2008 Housing Bubble: The Law, Speculation, and Rating Agencies

After identifying the role of GSEs such as Fannie Mae and Freddie Mac in the 2008 housing bubble, in this article we will see three more culprits: the law, speculation, and rating agencies.

The particular law we want to identify is the one made during Carter's time and revived under Clinton's administration. It is the Community Reinvestment Act.

This law coupled with political pressure from special interest groups, bankers were forced to lower lending requirements to provide easy access to housing loan for low-income borrowers. "Racial discrimination" was the favorite rallying cry during those years. As a result, lenders afraid to go against a popular political tide and legal threat were forced to conform to pressure and thereby loosened lending requirements. 

Stan Liebowitz expressed an interesting observation about the absence of the most vital information in housing literature from 1990 to 2006. It was the connection of weaker lending standards to housing defaults. 

And so the banks simply followed what the law mandated them to do. But when the housing bubble burst, the role of the CRA was denied. 

Henry Cisneros served as the the best example of a public bureacrat who applied this weaker credit standard, and even used it in his private investment. In fact, he built around "428 homes for low-income buyers" (p. 19).

A chain of responses followed. Due to easy credit terms, the demand for housing increased. This provided the environment for speculators to flock into housing market. The price of houses artificially appreciated. This multiplied speculators, not only from low-income buyers, but also to higher-income borrowers. Speculation became viral. The two most notorious examples of this were house-flippers and market-timers. 

Private rating agencies were also have their share of responsibility in the housing bubble. They failed to do their duty due to SEC regulations. Like the bankers, they were also afraid to go against a popular political propaganda that caused them not to do their job. 

Personal Response

Reading this section of the book causes me to reflect on the stock market in the coming months. I suspect that as an outcome of the decision of the European Central Bank to inject $1.3 trillion into global economy until the end of 2016, this will motivate speculative stock trading. I think that this new money supply will find its way into stock market. This is advantageous for those who do both stock trading and investing, but detrimental to savers and those who depend on fixed salary. 

At the moment, I am seeing an unusual price appreciation in consumer products, in banking sector, and other related sectors of the economy. This happened during the first round of QEs from the Federal Reserve, and it appears that is is now being repeated in 2015 as a result of ECB announcement. Is this another bubble in the making?

As for rating agencies. I wonder how many stock brokers would give a "buy" rating on firms and yet would do otherwise in the their actual transactions. I saw company reports from 2006 to 2015 of one firm rated as "buy" in August 2007 and in the succeeding months, but after a year and 3 months, its price per share sunk down from 62.50 to 11.25. Even if you will use averaging I wonder how could "experts" advice their clients to invest long-term when the latter's equity lost 80% of its total value after investing for three years. 

Guide Questions:

1. Why were bankers forced to lower their lending regulations?

2. What was the observation of Stan Liebowitz on housing literature from 1990 to 2006?

3. How did Henry Cisneros implemented this lower lending standard in his private investment?

4. Describe the spread of speculation as a result of government easy credit. Give two examples of speculators. Define each of them.

5. Why private rating agencies failed to do their job?

6. What do you think would be the impact of the $1.3 trillion stimulus package from the ECB? How would it influence the stock market?

7. How about stock brokers' rating? Do you trust them? 

Source: Wood, T. E. Jr. (2009). Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Washington, DC: Regnery Publishing, Inc. 

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The 20008 Housing Bubble and GSEs

The problem with those who propagate the dominant story about the 2008 housing bubble was their failure to identify the real source of the crisis. They mistakenly pointed the finger to free market capitalism. As in the past, the interventionist hand of the government escaped public notice.

In chapter 2 of Thomas Woods' book, Meltdown, he identified six culprits including the Federal Reserve. In this article, we will just deal with the first culprit, Fannie Mae and Freddie Mac. 

Before we describe how the US government caused the housing crisis through Fannie Mae and Freddie Mac, let us first give a brief background to the crisis. 

