Saturday, November 15, 2008, 1:34 PM
After we talked a little about the economy on my birthday, I thought it would be helpful for me to write down my understanding of what has been going on for you. I also wanted to do this for myself to help organize my own thoughts. I was hoping to just do a quick write-up, but it turned into a 20-page essay that gets into a lot more detail. I tried to keep it non-technical without dumbing it down. I was also hoping to get into some predictions and investment advice, but I think 20 pages is long enough. I’d be happy to share my advice with you after you read this essay. Feel free to pass it on if you think anyone else would like to read it.
See you tomorrow!
Explaining the Economy to Dad
November 15, 2008 (Dow 8,497)
In order to understand what is happening in the economy right now, it is important to have an understanding of economic principles and history. Far from being a “natural,” emotional market cycle, this crisis is the direct and inevitable result of a fraudulent monetary system forced upon the world by their governments and banks. This broad manipulation of economic activity has been further aggravated by more specific governmental interventions in many markets, most notably the housing market. This essay is divided into four sections: Economic Principles, History, The Housing Bubble, and End Game. The first two sections explain the general causes of the current downturn, and the second two sections chronicle the specific events that have resulted from those causes to lead to the present situation.
Economic principles: Money
“Money” should be defined as the most commonly traded commodity in any given society. Barter without money is difficult because, for example, if a fisherman wants a loaf of bread and the baker doesn’t want fish, the fisherman has to trade his fish for some intermediary good that the baker wants. Most societies through history have found some commodity that can be traded broadly, whether it’s gold, silver, shells, crops, seeds, tulip bulbs, tobacco, cigarettes (in prison), etc. Throughout history, many societies have relied on gold and silver for money because they are durable, divisible, homogeneous, difficult to counterfeit, and tend to be valued consistently over time. An ounce of gold in ancient Rome could buy a nice toga, and an ounce of gold today can buy a nice suit.
Economic principles: Fractional reserve banking
In many gold based societies, many people have relied on banks (or goldsmiths with vaults) to store their gold for them. This is great if it is treated like a warehouse, and the money stored there stays there. However, banks have realized that their customers rarely take all of their money out at once. Unscrupulous banks have often chosen to lend out a fraction of the depositors’ money stored at their bank to earn interest on it. (Note that these are demand deposits, not “investments” that the depositor willingly puts at risk of loss or deferred payment for the bank to lend). The fraction of bank reserves that they lend out is determined by their confidence in the amount of money they think their depositors are likely to withdraw at any given time. When depositors discover that their bank is engaging in fractional reserve banking with their deposits, there can be a run on the bank where everyone tries to get their money out before everyone else does, since there is not enough money in the bank to pay back everyone. It should be clear that fractional reserve banking is a completely fraudulent activity.
Economic principles: Money supply and prices
The supply of money in a society is simply the amount of the money commodity (i.e. gold) owned within that society. Prices are determined in large part by the money supply. If the amount of gold owned in a gold-based society doubles, with other factors remaining the same, all of the prices in the economy can be expected to double. The money supply of gold tends to increase slowly and steadily since it needs to be mined and minted.
However, the recorded money supply under fractional reserve banking can be extremely erratic. Here’s an example:
There are three people on an island, a Buyer, a Seller, and a Bank, who use seashells for money. The Seller owns 100 seashells and all of the mango trees on the island. The Buyer and the Bank each own nothing. The Bank convinces the Seller to let him store his seashells for safekeeping, and the Bank believes that the seller will never take more than 10% of his seashells out at any given time (this 10% is the “reserve ratio”).
Once the Bank gets the 100 seashells, he keeps 10 shells (10%) and lends 90 shells to the Buyer. The Buyer uses the 90 shells to purchase a mango tree from the Seller. The Seller then deposits these 90 shells in the Bank, so that he now has a recorded balance of 190 shells with the Bank. There has been no increase in the actual number of shells on the island, but the money supply is perceived by all to have increased by 90%.
The Bank then keeps 9 shells of this new deposit and lends out another 81 shells to the Buyer. He buys another tree, the Seller deposits the 81 shells, and his balance increases to 271 shells. This cycle continues until the money supply is perceived to have increased by 1/0.10 (the inverse of the reserve ratio), or ten times the initial deposit, to 1000 shells, even though there are still only 100 shells in the bank. One day the Seller will ask to withdraw 101 of his 1000 shells. The bank will gladly pay him 100 shells and go out of business.
This example is overly simplified, but it shows how fractional reserve banking creates a “multiplier effect” on the money supply. If the bank decreases its reserve ratio, the money supply recorded as deposits will increase. If it increases the reserve ratio, recorded deposits will decrease. Since banks want to lend out as much money as possible to earn interest, it is in their interest to try to maintain as much confidence as possible among their depositors that the money is in the bank (even though it isn’t). For this reason, frequent bank runs are an important way to minimize fraudulent fractional reserve banking, by convincing other banks to raise their reserve ratio. A bank that does not engage in fractional reserve banking has nothing to fear from a bank run.
Economic principles: Bank notes
In a gold-based society, it is often inconvenient to carry around coins for purchases. Instead, banks can give their depositors paper receipts, or bank notes, that can be redeemed for the amount of gold they have deposited. Depositors can then trade these receipts with other people instead of the coins themselves, as long as everyone trusts their bank to be able to redeem their bank notes in gold. As long as the amount of bank notes a bank creates does not exceed the amount of actual gold reserves, bank notes are a perfectly legitimate and useful function of banks.
However, bank notes make it much easier for a bank to engage in fractional reserve banking. If a bank run occurs, a bank can temporarily shut its doors, print the amount of bank notes required to pay for all of its recorded deposits, reopen, and hand everyone their bank notes with a smile. As long as depositors don’t demand the actual fraction of gold held in reserve, the bank will be able to continue operating.
Over-printing bank notes is also restricted by competing banks. For example, some bank notes created by Bank A will be deposited in competing Bank B. Bank B may then ask Bank A to redeem these notes in the actual gold, in order to increase their own gold reserves. Bank A will soon see its gold reserves depleted to nothing by competing banks, unless it increases its reserve ratio and prints less bank notes.
