Housing Bubble Collapse, Credit Crunch, Peak Oil Present Serious Economic Challenges
James Bailey Brislin
The Carpet City Chronicle
The Enfield Press, July 24, 2008
“Inflation is the one form of taxation that can be imposed without legislation.“
—Milton Friedman
“Government is the only institution that can take a perfectly good piece of paper, print some noble words on it, and make it perfectly worthless.“
—Ludwig von Mises
We live in a time of great challenge. The current economic downturn has brought with it a maelstrom of crises: declining home valuations, bank failures, sky-high gas prices, increasing inflation, and declining purchasing power. Many people find themselves awash in uncertainty. In this column, I hope to provide a big-picture view of what is happening in the economy and why.
To understand the anatomy of the current economic crisis, it is necessary to look back to the beginning of the decade. Following the collapse of the dot-com bubble and the catastrophic events of 9/11, the Federal Reserve cut interest rates to historic lows. The low interest rates made possible unprecedented waves of borrowing and lending. However, they also increased the money supply, making the dollar less valuable than other currencies. This is often referred to as a “loose money” policy.
During this prior recession, consumer spending remained robust, in spite of 9/11 and the tech collapse. Low interest rates were left in place for over three years. Credit was so freely available that banks, mortgage lenders, and credit card companies could not sign people up fast enough. The Federal Reserve’s loose money policy served as a jolt to consumer spending. Anyone who wanted to could buy a house, a car, or many other consumer goods at low interest. With credit assured, homebuyers bid the price of real estate up to astronomical levels.
Meanwhile, the dot-com collapse pushed investment out of technology stocks and growth stocks (stocks that declare no dividend) and into bonds and other asset-backed-securities. Why? The collapse of the tech sector pummeled investors and sent them looking for investments that were less risky, and as a consequence promised lower and steadier returns.
Home loans, especially subprime loans were packaged together using complex mathematical models, and sold on Wall Street as securities that yielded higher interest than bonds. The idea was that even if a few homeowners defaulted on their loans, the vast majority would continue to repay. These “mortgage-backed-securities” gained popularity on Wall Street. The availability of easy credit and demand for mortgage-backed-securities facilitated a bubble in mortgage-backed-securities that paralleled the housing bubble.
Unfortunately, mortgage-backed-securities were fated to become the junk bonds of the 2000’s. Although the product mitigated the risks of lending to individual homebuyers, it contained a fatal flaw. It failed to anticipate the risks posed by sector-wide distress in the mortgage market: the impacts of rampant foreclosures and declining home prices.
Most economic crises have their origins in a lie. In this case, the lie propagated was that, “House prices will go up and never come back down.” This lie is best exemplified by a book published in February of 2006, on the eve of the real estate collapse. Written by National Association of Realtors’ Chief Economist David Lereah, it was entitled Why the Real Estate Boom Will Not Bust-And How You Can Profit From It.
This lie paved the way for more lies in the lending process: lies about the actual valuation of property, lies about borrowers’ jobs, income, assets, and ability to repay a loan. The failure to detect these lies led to the over-valuation of mortgage-backed securities.
The tech bubble was fueled by a similar lie, “The new economy is a world without gravity, in which traditional boom and bust cycles no longer occur.”
Ultimately, these lies were undermined by the efficiency of the free market. Following Federal Reserve interest rate hikes, demand for real estate began to weaken in 2005. Inventory began to grow, making the sale process take longer. Eventually, increasing inventory led to decreasing sale prices. As home prices declined, they dragged down the valuation of surrounding homes. Soon, this led to sector-wide distress, with many Americans finding themselves responsible for paying off mortgages that were now underwater. As you can imagine, these problems trickled up into the market for mortgage-backed-securities, leading to significant losses by investment banks.
This led to a credit crunch. The deception, lies and uncertainty caused banks to increases their cash reserves and tighten their lending standards, shrinking the pool of money lent, and making it harder to access. All of these factors eroded investor confidence.
In March, rumors began to circulate that Bear Stearns had solvency problems- that it did not have enough cash to meet operating demands. As a result of these rumors, banks stopped lending Bear the money that it needed to do business. This caused a run on the bank- as investors attempted to pull their money out of Bear Stearns and move it into commercial banks. Because banks only keep a fraction of deposits on hand, this situation could have very quickly turned ugly, with Bear eventually finding itself unable to support the tsunami of withdrawals. If Bear failed, there would have been major ripple effects throughout the economy. Lenders would have further tightened credit to cover losses to Bear, causing massive deflation. Because Federal Reserve Chairman Ben Bernanke spent his academic career studying the Great Depression, he saw the perils posed by deflation, leading to the joint bailout of Bear by the Federal Reserve and J.P. Morgan Chase. Recent weeks have seen more bank failures- most prominently, the failure of Indymac Bank. Congress is looking to bailout Fannie Mae and Freddie Mac, the government sponsored enterprises that guarantee mortgages.
