Whose Fault was It?
October 8, 2008
Alvaro Vargas Llosa
WASHINGTON—As was the case with the 1929 crash that ushered in the Great Depression, the current financial meltdown is giving rise to myths that will influence public policy for decades to come. It is imperative that those myths be debunked before the next U.S. administration starts to make important decisions, followed by many other countries. By far the most dangerous myth is that deregulation is the root cause of the problem.
Yes, Wall Street firms were greedy, irresponsible and, in many cases, downright stupid. But those are fairly constant features in any society and there is no reason to believe that investment bankers were any more greedy, irresponsible and stupid in 2007 and 2008 than, say, five or 10 years earlier.
As many authoritative economists are desperately trying to explain amid all the confusion, the culprit was a system geared toward loaning money to people who were not in a position to pay it back. Two policies underpinned that system: easy money by the Federal Reserve and the government-induced lowering of standards for approving loan requests.
Lorenzo Bernaldo de Quiros, a leading European economist, is adamant that the crisis could have been avoided but for “the lax monetary strategy put in place by the Federal Reserve between 2001 and 2004. … That is what caused the exuberant and unreal rise in the value of stock market and real assets, the excessive leverage on the part of families and companies, and the inevitable collapse of the house of cards once inflationary pressures forced the central bank to tighten its policy.”
The Fed’s policy would explain why asset values rose unrealistically, but not necessarily why they did so predominantly in the housing market. And here is where the second set of policies underpinning the system comes into play.
In a recent paper for the Independent Institute, University of Texas professor Stan Liebowitz argues that “in an attempt to increase homeownership…virtually every branch of the government undertook an attack on underwriting standards starting in the early 1990s.”
The government-promoted increase in homeownership dramatically increased the price of housing. As many as one in four buyers purchased property with purely speculative intentions. When prices stopped rising, the speculators tried to get out of the market. The rest is history.
Liebowitz chronicles the long march toward what we could call the Mortgage State, starting with the creation of the Federal Housing Administration in 1934 and all the way to the norms that made Freddie Mac and Fannie Mae acquire substantial loans given to people with weak credit. In between, legislation was passed requiring that banks serve the entirety of the geographic areas where they operate and that they receive scores from regulators on how they treat mortgage applications, factoring in race in order to expose discrimination.
Not surprisingly, once the Fed expanded credit, astronomical amounts of capital poured into a housing market that people assumed was protected by the government. What came next was a consequence of the original sin—Wall Street whiz kids creating, with the help of mathematical models, sophisticated financial instruments such as collateralized debt obligations and credit-default swaps, rating agencies giving those instruments AAA scores, and investors losing their mind over them.
Does the original sin excuse Wall Street from its colossal failure of judgment? No. The Wall Street geniuses should have figured out that scientific models cannot really predict human behavior and that any asset that experiences a quick, astronomical rise is suspect. But they acted on opportunities generated by the original sin.
The fact that, as Sebastian Mallaby pointed out in a recent op-ed in The Washington Post, “lightly regulated hedge funds resisted buying toxic waste for the most part” also belies the notion that deregulation was the culprit. The real purchasers were U.S. investment banks regulated by the Securities and Exchange Commission, U.S. commercial banks regulated by the Fed, and European banks that are among the most regulated in the world.
The crash of 1929 gave rise to an era of big government whose consequences millions of people continue to pay for today through deficits, debt and uncertainty over the future of Social Security. A politician is never more dangerous than in the midst of a commotion in which myth replaces reality. In an age where globalization has opened up extraordinary possibilities for billions of people, going back to overregulation and protectionism because of a myth would be a crime against humanity.
Alvaro Vargas Llosais Senior Fellow and Director of The Center on Global Prosperity at The Independent Institute. He is a native of Peru and received his B.S.C. in international history from the London School of Economics. His weekly column is syndicated worldwide by the Washington Post Writers Group, and his Independent Institute books include Lessons From the Poor: Triumph of the Entrepreneurial Spirit, The Che Guevara Myth: And the Future of Liberty, and Liberty for Latin America.
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