One man’s ‘crisis’ is another’s correction

Far from being caused by greedy capitalists and the market’s failure, the subprime crisis was the result of government intervention in the housing market, writes Leon Louw

HOW does twaddle get transformed into truth? According to peddlers of twaddle, the subprime crisis was caused by "greedy capitalists" and the ensuing financial crisis is the result of "market failure" or "capitalism in crisis". Not so. All of it was caused by extreme anti-market government intervention. Here follows my Idiot’s Guide to the Financial Crisis.

The European financial crisis is simply a matter of socialistically inspired governments spending themselves into bankruptcy. The US crisis is similar in principle. It started when the US government decided to promote private housing for the poor.

Because "the market" doesn’t provide mortgages to people with no incomes, jobs or assets, the government adopted a low-income, "subprime" housing strategy to induce banks to finance "toxic" mortgages. Its giant government-sponsored enterprises (GSEs), Freddie Mac and Fannie Mae, then bought these toxic mortgages from the banks, thus converting high-risk loans into zero-risk loans. US banks were ecstatic. The US government, intoxicated by its success as banks, realtors and developers responded enthusiastically, issued millions of tax-backed mortgages. But then the GSEs ran out of money.

No problem. The GSEs "securitised" their "secondary" mortgages into "derivatives" and sold them, using the proceeds to fund yet more mortgages, creating an inevitable bubble. Bubbles need infinite resources to prevent them from bursting. So the US Federal Reserve cut interest rates, increased money supply and promised "implicit" backing to persuade everyone to invest trillions of dollars in derivatives.

Investors, hedge funds, banks, institutions, trusts and foreign governments embarked on a derivative feeding frenzy. Thanks to endless assurances that everything was under control, investors trusted the government. Democrats and Republicans boasted about their derivatives being geared and leveraged to the point where the underlying security was a tiny fraction of nominal debt.

While the US government celebrated its triumph over the market, the market fought back. It had become clear that the government could not sustain the bubble and various putative "market corrections" began, but the Fed thwarted them by assuring doubters that it could and would fund a perpetual bubble … and so the bubble grew.

Free market advocates were ridiculed or ignored. Eventually, the market burst the bubble. Market success triumphed over government failure and set in motion the long overdue, painful and protracted correction, which has been called a "crisis".

The government did not give up. It adopted the New Deal — Keynesianism on steroids and the most extreme spending orgy in history, consisting of "bail-outs", "stimulus" and "quantitative easing". These are iatrogenic policies. "Iatrogenic" is a medical term for counterproductive treatment that harms or kills the patient. That antimarket remedial policies are failing may be the final nail in the Keynesian coffin and free market capitalism may prove to be vindicated rather than vanquished.

Is the market blameless? No. Many investors were reckless. Some broke the law. The difference is that government intervention was a necessary and sufficient condition for the "meltdown". What private institutions did was neither.

Despite these facts, anti-market fundamentalists and interventionism denialists continue blaming the "unregulated market". Financial markets are the most regulated of all. Financial crises, therefore, are attributable to excessive regulation. Much-vaunted deregulation could not possibly explain the crash because all that happened was that Bill Clinton brought the US into line with other countries with integrated financial services.

The basics are surprisingly simple — the confluence of extreme anti-market interventions including: GSEs, whose sole purpose was to deluge the market with toxic mortgages; the huge government-backed secondary mortgage market; fiscal and monetary profligacy; banking regulations that forced banks to undervalue derivatives; and the like.

Source: This article was first published in Business Day on 3 October 2012.This article may be republished without prior consent but with acknowledgement to the author.The views expressed in the article are the author’s and are not necessarily shared by the members of the Foundation.

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