Economic principles: Central banking
Fractional reserve banks have attempted to avoid these two restrictions of bank runs and competitive reserve depletion by forming a cartel with their competitors known as a “central bank.” This is an agreement among several banks to deposit a fraction of their gold reserves in a central bank, which they each own a share of. Instead of the individual banks creating their own bank notes, the central bank prints bank notes for all of the banks to distribute. The banks give the central bank the authority to establish a minimum required reserve ratio for all banks. The central bank often has other powers to provide money to banks in case they are at risk of a bank run, such as facilitating borrowing between banks and directly lending money to banks.
This tends to allow all of the banks to operate with the same reserve ratio, which removes their problem of reserve depletion from competing banks. It also makes bank runs less frequent, since a run on the entire banking system is less likely to occur than a run on any single bank.
Central banks are always granted special privileges by their governments. These can include laws that force all banks to join the central bank, “legal tender” laws that require all contracts to use central bank notes, requirements for taxes to be paid in central bank notes, taxes on buying and selling of gold. It can also include “emergency” measures such as prohibiting people from withdrawing their own money during a bank run. Governments may also appoint officials to the central bank or run the central bank outright.
It’s worth noting that when multiple central banks exist around the world and hold gold reserves, they are able to keep each other in check through competitive gold reserve depletion similar to competing banks.
Economic principles: Paper money
Once people have gotten used to using bank notes instead of actual gold, it is possible for banks to drastically lower their reserve ratio of gold, since depositors rarely redeem their notes in gold. People begin to perceive the bank note itself as money, not just a claim to real money (gold stored at the bank). As noted above, there are still reasons for competing banks to maintain gold reserves to redeem their own bank notes. However, if banks are joined in a central bank cartel and distributing only central bank notes, then everyone will use the same bank notes, the perception of central bank notes as money will be much stronger, and redemption in gold will be almost non-existent.
Once this perception of paper bank notes as real money is established, the central bank can declare that its bank notes can no longer be redeemed for the amount of gold written on it. Bank notes can be redeemed only for bank notes. If this is successful, it becomes possible for the central bank to reduce its reserve ratio of gold to 0%. This means that the central bank is free to print as many bank notes as it desires, with no regard to the underlying gold or other assets it holds in reserve. The central bank may still require individual banks to hold its paper money as a minimum required reserve ratio, since it is still possible to have a run on the bank for paper money.
Economic principles: Paper money creation
If the central bank decides to create money, all it has to do is write a check to purchase something in the economy. Central banks typically purchase gold or government bonds, but they could purchase stocks, real estate, oil, or anything else in the economy. The person they purchased the item from deposits the check in his bank. The bank sends the check to the central bank for redemption. The central bank then simply increases the recorded amount of that bank’s reserves by the amount of money on its check. This is money created out of thin air, since the central bank’s reserves have not been reduced.
Here is an example: Bank A has 10,000 dollars of reserve deposits recorded at the Central Bank, and a 10% required reserve ratio. The Central Bank wants to add 100 dollars to the money supply. It writes a check to buy 10 dollars worth of gold. The seller of the gold deposits the check at Bank A. Bank A then sends the check to the Central Bank for redemption. The Central Bank crosses out the number 10,000 on Bank A’s balance and writes down 10,010. Since Bank A’s reserves have increased by 10 dollars and it has a 10% reserve ratio, Bank A then lends out 100 dollars into the economy. The Central Bank created the 10 dollars out of thin air, and Bank A multiplied this to create 90 additional dollars out of thin air through fractional reserve banking.
Why does the central bank want to create money in this way? It is for the same reason that counterfeiters want to create new money, and counterfeiting is really what they are doing. The first person to spend new money gets the most benefit from that money. It takes time for prices to rise in response to increases in the money supply as the new money is spent across the economy. This means that the banks who make the initial loans, the borrowers who receive them, and the sellers of homes, bonds, or other goods who are paid with the new dollars all benefit. Everyone else in the economy loses out, since the dollars they are holding decrease in purchasing power as prices rise.
The reason that governments grant privileges to central banks is that the majority of central bank purchases are government bonds. When governments want to raise money, they can either collect more taxes, reduce spending, or issue bonds to borrow money from people. If they issue too many bonds, they will have to raise the interest they pay for these bonds to convince people to keep buying them. However, when the central bank can create money out of thin air to buy the bonds, the government can keep issuing the bonds without raising their interest payment. The government is the first recipient of the new money, so they get the most benefit from spending it. However, the new money eventually causes prices to rise, which results in a hidden “inflation tax” on everyone else. This inflation tax is most detrimental to people with low-income or fixed incomes whose incomes cannot be inflated to match the rising prices.
Economic principles: Interest
When someone earns money, they choose to either spend it at that time or save it to spend at a future time. The money that they save can either be held as cash or loaned to other people in hopes of earning interest on it. Interest is simply the price of “renting” the money over time. As people decide to save and loan more money, interest rates tend to fall. As people decide to spend more money or hold cash, interest rates tend to rise. Similarly, interest rates tend to rise when borrowers want more money and fall when they want less money.
Economic principles: Production and interest rates
Economic conditions are constantly changing in response to changes among individuals, societies, and the physical world. Entrepreneurs make guesses about what resources and products will be valuable in the future, and take risks investing money to produce these goods. If they are correct, they earn a profit and can expand their production of these valued goods. If they are wrong, they lose their investment and must sell off the resources they have been using to other people who can put them to more productive use.
Production processes take time to complete before producers are able to sell their products to earn money. This means that they must rely on saved money to pay for expenses until they can be paid. This saved money can be their own or money borrowed from other people who have saved.
When interest rates are low, it becomes profitable to borrow money for a longer time to engage in production processes that will take a long time to complete before they can produce final products. Mining, building factories, and producing manufacturing equipment are examples of these types of longer production processes. The profitability of these processes due to low interest rates is appropriate since the cause of the low interest rates is a reduction of current spending. The low interest rate sends a signal through the economy that people are not ready to buy final products yet, so they are willing to wait for longer production processes to be completed. Once these processes are complete, buyers will have enough money saved to purchase the products these processes produce.
When interest rates are higher, longer production processes become less profitable, and those activities are reduced. However, the reason interest rates are higher is that more people are spending money on final products instead of saving. This makes the production of final products such as cars, iPods, and clothes more profitable when interest rates are high. The high interest rate sends a signal that resources in the economy should be shifted away from longer production processes to production processes that result in more immediate sales.
