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The 2008 Financial Crisis Explained

Posted on: February 21, 2020

bandicam 2020-02-21 16-21-40-417

 

[LINK TO THE HOME PAGE OF THIS SITE]

 

THIS POST IS AN (EDITED) TRANSCRIPT OF THE TED TALK BY BRIAN WESBURY ON THE 2008 FINANCIAL CRISIS  

 

 

BLOGGER’S SUMMARY

The 2008 financial crisis caused a complete meltdown of the American economy that showed no positive response to the intervention by the Federal Reserve and the government in general with regulatory innovations. It turned out that the financial crisis and economic collapse of 2007/2008 was a replay of similar events in 1929/1930. Both of these crises were the result of the mark to market accounting rule. In both cases, the government’s effort to solve the problem with regulatory intervention failed and possibly worsened the crisis – and in both cases, simply rescinding the mark-to-market rule (by Franklin Delano Roosevelt in 1938 and by Barney Frank on April 2, 2009) brought about a recovery from the crisis and healthy economic growth immediately followed. The lesson is that free market systems are not operated by the government but by innovators and risk taking investors in new ideas and the financial system that funds these ventures. The government’s job is not to operate the economy but to provide the right kind of regulatory infrastructure where innovators and investors can thrive.

 

 

Brian S. Wesbury is an American economist focusing on macroeconomics and economic forecasting. He is the economics editor and a monthly contributor for The American Spectator, in addition to appearing on television stations such as CNBC, Fox Business, Fox News, and Bloomberg TV frequently. Born: September 8, 1958 in the United States. Education: Kellogg School of Management, Northwestern University, Rock Bridge High School, University of Montana. (Source: Wikipedia)

 

 

