Greedy speculators in housing and private bankers, financial innovation and failure of risk models, regulators and credit rating agencies were all deservedly blamed for the recent financial crisis. Behind this all is public policy that worsened the problems.
Long before the greed of speculators and bankers went wild and long before there were sub-prime housing loans, there was the US Government involvement in the form government subsidies as reflected in (i) the existing tax-deductibility of home-mortgage interest payments; (ii) Federal Housing Administration programs which provide credit to first-time home buyers and permit up to 97 percent leverage at origination and also permit cash-out refinancing that resulted in 95percent leveraging (take-out of $520 billion each year by households through re-financing); and (iii) government financial subsidies through federal home loan bank lending for owning ‘an American dream’ and directing credit to low-income communities in line with the spirit of Community Reinvestment Act of 1977 and establishment of quasi-government agencies such as Frannie Mae and Freddie Mac. In addition, there is ever increasing moral hazard in the financial sector over the past century in the form of deposit insurance, reduction in capital adequacy ratios, implicit and explicit guarantees for bank bailouts to all types of financial institutions, including the too big to fail institutions. These policies combined with Fed policy of cheap money by keeping interest rates low to help economic recovery from the dot-com bubble burst of early 2000s only fueled credit growth and exacerbated the speculative bubble in housing market. From Iceland to Ireland to other European countries and USA housing bubbles were spawned in this fashion.
Prior to the global financial crisis of 2008-09, there were rapid price hikes in food grains and fuel during 2007 and early 2008. Again, financialization of commodity markets and role of speculators was blamed for those bubbles. Without healthy behavior of speculators and traders markets would not function efficiently. It is only when speculation is out of control that everything goes hay wire. But behind the wild speculation there is always cheap money in the form of easy fiscal and monetary policies.
The financial reforms underway in a number of countries hardly any mention is made about government policy blunders nor does it deal with continued government involvement in housing. Instead they are exclusively focused on re-regulating financial firms, strengthening watch dog institutions, and restricting speculators. Such reforms will hardly prevent future crises because of ‘capture’ of all institutions (parliaments, regulators, credit rating agencies, policy making agencies).
Spurred by state directives, banks in China have been providing cheap money since late 2008 and this is now led to a housing and construction bubble in China. Similarly, the recent jump in stock prices in both emerging and developed economies is likely to be a manifestation of public policies of 2008-10 in the form of large fiscal stimulus packages and ‘quantitative easing’ of the central banks. Similarly, the recent jump in wheat prices is partially due to severe drought in Russia but also a precursor of search for higher yields by the excess liquidity now in place in the world. A bubble is created by the news of ‘artificial scarcity’ and here is where regulators and government agencies have to step in.
No one can deny that prudential (and not strangulating) regulations and their effective enforcement strengthen market efficiency. Rather than wait for bubbles to develop, regulators and government agencies should prevent the bubbles by raising margin requirements to reduce leverage, raising interest rates to mop up excess liquidity, and with use of ‘moral persuasion.’ But, governments should also not be involved in housing, land sales, take over of banks, industries, and running commodity marketing boards etc for this role signals a scarcity which exacerbates moral hazard.
How can ‘captured’ governments implement sound policies? Only if the citizens and media are vigilant, and seek full transparency, while holding government agencies accountable all the time.