This is a bit complex, but the simple point is that interest rates are important to the economy because they give entrepreneurs signals about what types of production are most appropriate based on people’s current spending and saving habits.
Economic principles: The business cycle (booms and busts)
At any given time, some entrepreneurs will be successful and some will be failing, and these tend to balance each other out as the economy adjusts to changing conditions. However, there are some times when almost everybody seems to be succeeding (a boom) and other times when everybody seems to be failing (a bust). This shifting between booms and busts is known as the “business cycle.” How is it possible for so many bad entrepreneurs to remain successful during a boom, and for so many good entrepreneurs to fail during a bust?
As long as interest rates are allowed to move up and down naturally to match peoples’ saving habits, entrepreneurs tend to be able to adjust their production appropriately between long term and short term processes.
However, if interest rates are manipulated to be artificially lower than the “natural” interest rate based on savings, entrepreneurs will tend to increase their spending on longer-term processes even though people have not reduced their spending on final products produced by shorter-term processes. The result is an excess of spending on both long- and short-term production processes. Since everyone is spending money on everything, this appears to be a boom in which everyone is making good investments. However, the reality is that many of these investments are bad investments that are not yet apparent. An example of a bad investment is building a new automobile factory to produce more cars when people have not saved enough to be able to buy the cars once they are completed. The longer that interest rates remain artificially low to prolong the boom, the longer it takes for the bad investments to be discovered and corrected.
Similarly, if interest rates are manipulated to be artificially higher than the “natural” interest rate based on savings, entrepreneurs will tend to increase their spending on shorter-term processes even though people have not increased their spending on final products produced by these short-term processes. Entrepreneurs will reduce their spending on long-term processes, while at the same time people have reduced their spending on final products in favor of saving. Since no one is spending money on anything, this appears to be a bust in which everyone is making bad investments. However, the reality is that investment in longer-term processes are needed to start producing things that people will eventually buy with their saved money. The longer that interest rates remain artificially high to prolong the bust, the longer it takes for entrepreneurs to start making necessary long-term investments.
Economic principles: Manipulation of the interest rate
How is it possible to manipulate the interest rate, and why would anyone want to do it? The interest rate is based on the amount of money being saved in the economy, since this is the “supply” of money that can be loaned out. The majority of cash savings are held as deposits in banks. When banks and the central bank create new money out of thin air through central bank purchases and fractional reserve banking, the supply of saved money in banks increases. As this supply of lendable money increases, the price of borrowing the money (the interest rate) tends to go down. However, since this drop in the interest rate is due to an artificial increase in the amount of savings, it is an artificial manipulation of the interest rate that does not reflect peoples’ actual preference for saving.
The reason the central bank wants to lower interest rates by creating money is so that the banks can all make more money through fractional reserve banking. Government wants the central bank to lower interest rates since the new money is used to buy their bonds. Homebuyers and sellers want the central bank to lower interest rates to make mortgages more affordable. Businesses want the central bank to lower interest rates because it creates the “boom” in which more business activities appear to be profitable.
Economic principles: “Austrian” economics
But what about the “bust”? Why don’t experts in the banks, central banks, government, and businesses realize that the boom created by the central bank is artificial? Why can’t they avoid the inevitable bust? The problem is that if you have read this much of this little essay, you have a better understanding of economics than almost all of those experts. Economics is a social science with different and sometimes contradictory schools of thought. The explanation of the business cycle given above is known as the “Austrian” theory of the business cycle. It was developed by a group of economists known as the Austrian school of economics (its originators were from Austria). Austrian economics were developed in the early 20th century and gained some popularity after its proponents correctly predicted the bust that started the Great Depression.
The Austrian solution to the bust is for central banks to stop creating money and for governments not to intervene in the economy. This will allow the resources tied up in bad investments during the boom to be sold off to entrepreneurs who can put them to more productive use. The result will be a sharp but short recession, followed by a productive recovery.
However, other schools of thought quickly became more popular in the chaos of the Great Depression. The solution of doing nothing and putting an end to the pyramid scheme of the banks and government printing money was not satisfactory to anyone benefitting from these practices. Other schools of thought say that the boom and bust cycle is just a natural part of free market economic activity, and that it is necessary for the central bank to print more money and for the government to regulate and spend money to keep the boom going indefinitely. To them, the boom and bust cycle is due to irrational societal emotional swings between greed and fear. Economists who make these rationalizations for the corrupt activities of central banks and governments believe that they can “manage” the economy to boost growth and reduce unemployment. The idea that any one person or group of people can be capable of knowing everything that is happening in the economy at any given time, know what is best for the economy in the future, and be able to act quickly and broadly enough to manipulate it with a positive outcome, is absurd on its face. The notion that they can achieve this through the corrupt practices of paper money and fractional reserve banking is despicable. Yet this is the dominant mindset among the “experts” in banks, businesses, governments, and the education system.
History: Governmental manipulation
Throughout history, governments have tried to control the money supply to their advantage. Kings minted coins and prohibited private minting of coins. When they wanted to raise money without taxing, they would shave the edges off of coins (some coins have ridges on the edge to prevent this) or confiscate all of their coins to be melted down and minted with less weight or less purity, but the same face value. Some governments experimented with paper money, but these experiments always failed as people rejected the paper in favor of holding real gold and silver coins. Gold tended to be used as the primary currency for regional and international trade through much of history.
Banking began to become widespread in the middle of the 18th century, along with the fraudulent practice of fractional reserve banking. This coincided with the spread of the Industrial Revolution. While booms and busts occurred prior to this time, they were often caused by observable factors such as wars, natural disasters, or government actions such as confiscating coinage, creating monopolies, or prohibiting trade. However, as fractional reserve banking spread, booms and busts began to occur in a cycle without an observable cause. People came to believe that this cycle was an inevitable result of the technological change and rapidly expanding market economy of the Industrial Revolution. Economists and governments tried to find ways to manage the cycle.
The first central bank was the Bank of England, created in 1690. Other European nations created their own central banks over the next century. After a paper money called the “Continental” issued by America’s Continental Congress during the Revolutionary War became completely worthless, Americans were skeptical of a central bank and its paper money. In their Constitution they restricted the new federal government’s power over money to the minting of silver and gold coins. The topic of a central bank was hotly debated throughout the next century. A central bank was established before the Civil War, and its ability to print money was used to fund the United States army’s adventures in the Confederate States (who printed their own paper money). After these paper moneys became worthless, the central bank was dissolved, and the United States remained on a gold standard with independent banks for much of the last half of the 19th century. This was arguably one of the most productive periods in U.S. history.
