Unraveling the Crisis: How Government Policies Fueled the GFC
By Armipotent
- Introduction
Anyone who’s investigated free market economics has heard it before: “The free market fails! Just look at the Global Financial Crisis! We need government intervention!” For over a decade, the government, mainstream economists, and the media have all pushed the narrative that problems with the free market caused an inflated housing bubble, whose inevitable bursting almost crippled the world economy. I’m here to challenge that. The truth is, the ticking time bomb of interest rates was planted in the early 2000s. Then, the government continued to fuel the asset bubble until it exploded due to poor policy. Left to sort out the mess, they patted themselves on the back for cleaning up their own problems and then used their “effective” response to justify further government intervention. People must understand that the GFC was not a standalone failure of markets and that government intervention caused the problems they claim it solved.
A crash course in case you’ve been living under a rock / are under 15 years old:
The 2008/2009 Global Financial Crisis was caused primarily by a massive asset bubble in the housing market, called the “Subprime Mortgage Crisis”. Housing boomed, and people purchased houses believing the growth would never end. People would take out loans they knew they couldn’t repay, and banks would lend them out without caring because as long as the price of housing increased, no money would be lost. This was a completely insane idea that fooled charlatans. But all bubbles begin with a kick. What kicked housing?
- The expansion of credit
The government has given itself a very strange power. A power that is not quite understood for what it really is, by the masses. Interest rates. If you live in a remotely developed society, it is likely the case that a centralized government authority sets the interest rate. The government and mainstream economists will tell you that the government needs to control the interest rate to control inflation and economic growth. They are wrong.
When in a recession, the government lowers interest rates. This purports to encourage spending to boost the economy. But you cannot increase real production by twisting dials. An increase in real production must be preceded by an increase in real savings to invest in that production. Lowering the interest rate encourages spending and discourages saving, so where is all this production coming from? Essentially, the future. The economy is destabilized as future production is sacrificed to increase current production.
Because credit is cheap, loans are easily available. Usually, this affects the economy in a roundabout way, but in our GFC example, it’s right on the money. Cheap credit means banks are willing to loan out riskier and riskier loans because they need lower returns to make a profit. These cheap loans come in the form of low-interest-rate mortgages. With artificially low-interest rate mortgages, the value of houses skyrocketed.
And this is exactly what happened in the GFC. Between 2001 and 2003, the Federal Funds Rate (which is what the Fed uses to set the interest rate) was slashed, from 6.5% to 1%. This spike in house prices triggered the start of the asset bubble, with unsustainable rises in prices and false market confidence leading to the continued growth of said bubble.
- Government policy
The government’s role didn’t end with tanking the interest rate. They had to take it a step further. Programs like, but not limited to, the 1977 Community Reinvestment Act encouraged loose lending to areas with poor credit, exasperating the issue.
The implicit backing of the government for large financial institutions also encouraged extremely risky behavior. The US government has discussed “Too big to fail” policies since at least 1984. “Too big to fail” (TBTF) means a business that is so deeply intertwined with so many areas of the economy that its collapse would trigger a domino effect, crippling the country. From regulators' perspectives, TBTF corporations should be provided with special treatment to keep them afloat in economic downturns, lest everyone suffers the consequences.
However, when these TBTF businesses are aware they will be provided with special treatment, they become comfortable taking on much more risk than they should be, knowing the government will bail them out if their bets go flat. This encouraged massive corporations during the housing boom to speculate heavily on mortgages and mortgage-backed securities (MBSs). This speculative lending and trading inflated the housing market further until it burst. And as predicted, the taxpayer had to bail out the banks.
In fact, the Government Sponsored Enterprises(GSEs) known as Fannie Mae and Freddie Mac are often mentioned by name in discussions such as these. They were explicitly backed by government money and implicitly would be bailed out if necessary. These GSEs were responsible for massive amounts of mortgage and MBS trading.
Another government policy that takes some heat is marking-to-market. Essentially, businesses are legally required to value their assets equivalent to what they would sell for on the open market, regardless of whether or not this reflects the true price of an asset. While this is an understandable requirement at surface value, it does create problems during economic crises.
If the value of a security or other asset dips suddenly, this forced “marking-to-market” will cause some businesses to become valued as illiquid. Facing bankruptcy, they have to sell off their assets, including this undervalued asset that was “marked to market”. This forces the price even further below “real” value, causing a cascade between financial institutions becoming illiquid one after another. Although the housing market had to burst eventually, these policies caused it to implode causing an economic crash, instead of a typical slow downturn.
And forced MTM accounting was implemented when? That’s right, late 2007.
- Conclusion
Although the powers that be would like you (conveniently) to believe that more government intervention is needed in the market, history shows the opposite. Their prime example, the GFC, clearly has its roots in government intervention and anti-market behaviors, including poor monetary policy, the CRA, “Too big to fail” businesses, and forced market to market. We need a freer market to ensure prosperity and security for the future.
Sources:
https://en.wikipedia.org/wiki/Malinvestment
https://www.investopedia.com/terms/t/too-big-to-fail.asp
