Can Government Correct the Economic Mess it Created?

By Robert E. Martin

        As America struggles with high gas prices and the ruinous aftershocks to the economy of the 'Sub-Prime' Lending Crisis, it strikes me that all this carnage to our economy could have been avoided had government simply been doing its job - namely, leveraging oversight over the financial markets it is supposed to be regulating.
 

An interesting profile that I read recently on a maverick economist named Hyman P, Minsky shed serious clarity on our current situation. Twenty-five years ago, when most economists were extolling the virtues of financial deregulation, Minsky maintained a more negative view of Wall Street, citing how they periodically set the entire economy ablaze.
  

Although he died 12 years ago, Minsky earned a Ph.D from Harvard and taught at Brown, Berkeley and Washington University. He also worked as director of the Mark Twain Bank in St. Louis and knew how these institutions worked.
       

In essence, Minsky believed Wall Street encouraged people and businesses to take on too much risk, generating ruinous boom & bust cycles and the only way to break this pattern was for government to step in and regulate financial institutions.
     

He developed a 'Financial Instability Hypothesis' that basically consists of five stages of the credit cycle: displacement, boom, euphoria, profit taking, and panic. A displacement occurs when investors get excited about something like an invention or a war.
     

With our current problems, the cycle began in 2003 when Fed Chief Alan Greenspan decided to reduce short term interest rates to one percent, and an unexpected influx of foreign money, especially Chinese money, went into U.S. Treasury bonds.
       

With the cost of borrowing at historic lows, mortgage rates in particular resulted in a speculative real estate boom that was unprecedented. As this boom leads to euphoria, banks and other commercial lenders extend credit to increasingly questionable borrowers, often creating new financial instruments to do the job.
  

During the 1980s, junk bonds played that role. More recently, it was the securitization of mortgages, which enabled banks to provide home loans without worrying if they would ever be repaid. Banks were off the hook because investors who bought the newfangled securities would be left to deal with any defaults.
 

Then at the top of this trend around mid-2006, smart traders started to cash in on their profits, followed last July by the panic created when two Bear Stearns hedge funds invested heavily in mortgage securities collapsed, only to have the company itself bottom out last month, which stock selling at $6.00 per share and the CEO walking away with $61 million.

According to Dean Baker, the co-director of the Center for Economic & Policy Research, average house prices are falling nationwide at an annual rate of more than ten percent, something not seen since before World War II. This means that American households are getting poorer at a rate of more than two trillion dollars a year.

For every dollar the typical American family's housing wealth drops in a year, that family may cut it's spending by up to seven cents. Nationwide, that adds up to roughly $150 billion dollars, which is much bigger than President Bush's stimulus package. Moreover, this doesn't take into account plunging stock prices and tighter lending practices.
    

In an election year, you would think politicians would be focusing on this crisis more than they would the words of church ministers and whether or not to make tax cuts permanent, and this aversion from the mechanics of what got us in this mess is most troublesome.
      

Since the 1980s and the Reagan Era, Congress and the Executive Branch have been working to weaken federal supervision of Wall Street. Indeed, the most fateful step came when during the Clinton Administration, Greenspan and then Treasury Secretary Robert Rubin championed the abolition of the Glass-Steagall Act of 1933, which was meant to prevent a recurrence of the rampant speculation that preceded the Great Depression.

If the lessons from that period proved anything it is that intervention and the way you structure financial institutions is essential for market economies to be successful. Rather than debate about tax cuts versus spending increases, policy makers need to be discussing how to reform the financial system so that it serves the working of the economy, as opposed to feeding off of it and destabilizing it.
   

In this election year, we need to hear politicians talk about issues that matter in the economy, such as how to address Wall Street remuneration packages that encourage excessive risk-taking; restrict irresponsible lending without shutting creditworthy borrowers out of the loop; help victims of predatory practices by perhaps extending mortgage loans to 40-year periods to avoid foreclosures without bailing out irresponsible lenders; and mainly, holding agencies accountable for their assessments and actions.