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Living in Economic Denial   December 21st, 2008


More observations...

It's impossible to avoid constant reminders in the news that we are apparently in the midst of the most serious economic crisis since at least the 1970's and possibly since the Great Depression. We got here primarily by living beyond our means and engaging in policies that simply were not sustainable. In short, we lived in economic denial. And it would seem that the "solutions" being implemented or discussed suggest that we haven't learned anything.

A Quick Review: Causes of the Crisis

Two months after I wrote an article on the causes of the crisis it still seems to me that my analysis was correct regarding the root causes. Having said that, there were certainly some contributing factors that helped exacerbate or accelerate the problem. Some points that have been mentioned by others include:

  1. Low Interest Rates. Many believe that the unusually low interest rates shortly after 9/11 contributed to the problem. In an effort to help the economy recover from the "dot com bubble" busting, and to try to avoid a recession in response to 9/11, Federal Reserve Chairman Alan Greenspan adopted a policy of low interest rates. The rates reached their lowest level in 50 years, 1%. With interest rates so low a large amount of liquidity (read: extra money) was pumped into the global economy and investors looked for more profitable (but more risky) investments to get a better return .

  2. Loaning to Unqualified Borrowers. In part due to investors looking for better returns on their investment in a low-interest environment and in part due to bad government regulation (Community Reinvestment Act), riskier and riskier mortgages were extended to people that simply weren't financially qualified to assume such a large financial responsibility. Unsurprisingly, many of these unqualified borrowers started defaulting on their mortgages leading to increasing numbers of foreclosures. This was the beginning of the subprime crisis which, in 2007, became the first thing most people heard about the upcoming financial crisis.

  3. Unsustainable Housing Prices. The subprime lending allowed a large number of people that weren't previously able to purchase a home to suddenly enter the market. This led to a quick increase in demand for housing and, as a result, more homes being built and higher and higher home prices. This growth wasn't sustainable, however. It would only last as long as the market was adjusting to all the new demand created by the new market of subprime borrowers. Unfortunately, subprime borrowers began defaulting and banks foreclosed on their properties. This resulted in the market being inundated with empty homes that banks wanted to sell to recover their money. Just as excessive demand caused housing prices to increase, excessive supply caused housing prices to fall.

  4. Bad Loan Terms. In addition to subprime, a lot of mortgages were extended with terms that historically would have been shunned both by banks and borrowers. Adjustable Rate Mortgages (ARMs) offered borrowers a seductively low interest rate for a few years but then could (and did) adjust to a higher interest rate later. Interest-Only loans meant the borrower was not even paying the principal on his home but only the interest; years later he would owe just as much on his mortgage as he did at the beginning. And then there were the "pay option" loans where the homeowner could essentially pay anything he wanted each month; however, if he paid less than the amount of monthly interest his principal balance would actually grow. These were all dangerous terms that a serious, conservative, long-term homeowner would traditionally reject.

  5. Cash Out Refinancing. As many homeowners saw the value of their houses rise quickly, less conservative homeowners decided to "put their equity to work" by refinancing their home and taking cash out. This was effectively free money since, it was thought, they could just pay that money back when they eventually sold their home at an even higher price. Homeowners were spending beyond their means (inasmuch as income) since they were spending equity they had in their home. That worked well until the housing prices started to fall as subprime borrowers began defaulting. When that happened all the sudden many homeowners found themselves owing more money than their house was worth.

  6. Too Much Borrowing. Consumers engaged in far too much spending of borrowed money. In addition to the "cash out" refinancing (or home equity lines of credit), many consumers found that even that was not enough to maintain their unsustainable lifestyles. So they borrowed from credit cards.

Now we find ourselves in a situation where people can't sell their homes because they owe more than the value of the house--so they simply abandon their home; or people with silly loans simply can no longer afford their home (truth is, they never really could). In either case, the house ends up being foreclosed on and adds yet another home to the glut of homes on the market that push prices even further down. As prices drop further, more and more people find themselves in the same situation and the situation spirals down. Likewise, more and more people are becoming delinquent on their credit cards.

Banks and investors, too, made very bad decisions based on greed and unsustainable levels of leverage (borrowing). Just as bad mortgages led to a housing crisis, bad investments and over-leveraging led to the financial crisis.

Government wasn't the exception. Spending increased massively during the Bush administration and state governments became accustomed to the increasing revenues of the bubbling economy--both from rising property taxes due to rising home values, as well as increased sales tax revenues from everyone borrowing and spending beyond their means. Now, as the economy cools off, states are projecting a combined budget deficit of $100 billion over the next two years .

