RALEIGH – Who caused the Great Recession? According to Johan Norberg’s masterful new book on the subject, Financial Fiasco, it would be a lot easier to list which recent policymakers and institutions were not at fault in the years leading up to the 2008 crisis.
Federal Reserve Chairmen Alan Greenspan and Ben Bernanke certainly were. Under Greenspan’s tenure, bankers, investors and other financial executives increasingly came to believe that the Fed had their back. They could take on greater amounts of leverage and risk, reaping higher profits while bubbles expanded and landing softly when the bubbles popped.
More recently, Greenspan and Bernanke kept the money-creation spigot on too long after the 9/11 attacks. A large amount of the new money ended up in housing and mortgage-backed securities, both in the U.S. and Europe, fueling a speculative boom that grew ever more disconnected from reality.
Norberg, a Swedish economic historian and senior fellow at the Cato Institute, offers one of the clearest explanations I’ve ever read of how loose monetary policy by a central bank skews economic decisionmaking:
Creating more money not only entails an indirect tax in that it reduces the value of citizens’ savings but also, and more importantly, undermines the price system by giving businesses incorrect information about demand. The additional money created does not end up everywhere at the same time but percolates into the economy in certain places, where it leads to price increases, which businesses interpret as an increase in demand, causing them to hire more people and step up production.
Only after a while do businesses realize that the prices of everything else have also risen and that their costs are increasing even though they are not selling any more than their competitors. In fact, the price increase did not indicate an increase in demand, only a deterioration in the value of money. As a consequence of these incorrect market messages, resources have thus been brought to places where they should not have ended up, meaning that the businesses now have to cut down on production and lay off people.
Speaking of incorrect information about demand, Norberg includes bond-rating agencies as culprits. After changes in government regulation required banks and investment houses to secure multiple ratings from the officially sanctioned firms – Moody’s, S&P, and Fitch – those firms responded to the changing incentives by treating bond issuers rather than bond buyers as their clients. They issued high ratings to increasing complex securities based on subprime mortgages, in a maneuver Norberg aptly calls financial “alchemy” – changing junk loans into gold.
The main alchemists, of course, were Fannie Mae and Freddie Mac, nominally private firms that were in reality massive government-backed political machines. They were both urged and forced by politicians into increasing their purchases of risky loans from banks that were, in turn, compelled to lend to less creditworthy households by Congress and by the threat of legal action by the likes of ACORN and the NAACP.
Which politicians enabled the ensuing financial fiasco? Just about everyone in Washington who exercised power during the housing and financial industries over the past two decades deserve some of the blame: Bill Clinton, George W. Bush, Andrew Cuomo, Henry Cisneros, Robert Rubin, Robert Bennett, Franklin Raines, Chris Dodd, Barney Frank – the list goes on and on. It also includes clueless economic commentators such as Joseph Stiglitz and Paul Krugman, who defended Fannie and Freddie and denied there was any systemic risk from all the junk loans they were buying.
Some of the culprits are now engaging in shameless demagoguery, trying to shift the spotlight away from their own foolish or nefarious deeds. Others are more apologetic, like former Freddie Mac CEO Richard Syron. Norberg quotes Syron as admitting that government had forced financial institutions to expand credit to households that couldn’t afford to own homes. Asked if there is anything he could have done differently, Syron replied, “If I had better foresight, maybe I could have improved things a little bit. But frankly, if I had better foresight, I would never have taken this job in the first place.”
There are some heroes in the story, people who saw the coming crisis and sought to head it off. They include Larry Summers, who served President Clinton at Treasury and now advises President Obama, and a few Republican members of the House and Senate. They sought to rein in Fannie and Freddie, reform perverse regulations, and limit the possibility of government bailout to increase market discipline on risk-taking behavior. They were ignored or attacked for their trouble, sometimes by the same morons now preening for the cameras.
Financial Fiasco is a carefully reasoned, brilliantly written little book that explains a lot of complex issues in very readable terms. It’s well worth your time.
Hood is president of the John Locke Foundation