Here is a question for you Wall Street protesters to ponder:
Why would any lender in their right mind lend to a potential home buyer who had a credit score of around 500, paid almost nothing as a down payment, and just told you what his or her income was without any proof (‘liar loans’)?
The answer to this question has a great deal of significance and it is the key to understanding why we had and are still having an economic crisis.
I bring this up because you folks are demonstrating your anger at “Wall Street” for our problems. The direction of your rage is misplaced. You blame “Wall Street” and the “corporations” and “greed” for the Great Recession. You are looking in the wrong place.
Start with “greed.” It isn’t the problem. “Greed” is a word which most folks associate with anyone who is successful and makes buckets of money. “You know they all stole it,” is a common idea. That is because most people don’t understand economics, entrepreneurship, and the fact that wealth is created, not stolen. How much did Steve Jobs ‘steal’?
“Greed” is a moral concept stemming from religious values (“excessive desire to acquire or possess more (especially more material wealth) than one needs or deserves“). That definition assumes that someone gets to decide how much you need or deserve. I would say that it is the definition itself that is immoral, not the act, but that is beyond the scope of this article.
I am sure “greed” exists, but so what. It isn’t confined to Wall Street. Such behavior is part of human nature and it exists at all times everywhere. Why all of a sudden did greed take over Wall Street and ruin us? Answer: It didn’t. There has to be another explanation don’t you think (it isn’t “animal spirits”, a simplistic cop out by an economist who had no answer to this questions)? Look beyond the easy, conventional explanations.
The proper question to ask is: Why do we have these boom-bust cycles? Greed or no greed, they keep occurring.
This is something Austrian theory economists discovered a long time ago. In fact Ludwig von Mises first dealt with this in 1912 (Theory of Money and Credit). It is a monetary phenomenon caused in modern times by central banks. Even if you know nothing about monetary theory or care not to know anything about it, you might wonder if the Fed bailout of the last crisis with cheap (fiat) money had anything to do with today’s problems. You may wish to ask why such explosions of fiat money are usually followed by a boom and then a bust. It’s nothing new. It’s happened for millennia, by Caesars, kings, war lords, juntas, dictators, banks which issued money, and central banks. These tyrants conflated money with wealth and believed they could create wealth by counterfeiting (printing) money.
Our Fed does this. One of the ways it creates money out of thin air is by lowering the Fed Funds rate. It is not a coincidence that a boom phase followed the rush of new fiat money. By looking at these charts you can also see when it went boom and then bust:
You can see that in response to the Dot.bomb recession, the Fed took rates from 6.5% to 1% (May 2000 to June 2003). This artificially pumped up the money supply as measured by M2 and resulted in another boom, and then when they started raising the rate in 2004, it went bust:
The rule of thumb is that these kinds of booms cannot be sustained: there is always a crack-up bust. Always.
Think about the one first question I asked at the beginning of this article. What idiot would lend money to someone who is obviously financially unqualified?
That is an interesting question. First you need to know that in these boom phases money flows somewhere. Historically it usually goes into stocks or real estate. If it’s real estate it can be commercial or residential. This time is was mainly homes. And flow it did and we all know where home prices went with the pressure of all that fiat money.
The answer to the idiot lender question is this: the government approved those loan standards and guaranteed the loans. These guarantors, Fannie Mae, Freddie Mac, FHA, Ginnie Mae, were created by the government to promote home ownership and were subject to the laws of politics rather than the laws of economics. If you want proof of this, read the testimony from the Congressional hearings pre-bust.
The lenders then didn’t really care about the financial worth of the borrower since “the government” was going backstop the loan. This was one of the unintended consequences of these laws.
If you wish to blame Wall Street, here’s where that comes in, but it isn’t what you think. Yes, they invented some really clever and complex financial tools to provide capital to the housing market. These were actually pretty good financial structures but for the fact that the whole enterprise was built on a house of sand and the system wasn’t set up for the collapse of the housing market. 
The blame of Wall Street has to do with something esoteric and that is the risk models they used when setting up these financial structures. Their risk models assumed that the housing market could never collapse. Their models were built on a statistical flaw going back to the mid-1800s that have been incorporated into all risk models used since then and still used on Wall Street. Philosopher Nassim Nicholas Taleb and the mathematician Benoit Mandelbrot figured all this out in their recent works (The Black Swan, Fooled By Randomness, The (Mis)Behavior of Markets). I urge you to read them.