History: The Federal Reserve
After a series of booms and busts around the turn of the century, a group of bankers and politicians led by a banker named J.P. Morgan gathered at his private club on Jekyll Island to develop a plan for a central bank. In 1913, the Federal Reserve Act was signed into law. This created a series of regional reserve banks of which each member bank owned a share. The regional banks were governed by a Federal Reserve board with members appointed by the federal government. Banks were required to maintain a minimum reserve ratio of gold and to store their required reserve gold with the regional reserve bank instead of in their own vaults. Banks had to use Federal Reserve Notes instead of issuing their own bank notes, and the federal government passed “legal tender” laws requiring these notes to be used to pay all debts, public and private. The “dollar” had previously been established under the gold standard as a bank note redeemable for 1/20th of an ounce of gold. The new Federal Reserve Notes adopted the “dollar” as their unit of measure, with 20.35 Federal Reserve dollars redeemable for an ounce of gold.
History: The Great Depression
In the 1920’s, the Federal Reserve increase the money supply by 62% from 1921 to 1929. This created a euphoric boom that ended in the middle of 1929 and inspired a spectacular crash on October 29, 1929, which began a decline in the U.S. stock market to 89% below its previous high by 1932. There were widespread bank runs in which thousands of banks failed. The Fed soon began trying to create new money to re-inflate the previous boom. However, their efforts had little effect as people took cash out of the banking system and banks held excess reserves to protect against further runs, which reduced the “multiplier effect” of fractional reserve banking. In addition, foreign central banks redeemed dollars that they received through international trade for gold. As the Fed tried to inflate, foreign central banks reduced the Fed’s gold reserves, similar to the process that occurs among competing banks. With less gold reserves, their ability to create new money became increasingly difficult. This reduction in the money supply combined with an excess supply of goods and equipment that had been created during the boom resulted in falling prices and wages.
The U.S. government took extreme actions, usually with disastrous results that prolonged the depression by preventing resources from being reallocated from failed investments to productive products. These included “bank holidays” in which depositors were prohibited from withdrawing their money from banks. In 1933, the ownership of gold by individuals was prohibited, although by this time few people still held gold. Once the gold was confiscated, the government announced that the dollar was now worth 1/34th of an ounce of gold rather than the previous 1/20th, an instantaneous 70% reduction in the value of the dollar. The government also created the FDIC, which holds a tiny amount of money in reserve to “insure” bank deposits in the event of a bank failure. Government borrowed money from investors through bond sales to spend on infrastructure projects, and the favorable bond rates diverted investment away from business investment, delaying the market’s recovery. Tax rates as high as 94% further reduced incentives to invest for profit. An example of the more deplorable government actions was a requirement for farmers to plow under half of their crops and slaughter half of their livestock in an effort to raise agricultural prices, at a time when many thousands were going hungry. A similar approach was taken to the problem of unemployment, in which thousands of working-age men were drafted into the military and sent to the slaughter in Europe’s most recent war.
History: World War II and post-war rebuilding
The U.S. remained one of the only industrial economies not destroyed by war. The government tightly controlled the distribution of resources to produce armaments and other supplies for the Allied armies, and the consumer economy continued to suffer through the war. During the war and in the rebuilding efforts that followed, the U.S. sent dollars to European nations and Japan in foreign aid packages, in exchange for some of their gold which by that time was viewed as having little real value. Gold flowed into the Federal Reserve, and the aid dollars flowed back into the US economy as the foreign nations purchased American goods and materials to rebuild their infrastructure. As wartime controls were lifted and government programs established during the Depression were overturned by the Supreme Court as unconstitutional, the U.S. economy was finally able to recover and become globally dominant as a manufacturer and exporter of products.
By the end of the 1960’s, many European nations had successfully rebuilt their economies and did not need to continue purchasing as many American goods, even as the U.S. government continued sending dollars in aid to them. France began demanding gold in redemption for their aid dollars at the price of $34 per ounce (which had never been changed since 1933 despite massive dollar creation) and the Fed’s gold reserves began dropping. In 1971, Nixon announced that dollars were no longer redeemable in gold, while at the same time making it legal again for individuals to own gold. This was the final transition from a gold-backed dollar to a paper money redeemable only for more paper money. Many European nations were already on a paper money standard, as several of them had gone off the gold standard to print money to fund their war efforts in both World Wars. Instead of gold, foreign central banks held U.S. dollars as their reserve currency, along with U.S. bonds and other assets.
History: The paper money experiment
With gold no longer restricting the creation of dollars, the Fed greatly expanded the money supply during the 1970’s, creating massive price rises despite a slow economy. This “stagflation” puzzled economists who believed that it was always possible to create new money to stimulate productive growth. A new Fed chairman named Paul Volcker at the end of the decade reversed policy and allowed interest rates to rise into the double digits. This was not enough to reduce the money supply, but it slowed the rate of expansion and allowed prices to fall. A Mexican banking crisis led Volcker’s Fed to reverse policy back to further inflation of the money supply starting in 1982, which produced a boom that ended in a stock market crash in 1987.
In 1987, Alan Greenspan became the new chairman of the Federal Reserve Board. He had once been a strong supporter of a gold standard and its ability to restrict money creation. However, as Fed chairman he quickly became known for his willingness to print money at any sign of a downturn to keep the boom going, after pumping money in response to the 1987 crash. His frequent expansions of the money supply created a boom throughout the 1990s that boosted investment in technology and housing. While many economists claimed that this was a new era of limitless progress made possible by the internet, Austrian economists predicted that the “Tech Bubble” would soon burst, which it did in 2000. After the start of a recession followed by the attacks of September 11, 2001, the Greenspan Fed dropped their Federal Funds Rate to the extremely low rate of 1% (this is the rate at which banks borrow from each other overnight). This reinflated the boom with new money pouring into the housing industry, as well as new financial instruments based on home mortgages. Greenspan retired in January 2006, leaving an overinflated time bomb of an economic boom for his successor, Ben Bernanke.