Thomas Woods narrates that from 1998 to 2006, there was a dramatic increase in housing prices. More houses were built and house flippers became a norm. In the third quarter of 2006, cracks in housing industry started to appear. Borrowers could no longer sell their houses for profit for price depreciation started. 

The eruption of this bubble rippled to the financial sector for many in the financial industry "invested heavily in mortgage-backed securities" (p.12). Before the crisis hits, homeowners were applying for mortgage at their local banks and paid their monthly obligation. But when bankers sold these mortgages in "the secondary mortgage market to institutions like Fannie Mae," the latter repackaged these mortgages and and sold them as "mortgaged-backed securities" (ibid.). Investors bought these products for credit agencies marked them with triple A rating, meaning, secured. But when homeowners started to default on their mortgages, foreclosures multiplied. And since increasing number of homeowners could no longer pay their mortgages, the value of "secured mortgage products" started to decline together with the companies that invested in them. Greedy lenders and foolish borrowers were blamed, but not the government.

The housing crisis that erupted in 2008 could be traced to the interventionist hand of the government. The crisis was the inescapable consequence of government intervention in the market. And let us see how the US government did it. 

Fannie Mae and Freddie Mac were "government sponsored enterprises" (p. 13). This meant that they enjoyed privileges that no private enterprises had. And besides, in case they would suffer trouble, the government was there to back them up by passing the financial burden to tax payers. 

When these GSEs bought the mortgages from local banks, with funds in their hands, bankers returned to mortgage market making it easier for people to own houses, and thereby boosted the housing market. The fund that caused this boom was not a product of capital accumulation, but derived from special privileges enjoyed by GSEs. Hence the boom was artificial, and it diverted capital from a more productive industry into the housing market. 

Fannie Mae and Freddie Mac could never cause the housing boom without the US government backing them up. Thomas Woods identifies the many privileges that these GSEs enjoy:

• with special tax and regulatory privileges

• traded on the NYSE

• considered as "government securities"

• considered low risk, and

• with $ 2.25 billion line of credit

"Fannie was also deeply involved in the politically instigated move to lower lending requirements in the name of helping 'disadvantaged' groups" (p. 15). So the housing industry was a hot political issue that time. The call of Republicans to regulate Fannie and Freddie was considered by the Democrats as an "attack on 'affordable housing'" (ibid.). Critics of Democrats saw that the party's hesitation to regulate Fannie was due to the fact that the latter was a source of political fund. 

Ron Paul, the retired libertarian Congressman of Texas and two time US presidential candidate captured the precise role of interventionism in the housing crisis:

"The special privileges granted to Fannie and Freddie have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions. As a result, capital is diverted from its most productive use into housing. This reduces the efficacy of the entire market and thus reduces the standard of living of all Americans. 

Despite the long-term damage to the economy inflicted by the government's interference in the housing market, the government's policy of diverting capitall to other uses creates a short-term boom in housing. Like all artificially created bubbles, the boom in housing prices cannot last forever. When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged overinvestment in housing" (pp. 16-17).

Guide Questions:

1. What do you know about Fannie Mae and Freddie Mac?

2. Briefly explain how the financial industry was affected by the housing crisis.

3. Whoe were the two primary scapegoats for the housing crisis?

4. Briefly explain the two primary advantages of GSEs over private enterprises.

5. Why is the housing boom artificial?

6. Enumerate the privileges that GSEs enjoy.

7. In what way the housing industry was used as a political battlefield?

8. Summarize in your own words Ron Paul's description of the role of the government in the housing market. 

Source: Wood, T. E. Jr. (2009). Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Washington, DC: Regnery Publishing, Inc. 

