With the clarity of time we can look back at the brink of the collapse that hit us just prior to the last national election.  In the midst of the collapse we were stunned and angry, and tended to blame the party in power. Although the Democrats had controlled both houses of Congress since 2006, the disaster took its bigger toll on the Republicans.

While the roots of this collapse extend back through many administrations of both parties, it is important to know what did not cause this as well.

Some blamed the deficits, others blamed deregulation, but many just saw the main cause as unbridled greed.  I contend that while there were deficits, and there was greed, none of these played a critical role in fomenting this crisis.

As Thomas Sowell noted, blaming this crisis on greed is like blaming an airplane crash on gravity.  It is true but it doesn’t really explain anything. Worse if we just blame the undeniable then there is no need to examine human error, design flaws, or study ways to keep it from happening again.

Greed has been with us since the dawn of man. Why did it decide to show its ugly face in September of 2008? Greed is encumbered by the limits of a rational society and in a capitalist system it is encumbered by competition.  I may want to charge $2,000 a ton for steel, but competition keeps me from charging what I want, and even forces me to keep my payroll and expenses in line.

Our government tries to contain the fear of greed with regulations. If we are to blame greed we must face the failure of our regulations, or we may even need to face the possibility that our regulations fostered greedy behavior.  The second most common blame was the laissez faire attitude that had fostered deregulation of the financial markets.   Usually this is directed at the repeal of the Glass Steagal Act which separated lenders from investment banks. This law was repealed under The Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act of 1999, which was signed by President Clinton.

But other nations, notably Canada, also repealed similar legislation and they did not experience the financial crisis we did. But Canada also did not suspend prudent lending standards to force the spread of home ownership beyond its natural market.

Nor was deregulation the norm under George W Bush. In fact just the opposite was true.

Elliot Spitzer noted that we did not suffer from the lack of regulators or regulations. There were plenty to do the job, but they seem to lack the courage and the will to do the job.  We needed better regulations, not more of them.  In many cases the regulated industries such as Fannie Mae  (exempt from SEC and FDIC regulation) spent enormously on lobbyists and campaign contributions to thwart efforts to regulate them.  It was successful for them.

The biggest recipient of campaign contributions from AIG was Barak Obama. The biggest recipient of the PAC assembled by the largest mortgage lender for Fannie Mae, Country Wide Finance,  was Barak Obama. The largest recipient of campaign funds from Fannie Mae was ….. yes, Barak Obama. The second largest recipient in these three cases was Chris Dodd, Chairman of the Senate Banking Committee.

The deficits which seemed so irresponsible at the time now look like pocket change.  Deficits do matter but it depends how long they last, how large they are relative to GDP, prevailing interest rates, and what the deficits are spent on.  Personal debt spent on a house or investment equipment may seem prudent, the same debt spent on a boat or jewelry would not.

While the debt incurred under George Bush was arguably bad, it was not a critical factor in causing the meltdown.  We incurred controversial debts under Ronal Reagan and incurred little repercussion from the financial industry.

Bubbles are nothing new and may just be a part of the pricing mechanism. The Federal Reserve was created to bring stability to our financial system. It first test was the Great Depression of 1929, and it failed miserably.  Nearly 80 years later with the value of the dollar down 95% and in the middle of the worst financial crisis in our adult lives, we should ask if it is part of the problem.

Eliminating commonly perceived causes should help us focus on solutions that will work. If we delude ourselves into blaming greed, deficits, and individual demonas we risk designing solutions that not only will not work, but will like make the problem worse

My first article published at American Thinker-

The iron law of bubbles

excerpts:

But this same infatuation with talent can be attached to more than money; it can be attached to power.  With capitalism struggling to recover from yet another smackdown bubble we seem inclined to somehow believe that academics in political power will yield better results.  The same uncertainty that plagues the financial markets also plagues the political environment. The biggest difference is that a financial bubble will be brought down much more quickly. Bad political solutions become institutionalized and linger for decades. In many ways the current financial mess was born from political solutions imposed in response to our previous bubbles.

Our political discourse is largely about the balance between the need to smartly regulate a very efficient but imperfect market, and the desire to merely replace financial power with political power. It often means the balance between individual rights and the interests of the collective. While the economic self-interest of capitalism is suspect after the bubble is burst, we often suffer more from the political self-interest that seeks to correct it.  Our most oppressive laws are often the ones designed to protect us from our own stupidity.

One of the most intriguing concepts of economics is the concept of “moral hazard.”  It is a corollary to a more obvious principle that everything has a cost. An understanding of it is critical for those whose world view is a never-ending series of crisis that demand a government solution.