In short, it seems that what got us into the current situation is absurdly low interest rates, unsustainable home prices, unsustainable borrowing, and unsustainable spending.

Fast Forward To Today

As the crisis seems to constantly expand, bad news gets worse, and the Obama administration tries to come up with a bold plan that is somehow different from what Bush has been doing, I see some eerie red flags.

  1. Low Interest Rates. The Federal Reserve's interest rate was recently dropped to nearly 0% . Mortgage rates have been volatile, but they've generally been falling. And the Treasury Department is reportedly considering a proposal to push rates down to 4.5% . This would presumably increase demand for homes which would hopefully stop home values from falling. Problem: Low interest rates are what helped get more unqualified buyers into the market in the first place. Pushing interest rates lower is essentially an attempt to re-inflate the popped housing bubble.

  2. Keeping Unqualified Borrowers In Their Homes. There have been efforts to stop foreclosures... either by extending a moratorium on foreclosures (which would give delinquent borrowers more time to be delinquent) or by trying to help these borrowers with their payments. Problem: Neither response solves the underlying problem that many unqualified borrowers are in an unsustainable financial situation. You can prolong the death of these mortgages but it doesn't seem that most of them are avoidable.

  3. Bad Loan Terms. Another "solution" is the concept of loan modifications. Some want the U.S. Treasury to buy up risky mortgages so that the Treasury can then unilaterally make the terms of the loan more affordable. Others want the banks to do it. Others want the Treasury to help the banks absorb the losses involved in doing so. Problem: Most mortgages that have been modified to make them more affordable actually end up re-defaulting within six months . This comes back to the point mentioned in the previous paragraph: You can prolong the death of these mortgages, but most of these deaths can't be avoided.

  4. Too Much Borrowing. Interestingly it seems that consumers have awoken to reality: Consumers reduced their debt for the first time since 1951 in the third quarter of 2008 . Consumers have realized they can't keep borrowing and spending. Problem: The federal government hasn't realized the same thing. Reports are now circulating that what was once a proposed stimulus package of tens of billions of dollars during the campaign, Obama's administration may now be contemplating a $1 trillion package .

Living in Economic Denial

I'm convinced that we are living in economic denial.

Apparently the solution to the housing crisis is to lower interest rates to re-inflate the housing bubble that was fueled by low interest rates. The solution to unqualified homeowners defaulting on their mortgages is to extend how long the whole process of foreclosure draws out--making sure the financial and emotional pain lasts as long as possible. The solution to defaulting bad mortgages is to modify them into even worse mortgages--the majority of which re-default within six months. And the solution to too much borrowing is to have the government borrow and spend another trillion dollars on a stimulus package. The solution to the automobile industry isn't to fix their underlying costs or to look at the reasons for low sales, but rather the solution is to give them federal money without fixing their costs or their sales.

What all of these "solutions" have in common is denial. We don't want to accept that housing prices have to finish their correction by dropping a bit further--or at least bottoming out where they are now--because no-one wants to be trapped upside-down in their house, or see others trapped in that situation. We don't want to accept the reality that some existing homeowners simply shouldn't be homeowners because no-one wants to see someone lose their home. We don't want to accept the reality that the automobile industry is broken because we don't want to see hundreds of thousands more people lose their jobs. And we don't want to accept the reality that more borrowing and spending by the government (which Bush already did more than any previous president in history) hasn't helped the situation because a lot of us don't want to admit that the government can't fix everything with a magic wand.

It's all about denial. We've admitted we have a problem but we're in denial when it comes to our response. It's like being hooked on cigarettes, smoking two packs a day, and admitting that's a problem--yet we live in denial by thinking we can actually make things better by smoking a third pack a day.

We can't solve a housing bubble that was fueled by low interest rates by again lowering interest rates to re-inflate the bubble--that's just creating a new bubble that will crash in the future.

We can't magically make houses more affordable for people that can't afford houses--rather we need to be looking at ways to facilitate people earning more money so they can afford a house.

We can't fix the auto industry's problems by giving it money--that's just avoiding taking a cold hard look at its sales and cost problems.

And we can't fix an economy that is experiencing a credit crisis by having the government borrow and spend more money than the already insane amounts it has been borrowing and spending for the last eight years.

In short, we can't fix our problems by repeating our mistakes. We got where we are by committing mistakes that allowed us to live temporarily beyond our means. The "solutions" currently being offered all seem to be efforts that intend to allow us to go on doing what we've been doing without any pain. But that's exactly what got us into this problem in the first place.

We know we have a problem. Now we need to stop living in denial in regards to the solution: We need to change our fiscal ways and we need to do it fast. We desperately need fiscal conservatism.

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