The Root of the Problem

In looking for a reason for our current economic issues it appears that most people think the problem is just a few years old. They find a point that backs their cause and stop looking. Democrats point to Gramm-Leach-Bliley and say 'look, deregulation!' Republicans point to the Community Reinvestment Act and say 'look, social engineering'. And while both are partially right, and partially wrong, they both stopped looking at the real core problems that started in late 1970s that really opened the doors to this mess.

Anthony Randazzo and J. Dustin Pope have found some interesting information that helps to really get to the heart of the problem, America's obsession with ever increasing prosperity at the cost of putting ourselves in much worse shape for future generations. Instead of allowing our economy to move along with ups and downs as they are needed, we have become addicted to having an expanding economy at all costs. And by not allowing the natural ebb and flows of a free market, made free by appropriate and limited governmental regulation, to work as they need to to ensure that ideas and businesses that need to fail should so that newer and better business models come to the take their place, we elect those that can artificially pump up the numbers to make themselves look like the saviors in a political environment engorging on more and more power. All of the while letting future generations pay the cost.

Specifically, in this case. we find that in the late 1970s, the idea of mortgage backed investments were a non-starter. The wouldn't work in the free market so they were abandoned almost immediately after they were conceived.

Ironically, the whole mortgage-backed investment model almost never got off the ground. Lewis Ranieri, a trader at Salomon Brothers (now a part of Citigroup), is credited with first conceiving the idea in 1978. But Salomon Brothers almost canned Ranieri’s whole department because there didn’t seem to be a profitable future for mortgage trading.

Former Salomon broker Michael Lewis writes in his book Liar’s Poker, “The mortgage department wasn't making money. The other mortgage units on Wall Street—Merrill Lynch, First Boston, Goldman Sachs—were stillborn. They closed almost before they had opened. The prevailing wisdom was that mortgages were not for Wall Street.”

That’s when the government stepped in.

You see, were were in an economic contraction in the 1970s. The Fed wanted to manipulate the market to ensure that we would see growth instead of letting the market correct itself and enacted some policies that ended up causing 'stagflation'. So, more action was needed to fix the results of the previous actions.

A side effect of the Fed decision to increase the money supply was an uptick in interest rates after 1979. This negatively impacted mortgage lending at Savings and Loan banks (S&Ls). Under “Regulation Q” of the 1933 Glass-Steagall Act, the government, seeking to promote homeownership, exercised its power to place a ceiling on the interest rate S&Ls could charge a borrower for a mortgage. But this limited their ability to compete with alternative, unregulated funds for capital. The unregulated funds (such as money market funds) could offer a better rate of return for investors

The S&Ls had two options: make no further loans until interests rates went down, leaving them with no revenue, or sell off their loans at a loss and hopefully last long enough for rates to decline. As a result, many S&Ls without enough capital to wait for lower interest rates were forced to shut down.

In late 1981, seeing the error of their ways, Congress offered S&Ls a tax break. As a reward for their advocacy of homeownership, the banks could get up to 10 years of taxes per loan back, if they showed a loss on the sale of that loan. Essentially the government gave S&Ls an incentive to take a loss.

Selling off the mortgages was easy. All S&Ls had to do was call an investment bank and take whatever price they could get. Salomon Brothers and others snapped up the mortgages at rock bottom prices. Then investment banks began bundling these cheaply acquired mortgages into different investment vehicles, and sold them to investors looking for a quick dollar. Suddenly, mortgages were more profitable for Ranieri’s department. Mortgage-backed investments were saved, thanks to Uncle Sam.

The fact is that the free market itself would never have invented credit default swaps on its own. The Fed, trying to fix its past mistakes and artificially engineer 'long term economic growth' created the environment where they could be considered profitable. Then once you couple in the idea of deregulating that market, encouraging home ownership among those who couldn't afford to purchase homes, the results of the fed again trying to artificially increase the economy keeping interest rates low and homeowners looking for a quick buck and refinancing their houses with adjustable rate mortgages during this 'interest rate boon' all at the same time, when the bills came due we were in for trouble.

Trouble that would likely have been avoided by not trying to build an economy on hope and instead letting real growth, and contraction, take place when they are necessary.

Examples of this can be seen throughout the 20th century. The federal economic manipulation of the 1920s led us to the depression. The federal economic manipulation of the 70s led us to the stagflation of the late 70s and early 80s recessions. The federal economic manipulation of the 80s led us to the S&L crisis and market crash of 1987.

And the beat goes on.

Americans need to accept that we cannot, should not, want and expect our economy to always be growing, propped up by putting ourselves in danger in later years. The unintended consequences of attempting to manipulate our economy has always brought about pain to future generations, a lesson we are not learning as we continue to make the same mistakes now as we made then. Most of the principles who caused these very issues are in charge again, leading us down the same road. For example, then Fed Chairman Paul Volcker (now chairman of the President’s Economic Recovery Advisory Board) was instrumental in putting the US into stagflation in the 1970s.

The real desire should be for us to foster a society where individual liberty is the main focus, for good and ill, and allow our economy to expand and contract AS NEEDED in order to allow those liberties to remain. It's not an easy choice, but the right ones usually aren't. Instead, we use the political arena to attempt to provide for us instead of providing for ourselves by growing real wealth, not artificial imagined paper wealth that will, as we have seen again and again, disappear at the slightest loss of faith.

It is only then that we will our country return to being a creator of ideas, of invention and of imagination.