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Bad management and policies are at the root of the U.S. crisis

With turmoil in the world’s markets, politicians and commentators have been demanding more regulation and control of the financial sector. Their reaction is entirely predictable — but entirely wrong.

This crisis was not caused by capitalism being fatally flawed. It was caused by politicians forcing the banks to give out bad loans, monetary authorities flooding the West with cheap credit and regulators being asleep at the wheel.

Indeed, one can date its origin precisely, to 12 October 1977, when U.S. President Jimmy Carter signed the “anti-redlining” law. Before then, lenders generally denied loans to people in poor neighborhoods, believing that the local mix of low incomes and a weak housing market would lead to many people defaulting. But the politicians — with good intent — wanted to make home ownership available to all Americans. So lenders were forced into giving out risky mortgages — what we now call “sub-prime” loans.

By 1985, this torrent of bad business had nearly bankrupted America’s Saving & Loan institutions. So the government took on their bad debt and encouraged them to consolidate — unwittingly making them too big to be allowed to fail.

Meanwhile, several other problems worried the monetary authorities. In 1987, the U.S. stock market plummeted, fearing that other lenders could collapse. Asia’s markets sank. Mexico, Argentina and even Russia defaulted on their loans. Over-valued dotcom stocks crashed. And then there was 9/11. Each time, the Western authorities responded by flooding the markets with cash.

After 9/11, the Federal Reserve took U.S. interest rates down from 6.25% to just 1%, fearing this blow to investor confidence could sink the markets. But again, their action boosted the wrong market by sustaining the credit bubble. With loans now six times cheaper, mortgage applications soared. Lenders, awash with the Fed’s cash, happily issued more sub-prime loans. With more people buying homes, house prices soared. Buying a house seemed a certain money-maker, so more people got more loans and bought more houses, continuing the spiral.

In London, that other great financial center, a decade of government overspending saw public debt soaring. Private debt and house prices soared even faster.

So for ten years, economies boomed, the champagne flowed and everyone had a great party. But it was financed by fake money — printed by the authorities solely to keep the party going. When the dawn of realization broke, the long party turned into the inevitable hangover we suffer today.

The regulators, meanwhile, were unconscious on the floor. The U.S. mortgage institutions, Fannie Mae and Freddie Mac, had 200 regulators on their case, but still went bust for US$5 trillion. These semi-governmental companies allowed investors to believe the bad mortgages were guaranteed by the government, causing credit rating agencies to give their dodgy bonds high scores.

1 Comment
October 12, 2008    carol251@
You are entirely right, but now what can we do about it?

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