of politics rather than the laws of economics. If you want proof of this, read the testimony from the Congressional hearings pre-bust.

The lenders then didn’t really care about the financial worth of the borrower since “the government” was going backstop the loan. This was one of the unintended consequences of these laws.

If you wish to blame Wall Street, here’s where that comes in, but it isn’t what you think. Yes, they invented some really clever and complex financial tools to provide capital to the housing market. These were actually pretty good financial structures but for the fact that the whole enterprise was built on a house of sand and the system wasn’t set up for the collapse of the housing market.

The blame of Wall Street has to do with something esoteric and that is the risk models they used when setting up these financial structures. Their risk models assumed that the housing market could never collapse. Their models were built on a statistical flaw going back to the mid-1800s that have been incorporated into all risk models used since then and still used on Wall Street. Philosopher Nassim Nicholas Taleb and the mathematician Benoit Mandelbrot figured all this out in their recent works (The Black Swan, Fooled By Randomness, The (Mis)Behavior of Markets). I urge you to read them.

There was no crime in what Wall Street did. I am sure there probably was some illegal activity but that wasn’t the cause of our malaise. The cause was the Fed, the federal government, and bad risk models.

The next question you should be asking is: why haven’t we recovered? This is where we have something in common: bailouts. I believe that the world wouldn’t have disappeared into a Black Hole without the bailouts. In fact everything that the government and the Fed have done since the Crash has delayed a recovery and has resulted in stagnation, maybe permanent high unemployment, and a decline in the value of your money. We can argue about this, but, so far we have called it correctly and the Fed and the Obama Administration have been dead wrong.

What you see is not capitalism. Rather it is called by a lot of names: crony capitalism, national corporatism, mercantilism, oligarchy or plutocracy, dirigisme, and fascism. It isn’t capitalism, the free market, or the libertarian vision set forth in our Constitution and Bill of Rights. And the fountain of this system is the centralization of the power into our federal government; they wish to substitute their decisions for your decisions.

To you, proponents of one form of conventional wisdom, I urge you to think.

Copyright © 2011 · The Daily Capitalist

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Published by kind permission of Jeff Harding.
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