Economically Confused

In chapter 4 of Leviathan, Thomas Hobbes identifies four misuses of speech. I think if this writer will use his article as a speech, he committed the first three misuses: 

"(1) When men register their thoughts wrongly through inconstancy in the meanings of their words, leading them to register for their conceptions something that they never conceived, thus deceiving themselves. (2) When they use words metaphorically, that is, in senses other than the ones they are ordained to have, thereby deceiving others. (3) When by words they declare something to be what they want which isn’t what they want."

This economic analyst advocates what Mises called as the "third way," a combination of free market and statism, as if this is achievable. The writer is a master in double talk. 

Of course, his academic and professional credential is really impressive. But this does not mean that he is right, just like the many top leaders and the 15, 000 professional economists in the US who are clueless how to solve the problem that the US government caused (Thomas E. Woods Jr., Meltdown, 2009, p. 8).  

Here are two examples that he got it right: 

First, I think the writer is correct in saying that the Philippines remains a "semi-feudal society" under "crony capitalism." I just wonder why he did not indicate that in his article's title. 

Second, he is also correct in stating this:

"Modernity, above all, is about placing efficiency, meritocracy and knowledge above connections, patronage, and discredited traditions. This is precisely why many of the Philippines' neighboring countries, which have held onto much of their cultural heritage, stand as significantly more modern and prosperous: Social mobility, merit-based success, and knowledge-intensive productivity are incredibly more visible in places such as Taiwan or South Korea than the Philippines."

This is capitalism! This is classical liberalism! But to think that these things can be achieved through the state is a product of a confused mind. 

On the other hand, he got it wrong when it comes to assessing the Korean economy, public infrastructure, view of the state, mixing egalitarian with capitalism, and advocating "inclusive growth" using "modern state institutions" and regulating the "overweening markets."

1. Assessment of Korean economy

Among several sides to the story of Korean economy, the writer just picked up the most unlikely explanation adding "high rates of household saving rates" and "mass production of affordable exports." He ignored other explanations such as the chaebol’s collaboration with the government, American intervention, an outcome of economic experiment between socialism and the free market, and chaebol using the government. Consistent to his statist stance, he just saw the government as the leader in the industrial development of South Korea. 

2. Public infrastructure

"The mind-boggling expansion in the Philippines' real estate sector has gone hand in hand with the perennially disappointing absence of modern public infrastructure. . . . Public spaces are often neglected by the authorities or vandalized by uncaring residents."

"There is limited public space for (spiritual and physical) disengagement from the hustle and bustle of everyday life. The Filipino state has basically outsourced such responsibilities to profit-driven enterprises."

"The country's public infrastructure is among the least developed in Asia. . . ."

Why do the authorities neglect the public infrastructure? Is it the fault of "profit-driven enterprises"? Does the writer suggest for more taxes to motivate the authorities to build and care for public infrastructure? 

3. View of the state

"We are yet to see truly rational, impersonal state institutions, which stand beyond patronage and personalized politics. Even much of the business sector is dominated by few old families, so it is preposterous to talk about 'free market' competition."

We have been hearing this kind of message for so long. It is an illusion to believe in the existence of a "rational, impersonal state institutions, which stand beyond patronage and personalized politics." And why is it that only few old families dominate the business sector? Is it the fault of the market? Or is it because of too much government interference that kills competition and hands business monopolies to these families? 

4. Combining egalitarian with capitalism

"More importantly, the Philippines' rapid rates of economic growth in recent years haven't brought about an egalitarian, modern form of capitalism, which is capable of generating waves of prosperity that lift all the boats regardless of gender, class, and ethnicity."

Here again, the confusion comes in! What does he mean by "egalitarian, modern form of capitalism"? He is mixing the two, egalitarian and capitalism. Government intervention is the means to realize an egalitarian vision, but it suppresses capitalism. The two cannot co-exist. A society must pick one. 

5. Advocating inclusive growth using state institutions and market regulation

"The tremendous lack of inclusive growth in the country is a reflection of the absence of modern state institutions, which can efficiently provide public services and regulate overweening markets. . . ."