There was no crime in what Wall Street did. I am sure there probably was some illegal activity but that wasn’t the cause of our malaise. The cause was the Fed, the federal government, and bad risk models.
The next question you should be asking is: why haven’t we recovered? This is where we have something in common: bailouts. I believe that the world wouldn’t have disappeared into a Black Hole without the bailouts. In fact everything that the government and the Fed have done since the Crash has delayed a recovery and has resulted in stagnation, maybe permanent high unemployment, and a decline in the value of your money. We can argue about this, but, so far we have called it correctly and the Fed and the Obama Administration have been dead wrong.
What you see is not capitalism. Rather it is called by a lot of names: crony capitalism, national corporatism, mercantilism, oligarchy or plutocracy, dirigisme, and fascism. It isn’t capitalism, the free market, or the libertarian vision set forth in our Constitution and Bill of Rights. And the fountain of this system is the centralization of the power into our federal government; they wish to substitute their decisions for your decisions.
To you, proponents of one form of conventional wisdom, I urge you to think.
Bullseye, Jeff! The malinvestments must clear before a recovery can take hold. Government is only prolonging the pain by attempting to prop up failed cronies… ahem, institutions. Government creates a problem… and then government rushes in to fix the problem that they created, causing yet another problem. Rinse and repeat ad-infinitum, and you have discovered the source of the boom-bust cycle.
Is there any rational ECONOMIC defense for the existence of the Federal Reserve?
A bigger question, how will a more connected world (Internet, smart phones, social networking) change people’s relationship to the State?
This is one of your best articles. Great work!
Thanks, Junior!
Amen.
Should you start #OccupyTheFed, we’ll second you with #OccupyTheBCE
Congratulations on the piece.
Thanks, Juan Luis.
It all sounds logical and I can agree with some parts of this essay. However …
We presently live in a extremely corrupt system where the major financial institutions were able to influence the legislators to make rules in their favour; and this they did allowing the few atop to use this situation for their personal benefits at the expense of the many. I do not mind an entrepreneur to earn millions as he is also risking loosing millions. What I object is the fact that today’s business leaders (mainly banks) have corrupted the system that they can loot without the appropriate downside risk as a matter of fact they are simply employees.
Occupy wallstreet does address the injustice that occurred due to the violation of the spirit of the rule of law. No society, especially not a capitalistic one, can function well with such a situation where basically this spirit is replaced by MIGHT IS RIGHT.
Those who enriched themselves whereas the downside risk is covered by the government (or tax payer) have to be made accountable on a personal level as nothing else will stop them to continue their looting.
Linus, no one disagrees with the fact that the bailouts were wrong and we live in a world of Crony Capitalism.
There was no crime in what Wall Street did. I am sure there probably was some illegal activity but that wasn’t the cause of our malaise. The cause was the Fed, the federal government, and bad risk models.
I doubt that this statement would hold when the spirit of the rule of law would not have been perverted as a result of the lobbying activities of those large corporations where the looters have influenced legislation to legalize those thefts that definitely are an injustice. The spirit of the rule of law has been corrupted to a degree that endangers the whole system.
Hate to interrupt your Randian wet dream but this statement in blatantly and demonstrably false:
The answer to the idiot lender question is this: the government approved those loan standards and guaranteed the loans
The government never, ever guaranteed any obligation of FNM or FRE until the man for whom you voted for twice socialized their losses. Every trust indenture document issued by FNM/FRE (this covers their bond offerings as well as their MBS) specifically stated in bold letters that they were not an agency of the US government and that the investor could not look to the US government for payment.
Until George W. Bush bailed out Wall Street and added $5 trillion + obligations to the backs of the taxpayer. And the Randian GOP=TeaParty crowd considers him a great President!
Sorry to burst your bubble. Radians are minarchists.
Ayn Rand believed in very small government designed to do nothing beyond the defense of life and property. She abhorred the initiation of force and applied that prohibition to everyone in society, including the thieves who call themselves government.
George Bush was no Randian.
