When Up is Down and Rocks can Fly

The New York Times published an article today placing blame on the Bush Administration for the current (latest) global economic meltdown.  The staff piece recounts the actions of George Bush- in championing home ownership, in allowing banks, brokers, and finance companies to expand home lending, and in failing to reform Fannie Mae and Freddie Mac- and comes to the conclusion that this led to a housing bubble doomed to inevitable collapse and ensuing loss of wealth.  This not new thinking, just another biased account focusing on George Bush’s role in this latest mess.

What the authors fail to recognize, however, are three important facts.  The first fact is that home prices increased at historic rates after the double whammy of significant capital gains tax changes in the late 90s and historically low interest rates.  The second fact is that this led to major investment in housing, and a vast increase in housing in the US- actually a good thing.  And the third fact is that the economic tailspin was not created because too many people had houses with mortgages.  It was created because 18 Fed rate hikes created a tripple whammy- crushing debt service, reduced homeprices, and slowed business expansion- that turned into rolling financial crisis.

The result is that a normal citizen, the vast majority never having taken a single course in economics, is to believe that championing home ownership is wrong, is to believe that free markets are destructive, is to believe that asset bubble always produce financial crisis.  This is akin, however, to believing up is down, and that rocks can fly.  It is nearly the opposite of truth.

Home prices rose thanks to the 1997 tax reform bill.  Profits from selling a home could now free from taxation up to $500,000 a couple, and no longer limited to a single instance.  Coupled with historically low interest rates, the financial incentive for home ownership had never been higher- but this occurred before, and largely independent, or George Bush.  And, these incentives were, in fact, productive.

The goal of an economy is to create and distribute goods and services.  History has proven that economies are more effective at doing this when excess production can be invested to create additional supply capacity- capital.  So, creating more housing is good.  This increase in housing meant that there were larger, nicer, and usually more efficient, homes.  People had room to put in home offices, home gyms, home workshops, and larger kitchens with more ovens.  Meanwhile, houses were purchased by investors and put up for rent, keeping rents lower and more affordable.  The NY Times authors prefer to look at this glass as half-empty, citing a former Bush official who felt a housing bubble was evident because rents didn’t rise as fast as home prices.  But the effect was to more effectively distribute housing- a good thing.

All this progress did not have to lead to an economic collapse.  As of 2004, homebuilding costs were rising, and supply would have begun to catch up with demand, eventually slowing the market.  But, ever cognizant of the “Scarcity Paradigm” crowd that was in full voice about “suburban sprawl”, “unsustainable growth”, “global warming”, and an “overheated” economy, the Fed raised rates 18 times, to 6%, between 2004 and 2006.  The effects were chilling.  As ARM rates climbed, the most vulnerable homeowners were faced with increases in debt service of 50% or more.  This led not only to climbing default rates, but responsible homeowners putting their homes for sale- quickly creating excess supply and dropping prices.  We all know what happened thereafter- and it didn’t require Fannie and Freddie.

The Federal Reserve has reversed course in a big way, but is learning the lesson that destruction is much easier, and faster, than construction.  Monetary stimulus takes time, usually 6-9 months, and the (well-placed) crisis in confidence in our financial system will slow this recovery further.  Eventually, inflation will emerge, creating incentives for money to be spent and invested, and economic growth will resume in a world of 3 billion people living on less than $2.50 per day.

But the lesson of this downturn cannot be that production- even if it creates temporary imbalances- is bad.  It cannot be that wider distribution- even in the face of risk- is bad.  It must be that the Federal Reserve should never increase debt service requirements by a factor of 2-3X on households and companies in less than, say, 5-6 years.  Because our economy, like rocks, can fall very fast when they do.

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