What does he mean by "modern state institutions"? Is the state capable to come up with productive institutions apart from bureaucratic management? Bureaucracy produces anything, but inclusive growth. Isn't the exercise of freedom in the market the way to achieve inclusive growth? Isn't too much regulation the reason for the absence of inclusive growth? And yet, our economic analyst is advocating the regulation of something that he doesn't even know how it works. 

Macroeconomics

The study of economics has two major branches: macro and micro. Macroeconomics deal with "national, regional, and global economies." Microeconomics on the other hand include individual and household decisions to engage in voluntary exchange. In this article, we will present an overview of macroeconomics touching the basic concepts, models, policies, and historical development. 

1. Basic Concepts 

Output. The basic concepts of macroeconomics include output, unemployment, and inflation. Output is the total production of a specific country in a given period of time. Since products that are sold generate income, typically output and income are terms used interchangeably. 

Another important term related to output is Gross Domestic Product (GDP). It is the price tag on total output of a nation in a specific period of time. It covers private consumption, government spending, investments, and total net exports. This formula helps us understand GDP:

GDP = C + G + I + NX

Legend:

C - private consumption

G - government spending

I - investments

NX - total net exports (exports minus imports)

Source: http://www.investopedia.com/terms/g/gdp.asp

In order to increase output, economists study the factors for economic growth. This study serves as a reference for governments' economic policies. Three main factors of economic growth include technological innovation, capital accumulation, and human capital. However, macroeconomists think that continuous increase of output is usually arrested by seasonal business cycles. Again, it is the task of these economists to come up with proposals for government policies to prevent economic recessions. 

Unemployment. Another important macroeconomic concept is unemployment. For macroeconomists, there are at least four types of unemployment related to their causes: 

• Classical unemployment. This type of unemployment "suggests that unemployment occurs when wages are too high for employers to be willing to hire more workers." Two theories are raised to qualify this view on classical unemployment. One theory suggests "that increased wages actually decrease unemployment by creating more consumer demand." Another theory suggests "that unemployment results from reduced demand for the goods and services produced through labor and suggests that only in markets where profit margins are very low and the market will not bear a price increase of product or service, will higher wages result in unemployment."

• Frictional unemployment. This type of unemployment "occurs when appropriate job vacancies exist for a worker, but the length of time needed to search for and find the job leads to a period of unemployment."

• Structural unemployment. This type of unemployment has diverse causes: skills mismatch, economic transition, and skills acquisition. 

• Cyclical unemployment. This type of unemployment is an outcome of economic stagnation. 

Inflation. The third and last macroeconomic concept is inflation. This term refers to a general increase of prices of products and services. Various theories are attempted to explain the root causes of inflation. Two popular explanations are the overheating of economy (the economy "grows too quickly") and the "changes in aggregate demand and supply." 

On the other hand, the Austrian explanation, which is considered unpopular in the past is now gaining increasing attention. Austrian economists claim that price increase is an inevitable result of the increase in money supply. It is therefore not true that central banks prevent price increase through monetary policy such as raising interest rates and reducing the money supply. In reality, the printing of paper money by the central banks is the source of inflation. 

The opposite of inflation is deflation. Again, for macroeconomists, "deflation can lower economic output," and is a sign of economic decline.

2. Models

We will not discuss the four macroeconomic models found in Wikipedia. It is sufficient for our purpose to simply identify them. The student is advised to study these models as either part of classroom discussion or in his personal research. 

The four models are aggregate demand-aggregrate supply (AD-AS), equilibrium in savings and investments in the goods market and equilibrium between the money supply and liquidity preference in the money market (IS-LM), and the two growth models. These latter models originate from the "neoclassical growth theory" and the "endogenous growth theory."

3. Policies

Monetary policy. "Central banks implement monetary policy by controlling the money supply through several mechanisms. Typically, central banks take action by issuing money to buy bonds (or other assets), which boosts the supply of money and lowers interest rates, or, in the case of contractionary monetary policy, banks sell bonds and take money out of circulation."