I agree with Tibor. And I would add that Rand was against paper fiat money, against the Fed, and against every welfare agency such as Fannie and Freddie and Ginnie Mae, every regulatory agency, every moral hazard agency such as FDIC.
Bush and his so-called “compassionate conservatism” (i.e. religious socialism and endless wars without naming an enemy, victory conditions or strategy) stood against everything Rand believed.
If I can suggest something, Barry, look up the term “false dichotomy”. There are many other views than “Democratic” and “Republic”. You can’t understand Rand or Objectivism if you think “well, it’s not Democratic therefore it’s Republican.” It is neither.
Thank you.
Barry, there is no question that the GSEs were implicitly, and as we found out, explicitly backstopped by the government. We are still as taxpayers funding Fannie’s losses. This is the problem with how things work in a fascist system. The implicit guarantee encouraged riskier behavior. About one-half of the residential mortgages in America were guaranteed by the GSEs. The mortgage market is founded on that fact. The problem for the government is that the problem is too big to bail out.
And, I think the others have answered your question about Bush. Why do many people assume that if you criticize the government or Obama that you are a Republican or support Bush? Not the case on this blog. I’ve often said that Bush was one of the worst presidents in history.
Thanks for reading and thanks for the comment.
Barry, what on earth are you on about?
The people you list stole nothing. It is more appropriate to say they accepted stolen property. Everyone would have accepted it.
50% of Americans are receivers of government largess. There isn’t one among us who has ever returned a single check because the loot was forcefully taken from our neighbors. We are all prostitutes. The only difference between us and the people you list, is, that they, unlike us, are high priced ones.
But, and this is the crux of the matter, very few would stoop to doing the forceful taking. The thieves, then, are people like George Bush, Barrak Obama and Ben Bernanke, to name a few. They were the men with the guns and counterfeit presses.
Let’s take away their guns and printers. Let’s reduce the power of government to its constitutional limits. And, let’s return to honest money.
Only through these actions will the looting ever end.
http://www.youtube.com/watch?v=kNqQx7sjoS8&feature=youtube_gdata_player
I remember the Randians rushing out to the streets attacking George W. Bush. I remember the CNBC crowd rail against the socialization of the losses of FNM and FRE.
I think 99% of the Randians twice voted for George W. Bush and still and the 1% are illegal aliens.
I agree they did exactly what you say. But, they were not Randians. Radians would either refrain from voting. Or, they would vote for Ron Paul.
Speaking as a “Randian”–Objectivist is the right word–we were no fans of Bush nor of the Libertarian Party.
You are right, Keith. The correct term for Ayn Rand’s phylosophy is Objectivism. Ayn Rand called her self an Objectivist. But, she never permitted anyone else to call themselves by that name. She insisted everyone else call themselves “Students of Objectivism,” highlighting that no one but she can properly/correctly present her philosophy.
I like to use the term “Randian” because, while there are many who have read, or, are familiar with, Ayn Rand and her writings, few recognize the term “Objectivist.”
She called herself that because she was the first ever to define a moral code “objectively” by using “man’s life and well being” as the absolute measure of value.
Even her idol, Aristotle, defined his moral code subjectively. He said to go see what the prominent people do and follow their ways. But, Aristotle could never explain why these people are considered prominent and what exactly it is they do that we should copy.
Keith, I wish we had more people like you posting to Jeff’s blog.
Um, he could. He wrote the entire Nichomachaean ethics in that spirit. Whether he succeeded or not is another matter, but he referred to them precisely because they were individuals in a state of virtue.
“Even her idol, Aristotle, defined his moral code subjectively. He said to go see what the prominent people do and follow their ways. But, Aristotle could never explain why these people are considered prominent and what exactly it is they do that we should copy.”
What of his work have you even read?
“Um, he could” what? In what spirit did Aristotle write his Nichomacaean Ethic. What of his work did you comprehend.
Aristotle was one of the greatest philosophers of all time. I in no way denigrade him. Even though I admire Ayn Rand, I recognize, as did she, that her greatness only came to her because she had Aristotle’s shoulder to stand on.