The current decade has been a time of significant growth in the developing world, especially in India and China. Development brought with it a significant demand for commodities and energy. Citizens of these countries found themselves the beneficiaries of newfound wealth, made possible by the globalization. This wealth funded the construction of cities and the purchase of consumer goods, fueling demand for commodities, such as oil and metals.
These conditions laid the foundation for the current situation. Among democrats, it has become fashionable to blame “speculators” for the high price of oil and other commodities. However, this simplistic approach fails to ask the question, “Why are ‘speculators’ speculating in commodities?” Falling stock prices, the weak dollar, and the credit crunch pushed investors to retreat to commodities. Of course, the corollary to that question is, “What will make the ‘speculators’ exit the commodities market and move back into stocks and bonds? Bad loans must be purged, the dollar must be strengthened, and production of commodities must increase. Once steps have been taken to achieve these three objectives, the same traders who contributed to price increases will lead the charge to lower commodity futures.
In the short and long term, what steps can the government take to turn around the economy? To fix the dollar we need to return to a gold/silver standard, cut spending, and bring deficits under control. Newt Gingrich has also proposed a number of good ideas: Cut the corporate income tax rate of 35%, which is higher than European countries. It is widely accepted that a corporate income tax rate of 12% contributed to the resurgence of the Irish economy, nicknamed the Celtic Tiger. Research has shown that low corporate income tax rates pave the way for more hiring and jobs. To stimulate consumer spending, Congress should cut marginal tax rates, especially in the lower brackets. Studies show that people base spending decisions on long-term earnings expectations. Additionally, the federal government should allow businesses to depreciate equipment more quickly, providing corporations with incentives to acquire and replace capital equipment. Last, we need to “drill here” and “drill now”. The federal government should remove restrictions on oil drilling off our coasts and in Alaska. The people of Alaska want to see drilling in ANWR. It is environmentalists from the lower 48 states who are holding the project up.
As bad as things may seem now, there is a silver lining: things will get better. The return to economic normalcy may seem long and hard. However, when America has faced crises, we have always bounced back strongly. Ultimately, the market fundamentals are in place for us to do so again.
July 24, 2008
Housing Bubble Collapse, Credit Crunch, Peak Oil Present Serious Economic Challenges
Posted by James Bailey Brislin under Commentary & Politics, Economics, News, The Enfield Press | Tags: Bank Failures, Bear Stearns, Celtic Tiger, Commodity Standard, counterparty risk, Credit Crunch, Derivatives, Drill Here, Drill Now, Economy, Fannie Mae, Federal Reserve, Freddie Mac, Gas Prices, Gold Standard, Housing Bubble, Housing Collapse, Inflation, Loose Money, Mortgage Crisis, Mortgage Mess, Mortgage-Backed Securities, Peak Oil, Tight Money |Leave a Comment
Housing Bubble Collapse, Credit Crunch, Peak Oil Present Serious Economic Challenges
James Bailey Brislin
The Carpet City Chronicle
The Enfield Press, July 24, 2008
“Inflation is the one form of taxation that can be imposed without legislation.“
—Milton Friedman
“Government is the only institution that can take a perfectly good piece of paper, print some noble words on it, and make it perfectly worthless.“
—Ludwig von Mises
We live in a time of great challenge. The current economic downturn has brought with it a maelstrom of crises: declining home valuations, bank failures, sky-high gas prices, increasing inflation, and declining purchasing power. Many people find themselves awash in uncertainty. In this column, I hope to provide a big-picture view of what is happening in the economy and why.
To understand the anatomy of the current economic crisis, it is necessary to look back to the beginning of the decade. Following the collapse of the dot-com bubble and the catastrophic events of 9/11, the Federal Reserve cut interest rates to historic lows. The low interest rates made possible unprecedented waves of borrowing and lending. However, they also increased the money supply, making the dollar less valuable than other currencies. This is often referred to as a “loose money” policy.
During this prior recession, consumer spending remained robust, in spite of 9/11 and the tech collapse. Low interest rates were left in place for over three years. Credit was so freely available that banks, mortgage lenders, and credit card companies could not sign people up fast enough. The Federal Reserve’s loose money policy served as a jolt to consumer spending. Anyone who wanted to could buy a house, a car, or many other consumer goods at low interest. With credit assured, homebuyers bid the price of real estate up to astronomical levels.
Meanwhile, the dot-com collapse pushed investment out of technology stocks and growth stocks (stocks that declare no dividend) and into bonds and other asset-backed-securities. Why? The collapse of the tech sector pummeled investors and sent them looking for investments that were less risky, and as a consequence promised lower and steadier returns.
Home loans, especially subprime loans were packaged together using complex mathematical models, and sold on Wall Street as securities that yielded higher interest than bonds. The idea was that even if a few homeowners defaulted on their loans, the vast majority would continue to repay. These “mortgage-backed-securities” gained popularity on Wall Street. The availability of easy credit and demand for mortgage-backed-securities facilitated a bubble in mortgage-backed-securities that paralleled the housing bubble.