THE HOUSING BUBBLE
The housing bubble: Government causes
In the early 20th century, personal homeownership was much less common than it is today. Lenders had established requirements for borrowers such as reliable income, a 20% down payment, a record of good credit, and simply getting to know the borrower. Such measures protected lenders from defaults and falling house prices, but there was a limited number of people able to meet these qualifications.
During the Great Depression, the federal government created two departments known as Fannie Mae and Freddie Mac to purchase more risky home loans from banks in an effort to boost the housing market. This allowed banks to relax their lending standards and lend to more people who were less qualified, resulting in an expansion in homeownership that fueled the postwar growth of suburbs. Fannie Mae and Freddie Mac were later converted to private stockholder-owned companies, but there was always a broad assumption in the market that the government would bail them out if they were ever in trouble. With this implicit guarantee, Fannie Mae and Freddie Mac were able to raise money by selling bonds at very low interest rates, and use that money to purchase mortgages from banks and other lenders.
In the 1970’s, some people began accusing lenders of racism, since they tended to give more loans in more wealthy neighborhoods that tended to be more populated by whites than in poorer neighborhoods that tended to be more populated by African Americans and other minorities. Some banks had a policy of “redlining” certain neighborhoods in which they would not consider giving mortgages. While it is possible that there was some institutional racism at some banks, the reason for redlining neighborhoods was that loans in those neighborhoods tended to be too risky for the banks, either because of falling property values or a higher risk of defaults from their lower-income inhabitants. Nevertheless, in 1977 the federal government passed the Community Reinvestment Act which forced banks to take on more risky loans in neighborhoods deemed to be racially preferable by politicians.
In 1991, the Federal Reserve Bank of Boston issued a report that used flawed data to show that lenders were still being racist in their loan practices. In reality discrepancies in loans were due to the familiar risk-management metrics of a down-payment, income, good credit, and reliable property values. However, nearly every governmental department called for change and increased pressure on lenders to make more risky loans. Fannie Mae and Freddie Mac reduced their lending standards further. With guarantees from Fannie Mae and Freddie Mac, fear of lawsuits or bad public relations from government and community organizations (such as ACORN, a group Barack Obama was associated with), higher potential profitability from more risky loans, and easy money from the Greenspan Fed, lenders were left with little rationality in maintaining their traditional risk-management practices. These more risky loans are known by the now familiar label of “sub-prime” loans.
The housing bubble: Market effects
To fulfill their requirements for more risky loans, lenders developed new lending practices such as “no documentation” loans that did not require proof of income, “piggyback” home equity loans that reduced or eliminated the need for a down-payment, “interest-only” loans that reduced initial monthly payments, “adjustable-rate mortgages” that provided a lower interest payment for a fixed period of time but fluctuated with the market after that time, “option” mortgages that allowed the borrower to choose how much to pay each month, and “negative amortization” mortgages and home equity loans that allowed borrowers to take on more debt with the equity of their house as collateral. Many of these “innovations” were developed for low-income sub-prime borrowers to comply with regulatory pressure from federal and state governments, but they soon spread to the broader prime mortgage market. Many of these are perfectly valid loan instruments that can benefit the right borrower and may reduce short-term risk, but they often increase the risk of the loan over a longer term. Governments and lenders alike celebrated these “innovations” and their ability to bring about more “equal opportunity” in home ownership.
Lenders also found ways to disperse the risk of their loans to third parties in the marketplace. They continued to resell loans to Fannie Mae and Freddie Mac. They began to group low-risk and high-risk loans together in bond packages called “mortgage-backed securities,” which were purchased by investors and money market funds. Purchasers of mortgage-backed securities would often buy a type of insurance policy called a “credit default swap” which would pay them back if the mortgage-backed security lost value due to loan defaults. This dispersion of risk away from the lender changed the role of the lender from a real risk evaluator to a simple loan retailer with little interest in the longer-term loan risk.
The housing bubble: Leverage
“Investment banks” raise money from investors to invest in the market, which differs from “commercial banks” who steal money from depositors to lend out in the market. The Securities and Exchange Commission, which regulates investment banks, had previously established a ratio of 12:1 for the amount of debt and obligations investment banks could take on relative to their initial investments. This ratio is called “leverage,” and it differs from a commercial bank’s reserve ratio, which is the amount of debt a commercial bank can take on relative to the amount of other peoples’ deposits they hold in reserve. For example, a homeowner who puts down a 20% down payment on a house and takes out a loan for the other 80% has leverage of 5:1.
Investment banks, hedge funds (super-exclusive mutual funds with minimal regulatory restrictions), and others who purchased home loans through mortgage-backed securities or other means had developed complex financial computer models to help them evaluate their own risk. These models were able to show how they could take on much more debt and other obligations to increase their profitability, while maintaining their risk at tolerable levels. On April 28, 2004, the five major U.S. investment banks (Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley, and of course Goldman Sachs with then CEO Henry Paulson) met with the S.E.C. to request that the 12:1 leverage requirement be removed since they were now able to better evaluate their own risk through their computer models than the S.E.C. was. The S.E.C. agreed, and these investment banks soon began increasing their leverage to as high as 40:1 or higher. This is the equivalent of putting a 2.5% down payment on a house. This is very profitable when the market is going up, but it only takes a drop in the market of 2.5% to wipe out all of the equity.
There is nothing wrong with investment banks taking on risk, as long as they are allowed to fail when the risk turns against them. However, these banks were all believed to be “too big to fail,” meaning that people believed the government would bail them out if they ever got into trouble. This removed the fear of loss as a check on the amount of leverage they took on.
Apparently none of these risk modelers believed that housing prices could ever drop significantly for an extended period of time, since they hadn’t since the Great Depression. Investment banks and hedge funds created and purchased mortgage-backed securities and other loan instruments with high leverage. This fueled the expansion of home loans, reduced homeowners’ borrowing costs and requirements, and directed much of the Greenspan Fed’s newly created money into the housing market. Home prices rose by double digits, homebuilders expanded their supply of new homes, and speculators purchased multiple homes in hopes of “flipping” them at a profit. Ben Bernanke, the vice-chairman of the Fed under Greenspan, declared in 2005 that there was no housing bubble and that economic conditions were better than ever. Bernanke became chairman of the Fed when Alan Greenspan retired in January 2006. Ironically, the mistaken belief that home prices would never drop helped to create the oversupplied conditions that necessitated not only a brief drop, but a long crash.