But, Aristotle saw ethics in very subjective/relative terms. By way of example, Wikipedia states “Aristotle does not state how to decide who deserves more, implying that this depends on the principles accepted in each type of community…” http://en.wikipedia.org/wiki/Nicomachean_Ethics#Book_V:_Justice_and_Fairness:_a_moral_virtue_needing_special_discussion
The point is, there is just no standard, consistent, unchanging measure of value demonstrated in his works, which standard applies everywhere and always, regardless of place and time.
Once again,fantastic article.
I am just starting to read the books you have mentioned in your article and I hope they will have answers for a few questions I have,but for now may I impose upon you and your readers?
There seems to be a number of causes to booms and busts and as mentioned they have been around a long time.
I believe they all have as one of their causes “Leverage”.
Leverage of purchase funds allows the money to multiply
within the bubble.This compounding can then only have one conclusion-burst.There eventual will not be enought money
to continue the expantion.I believe that if there is a desire to stop any bubble in its tracks,one need only to require “no leverage be allowed” I do not believe the “next fool” required to keep it going will either have or be willing to put up the funds.
Was leverage one of the primary causes of the mortgage bubble (housing was the vehicle used)?Lenders were allowed to leverage their funds at a factor of at least nine (9).
Lenders with total assets of $9 trillion were able to inflate the bubble to $81 trillion.
Is there any wonder that when the burst reduced the EIGHTY ONE TRILLION to about THIRTY ONE TRILLION, no one has the ability to payoff the losses because 100% of the real money is only $9 trillion.If we factor in worldwide,this could be as one economis says ” a QUADTRILLION dollar problem”
Wouldn’t the prevention for this occuring again be to raise the “reserve requirement”(reduce the leverage)?
Thank you for the insite about “Greed”, and the multi facets of greed.I would define a way that excess is used.When any excess is used for ones own interest that is greed.Excess that is used for the better of others is the opposite of greed.
This leads us to the second part of the mortgage crisis (housing).Was the leverage used to produce “an excess profit” for the lenders? They were able to lend over $81 trillion using %9 trillion in their account,so how did they get an excesive profit?
They then broke the rule of nature and unleased the WMD,i.e., as Einstein said,”the most powerful force in the universe”….COMPOUND INTEREST.
They sold the notes for a price that allowed them to earn
an excessive interest for a short period of time.They were able to get a return of 5 or 6% or more in THREE MONTHS with their MBS (Mortgage Backed Security)
It did not matter how much money was in supply,or what the rate was,it only mattered how much of these notes they could sell and compound their ROE.
I believe that the real problem is ,as Greenspan stated,(our moneytary system ) “is flawed”.
Perhaps,it is time for “THE FEDERAL BANK OF THE UNITED STATES OF AMERICA” to become the lender of the US DOLLAR by the people,of the people,for the people.We must take this Weapon Of Mass Destruction,(the most powerful oin the universe) and use it for the general welfare,for life,liberty and the persuit of happiness.
justaluckyfool (Anyone who attemps to predict the future is a fool;if by chance,correct then justaluckyfool)
Basilovecchio: the problem with altruism is that it doesn’t answer the question. The question is: what is the good? Altruism says: the good is that which is good for someone else(!)
This is based on the idea that success is temporary, a matter of luck, and zero-sum. One man’s success, altruists believe, come at another’s loss.
So for thousands of years, altruism has demanded that people sacrifice their interests to others. Very few people behave this way. But it does give a mob, and the populist witch doctors who preach to them, license to condemn success.
I saw a cartoon a few years ago. It showed a smug-looking woman sitting at her desk in her office. She said “I keep my resume and my skills up to date to ensure I can get the highest salary”. Then it shows her at a gas station. The gas station owner says “I get the highest price for my gasoline” and the formerly smug woman is now livid with rage.
Why is it OK for the wage-earner to be “greedy” but not for the wage-payer?
Everyone needs to read Ayn Rand’s “The Virtue of Selfishness,” which you clearly have.
Well said.
Jeff: great article
Thank you for your thoughtful, well written and timely article.
Mises put it so well. He said “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
What he meant, was, that the collapse will either come via deflation or hyperinflation.
The “voluntary abandonment of further credit expansion” would cause deflation.