BRIAN WESBURY’S LECTURE

  1. How most people view the financial system:  “The free market system of capitalism is a domain of the greedy rich and particularly so, the bankers. Their greed drives them to go through periods of excess speculation that causes a collapse of the financial system. The financial crisis thus created then causes an economic crisis that affects the entire population including workers, investors, and small business – seen as victims of greedy rich speculators in financial markets. As for example, the Great Depression is described in this way in textbooks and in the popular press. This conceptual model of the financial system also forms the basis of the way the 2008 Financial Crisis has been presented the way most people understand it.
  2. How the financial system actually works:  A key element of the financial system is the Federal Reserve Bank (The FED) because it controls short term interest rates through the Fed funds rate. As it had done in the 2008 financial crisis, the Fed drops interest rates, to zero if necessary, to stimulate the economy in crisis situations – trying to get the economy moving again.
  3. Here is a financial history from 2001 that is relevant to the 2008 crisis in light of the elements of the financial system described above. In 2001, when the Fed funds rate was 6.5%,  the Fed began dropping the short term interest rate lower and lower until it had reached 1% in 2004. How does the Fed funds rate affect us? When you are making a decision to take out a loan or buy a house, the most important variable in that decision is the interest rate. bandicam 2020-02-21 17-40-54-575
  4. When Alan Greenspan had pushed interest rates down to 1% in 2003 and 2004, interest rates were below the rate of inflation for almost 3 years. So if you are shopping for a house with a mortgage rate proportional to the Fed funds rate, the lower the interest rate the more money you will spend – particularly so if the interest rate is below the inflation rate. Here is an analogy. When you drive up to a green light you don’t stop or look both ways to make sure it is safe. In that way, low interest rates are like a green light to spend and buy with little or no motivation to save and invest. This effect of low interest rates distorts not just the purchase habits of consumers but the financial system as a whole by changing the financial decisions of bankers investors, and business corporations of all descriptions. With interest rates at 1%, all the lights are green and that changes decision making across the entire spectrum of the economy.
  5. Housing prices went up 8% in 2001 but in 2004 and 2005 they went up 14% and 15% respectively. Low interest rate drives up housing prices and prices of non consumer goods in general. Thus, at low mortgage rates and high price appreciation rates of home prices, buying houses becomes an attractive option whether for a home or as an investment. The result was consumers and businesses over-invested in real estate and other investments in real assets with low interest loans and high rate of price appreciation.
  6. These conditions of course encouraged banks to give out more loans at higher and higher  loan to asset ratio and raise their risk level. This is what had created the housing bubble that preceded the 2008 financial crisis. If interest rates were higher – even 2 or 4 percentage points higher, the housing bubble would likely not have formed the way it did.
  7. This is not the first time that interest rates that are too low created an unstable economy. Back in the 1970s, the Fed had also held interest rates too low for too long. Farmers bought too much land, we sank too many oil wells betting on oil prices going up with cheap debt. Then in the 1980s when oil prices and farmland prices collapsed, banks also collapsed. In fact the entire savings and loan industry also collapsed. Although this crisis is remembered as the savings and loan collapse, it was in fact an economic crisis across the board that had affected the savings and loan industry most severely. They made too many loans at low interest rates and and when interest rates went up the market value of those loans shrank and they collapsed.
  8. At the same time, the government encouraged the big banks to make large loans to Latin American countries. So, in the 1970s the banks expanded making loans to farmers, home buyers, oil companies, and to Latin American countries – and all of those sectors of the economy collapsed in the late 1970s and early 1980s. The banking system was in big trouble. In 1983 the eight biggest banks in America had no capital because the very large loans made to Latin America were in default.
  9. The 1980s crisis contains insights and lessons that are relevant and useful in understanding the 2008 financial crisis the most salient of which is that the banking problems of the 1980s did not take down the entire economy but the 2008 financial crisis did take down the entire economy. The question is why this difference exists between these two otherwise similar financial crises.
  10. Below is a chart showing the collapse of the S&P500 index from January 2008 to March 2009. The S&P500 index tracks the stock prices of the 500 largest listed companies in the USA. The transcripts of all the Federal Reserve meetings in 2008, that recently became available to the public, contain useful insights into the causes and evolution of the 2008 financial crisis. The red dots in the chart below mark dates of the 14 Federal reserved meetings during 2008 and 2009. In these meetings there are 18 or 20 people sitting around a table and each of them talk for 3 or 4 minutes. The transcript is a record of what was said. Proposed actions to be taken are voted on and these propositions and the votes are also recorded in the transcript. The transcripts of the 14 meetings are 1,865 pages long.  bandicam 2020-02-21 20-52-12-833
  11. The chart above shows that the steepest decline in the S&P500 index in the 2008 financial crisis occurred during September and October of 2008. In the so called called “bloody weekend” of the 2008 financial crisis, September 13&14, Lehman Brothers had failed, and AIG, and Fannie Mac and Freddie Mac, and all those things had happened, and he Federal Reserve started a program called “Quantitative Easing” (QE) meaning that the Fed will buy back their bonds as a way of injecting cash into the system (increasing the money supply) in an attempt to save the economy from complete collapse. A few weeks later in October 8, 2008 Hank Paulson the Treasury Secretary in concert with the Bush white house and Congress passed TARP , the Troubled Assets Relief Plan that involved $700 billion of government spending to save the banking system.
  12. Note in the chart above that QE and TARP were passed during the near vertical decline of the S&P500 and they did nothing to stop it. In fact, the 2008 financial crisis escalated after TARP. The stock market lost 40% of its market value with financial companies losing 80%. The chart appears to indicate that the more the Feds met and the more the government took action to ease the crisis, the worse it got.  The government did not save us. It is wrong to think of the government as the architect and manager of the financial system.
  13. The free market of capitalism does not have a press agent but the government does, and the Federal Reserve does. Market forces are invisible but their agents aren’t. There are two thousand books about the financial crisis. The three main ones are:  (1) Geithner, Timothy F. Stress test: Reflections on financial crises. Broadway Books, 2014, (Geithner was head of the New York Federal Reserve Bank in 2008); (2) Bernanke, Ben S. The Federal Reserve and the financial crisis. Princeton University Press, 2013,  (3) Paulson, Henry M. On the Brink: Inside the Race to Stop the Collapse of the Global Financial System–With Original New Material on the Five Year Anniversary of the Financial Crisis. Business Plus, 2013. In all such books, speeches, and media commentaries these government agents credit government interventions such as TARP and QE as what Geithner calls “stress tests” (as for example, stress testing banks so that people will trust them again because they passed the test). bandicam 2020-02-22 09-05-37-770
