After all, we know that the macro models which supposedly led us through the great moderation offered zero guidance to prevent the crisis and its aftermath. As for World War I, Tooze never establishes any clear parallels, or provides any real insights into where such parallels might be found.
Perhaps one might view the popular dissatisfaction with centralized EU institutions and their recent policy miscalculations as rhyming with the rise of national movements in the nineteenth and twentieth centuries—movements which arose in part because incompetent monarchies failed to address urgent systemic problems. Even when Tooze is correct—for example, in making the rather trivial observation that financial and political matters cannot be separated—his language is so vague that it tells us little about the origins of the crisis, much less suggests any path forward:.
By dint of their massive weight, complex social systems such as financial markets, and apparatuses like the modern state and the interstate system that it inhabits, create a sense of solidity. They make us doubt whether they could possibly be amenable to political agency, decision or debate.
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We suspect technocratic preemption and usurpation around every corner and often with good reason. There are ways of describing the operations of these systems that void the presence of politics.
But if a history such as this has any purpose, it is to reveal the poverty of such accounts. Back to the s and the conjoined birth of capitalism and the modern state system, such moments of decision, contingency, choice and attendant drama have been constitutive of our sense of modern history.
Though that sense of history might temporarily have been in abeyance after , it has returned with a bang. Such moments are the coordinates of memory and commemoration. Public administration is not a real discipline like economics. Tooze summarizes the panic-driven, ad hoc reactions of governments and central banks to the events of the unfolding crisis.
Nonetheless, in much of the book, Tooze summarizes their views uncritically. Criticism is easy. But unless one provides an alternative view, the criticism is merely academic. Promoting home ownership has been a bipartisan goal of U. President George W. Instead of providing equity and down payment assistance, Congress crafted measures that increased maximum allowable mortgage debt and reduced minimum thresholds of creditworthiness. At the same time, regulators failed to rein in specialty mortgage companies which made some of the worst loans precisely because they were not subject to bank regulations.
Politicians, economists, and banking executives also failed to appreciate the significant changes to incentives that arose from the massive expansion of mortgage securitization as well as derivatives like credit default swaps. Of course, originators still had to make representations about the quality of the mortgages, but as long as the loans were not expected to stay on their books, default risk was not really their problem. This led to much undetected, or unacknowledged, fraud that only came to light after the crisis.
There are many reasons to aggregate and securitize mortgage loans, especially when real estate prices are assumed to be uncorrelated across states. Still, someone has to be responsible for doing the proper due diligence. This was not done. Moreover, because of incompetence or corruption, the credit rating agencies failed to recognize this risk. The rating agencies did not adjust to the new loan origination business model and disregarded warning signs such as the increasing default rates on mortgages relative to historic levels.
Domestic and foreign institutions—without doing due diligence either, believing in the implied security of high ratings—bought more and more mortgage-backed securities MBS.
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Meanwhile, Congress permitted Fannie Mae and Freddie Mac to expand their portfolios without taking steps to ensure accountability. The former proposed legislation to tighten oversight of Fannie and Freddie but was rebuked for inventing frightful scenarios about the GSEs. By the s, these mistakes in housing policy were compounding the effects of an earlier change in the tax code.
It is not difficult to predict how all of the above policies combined would change incentives and encourage more resources to flow into the housing sector.
The net effect of all this ended up being the exact opposite of the original intentions of the CRA and the stated goals of U. And, during the crash, many lost what little equity they might have managed to build up. The reason for going through these policy changes in detail and I am not even going into the misguided insistence on using mark-to-market accounting in , when markets froze, or the impact of arbitrary decisions, based perhaps on personal or political sympathies, to bail out one investment bank and not another is to show that the crisis can be understood without relying on abstract economic theories or complex statistics.
In fact, an obsession with fashionable theories and aggregate data often obfuscates what is happening on the ground, which is exactly what occurred at the time. Some investors, investment banks, and even economists started to see in and that something was likely to go wrong. Goldman Sachs, for example, started buying credit insurance on various tranches of MBS in December Once the cost of insuring mortgage-backed securities skyrocketed, MBS issuance fell drastically. Mortgage financing from MBS declined rapidly, too. With the severe drop in home prices combined with the misguided mark-to-market requirements for pricing these suddenly illiquid securities , the value of the assets that financial institutions had on their books became uncertain, and banks were only willing to make loans to one another at much higher rates.