This is what he recommended we do. This is the healthy way to permit the malinvestments to be liquidated. People would lose their jobs, as they must. For the building of two and a half million unwanted homes every year must stop. And incomes would fall. But, prices would fall too, making it easier to accept and survive the bust.
The only other alternative is a continuation of the credit expansion in a desperate attempt to avoid the unavoidable, the bust. The consequences of this route is “a final and total catastrophe of the currency system involved,” hyperinflation.
The hyper inflationary route would bring unimaginable horrors. No sophisticated economy can survive without a functioning money. Production would cease. The purchasing power of generations of savings would be wiped out. People would be unable to feed their children.
In this case, the inevitable political conclusion would be dictatorship. Hitler, Mao, Lenin, and the like, all came to power following hyper inflationary collapses.
The masses are ignorant. They do not read your posts. And, they learn nothing from history. Not understanding the cause of their problems, they repeat the errors of their predecessors. They look for scapegoats. They fault the capitalists, the Jews or both.
Just listen to the ”Guevaristas.”
http://www.youtube.com/watch?v=l3Y9CARUwio&feature=youtube_gdata_player
I regret providing the link at the end of my post. The person showcased at that link is clearly deranged and does not represent the “Guevaristas,” My comments, however, are still valid.
It’ll be interesting when (if) in a couple weeks this is still going on, just how many of the Guevaristas happen to wield the iPhone4S.
Re:Keith Weiner’s reply.
First,Thank you for a reply.
It feels great to know someone has at least read my comment.
I do not believe all success comes at another loss.
If so,who has loss from the great successes in medicine?,
Who losses in promoting the general welfare?,certainly not the wealthy because it only increases the base from which
more wealth can be made.
This perhaps may show the flaw in capitalism,the acumulation of gain (interest) does in fact come “from another’s loss.” Any some of money lent at any compouded rate over a period of time will by definition give the lender ALL THE MONEY IN EXISTANCE.If that lender does not apply the some of the gains back to the losers we have slavery.
RE: Tibor Silber reply
“Mises put it so well. He said “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
Yes,the collapse has occured.But the consequences need not to be disasterous !
WHY could this NOT work?
There will be at least a hundred banks failures within this coming year and they will be put into receivership by the FDIC.(My hope and prayer is “AUDIT BAC” ,that could put them in receivership.Blair , DeMarco are you reading this?)
Why not sell their assets to the taxpayers,you know the people who are paying the bills.Make them the owners of a new bank which we can name THE FEDERAL BANK OF THE UNITED STATES OF AMERICA.A bank which functions to make a profit for the people.The FED B of USA could then buy all,all loans at fair market value (or even at FMV plus 10%).
Give the taxpayers new loans at 4% for 40 years.(85% of all delinquent and underwater homeowners want to stay in their homes,if payments were affordable.)
Let’s say for argument sake that this would need $20 trillion.I hope so,I would like it tobe more maybe $51 can include commercial loans.
WHY?? As Einstein said,”make it simple”
$51 trillion worth of loans as an asset @4% a year would double every 18 years-giving the taxpayers a return
of $102 doubled to $204 TRILLION.It would really come to
$255 trillion or so but we would use the $51 trillion
as cost to service and maintain the loans.
Another question,that only justaluckyfool could ask?,
Why not then take Freddie and Frannie after all their loans are purchased and sell them back to the public as
an IPO.They will be worth it because they will have a contract to SERVICE the loans that FED B of USA makes.(How this for solving more than one crisis at the same time)
How would you like to have a contract that guarantees $51 trillion income over the next 40 years?
Bottom line:Taxpayers paying interest for taxpayers,what a hellofanincometax!!
justaluckyfool.
Basilovecchio,
You need to keep reading down my list. I urge you to read my What is Money articles and then read Rothbard’s, What Has The Government Done To Our Money? It is a short but potent book explaining what money is. I have tried to point out in most of my articles that “money” is not something that can be printed and that it is often confused with wealth. You need to create wealth first, and then money, not the other way around. Your solution would just compound the problem and allow money to be directly controlled by Congress which would soon lead to hyperinflation exactly because they don’t understand what money is either. If you think the Post Office is run poorly, can you imagine what your national bank would do? Think Solyndra.
Thanks for reading and commenting.
