How Did We Get Here?
Referring to the economic situation in the Untied States, many clients have asked us, “How did we get here?” In part this question is a reflection of the surprise at the sudden realization of the problem and in part it is a quest for understanding of a very complicated issue. While there are no easy answers, there are a few key economic principles to note that have largely contributed to the problem that we now face.
In the United States we don’t enjoy a free market economy, although we would like to think that we do. We enjoy a quasi-free economy that creates incentives and regulation to fix the most recent problem in the economy. Over time this has created an unwieldy set of incentives, rules and regulations that provide a “box” for our free market to operate within. The result of the problems in the 70’s, 80’s, 90’s and the early years of this century created a set of incentives, rules and regulations that provided easy monetary policy (i.e. cheap money for borrowing) and incentives for companies to grow very, very large.
Easy monetary policy, as applied in the United States combined low interest rates with incentives for less creditworthy borrowers to borrow more than they can afford. This created incentives for lenders to lend without regard to the creditworthiness of the borrower. For example, the bank was not concerned about whether the high risk borrower could ever pay back the loan; the bank was only concerned about whether the Fannie Mae or Freddie Mac program for “less-creditworthy” borrowers would purchase the loan from the bank. Can you imagine a bank that is not concerned about whether a borrower can ever repay a loan? Can you imagine a thousand banks lending money without regard to any repayment from the borrower?
In addition to the easy monetary policy and incentivized lending, companies were continuing to consolidate programs because of the tremendous incentives and economies of scale in the lending business. Fannie Mae and Freddie Mac were consolidating billions of dollars of loans weekly into securitized pools that were packaged and sold back to the very same banks that had issued the original loans. The banks enjoyed the safety of diversification and government or insurance backing, despite the poor credit quality of the original borrower. As all banks profit through leverage, the safety of the government and insurance guarantees incented these banks to borrow as much money as possible to buy more and more of these assets. The high level of financial leverage created attractive potential profits and a system-wide dangerous downside risk.
As is the unfortunate tradition in the United States, the combination of incentives, rules and regulations created a very large pool of borrowers incapable of repaying loans and these loans were packaged into securities that were owned by very large institutions with large amounts of financial leverage that are “too big to fail.” The reasoning is that if these large institutions fail, what does that mean for the other large institutions that will also fail?
What we have created is not a free market economy; we have created a system where profits are recognized privately by the creators, builders and managers of these large financial institutions and where losses are recognized publicly by the taxpayers and citizens of the United States.
The additional incentives, rules and regulations being created today and being added to the existing list, will continue this migration away from a free-market economy toward an even smaller box within which our quasi-free market economy can operate. The only guarantee that will result is that at some point in the future we will, once again, continue to privatize gains and socialize losses.
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