The spread between short-term U. Treasuries and libor rose from 0. This raises the question of why Bernanke, Yellen, Geithner, and so many others failed to comprehend the unfolding crisis until much later. Tooze never asks this question, but the topic is worth exploring. As a consequence, the Fed failed to understand the meaning of its own statistics and the implications of its own actions. The combined impacts of regulatory, legal, and monetary policy changes not only affected incentives but distorted the meaning of macroeconomic statistics, price indices in particular.
Between and , the price-to-rent ratio was stable at around 20, but between and , the price-to-rent ratio jumped to Nevertheless, an army of economists, at the Fed in particular, were buried in their models and jargon, pursuing a 2 percent yearly inflation target, a number that may as well have been picked out of a hat. Starting in March , the Federal Reserve lowered interest rates from 5. It then made seventeen increases of 0. Following prime interest rates, the typical initial rate on adjustable rate mortgages ARMs declined from 7. Borrowers from to , with initial ARM interest rates of 4—5 percent, started paying double that between and , around 8.
As long as rates stayed low, incomes stable, and prices were rising, the large increases in mortgage debts were not perceived as a burden. Taking on a larger mortgage or flipping houses seemed like a great idea—until rates doubled. Consider Greece, whose main business sectors are hotels, restaurants, and agriculture; many of these are family-owned companies notorious for tax evasion.
Add to this the estimated 43 to 45 percent of self-employment income that of physicians, lawyers, etc.
Will we survive the next financial crisis?
In addition to the national sport of tax evasion—shared with the Italians and Spanish—Greece also faces major demographic challenges. In many respects, the consequences of the crisis have become a way of life; while the world economy is slowly improving, the financial crisis fundamentally changed many economic relationships between governments, financial institutions, markets, and consumers.
The chain of events that explains the financial crisis is relatively simple. Naturally, each of these steps involved a large number of contributing factors. The expansion of consumer credit in home loans also led to an increase in credit-funded consumer spending in other parts of the economy as well, fueled in large part through loans against home equity; as long as demand for housing remained strong — which was encouraged by looser credit standards — home prices and property values remained high, and consumers could use that value as collateral for additional spending.
Because the demand for mortgages was roughly equal to the demand for houses, a large number of lending businesses — most operating under regulatory guidelines that were much less strict than for banks — were started after The problem this caused was a lack of funding; mortgages take a little time, from the perspective of the lender, to start providing a stable revenue stream that can be used for new loans, unless the lender has a large initial financial reserve, which many did not. That led to the growth of creative funding concepts, such as…. In order to fund the lending boom, large and small lenders alike bundled their outstanding mortgages into financial derivatives called mortgage-backed securities, which took a variety of forms.
An MBS is essentially a claim on a percentage of the cash inflow from a mortgage or group of mortgages and is generally paid on a monthly or quarterly basis, similar to a bond coupon. Once an MBS is created, however, its value as a tradable security is not necessarily limited to the expected revenue on paper from the mortgages in the pool; prior to , the market value of these derivatives grew to several trillion dollars, many times the value of the properties they represented.
The volatility of these MBS derivatives was a significant trigger for the financial disaster, because…. This created one self-feeding cycle because it led to less financing for new mortgages; it led to another because the only way the lenders could compensate was to raise the interest — sometimes precipitously — on their adjustable-rate mortgages, which in turn led to an accelerating number of mortgage defaults by borrowers.
The Financial Crisis Was A Failure Of Government, Not Free Markets
A mortgage that is not being paid has zero value as part of an MBS; in what seemed to be overnight but in reality was a period from late to mid, an enormous amount of asset value held by financial institutions in the form of mortgage-backed securities simply vanished. The impact on financial institutions meant that, at a minimum, lending became severely restricted, and a large number of institutions failed outright — 25 in the US in alone. The MBS problem affected a large number of investment organizations as well, companies and government bodies who held a large number of derivatives as part of the financial portfolios for pensions and retirement savings for workers.
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The history of the financial crisis is mainly a lesson about the complex — and evidently potentially-risky — connections in global economics. The entire world economy suffered because of an unsustainable condition in the housing market in the US, and the financial products and processes that evolved as a result of that condition.