Archive for October 9th, 2008
In reading the various analyses of the current economic state of affairs, one gets the sense that there is a lot of confusion, with no one really sure what the cause of the current crisis is, how deep it will become in terms of broad economic pain, or what the proper solution is. I believe that at a fundamental level the cause is psychological, or social-psychological. It is a kind of collective groupthink whereby people simply trusted “the system” and ignored all the warning signs that trouble was coming.
One common view is this: The current crisis was caused by home loans to people who couldn’t afford to buy houses, with entities like Freddie Mac and Fannie Mae being especially to blame. This, I believe, is only partially true. Without a property bubble, there is nothing wrong with the idea of expanding home ownership, and making it easier for low income people to get credit. The fundamental idea behind Freddie and Fannie isn’t necessarily bad. Home ownership has a positive impact on families, tends to promote economic responsibility, and can work to give people opportunities they would not otherwise have.
The problem came about because this morphed into a bubble. This meant in cities even basic home ownership became exceedingly expensive, and people who otherwise could have afforded a reasonably priced home (i.e., at actual value) either had to purchase a tremendously over-priced house, or were convinced that due to increasing values, they could afford a more luxiourous home. This wasn’t just due to government or Freddie and Fannie, but also aggressive efforts to convince people to refinance, take out a subprime loan, or see property as an easy money investment. All of that, of course, fed into the bubble.
The blame for that can’t easily be pinned solely on government, a political party, or even an economic philosophy. John McCain is wrong to focus on Freddie and Fannie, just as conservatives are wrong to fixate on Congress. However, Barack Obama is wrong to simply blame de-regulation, or the “Republican economic philosophy.” If only it were so easy to lay blame! What happened was a dynamic similar to the 1929 stock market bubble. People became convinced that the value increases were real, sustainable, and thus rational. The psychology of bubbles should not be understated. Bubbles induce behavior that in retrospect appears irrational because people get caught up in the illusion that things are as good as they seem. The house will go up in value in 2 years allowing one to refinance that subprime loan into a good fixed mortgage. The refinancing to get cash for a vacation, a boat, or home improvement does make sense, because the value of the house will increase.
Who do you blame for this kind of mass delusion? It isn’t just the government, or Wall Street, or big business. It isn’t an ideology or philosophy. The blame permeates every level. Mortgage brokers worked hard to convince skeptical clients that, yes, they could afford this house and the subprime loan would be no problem (indeed, they were counting on the money they’d earn refinancing down the line). But these brokers were part of a system where all that made sense, they believed they were helping people work the system to their advantage, and they were being given incentives by the big companies who would then buy these mortgages and bundle them into securities and use those as an investment. Since property values were rising, it could be seen as even a safe investment, one backed up by real property — secured rather than unsecured debt.
Why did people all buy this delusion? Well, let’s look at another argument, I’ll connect these shortly: The current crisis is unlikely to become a depression because unlike after 1929, we’re not going to undertake deflationary and protectionist policies. The argument being made is “don’t over-react,” the Great Depression was caused by a lot of really bad economic decisions after the crash, and while crashes and panics can be painful, they usually are not long term or extremely broad in their impact. The idea here is that once the credit crisis is taken care of and we go through a needed recession, we’ll start moving up again and this crisis will be more like 1980 than 1929.
That argument is accurate, but only to a point. What it ignores is that the economy of the last three decades has been on overdrive, with massive public and private debt piling up. The situation has been especially bad in the United States, where a shift from production to service helped engineer a debt-driven boom, with a negative savings rate, very low equity in property (thanks to refinancing), and increases in personal and government debt. That imbalance was sustained because of external factors: the willingness of the Chinese, Saudis and others to finance America’s binge, and allow our current accounts deficit to balloon to over 6% of GDP (it’s dropped a bit since then). Globalization, in other words, allowed the US to dramatically shift from being a net investor in the world economy to a debtor, creating unsustainable imbalances. This was a crisis waiting for a spark. Just as one can’t blame World War I on the assassination of Arch Duke Franz Ferdinand — political and systemic problems made war in Europe all but inevitable, the powderkeg just needed a spark — the housing bubble and credit crisis we now see is unleashing the consequences of ignoring economic reality.
At this point, I’m veering away from the current consensus. Most still see the credit crisis as containable, and are not ready to indict the fundamentals of the economic system that’s been driving growth and apparent prosperity for decades. I’m convinced that many economists and politicians are still caught up in the ‘collective groupthink’ that comes from trusting the system. Everyone has a reason to. From mortgage brokers, to people taking out a subprime loan to big banks like Lehman Brothers to politicians wanting to spend money to gain to supports to consumers running up credit card debt and beyond, people want to believe that the system works. Surely if it didn’t, someone would notice!
The Cassandras, however, have been vocal, but have not been listened to. Whether it’s Matthew Simmons warning about peak oil, or those economists warning about the long term consequences of a debt driven economy, it’s easier to simply buy the notion that the system works and should be trusted. The ‘gloom and doomers’ can be ridiculed, especially when the system seems resilient to crises, as it has for the past thirty years. And, of course, when something goes wrong, it’s easy to simply blame someone for screwing up. It’s the Democrats wanting minorities to buy more homes! It’s the Republican economic philosophy! It’s the greed on Wall Street! It’s the Federal Reserve Board! The system works, but someone in the system screwed up. Fix that, and the system will function good again. (Regulate more, or regulate less, etc.)
That blame game only allows people to hold on to the collective delusion a little longer. The reality is that the system itself was built on a kind of house of cards, and this crisis is, in my opinion, unlikely to be brief or shallow. The entire global political economy will need to rebalance and adjust. This will be especially painful for the US and Europe, as unsustainable debt and deficits will be fixed at a very high cost. A great depression? Probably not; as noted last week, the situation is far different from 1929. Yet it may hurt almost as bad.
The cause for all of this lies in the ability of pretty much every level of society, from government to home buyers, to trust a system that was, and remains, fundamentally flawed. Economic realities are ignored in favor of fantasy and economic myth. That can work for awhile — and bubble after bubble sustained it, as people found creative ways to avoid confronting the truth. But reality bites. Cassandra can be right.