The Recession's Regulatory Causes
by Michael S. Rozeff
by Michael S. Rozeff
The U.S. economy may or may not be in recession now. But why split hairs? Why use official definitions? Why use official statistics? Why wait for the NBER to anoint the next recession? The fact is that important segments of the economy, such as banking, homebuilding, and real estate, are in recession now. The odds are that they will soon be joined by others.
Exchange-traded funds for real estate investment trusts peaked in February of 2007. They have declined by over 35 percent since then. The homebuilders exchange-traded fund (XHB) has fallen from over $45 to $16 since early 2006. The financial fund XLF has dropped from 38 to 26 in the last six months. Damage in individual stocks in these sectors is much greater. Retailers are now feeling the heat. Target Corporation (TGT) is under 50 from a high of 70. Sears Holding, which peaked over 195, is down to 96. These stock price drops are the stuff of recessions in these businesses. Even before these declines, shrewd investors were assigning very low price-earnings ratios to mortgage companies and title insurers. They knew that the housing bubble would burst.
Since the economy is made up of markets, critics of capitalism will now have a field day blaming the market economy for its imagined shortcomings. Do they praise markets when the economy is growing and creating millions of new jobs and vast new wealth? Of course not, because these critics are biased government apologists. They seize any chance to pound the daylights out of free markets.
We can hardly expect the beneficiaries of big government and haters of free markets to communicate the simple truth: Recessions do not and cannot occur on a systematic basis in a diversified economy composed of free markets.
Since the U.S. economy's markets are typically not free markets, it does experience recessions as a systematic feature, with the banking system being the usual method of propagation. Recessions only can occur when the government curtails free markets by its usual means: direct control and interference, taxes, subsidies, and regulations. They occur when the government, through these coercive means, manages to create pervasive shocks that mislead so many market participants that recession becomes inevitable.
In the 4 years starting in 2001, the Federal Reserve System (the Fed) increased the M1 money supply by about 6 percent a year. This followed a 7-year period in which M1 was basically flat, or stable, not rising at all. Those 7 years were a non-inflationary period for M1. The rapid and prolonged increase in M1 between 2001 and 2005 after such a lengthy period of stability was an important inflationary shock to the U.S. economy.
Suddenly the banking system was flooded with reserves, which is the fuel behind the M1 increase and a vast increase in loans. The Fed had supplied the banking system with the means to increase its loans dramatically. The housing sector took off. Housing prices began to rise.
It should be noted that some foreign central banks have inflated even more since 2001 and created their own real estate booms. This enhances the odds of a severe worldwide recession.
In the fractional-reserve system that we have, the growth of loans can exceed that of M1 through a multiplier effect. Real estate loans increased at a rate of over 14 percent a year in the same 4-year period. So much credit fuel was injected into the banking system that even after the Fed stopped increasing M1 at the start of 2005, the loans kept right on rising. Between 2005 and the end of 2007, real estate loans rose at only the slightly lower rate of 11% a year.
This was a real estate bubble, a rise in prices and activity that had no basis in the real economy, its source being the inflationary rise in the supply of bank reserves and money created out of nothing, by accounting entries and not by real savings.
Our government was well pleased with the bubble and itself. Officials liked the fact that consumers could refinance their mortgages at lower rates and, because their home prices had risen, extract home equity loans. The government encouraged these loans because they stimulated consumption. The economy was slow to recover in 2003 and 2004. Our leaders thought that these mortgage loans were leading the way out of the 2001—2002 recession. The government basked in the systematic illusion (because of all this new paper money) that the consumer was wealthier and was leading the economy out of the recession. This was deemed a good thing. This was thought to be Keynesian economics at work. Politicians, regulators, the Fed, and Alan Greenspan could all congratulate themselves at this economic fine-tuning success story. Most of all, they counted on getting more votes.
If Greenspan was the Sorcerer, his Apprentice was the fractional-reserve banking system. The banks could lend to mortgage companies, investment bankers, and hedge funds. They could create a geyser of mortgage loans themselves or finance mortgage companies that would originate mortgages. The banks could sell the loans off to others, financed by loans that it itself extended!
Along with letters bombarding Americans to apply for 0% credit cards came incessant appeals to buy the home one always wanted and could not afford, or buy that second home, or sell the home one had and buy an even larger one that was sure to rise in price. The mortgage origination industry boomed. It sought out and found new customers.
Certain excesses began to appear. In time, these excesses will be investigated. They will find their way into headlines, fines, and maybe handcuffs. The rocks will be turned over. We will see the worms underneath. A great many headlines await us, but will they blame Alan Greenspan and the Fed, as they should? Will they blame the fractional-reserve banking system, as they should? Will they blame the government, as they should? Will they blame regulators, as they should?