Unfortunately, mortgage-backed-securities were fated to become the junk bonds of the 2000’s. Although the product mitigated the risks of lending to individual homebuyers, it contained a fatal flaw. It failed to anticipate the risks posed by sector-wide distress in the mortgage market: the impacts of rampant foreclosures and declining home prices.
Most economic crises have their origins in a lie. In this case, the lie propagated was that, “House prices will go up and never come back down.” This lie is best exemplified by a book published in February of 2006, on the eve of the real estate collapse. Written by National Association of Realtors’ Chief Economist David Lereah, it was entitled Why the Real Estate Boom Will Not Bust-And How You Can Profit From It.
This lie paved the way for more lies in the lending process: lies about the actual valuation of property, lies about borrowers’ jobs, income, assets, and ability to repay a loan. The failure to detect these lies led to the over-valuation of mortgage-backed securities.
The tech bubble was fueled by a similar lie, “The new economy is a world without gravity, in which traditional boom and bust cycles no longer occur.”
Ultimately, these lies were undermined by the efficiency of the free market. Following Federal Reserve interest rate hikes, demand for real estate began to weaken in 2005. Inventory began to grow, making the sale process take longer. Eventually, increasing inventory led to decreasing sale prices. As home prices declined, they dragged down the valuation of surrounding homes. Soon, this led to sector-wide distress, with many Americans finding themselves responsible for paying off mortgages that were now underwater. As you can imagine, these problems trickled up into the market for mortgage-backed-securities, leading to significant losses by investment banks.
This led to a credit crunch. The deception, lies and uncertainty caused banks to increases their cash reserves and tighten their lending standards, shrinking the pool of money lent, and making it harder to access. All of these factors eroded investor confidence.
In March, rumors began to circulate that Bear Stearns had solvency problems- that it did not have enough cash to meet operating demands. As a result of these rumors, banks stopped lending Bear the money that it needed to do business. This caused a run on the bank- as investors attempted to pull their money out of Bear Stearns and move it into commercial banks. Because banks only keep a fraction of deposits on hand, this situation could have very quickly turned ugly, with Bear eventually finding itself unable to support the tsunami of withdrawals. If Bear failed, there would have been major ripple effects throughout the economy. Lenders would have further tightened credit to cover losses to Bear, causing massive deflation. Because Federal Reserve Chairman Ben Bernanke spent his academic career studying the Great Depression, he saw the perils posed by deflation, leading to the joint bailout of Bear by the Federal Reserve and J.P. Morgan Chase. Recent weeks have seen more bank failures- most prominently, the failure of Indymac Bank. Congress is looking to bailout Fannie Mae and Freddie Mac, the government sponsored enterprises that guarantee mortgages.
The current decade has been a time of significant growth in the developing world, especially in India and China. Development brought with it a significant demand for commodities and energy. Citizens of these countries found themselves the beneficiaries of newfound wealth, made possible by the globalization. This wealth funded the construction of cities and the purchase of consumer goods, fueling demand for commodities, such as oil and metals.
These conditions laid the foundation for the current situation. Among democrats, it has become fashionable to blame “speculators” for the high price of oil and other commodities. However, this simplistic approach fails to ask the question, “Why are ‘speculators’ speculating in commodities?” Falling stock prices, the weak dollar, and the credit crunch pushed investors to retreat to commodities. Of course, the corollary to that question is, “What will make the ‘speculators’ exit the commodities market and move back into stocks and bonds? Bad loans must be purged, the dollar must be strengthened, and production of commodities must increase. Once steps have been taken to achieve these three objectives, the same traders who contributed to price increases will lead the charge to lower commodity futures.
In the short and long term, what steps can the government take to turn around the economy? To fix the dollar we need to return to a gold/silver standard, cut spending, and bring deficits under control. Newt Gingrich has also proposed a number of good ideas: Cut the corporate income tax rate of 35%, which is higher than European countries. It is widely accepted that a corporate income tax rate of 12% contributed to the resurgence of the Irish economy, nicknamed the Celtic Tiger. Research has shown that low corporate income tax rates pave the way for more hiring and jobs. To stimulate consumer spending, Congress should cut marginal tax rates, especially in the lower brackets. Studies show that people base spending decisions on long-term earnings expectations. Additionally, the federal government should allow businesses to depreciate equipment more quickly, providing corporations with incentives to acquire and replace capital equipment. Last, we need to “drill here” and “drill now”. The federal government should remove restrictions on oil drilling off our coasts and in Alaska. The people of Alaska want to see drilling in ANWR. It is environmentalists from the lower 48 states who are holding the project up.
As bad as things may seem now, there is a silver lining: things will get better. The return to economic normalcy may seem long and hard. However, when America has faced crises, we have always bounced back strongly. Ultimately, the market fundamentals are in place for us to do so again.