End game: Housing market downturn
The national housing market peaked in 2006 with asking prices at record levels above peoples’ income. Even with all of the easy credit available, people had finally reached the limit of their desire to take on debt. Fewer sales resulted in more homes on the market for longer periods of time, and sellers had to begin dropping their prices in order to make sales. The areas that had increased the most during the housing boom, such as California and Florida, now saw their prices dropping as quickly as they had risen. People with low equity soon found themselves “upside-down” on their mortgages, owing more on their mortgage than the house was worth. In addition, adjustable-rate mortgages that had established a low fixed 5-year interest rate around 3% in 2001 began “adjusting” to the current interest rates around 6%. This meant a doubling of monthly payments for many new homeowners. With no equity and increased payments, more people began selling their home to get out of debt, defaulting on their loan payments and being foreclosed, or sending “jingle mail” to their lender – an envelope with the keys in it. All of this increased the supply of homes for sale and pushed prices lower, causing more loss of equity and debt problems in a downward spiral of defaults and falling prices. People who had been promised an equal opportunity for homeownership now had an exceptional opportunity for bankruptcy and poverty.
The increase in default rates began to reduce the value of mortgage-backed securities and other loan instruments on the market. “Mark to market” accounting rules required financial firms to record the value of their investments based on the current market price to sell them, rather than a calculation of the expected longer term value. As home loan investments began dropping in value, it became more difficult to resell them on the market and the market prices fell. Everyone had to mark down the value of their loan investments at these lower prices, showing a loss on paper. Since many financial firms had purchased these loan instruments with high leverage, small losses in their value resulted in large losses to the firms.
End game: Financial collapses
By the beginning of August 2007, the Dow Jones Industrial Average had risen to record highs just under 14,000 points. On August 3, 2007, these pressures caused the market for mortgage products to freeze up, with no one willing to purchase lower-quality mortgages. Countrywide Financial, one of the nation’s largest lenders, had previously been celebrated by government and the market for its innovation and diversity in subprime lending. On August 10, 2007, there was a good old-fashioned run on the bank by Countrywide depositors and investors and its stock plummeted days later. The Fed, which had slowly raised interest rates since 2001 and kept them unchanged for the previous year, began dropping them again to reinflate the bubble. Countrywide was able to raise funds from investors including Bank of America, but by the end of the year they were facing bankruptcy and were purchased in full by Bank of America on January 11, 2008.
The problems that Austrian economists had identified years before should have been apparent to “expert” economists and investors by this time. However, the Dow continued to trade above 13,000 for the rest of 2007, and above 12,000 for the first 6 months of 2008. On March 14, 2008 there was a “run” by investors withdrawing investments from Bear Stearns, one of the big five investment banks, which had leverage as high as 30:1 on many mortgage-based investments. Over the weekend the Fed arranged a sweetheart deal for commercial bank J.P. Morgan to purchase Bear Stearns, with the Fed guaranteeing some of Bear Stearn’s bad debt. While some described this as a “bailout” of Bear Stearns, it was more likely a bailout of J.P. Morgan which had many contracts with Bear Stearns that would have cost them dearly if Bear Stearns collapsed. Despite this landmark collapse of a financial giant, the Dow maintained a steady level above 12,000.
End game: Commodities and currencies
As financial firms were struggling, commodities such as oil, gold, steel, agricultural products, etc. were rising. After dropping in price since the 1980’s, commodities had bottomed around the year 2000, with oil around $10/barrel and gold under $300/ounce. 20 years of falling prices had led to many producers shutting down mining and drilling operations to reduce production. However, at the end of the 20th century countries such as China, India, and Russia had begun to rapidly industrialize as their governments had significantly reduced their controls over economic activity. These emerging economies began to demand more commodities to build their infrastructure, produce goods for export, and improve their diets and living standards. It takes years to complete mining and drilling projects needed to increase production of commodities, so commodity prices began rising quickly from 2001 on as demand outpaced supply. New money created by Greenspan’s Fed amplified these price increases. By March of 2008, commodity prices had reached all-time highs with oil around $145/barrel and gold above $1000/ounce.
As U.S. consumers borrowed newly created money to purchase goods from China and other foreign economies, U.S. dollars flowed into those countries. When foreign producers received the dollars, they used them to purchase their own currency, which had the effect of making the value of their currency increase relative to the dollar. However, central banks in these countries did not want their currency to get stronger against the dollar, since this would tend to make their exports less profitable. Foreign central banks began printing more of their own currency out of thin air to buy the dollars being imported, which tended to “peg” the value of their currency to the value of the dollar. As the dollar lost value due to overprinting by the Greenspan Fed, these countries reduced the value of their own currency to match it. Foreign central banks then took the U.S. dollars they had bought up and used them to purchase U.S. government bonds, Fannie Mae and Freddie Mac bonds, and other dollar-based investments. Foreign central banks now own around 60% of the U.S. government’s debt, which has increased from under $3 trillion in the 1980’s and 90’s to over $10 trillion and rising. All of this global money creation fueled increasing commodity prices in all currencies through 2008.
End game: Fannie, Freddie, and Henry
By July of 2008, problems had begun to appear with Fannie Mae and Freddie Mac. These agencies existed to purchase risky loans from banks, and they had done so with great fervor over the previous two decades. As it became clear that the problems in the housing market were not going away, many investors began making leveraged bets against Fannie Mae, Freddie Mac, and other financial firms, while maintaining their leveraged bets on rising commodity prices. Foreign central banks who owned significant quantities of Fannie Mae and Freddie Mac bonds began to pressure the U.S. government to take action to prevent these bonds from losing value. If foreign central banks chose to stop buying U.S. government debt, or even worse sell the debt, it would cause interest rates on these bonds to skyrocket, making it necessary for the U.S. government to greatly reduce spending , greatly increase taxes, or print massive amounts of new money to buy up the bonds at favorable interest rates. None of these options are desirable to the U.S. government.
Henry Paulson, the Goldman Sachs CEO who had convinced the SEC that investment banks were capable of managing their own risk at leverage of 40:1 or higher, had been rewarded for his idiocy with appointment as Secretary of the U.S. Treasury. On Saturday July 13, 2008, he announced that the U.S. Treasury would guarantee the bonds of Fannie Mae and Freddie Mac. All of the bad mortgage products he and his cronies had created at Goldman Sachs and other financial firms and sold to Fannie and Freddie for a profit would now be paid for in full with money taken by force from children and grandchildren of the U.S. taxpayers.
