An economic boom based on nothing more than optimism

An excess of available credit inevitably leads to an economic collapse.  The events of the 2008 global financial crisis are evidence of this.  But easy access to credit can only exist in the absence of the perception of risk.  Our model of centralized banking has created a moral hazard in an otherwise efficient private sector.  They manipulate interest rates and allow reserve institutions to socialize their losses while at the same time keep their gains.

When an unemployed individual could get a zero down mortgage for over $500,000 on an already highly speculative property, alarm bells should have been ringing.  Such a person is unlikely to even be able to service the minimum monthly payments on their own, much less repay the mortgage.

Lenders being aware of this, often approved 125% cash back mortgages(based on optimistic estimates of the homes future value).  This way the borrower could use the extra funds to service the minimum mortgage payments for a couple of years and then either “flip” the home for a profit, or just walk away in some cases without recourse.  The banks bet on property values rising indefinitely and saw little risk involved in the transactions.

Of course we know how the story ends, but at the time it appeared everyone was a winner and U.S. GDP numbers reflected this.  For instance:

• The person selling the home pockets a hefty profit
• The realtor and mortgage brokers involved make a fat commission
• Wall street underwriters buy the mortgage along with hundreds of thousands of others like it, then repackage them into tradable asset backed securities
•  The ratings agencies make their cut by stamping these securities with a AAA rating
• Wall street brokers make fat commissions selling the repackaged debt to the market
• Banks purchase these AAA securities and receive fat dividends each quarter from holding these “risk free” assets
• The home buyer gets to live in their dream home with a hefty bank account balance from the “cash back” they received
• Retailers see their sales grow as this “new” money seeps from buyers bank accounts and floods into their cash registers
• Retail jobs are created as stores hire additional staff to keep up with consumer demand
• Developers rake in windfall profits and can’t build malls and retail outlets fast enough to keep up with demand
• Stock markets soar as homeowners “invest” their new wealth seeking greater returns

Of course this is an over simplified example, but it illustrates the typical cycle we saw during the real estate boom.  This cycle continued for several years as borrowers and lenders took on ever increasing amounts of debt, all the while reporting significant increases in their wealth(on paper anyway).  But it only tells half of the story.  A silent partner working behind the scenes made all of this possible.

The Silent Partner

The Federal Reserve was created in 1913 with the enactment of the Federal Reserve Act, largely in response to address a series of financial panics.  It’s evolved into its present day role which is to conduct the nation’s monetary policy, supervise and regulate banking institutions, maintain the stability of the financial system and provide financial services to depository institutions, the U.S. government, and foreign official institutions.*Courtesy of Wikipedia

Perhaps the least understood role of central bankers is their indirect influence on the free market economy and its economic cycles.  Based on theories developed in the early 1900‘s by John Maynard Keynes, modern day Keynesians believe that the free market can’t function efficiently on its own.

They prescribe regular doses of government intervention, administered by a small panel of “experts” looking down from an ivory tower.  With methods about as reliable as consulting tea leaves, they decide when an economy is expanding too rapidly or contracting too severely and adjust monetary policy accordingly.

Keynes was a free thinking and somewhat eccentric intellectual, with overall rather fragmented logic.  He became famous for his fresh ideas on the stale subject of economics.  Armed with an above average intellect, he often publicly humiliated those who dared challenge his ideas.  He was a force to be reckoned with, garnering the respect of the most powerful influencers of his time.  He soon became an authority on economic policy.

Arguably one of the most influential economists of our time, he pioneered the field of macroeconomics.  But while many of his ideas appeared brilliant in theory, they often proved to be quite flawed in practice.  Keynes regularly contradicted himself throughout his career, even publicly refuting his own theories at times.

Despite the flaws in his theories, many of Keynes ideas are still practiced in modern economic policy.  The idea of a panacea for all financial woes continues to prove irresistible to policy makers and politicians.

The Federal Reserve and government policies created a moral hazard in an otherwise efficient free market economy.  By lowering and holding interest rates too far and for too long, they fueled speculation in leveraged investments.  In addition, policy supporting home ownership distorted an otherwise reliable risk/reward system of checks and balances in the financial sector.  We are living through the consequences of this self imposed economic crisis.  Some say we’ve averted a depression, but I fear we’ve simply postponed it.