As a result of 2008 economic crisis, a monetary policy designated as "quantitative easing" became popular. Wikipedia describes it as "unconventional." The aim of this policy is "to help increase output." Austrian economists see this as economically disastrous for instead of allowing the market to follow its natural course, quantitative easing artificially stimulates economic output. 

Fiscal policy. "Fiscal policy is the use of government’s revenue and expenditure as instruments to influence the economy. Examples of such tools are expenditure, taxes, debt."

It is commendable that the Wikipedia article identifies the setback of fiscal policy. "When government takes on spending projects, it limits the amount of resources available for the private sector to use." 

4. Historical Development

Macroeconomics were claimed to be the offshoots of business cycle theory and monetary theory. At this point, we will give a historical overview of five stages in the development of macroeconomics: the Austrian School, the Keynesian School, monetarism, the new classical macroeconomics, and the new Keynesian economics.

The Austrian School. Ludwig von Mises book, The Theory of Money and Credit remains one of the most important book in monetary theory. The Wikipedia article claims this "was one of the first books from the Austrian School to deal with macroeconomic topics."

The Keynesian School. The publication of John Maynard Keynes' General Theory of Employment, Interest and Money inaugurated macroeconomics in its modern form.

Monetarism. Another reputable economist, Milton Friedman is considered as the father of monetarism. He "updated the quantity theory of money." He also "argued that the role of money in the economy was sufficient to explain the Great Depression and aggregate demand oriented explanations were not necessary." Furthermore, he "doubted the government has ability to 'finetune' the economy with monetary policy. He generally favored a policy of steady growth in money supply instead of frequent intervention."

New classical macroeconomics. "New classical macroeconomics challenged the Keynesian school." Robert Lucas is considered the prominent economist of this school. 

New Keynesian economics. "New Keynesian economists responded to the new classical school by adopting rational expectations and focusing on developing micro-founded models that are immune to the critique of the new classical school. In short, new Keynesianism "which developed partly in response to new classical economics, strives to provide microeconomic foundations to Keynesian economics by showing how imperfect markets can justify demand management." The models, which resulted from this school "are now used by many central banks and are a core part of contemporary macroeconomics." 

Conclusion:

No wonder, nations' economies are in bad shape. The typical economic course taught in colleges remains Keynesian in its outlook despite the havoc it created since 2008. The market is blamed for the crisis and macroeconomic models are created to justify further government intervention. Unless the voice of the Austrian economists is given serious attention and their ideas are implemented, nations cannot expect a recovery from economic crisis. 

Guide Questions:

1. What are the two major branches in the study of economics?

2. What are the four topics covered in this article?

3. What are the three basic macroeconomic concepts? 

4. Explain the meaning of output and GDP.

5. What are the four types of unemployment? Briefly explain each.

6. Enumerate the four macroeconomic models.

7. What are the two primary macroeconomic policies? Briefly explain each. 

8. How do Austrian economists see quantitative easing?

9. According to Wikipedia, what's the setback of fiscal policy?

10. Give an overview of the historical development of macroeconomics.

11. Considering the present status of economic education in colleges, what do you think will be the future of global economy? Why? 

Source: http://en.wikipedia.org/wiki/Macroeconomics

The Real Culprit

Capitalism has failed! This is the constant message that people have been hearing since the 2008 economic crisis. Politicians, economists, and mainstream media agree that free market capitalism is the culprit that caused such economic mess. Greed and excessive risk taking claimed to be inherent in the market are to blame. 

"The crisis was the fault of libertarianism," an editor of a popular website actually believed this claiming that "'unregulated markets'" (p. 4) caused the problem. And since this is the case, that editor thinks that the 2008 crisis marked "the end of libertarianism" (ibid.).