End game: The July massacre
Whether by design or by accident, this announcement triggered a reversal in the market. The Friday before Paulson’s announcement, a California bank called IndyMac had experienced a bank run and been taken over by the FDIC in the second largest bank failure in U.S. history. Many investors had begun making leveraged bets against Fannie, Freddie, and other financial companies, who stocks had been declining. At the same time, these investors had made leveraged bets for increases in commodity prices, which were at record highs. The Treasury’s guarantee of Fannie and Freddie sparked the biggest gain in financial stock values in history, with the BKX index of bank stocks rising 40% in two weeks.
This forced those who had bet against financials to cover their bets. For example, an investor may have had an initial investment of $10, borrowed $90, and invested the whole $100 in a “short sale” against Fannie Mae. In a short sale, an investor borrows stock from a stockholder, sells it at the current price, waits for the price to fall, buys it back at the lower price, and returns the stock to the stockholder he borrowed it from, pocketing the difference in the prices. If the stock dropped 10%, he could earn a $10 profit to double his initial investment of $10. However, if the stock rose by 10%, his initial investment would be wiped out. If it rose by 20%, he would have to raise an additional $10 to pay the additional cost.
As financial stocks rose, investors were forced to buy them to close out the short sales they had in place. Many investors needed to raise extra money to cover losses from these short sales, so they began selling their commodity investments. This triggered a drop in commodity prices that was accelerated due to the leverage originally used to purchase them. For example, an investor may have had an initial investment of $10, borrowed $90, and bought a $100 oil contract. If the price of oil rises 10%, he sells the contract, earning $10 to double his initial investment. However, if the price of oil drops by 10%, his initial investment is wiped out. If it drops by 20%, he has to raise an additional $10 to pay back the $90 he had borrowed.
This reversal carried through the next month as investors “deleveraged,” selling their commodity bets to raise cash, buying back their bets against financials, and paying back the money they had borrowed to make these investments in the first place. Financial stock prices stayed relatively high while commodity investments dropped. However, by the end of August it had become apparent that the Treasury’s guarantee of Fannie and Freddie debt had not saved them from increasing loan defaults and declining stock values. On September 7, the Federal Housing Finance Authority took over ownership of Fannie Mae and Freddie Mac, stealing all of the investment value from their few remaining stockholders.
End game: The Panic of 2008
With the federal government now keeping Fannie and Freddie’s loan activities in operation (and thus keeping foreign central banks from dumping their U.S. bonds), some hoped that other troubled financial companies would either be able to recover or would be bailed out by the government before they failed. This hope was short-lived. Two weeks later two of the four remaining major investment banks, Lehman Brothers and Merrill Lynch, put themselves up for sale. Merrill Lynch was purchased by Bank of America. Lehman Brothers’ potential deals fell through, the Fed and Treasury declined to bail them out, and on Monday September 15, 2008, Lehman Brothers declared bankruptcy.
The Lehman Brothers bankruptcy was the final wake up call for the markets. All stocks began selling off sharply as leveraged hedge funds and investors sold anything they could to raise money to pay off obligations based on their losses. Banks significantly decreased their lending to each other and to other businesses and individuals, as they held cash in anticipation of further losses.
In addition, Lehman Brothers’ failure triggered contractual obligations for other investment banks, hedge funds, etc. For example, Bank A may have bought a bond from Lehman Brothers. To protect itself from a possible default or bankruptcy by Lehman, it may have purchased a type of “bond insurance” from Bank B, Bank C, and Bank D. Bank A would pay a premium each month to each of these banks, and these banks would be obligated to pay Bank A some amount of the value of the bond if Lehman Brothers went bankrupt. When Lehman Brothers did go bankrupt, it triggered many of these types of insurance payments. Many investment firms now took significant losses as they had to pay out this insurance money to Lehman Brothers bond holders.
One firm that was heavily invested in these bond insurance contracts as well as mortgage-based investments was AIG, the largest insurance company in the world. The day after the Lehman collapse, AIG was itself on the brink of collapse due to investments made by a small financial branch of the company. Having observed the crash following the Lehman collapse, the Fed reversed policy and decided that this time they would bail out AIG, promising them $80 billion to pay off bad debts (that number was recently doubled to $150 billion, but who’s counting?). This was intended to avoid a “systemic” failure, since so many other investment firms were dependent on bad deals they had made with AIG.
The AIG bailout did not calm the markets as stocks continued to tumble and other dominoes continued to fall. On September 22, 2008, the two remaining major investment banks, Goldman Sachs and Morgan Stanley, converted from investment banks to bank holding companies to take advantage of Fed protections, thus ending the era of investment banking. Commercial banks Wachovia and Washington Mutual were taken out by the FDIC and sold off. On October 3, 2008 the federal government authorized the Treasury to borrow and spend $700 billion to purchase bad mortgage backed securities and other “troubled assets” that could not be priced because no one in their right mind wanted to own them. Instead, the Treasury invested the money directly in the banks, making 9 of the largest surviving banks “an offer they couldn’t refuse” to sell stock to the Treasury, thus ending the illusion of capitalism in America. On the same day the bailout bill passed, the Fed injected $800 billion of new money into markets. To date the Fed has expanded their balance sheet by over 100% to $2 trillion since August 2008, while simultaneously dropping their target interest rate back down to 1%.
The Dow hit a low of 7,884 on October 10, 2008, a year and one day after its high of 14,164. Foreign markets were crashing as well. US commentators mocked the Russian stock market for closing several times each day, until the US stock market was itself forced to close on October 24, 2008. Iceland’s currency has become worthless. Losses have spread beyond the financial sector, as automakers, manufacturers, retailers, shippers, and other business in the “real” economy have made layoffs, declared bankruptcy, or gone sniveling to the federal trough for their own bailout.
End game: Idiots and assholes
You don’t get collapses of all five major investment banks (all of whom survived the Great Depression), the collapse of the world’s largest insurance firm, the collapse of the country’s biggest mortgage lender, collapses of some of the biggest commercial banks, collapses of well established businesses, and collapses in global markets because decision-makers in business and government know what they are doing. These people simply do not understand economics correctly. They believe it is possible and desirable for central banks and governments to create never-ending asset-price increases by creating new money and taking on new debt to spend. These are all smart people, but they are all complete idiots in their understanding of economics.