  14. The underlying question is how a banking crisis turned into an economic crisis that caused the collapse of the world’s largest free market system. The data show that in the late 1970s and early 1980s banks suffered more financial losses than they did later in 2008 and yet the economy had not collapsed back then and in fact it had actually started to grow without government interventions like TARP and without QE. In fact, in the early 1980s, Paul Volcker was raising interest rates as the economy recovered; whereas in TARP & QE the government cut the interest rate essentially to zero and the economy has grown relatively slowly – slower than in the early 1980s. {Footnote: In the Fed transcripts we find that Ben Bernanke had asked his staff of 200 PhD economists to “Go out and find out how big the problem is and how many sub-prime loans were made, how many losses we could face“. This research estimated that the loss could be as high as $228 billion. This loss estimate is only 1.52% of a $15 trillion economyobama.volcker
  15. Therefore, the question here is how this relatively small problem brought the $15 trillion economy down into an economic crisis. The answer to this question is the accounting innovation called MARK TO MARKET ACCOUNTING.  It was re-adopted and enforced in November 2007 after the concept had sat in the accounting books without enforcement since 1938. mark2market
  16. This accounting rule is best understood in the historical context. In the 1800s accountants were yet not elevated to a professional category and were called bookkeepers and bookkeepers of that time did in fact mark all valuation to market instead of computing inflation adjusted historical cost. So as assets went up in value, the bookkeepers marked them up in the books. So in good times things look better but then when you start marking things down to market they look worse. This is surely one of the reasons why the economy in those times was so volatile with panics and depressions alternating with good times. In other words, mark-to-market accounting causes economic and financial volatility. In fact in the crash of the 1930s, mark to market accounting caused many bank failures. It was then that mark to market accounting was considered to be a bad law by the Securities and Exchange Commission (SEC) and the SEC advised President Franklin D Roosevelt to abolish mark to market. Roosevelt complied and Mark-to Market was abolished in 1938. And it did not come back until 70 years later in 1970.
  17. What does mark-to-market do? How does it affect financial and economic volatility? Suppose that you live on the coast in Galveston TX and you have a $500,000 house on the beach with a $300,000 mortgage; and there is a hurricane on the way and you are told to evacuate. So you pack up all your most important belongings and as you are leaving, your mortgage banker shows up and worried about their loan of $300,000 because of the risk that the asset on which it is based may be worthless after the hurricane hits. If they choose at that point to mark to house to market. The problem is that in the hurricane crisis situation there is no one around to bid on the house so that its market value can be determined. Let us suppose that a random stranger is summoned and asked for a bid and they bid $20,000. That then is the best estimate of the market value of the house at that precise moment in time. In that situation mark to market accounting would imply that the homeowner should pay the balance in cash ($280,000) or lose the house. Essentially, the homeowner is bankrupt. This is what mark to market accounting can do although the example is somewhat theatrical.  mark2market
  18. It is in this context that we can understand what happened in 2008 after mark-to-market accounting was reinstated in 2007. What happens in bad times with mark-to-market accounting is that banks can’t sell assets and they won’t buy assets and what happens as a result is that their losses spiral out of control. And this is how a $300 billion banking problem blew up into a $4 trillion economic collapse.
  19. The amazing thing is what happened right at the bottom when the SP500 indexed had bottomed out on March 9 2009. Something changed the world on that day. It involved Congressman Barney Frank, now retired. His financial services committee actually held for a year and he brought the accountants in and argued against mark-to-market – and this is how mark-to-market was removed once again. They announced that the hearing would be held on March 9. The hearing was held on March 12; and the accounting rule was changed on April 2 and mark-to-market was removed from the accounting rules once again. frank
  20. It was then that the both the stock market and the economy reversed their slide and began to grow. From that point on, the economy has grown. The stock market is up 200% (in 2014) Thank you Barney Frank.
  21. We conclude from the data and analysis presented that the 2008 financial crisis was not a creation of over-speculation that may in fact have been triggered by the Federal Reserve’s low interest rate policy in the first place – and it was the change in the accounting rule that brought about the recovery of the economy from the depths of the 2008 financial crisis.
  22. It is a generally held belief that the government has brought about the recovery with the Quantitative Easing policy of the Fed and the TARP initiative of the Obama administration. The role and effectiveness  of the Fed can best be understood in terms of their activity which involves either buying or selling government bonds. When they buy bonds they inject cash into the banking system which in turn increases lending. But in the last 5 years (2009-2014) that did not happen. Instead, the banks just sat on the excess reserves. The economic growth seen in the economy today (2014) is driven by entrepreneurship.
  23. Ben Bernanke and Janet Yellen never stayed up all night drinking Red Bull, eating pizza, and writing Apps. They’ve never fracked a well, they never built a 3D printer. So when you look at the economy and try to understand its behavior, you must see it in terms of free market capitalism and that if the free market actually works we will see economic growth and prosperity. The appropriate role of the government is to provide the appropriate legal and regulatory infrastructure, for example for interest rates, where the free market can function at its best. The people are the actors and drivers of the free market system with the conventional wisdom and motivation needed for their primary role in capitalism. They are not puppets that move when the government pulls the string. Although the free market system needs to be regulated, regulation can be flawed or overdone when governments misread their role in a free market system where wealth creators can create wealth by “staying up all night drinking Red Bull, eating pizza, and writing Apps” when the government provides the optimal regulatory regime for the free market system.
  24. The conventional wisdom that the 2008 financial crisis was brought about by banking failure because the bankers lost control is wrong. It was the government that lost control or misread its ability to control economy with more and more  regulation. In this case it was a case of regulation gone wrong with a flaw in the accounting rules and the government’s efforts to overcome that flaw with more and more regulatory interference with the free market system. In this case it turned out that not more and more government regulation but simply changing a flawed accounting rule fixed the economy.

6 Responses to "The 2008 Financial Crisis Explained"

Brian Wesbury is absolutely correct with this analysis.

I watched my net worth plummet minute by minute in September 2008, praying that mark-to-market would be abandoned. When it was, the market immediately rebounded. No other event correlated with the market reversal, including TARP and Fed actions. To those paying attention at the time, it was quite clear that mark-to-market was the problem.

And you are right for putting this matter up on your blog. It is another example of government and “experts” in the field being totally clueless, yet absolutely convinced they know it all. Just like in alarmist climate science.

And like climate modelers, Fed economists wrongly believe that they can accurately model and predict the future in a chaotic system. Nope, not possible.

Thank you again for your blog.

Thank you sir for your insightful comment

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