No, the collapse has not occurred yet. And, the consequences have necessarily to be disastrous. Because, the money printing to date has been so extreme. And, the economic distortions are so severe.
You recommend that the assets of the insolvent banks be sold to the taxpayers. Did someone forget a pesky little thing called liabilities. The reason the banks are insolvent is because their liabilities exceed the value of their assets. And, it is the creditors who are the rightful owners of the assets. Not the “taxpayers.”
Next, who will sell them? And who will represent the purchasers? That is, who will represent the taxpayers? The reality of your recommendation is that the government would steal the assets of the insolvent banks and give the loot to the very same government who would claim to represent the taxpayers. We call that “nationalization.” The wet dream of every socialist. Then, Barak, Timmy and Benny can team up to operate the stolen property in the “interest” of…… you and me. Right. By the way, are you interested in purchasing a bridge?
As far as all the profit you project from the stolen property, which would be invested In mortgage loans at 4%, why not just distribute the loot to the mortgage borrowers so they can own their homes free and clear? And, while you are at it, send a couple of trillion dollars to me.
Amigo, I don’t tolerate bigotry on this site. I am going to leave it up temporarily as an example of what not to do. You are the problem, not the solution. I am going to mark you as “spam” which effectively bans you from this site. Trash like this is not worthy of reply, so, to my readers, ignore him.
Readers, this article was meant to be a simple explanation of the Crash not very deep or complicated in the hope that non-free market types could read and understand it. So, if you would be so kind, please forward it to as many people as you can.
Thanks,
Jeff
[...] via Message To Guevaristas Occupying Wall St. | The Daily Capitalist. [...]
Hi,Mr Jeff Harding,
I have just started reading books like those you have mentioned and I will read your list for sure.You can say I am a newbie,influenced by Ellen Brown,(I am 75 years old,a retired real estate broker ) I have also read some L Randall Wray,William Black,Cullen Roche,Robert Shiller,Henry Paulson,Alan Greenspan.I love Dr M. YUNUS’s “Banker to the Poor”.
I have no formal education in economics.
WITH THAT SAID,”I THANK YOU,I thank you for acknowledging my thoughts as well as printing them so that they are not just a sound in the forrest.
I beg forgiveness for my lack of communication talents,but I hope that at least my desires show.
The Bank of USA would create “money” and it would be wealth.
If $51 trillion as a start would it not create an asset of $254 trillion.An ASSET that is 100% based upon the faith and credit of the AMERICAN taxpayers.The difference is only that instead of giving a guarantee to a lender that is using your money to keep the profit,the taxpayer becomes the lender of their own money and reaps the profits for the betterment of the people.
As to running of the Fed Bank,I am glad that it was mentioned what if as an unintended consequence it became “a postal type”.The answer there is in how it would be managed.This would be a great discussion but I’m sure that with our great constitution in mind and guidance from BEN and ALEXANDER,and THOMAS we would sertainly do better that what we have done so far.I believ we are in this mess
(of course you would get a simple version from me)is because we were so dumb as to PAY interest to PREFFERED BANKERS to lend US our own money.Since we continue to do that there is no end in sight for that bubble-except to
burst.
Even now at $14 trillion we know we can not pay it off.
Find a way for the taxpayer to earn the interest on the money it borrows,and you will have followed “the yellow brick road.
Thank You again,
MAY GOD CONTINUE TO BLESS AMERICA
Ellen Brown is in my opinion completely uninformed about money. It is a populist concept not grounded in good economics.
Nicely done. I would only add one thing: Follow the money.
Yes, Wall Street took advantage of lax underwriting standards lowered by Congress. But no more so than there was demand for their sub-prime products.
We know what allowed the junk. We know who created the junk. Neither would last very long without someone to buy the junk.
Congress may as well have mandated making loans to the deceased. The product would not have moved without investors willing to buy it.
Who are those investors? Primarily, underfunded pension plans seeking to close the gap between unrealistic return projections (e.g. Defined Benefit plans).
Your excellent article began with a question. I will end my mediocre comment with a question, too: Where is the greatest preponderance of underfunded plans, and/or unrealistic Defined Benefit assumptions? Hint: Their members are protesting alongside the OWS crowd.