But ignorance is not the worst of their sins. Most of these people, while blindly trusting in their illusory ability to “fix” everything, know that their actions benefit a few at the expense of many. They believe it is their job to choose winners and losers in the economy, and to use force, fraud, and theft to do it. Guess who the losers always are? Here are some hints: Do you have the biggest lobbying team in Washington, like Fannie and Freddie did? Are you Barack Obama’s largest donors, like Goldman Sachs, JP Morgan, Citigroup, and Morgan Stanley are? Did you give sweetheart mortgages to congressmen, like Countrywide did? Do you have former employees and CEOs running the US Treasury, like Goldman Sachs does? Do you own a share of the Federal Reserve, like Bank of America, Citigroup, J.P. Morgan, and other commercial banks do?
If your answer to these questions is “no,” then guess what? You are the loser. These people are assholes who know how destructive their actions can be to people like you and choose to force their misguided will upon you. This downturn is not some natural cyclical hiccup in the emotional uncertainty of an untamed “free” market. It is the inevitable destruction of wealth caused by decades of deliberate forceful manipulations of economic activity by the government, the Federal Reserve, and their cronies in the financial industry for their gain, at your expense.
When the $700 billion bailout package was being debated, one congressman reported receiving opinions from his constituents that ranged widely from “no” to “hell no.” American citizens were monolithically opposed to the bailout. Although the first draft was just barely voted down, the second bill included a few more pet projects and was easily passed. People in Congress did not care what their constituents wanted, even in the face of elections in the coming weeks. Over 90% of Congressmen are reelected in every election. Alaska senator Ted Stevens appears to have won his reelection (votes are still being counted, or manufactured) despite having been convicted the week before the election of felony charges for accepting bribes. Your vote does not matter to these people. What you want and what you think do not matter to them. You do not matter to them. Your children matter even less to them, as it is your children and grandchildren who will pay for the debts that they have incurred in your name. They prey upon your ignorance, feed upon your apathy, and thrive upon your obedience.
If you are like most people who have worked for their earnings, saved for retirement, paid their mortgage on time, and paid their taxes, your responsibility has been rewarded with your house dropping in value, your invested life savings being cut in half, your taxes rising, and the costs of everything skyrocketing. And this is just the beginning. If you believe that the government and economic “experts” will be willing and able to manage the economy to save you, you will probably lose everything you own. If you believe that the government should manage the economy, you deserve to lose everything you own. They got you into this mess, and they are neither willing nor able to get you out. You are being ripped off, and you should be outraged.
End game: The Austrian solution
The few who understand the correct theories of Austrian economics know that it is central banks’ creation of money and debt that creates artificial booms that must end in busts. The longer the boom is propped up by government intervention, the longer it takes for bad investments to be discovered, and the more devastating the inevitable crash will be. This has possibly been the longest boom in history, lasting for two decades. The bust that has just begun will be truly historic.
Governments around the world have a choice to make. They can continue to forcefully intervene in the markets, sell debt to foreign central banks, print money out of thin air, and pick winners and losers (you!). This will not avert a depression, instead it will drag it out for as long as their actions persist. Their other option is to stop doing all of this, to stop diluting your money, to stop taking your money by force, to stop forcing you to live your life and run your business according to their whims, and to allow the market to liquidate bad investments and redistribute them to productive, socially beneficial uses. This too will result in a depression, but it will be much shorter than the alternative, and when it is over the stage will be set for real, lasting, productive growth. Unfortunately, every government will choose the first option, and there is nothing you can do to stop them.
What could you have done if you had understood Austrian economics before this mess began? Unlike other schools of economics, Austrians don’t believe that there are magical formulas to predict the movements of markets, since market prices are ultimately determined by the unpredictable subjective wants of individuals engaging in trade. However, it was possible to recognize the boom and realize that a bust was coming and to take precautions to protect yourself from it.
Everyone’s situation is different, but as an example I can tell you what I did with my investments based on my expectation of the bust. Other than the house we bought in 2006 (fortunately when prices had been falling), my investments consist mainly of a 401k, along with a small amount of gold and silver I own through a company called Goldmoney. My 401k had been invested heavily in international stock funds to take advantage of the weak dollar and global growth, with some diversification in small, mid, and large cap domestic stock funds. My plan was to stay fully invested in these stocks until the parade of happy idiots on CNBC started to wake up to the coming crash in the housing market. This happened in August of 2007 when Countrywide began its fall from grace. We were blissfully on our honeymoon at this time, but when we got back I took half of my 401k money out of stocks, putting 25% into a money market fund and 25% into a inflation-protected bond fund (8/16/07, Dow 12,845). If stocks crashed, I thought at least half of my savings should be safe. If the market resumed its rise, I would still be making gains on the other half. As it turned out, I had sold at the temporary low. The market did go up to its high in October 2007, then began declining again. By the middle of March 2008 I had seen enough of the decline to believe that people were beginning to understand what was coming. I moved another 35% out of stocks and into the bond fund, keeping 15% in international stocks in case the dollar collapsed, or in case global growth somehow survived while the US economy circled the bowl (3/13/08, Dow 12,145). The next day was the run on Bear Stearns, and that weekend they were taken out (I did not anticipate this, although it did justify my decisions to sell). A few days after Lehman Brothers went bankrupt, I took my remaining 15% in international stocks off the table (9/17/08, Dow 10,609) I now have 75% in the money market fund and 25% in the inflation-protected bond fund.
My 401k is currently down 15% over 12 months, and up 2% over 3 years, according to the website. I’m down because of some losses in the bond fund and big losses in the international stock funds that I held on to. However, over the past year I have beat the S&P 500 by 20%. I’m guessing that’s better than anyone you know who has an investment portfolio. I’m not saying this to brag, only to show how a correct understanding of and belief in Austrian economics allowed me to anticipate the crash and avoid it. My intent in this essay has been to share that understanding with you so that you too can take measures to protect your wealth in the difficult times ahead.
Postscript: When I wrote this in 2008, it was not intended for publication. As such, I have not documented sources. Most of the Austrian economic principles and history were most likely gleaned from Mises.org, and most of the facts, figures, and dates surrounding the housing crisis and financial collapse were probably from Wikipedia. If there are any specific ideas that I have failed to credit, please notify me and I will update the post to reference them appropriately.
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