Blame game for the financial crisis

David Blake at FT indicts Alan Greenspan's Federal Reserve for creating the housing bubble. While I would disagree with Blake's assertion that the Fed did not keep interest rates artificially low in the early 00's, his fundamental conclusion is sound. Greenspan's activist Fed, in a quest to manage the macro-economy (instead of just fighting inflation), helped create two massive asset bubbles (tech and housing) that subsequently deflated and hit the U.S. economy hard over the past 8 years.

Meanwhile, Kevin Hassert, a McCain economic advisor, blames the Democrats in a Bloomberg op-ed piece. He contends that Fannie and Freddie directly created the sub-prime mortgage market, which contained risks that remained hidden as long as home prices rose. But when prices fell, the systematic risk created by the securitization of this debt walloped the entire financial industry. Hassert blames Senate Democrats for holding up reform bills during 2005-2007, and calls out Obama for receiving $125,000 in campaign contributions from various Fannie and Freddie sources.

Putting aside the partisan blame (and I don't follow Congress enough to comment on the validity of Hassert's charge), these viewpoints seem like two sides of the same coin. We know from history that markets are susceptible to occasional asset bubbles; it can be difficult to establish prices for certain types of assets, especially in the face of new technologies or changing economic conditions. But this susceptibility didn't cause the crisis. Structural flaws in the housing market, created by Fannie and Freddie's efforts to separate the risk of sub-prime lending from the lenders themselves, were the underlying problem. And the Greenspan liquidity bubble fueled this dangerous habit, so much so that these dangerous securities, which were sold as "risk free," flooded the financial markets and created the systematic danger that has engulfed Wall Street in recent weeks.

Wall Street surely deserves some blame in this mess, but from where we now stand, it appears that Greenspan, Congress, Fannie, and Freddie are the culprits who distorted the market and added fuel to the fire.

What's really scary about this financial crisis...

What to say about the unfolding crisis on Wall Street? In the past two weeks, Lehman Brothers has gone bankrupt, and Morgan Stanley is looking for a buyer. But more earth-shaking is the fact that the feds have nationalized the mortgage market (Fannie and Freddie) and the nation's largest insurer (AIG). This quote from an article in Der Spiegel entitled "The World As We Know It Is Going Down" sadly says it all:

"I fear the government has passed the point of no return," financial historian Ron Chernow told the New York Times. "We have the irony of a free-market administration doing things that the most liberal Democratic administration would never have been doing in its wildest dreams."

Thoughts on the Fed trying to clean up its own mess

David Wessel of the WSJ has an excellent column today entitled "Ten Days that Changed Capitalism" that explains the significance of the recent steps undertaken by the Federal Reserve and Bush Administration to address the current financial crisis. To sum it up, Wessel quotes economist Ed Yardeni: "The Government of Last Resort is working with the Lender of Last Resort to shore up the housing and credit markets to avoid Great Depression II."

Wessel certainly makes some good points. It may be too early to tell how all of this will play out. While government involvement in the economy via the central bank or Treasury is generally undesirable and will most certainly have long-run unanticipated consequences, I am sympathetic to Fed Chair Ben Bernanke in one regard. He inherited a mess that his predecessor, Alan Greenspan, played a large role in creating. Greenspan's manipulation of interest rates following 9/11 caused a distortion in the free market, injecting excess liquidity that largely made its way into real estate and set the stage for a bubble.

In a way, it's deja vu all over again. As I wrote in my book The PayPal Wars, we saw the same drama play out eight years ago in Silicon Valley. Currency market "contagion" in the late '90s had been the catalyst for Greenspan's interest rate roller coaster, and tech stocks were the asset class that was taken along for the ride. That bubble burst as rates were rapidly jacked up by the Fed after it had concluded a period of aggressive cutting. Sound familiar?

Wessel makes the point that capitalism might be profoundly changed by this current crisis. And that seems possible. But can the Fed's policy of using interest rates in Keynesian fashion -- to "stimulate" the economy -- really be called a form of capitalism? It seems more like central planning than the Invisible Hand. But I doubt that any of the presidential candidates, and certainly not Hillary or Obama, will cite this crisis as a reason for less government meddling in the economy.

Americans oppose mortgage bailouts

A majority of Americans oppose federal assistance to homeowners who borrowed more than they can afford. A Rassmussen Reports survey indicated that 53% disapprove of Washington taking action, while 29% support it. Also, contrary to the liberal stereotype that conservatives favor big business, the poll suggests Republicans are more likely than Democrats (by 68% to 53%) to oppose bailing out the banks who made bad loans.

It will be interesting to see if this skepticism of federal handouts holds up should the mortgage crisis worsen. Over the past week, investment banks have averaged $32.9 billion per day in borrowing from the Federal Reserve's new emergency lending facility. No doubt Hillary and Obama will be ratcheting up their calls for command economy solutions to address the problem, but hopefully the American people will remain skeptical.