Connecting the Dots

The stock market crash of 1929 precipitated the period of economic decline we know as “the Great Depression.” The cause of the depression was not the crash of 1929, but instead the economic circumstances that led to the crash. Certainly, there were many contributors to the depression, including protectionist trade policies. Probably, the most clear cause of the depression was the roaring “20”s environment that led to over speculation in stocks and real estate and the reliance of businesses and individuals on too much debt. The crash of 1929 was simply the event that began a massive contraction of liquidity, which ultimately led to the economic demise of many individuals, businesses and banks.

The “New Deal” was the Roosevelt administration’s controversial plan to move the economy to recovery. For staunch free market economists that view any government influence in as anticapitalistic, this was an attempt to move the country toward socialism. While this set of acts clearly created social programs that exist today, i.e. social security, unemployment insurance, it would be difficult to argue that they did not enable the economy to recover and actually put us in a position to take great advantage of the post war boom.

In fact, one of the pieces of regulation that was passed as part of the “New Deal” was the “Glass Steagal” Act, which established the Federal Deposit Insurance Corporation (FDIC), improved capital standards for banks, and established a regulatory system of banks to insure their safety and soundness. Few people would now argue that “Glass-Steagal” wasn’t largely responsible for creating today’s strong banking system that is able to withstand significant shocks to our economic system.

The Savings and Loan crisis of the early 1990’s was brought on by a similar set of circumstances. Over-speculation in real estate, unsound lending practices and extraordinarily high debt levels caused the crisis to occur. In order to preserve the banking system, stabilize real estate, and insure the faith of depository money, the government again acted to bail out the banking industry. There was a significant regulatory cost to the banking system, ie. FIRREA, greater capital standards, increased regulatory scrutiny. While it was difficult for many of us to accept and absorb this new regulation, it did have the effect of making our banking system stronger. And, the fact we did not have a significant hangover from massive bank failures in the ‘90’s allowed our economy to experience a record expansion.

The point of this history lesson is that there are times, places and economic events which require the government to act in order to preserve the long term well being and competitive position of our country. This is a truly capitalistic viewpoint as it utilizes all resources in order to maintain a competitive advantage. Government is simply one of those resources. Every other industrialized nation on the earth, without exception, views it that way.

Given the economic events that are currently unfolding around us, government certainly has its role. The Federal Reserve exercised that role in opening up their discount window to the investment banks. As a banker I can tell you it is an unprecedented move to put the nation’s liquidity at risk by offering it to the unregulated entities that primarily caused this sub-prime problem. Keep in mind, this window was reserved for federally regulated and insured banks. Again as a banker, part of me is appalled that the investment banks caused this problem and then took our window. Hopefully, it is available if insured banks need to use it.

The government presumably did this, and also acted as a backstop to save Bear Stearns, which really does constitute a bailout, so that the financial markets would not dissolve into utter chaos and do serious damage to the nation’s economic well being. Were they right to do this? Doesn’t this interfere with free market economics? The answers are yes and yes. No capitalistic system truly operates on free market economics, and the government resources should be used as they were in the 90’s and 30’s to avert long term economic damage.

But what about the struggling homeowner? It seems we have no compunction to bail out “Wall Street”, which again is largely responsible for this crisis, but have very little sympathy for the homeowners who may be facing foreclosure. The implication that I get is that the ignorant homeowner should have known better and not gotten themselves in that situation, or that the fact that millions of homeowners will lose their homes to foreclosures will not cause lasting damage to the economy. Frankly, I think both arguments are laughable.

Bear Stearns, Morgan Stanley, Merrill Lynch, Countrywide, UBS, Standard and Poor, and Moodys should have known better. All of the folks in the upper echelons of those organizations were highly educated and graduated form the nations best graduate schools. On the other hand, many of the folks that took out mortgages were simply looking to exercise the American dream of home ownership, were not sophisticated about the process, or worse, were lied to or manipulated by their mortgage broker.

Furthermore, let’s be clear that millions of foreclosures in this country will do lasting damage to our economic system. Some economists I hear in a Pollyannaish way simply feel that these foreclosures and the subsequent price drops will just allow home prices to drop down to more affordable levels, which once achieved will create a market. Hmmm! That certainly works in a vacuum and on paper very nicely. I would ask those economists in what period of history, either US or in any other nation, could they reference an experience of the amount of foreclosures and the subsequent elimination of wealth we currently face. Also, I would ask the economists if they believe the foreclosed borrower will still be available in the system to create that market.

As in the 30’s, the 90’s and several other periods of U.S. history, we are experiencing a crisis that requires government interaction in order to preserve our competitive capitalistic system. Respected Harvard economist, Martin Feldstein, developed a plan that would in effect create a federal backstop for lenders that chose to restructure loans so that they were more affordable to borrowers. These are the type of plans we should be exploring aggressively in order to stabilize real estate prices in this country, preserve the credit system and help more homeowners avoid the economic and personal stain of foreclosure. If we can provide a backstop to Bear Stearns, we should be able to provide one to homeowners.