Of course not. They will blame the market economy and call for revamped and new regulations. They will single out certain companies and institutions as the sacrificial lambs. It will be discovered that the excess money corrupted a great many of those whom it touched. It will be found that banks relaxed their lending standards, that underwriting standards were lowered, and that investment bankers stopped doing the due diligence they should have. It will be found that the abundant money tempted many and brought out the greed in some. Investment fraud will be charged against some big and established players who originated and sold loans to other big players, all of whom either knew better or should have known better that the loans were of poor quality. They will incur some fines and write them off.
Meanwhile, falling below the radar will be a surprisingly large amount of fraud executed by small and unknown criminals or perhaps by mob-related figures. According to the FBI, 30 to 70 percent of defaults on payments early in the life of a mortgage are linked to misrepresentations on the loan applications. Mortgage fraud goes well beyond an individual who is fudging his answers. There are countless schemes and scams by which criminals have tapped into the banking system's money gravy train. One method is to buy a house. Then have it fraudulently appraised at a much higher value. Then sell this to a straw buyer (whom the house owner controls) who finances it with a bank loan. The bank loan goes to the seller who then walks away from the deal and keeps the money. This is a Mafia-type "bustout" scheme. Another method is to make multiple applications in a short period of time for home equity lines of credit, and then bust out with the money. Other schemes defraud homeowners who have been induced to make deed transfers in order to obtain loans that could save their homes.
In addition to the money-creation of the Fed that spawned this credit creation bubble, there exists an immense government regulatory apparatus that pervades the housing market. Just as there is no free market in banking, there is no free market in housing in the U.S. The two sectors, banking and housing, are joined at the hip. There has been no free market in housing for a very, very long time. The Federal Home Loan Bank system began in 1932. The Federal Housing Administration began in 1937. The Department of Housing and Urban Development (HUD) has been around since 1965. It absorbed the Federal Housing Administration which began in 1934. Fannie Mae (FNMA) began in 1938 and was rechartered and expanded in 1968.
The government officially and institutionally stepped into the housing markets in a big way under Franklin Roosevelt and Lyndon Johnson. The federal government has found it politically favorable to encourage home ownership and the accompanying bank loans. The tax structure has been manipulated to favor mortgage as opposed to other loans. The entire structure of where people live, work, and travel has been skewed by these government manipulations.
If banks can count on loan capital being supplied by the Fed and deposits being insured, a large element of moral hazard is introduced into the system. Banks will make loans that are too risky, knowing that they can and will be bailed out. To counteract this, there is state regulation and oversight of bank loans. It is a second-best or third-best solution to problems caused by other of the government's perverse regulations and incentives. However, since oversight is also a government activity, it is often too little and too late. Lax oversight has surely contributed to the granting of loans to individuals who were poor risks and to high-pressure and misleading tactics that induced people to take out loans who should not have.
The boom in residential real estate is over. It will stay over for a good number of years. The peak prices will not soon return. The sectors affected by this boom (and now collapse) are large enough to affect the entire economy. Other kinds of loans than low-grade mortgages will start to go sour and create further problems. The stock market is already in a bear market.
The Fed's money policy from 2005 to now has been one of stability. The M1 money supply is at the same level it was 2 years ago. This policy is being threatened by the recession and by the banking problems. So far the Fed has not unleashed a torrent of money as it did in 2001 under Greenspan. The current rise in the price of gold signals that the Fed, under the pressure of such legislation as the Employment Act of 1946, will again inflate. Congress has mandated that the Fed inflate in order to promote employment, and, at times such as are about to hit us, that is what the Fed does. How much it inflates and when it does are anyone's guess. Mine is that it is unlikely that Bernanke will turn on the money spigots as quickly or as much as did Greenspan.
Freedom is given lip service by our government officials and regulators. We are not made more free when the government exercises its powers over money creation, housing regulation, and the banking system.
The exercise of these government powers does no recognizable good. In the last few years, it has done clear harm. It has stimulated a housing bubble. The government caused overbuilding of houses financed by bad loans. The overbuilding of houses will take years to work off. In the meantime, important sectors of the economy will be depressed and unemployment high in those sectors until people find new work. The bad loans will have to be sorted out, which means problems and dislocations for many individuals. Taxpayers will be footing the bill for bailouts of financial institutions. The banking system will remain fragile, impeding future growth.
Stock market declines and housing price declines are the destruction of wealth. Consider homebuilder Hovnanian (HOV). Its stock was $5 in 1998, over $70 in 2005, and is now back to $5. It built a lot of houses that are now not worth the price that people paid for them. Capital flowed into homes rather than some other activity where it might have produced some permanent wealth increase.
The Keynesian remedy for the last recession has proved to be impermanent, unreal, and short-lived. It has nurtured a set of new problems for us to work through. The Fed will soon be asked to implement another Keynesian fix by again ballooning the money supply. Bernanke has said that he would accede. We can only hope that he is staving off the pressures to inflate by use of his assurances. It would be most unwise to repeat a mistake that is so fresh in our minds and experience.
January 14, 2008
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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