Since capitalism and libertarianism were considered responsible for the 2008 economic trouble, any free market solution to the crisis was automatically dismissed and persisting to do so would be considered insane. The proposed remedy was greater government intervention in the forms of increasing the money supply, more debt, and bigger spending. 

The problem with the above conclusion is that the real culprit escaped public attention and shifted the limelight into the market. And since the diagnosis of the crisis was mistaken, the proposed solution, instead of addressing the problem, would aggravate it even more. 

For Thomas Woods, the reason people were misled was because almost nobody asked the right question. "Where did all the excess risk, leverage, and debt, not to mention the housing bubble itself come from?" (p. 2). Once this question was asked, the direction would be pointing not towards the market, but to government intervention in the market. And "the greatest single government intervention in the economy" (ibid.) is through the Federal Reserve System, which is the real culprit. This is the institution responsible for the "inflationary monetary policy," (p. 3) which causes the business cycle and for setting "artificially low interest rates of 1 percent" that placed "world's economies on unsustainable paths. . . ." (ibid.).

Thomas Woods anticipated in 2009 that "There is nothing the government or the Federal Reserve can do to improve the situation, and a great deal they can do to prolong it" (p. 7). For Woods, the crisis will never be solved unless people would understand how the world entered into this mess in the first place. 

In Meltdown, Woods explains in layman's term "where the economy is and what should be done next" (ibid.). There is nothing new in his message. His ideas are old, but they are ignored. 

Woods' ideas are common among the economists of the Austrian School. Hundreds of economists from this school have seen the crisis coming several years before it happened. Unlike the mainstream economists who subscribe to diverse versions of Keynesianism, very few of them have seen the crisis in advance. Woods mentioned that only about 10 or 12 among 15,000 professional economists in the US have seen the crisis coming. 

Guide Questions:

1. Who were to blame for the 2008 crisis according to politicians, economists, and mainstream media?

2. What was their proposed solution? Explain further. 

3. What was the problem with the dominant story about the 2008 crisis? What would be its future consequences if it is not corrected?

4. For the Austrian School and Thomas Woods, which institution is responsible for the 2008 global economic crisis? 

5. Explain the role of the Federal Reserve System in causing the crisis.

6. Why do you think most mainstream economists failed to see the coming of the 2008 crisis?

Source: Wood, T. E. Jr. (2009). Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Washington, DC: Regnery Publishing, Inc. 

My Version of Libertarianism

Libertarianism is more of a political than an economic philosophy. Though many libertarians owe their economic perspective from the Austrian School of economics, a distinction must be maintained between the two. Furthermore, libertarianism has diverse schools of thought under it including anarchism, left libertarianism, classical liberalism, and many more. Classical liberalism upholds minarchism, the concept of limited government. With this kind of libertarian political economy, we will see a society with lesser government intervention in economic affairs, fewer number of bureaucrats, lower taxes, reduction in government spending, and maximum exercise of both personal and economic freedom. 

Photo Credit

Classical liberals are realistic in their political assessment that to completely abolish the civil government is not only an impossible task, but a utopian dream; it is unachievable. Minarchist libertarians dream of a limited government, which role is confined to make the economic environment conducive to the free operation of the market. The focus of the government is not to intervene in economic affairs, but to protect life, freedom, and private property of the citizens both from domestic and foreign aggression. 

For classical liberals, the increasing number of bureaucrats is an evidence of the gradual loss of personal and economic freedom of the people simply because maintaining the bureaucratic machinery requires increasing amount of taxes. This is the reason why libertarians advocate lower taxes for they see taxation as the means for civil government to grow its size and its spending. By reducing taxation and government spending, people are left with bigger amount of cash in their pocket, which they can spend in whatever ends they choose. 

The maximum exercise of personal and economic freedom is related to all these previous considerations: government intervention, bureaucracy, taxation, and government spending. Economic freedom is just an extension of personal freedom and access to sound money is its very substance. To advance freedom, the government should refrain from its monopoly of the money supply and return the control of money back to the market.