Insurance, for example, encourages the risk it is designed to protect us from.  Seat belts may make us more reckless drivers.  I may be more inclined to eat the high fat burger with cheese if I think I am protected by Lipitor.  Free health care may make us less healthy and more obese.

But nowhere is the cost of moral hazard more significant and more obvious than in our financial system.

We insure bank depositors to bring stability to our financial system, but such insurance means that the depositors are freed from the responsibility of even caring about the bank’s stability.  It also increases the bank’s proclivity for risk taking. They get to pocket profits and get bailed out of losses. We privatize the profits and socialize the risk.

FDIC protection started out at $10,000, and soon went to $40,000. Jimmy Carter raised it to $100,000 and some partially faulted this move with creating the savings and loan fiasco about ten years later.  In the midst of our recent crisis the limit was raised to $250,000 to avoid another bank run.  Given our historical correlation of increasing FDIC protection limits with worsening crisis, I wonder if in our effort to avert the current crisis whether we have simply sown the seeds of the next one.

Those who fault the absence of regulation for our current crisis should look further at the moral hazard created by the very protections embodied in our current regulations.

Regulations written in response to our last crisis do not seem to protect us from the next one.  Rules written as a result of the dot.com bubble did not protect us from the ensuing housing bubble.  In fact our regulators and our government was more of a willing participant via Fannie Mae and Freddie Mac.

In the absence of FDIC insurance perhaps the consumer and society would be better served by an “independent” rating such as the AM Best rating service is for life insurance companies or an equivalent of Moody’s or S&P for small banks.  I do stress the independence which had been seriously compromised in the past.

There will never be enough regulators to counter the number of people who seek loopholes, ply lobbyists, create new products or who otherwise seek to game the system.

Even if we were able to staff enough bureaucracies to squeeze excess risk and abuse out of our financial system, it would likely restrict growth so severely that we may long for the days of a few bubbles and the ensuing market correction.

Facing record deficits this administration needs economics growth desperately. The union card check bill, the budget deficit, the uncertainty of cap and trade, higher taxes on the wealthy and private businesses, and the cost of the health care proposals severely threaten business growth.

But the biggest hindrance may be both an increase in moral hazard that increases the likelihood of the next bubble, and overly restrictive regulations that retard the growth we need to recover from the last one.

Obama has posed this question and seems to think we can.  William Dudley the new president of the New York Federal Reserve thinks they can and should act to identify and prevent asset- price bubbles.  I remain very skeptical.

The Federal Reserve was formed in1913 to bring stability to the financial system.  Yet in its first test, responding to the Great Depression, its actions made the depression last longer than any previous recession.  The Fed had problems controlling inflation from the 1960’s until Reagan and Paul Volcker painfully wrestled it under control in the early 1980s.

Should all bubbles be contained?  Is gold in a bubble now? If it is should we be concerned? Or should we just let gold prices take its course as it eventually did in the 1980’s?  Bubbles seem to be clear only in hindsight.

Is it possible for the Fed to be truly independent of politics? I doubt it.  The recent housing bubble was largely caused by political pressure to make  housing more affordable.  President Clinton thought this was a more progressive approach than just building more government housing projects.  While this idea had considerable merit the devil is in the details and the execution of the laudable goal was a great driver of the housing bubbles.

Fannie Mae was driven by political goals and Congress fought efforts to bring it under control, almost along distinct party lines.

We had bubbles before the Fed and we have had bubbles after its formation. They seem to be more drastic since the Fed was created.  The market forces may have popped bubbles quicker without the intrusion of political objectives into the mix.

But can the Fed even foresee and manage bubbles? If they can why haven’t they before?  Greenspan noted that growth in wealth creation and savings in foreign countries had a great influence in the last bubble and was largely outside the control of the Fed.

Governments try to fight the last battle, leaving them wholly unprepared for the next one.  It is like trying to play a board game when the rules and the board surface constantly changing. That is just the nature of the market.  Those who think this beast can be tamed assume that all of the unknowns are known when the unknown unknowns are the real problems. Government always thinks they can analyze the last problem well enough to prevent the next one and they are rarely correct.

Efforts to contain bubbles may create such stagnation that the true cost of such policies will be hidden.  While we desire stability do we really want it at the expense of economic growth?   If the government is so willing to engage in economically destructive behavior such as massive debts and intrusion into markets how can we truly expect them bring such discipline to our economy to ‘manage’ bubbles, especially given their role in creating them?

“Nobody wants sound money.”  It requires a discipline that our leaders clearly have not shown before, and this administration certainly doesn’t seem to have any. Trying to segregate politics from the management of credit and the money supply may be another utopian dream that costs far more than anyone is willing to pay.