June 27, 2017    9 minute read

Don’t Blame Laissez-Faire Capitalism for the Financial Crash of 2008

10 Years on from the Financial Crash    June 27, 2017    9 minute read

Don’t Blame Laissez-Faire Capitalism for the Financial Crash of 2008

The 2008 recession was one of the worst recessions we have ever had. The recession originated in the US housing sector but went on to affect every country. This article will argue that it was actually big government and deviation from free markets, which caused the crash. The popular myth is that the laissez-faire Republicans deregulated Wall Street and this led to the financial crash. The main culprits are the Federal Reserve and Congress. Almost 10 years on, we have still barely recovered from the Great Recession. The Austrian school of Economics is a laissez-faire school of thought that was actually the first to predict the 2008 recession as well as 1929.

The Austrian Business Cycle Theory

To understand the cause of the crash we must talk about the events leading up to the recession in the context of the Austrian business cycle theory. Interest rates are determined by people’s desire to save or consume. The market interest rate would be based on people’s time preferences. A lower time preference would indicate that people have more desire to save as opposed to consuming now. This increases the supply of loanable funds and hence lowers the market interest rate. This, in turn, allows other people to borrow more money for capital investment. This results in more investment on long-term projects and hence allows us to supply more goods in the future. As there is more saving, it means there will be more consumption in the future and hence the capital investment is thus justified.

  1. However, when the central bank increases the supply of money and increases the amount available in the loan market, it reduces interest rates. This would make it seem that there is an increase in ‘delayed consumption’ and hence more funds for investment.
  2. Businessmen are misled into thinking that there is a large amount of savings that will be spent in the future.
  3. Therefore capital investment and investments into ‘’longer processes of production’’ (higher order goods) all increase. Hence the capital structure is lengthened.
  4. Businesses take the newly acquired funds and bid up the prices of capital and hence shift large amounts of investment from consumer goods to capital goods.
  5. This marks the boom period of the business cycle. The large investments made in capital goods stimulate more employment in these industries. This is known as ‘malinvestment’.
  6. These long-term projects are erroneous as the demand was never there and hence the investments are abandoned. Asset prices begin to fall and labour that was employed in these capital goods industries are now unemployed. The bust period now begins.
  7. Capital goods industries are the ones that suffer the most in the economy.
  8. Asset prices fall, consumer confidence falls, more labour becomes unemployed and economic growth slows and more business and households enter bankruptcy.
  9. The bust also includes the liquidation of the malinvestments and hence a reallocation of capital in the correct proportions (according to consumer preferences). This is the readjustment process. The greater the misallocation, the more violent the readjustment process. This marks a recession.

A Repeat of the 2000s? And Why Has Recovery Been So Weak?

In January of 2001 interest rate was 6.5%. After 12 successive cuts, the rate stood at 1.25% by Dec 2002. This was not caused by an increase in the savings rate. The personal savings rate in Jan 2001 was 6.3% but by Aug 2002 it had fallen to 4.4%. This implies that businessmen have been misled and hence sets the stage for malinvestment.

There were large investments in housing (and the financial products that derived their value from housing) and the auto industry. According to ABCT, it is capital goods industries that suffer the most. Ultimately it was banks, financial institutions and the auto companies that needed a bailout from the government and on the brink of collapse.

House prices begin to level off in 2006. As a result, the boom period is about to end and economic growth rate falls from 2.7% to 1.8% from 2006-2007, the same time when the malinvestments unfold.

House prices begin to fall, the financial products which derived their value from housing begin to lose value and hence a fall in asset prices.

National default rates increase and the construction industry reduces employment. This marks the liquidation of the malinvestment in housing.

The Bust/Readjustment Period

An integral part of the Austrian theory is what exactly happens during the readjustment process.

According to Murray Rothbard, there is an increase in demand for money when capital and resources, has to now readjust in correct proportions between higher order and lower order goods. The demand for money increases for many reasons. The first is that people expect falling prices and hence hold money. Also, people must pay off their debts by liquidating assets in exchange for cash. Also, the bankruptcies make entrepreneurs cautious about investing. As a result, demand for money increases and hence falling prices result (deflation) and higher interest rates (credit contraction). The money supply may contract because banks fear that there will be a run on the banks. However, this is less relevant today due to the fact that we have central banks.

Deflation of the money supply (deflationary credit contraction) is a key form of recovery. Falling prices encourage greater savings in the economy by making it easier for businesses to replace their assets. Hence businesses may recover more quickly during a recession, as the natural rate of interest is lower. The natural rate refers to the interest rate set by the balance of savings and consumption minus the entrepreneurial risk and depreciation of capital.

The Austrian school calls for the government to adopt a laissez-faire attitude. This is so that government does interfere with the necessary readjustment process.

The government should not do:

  1. The Government must not call on banks to lend further as we have established that credit contraction is beneficial.
  2. Further credit expansion- encourages credit contraction, and do not bail out banks. This would give banks the confidence that they can continuously expand credit, inflate and not have to pay their debts.
  3. Keep wage rates as they are
  4. Stimulate consumption- increases in government spending will lead to more consumption. Any increase in the size of the government shifts the consumption-saving ratio in favour of consumption, hence prolonging the recession. The Government must encourage saving by cutting government spending and cutting tax rates.
  5. Subsidise unemployment- this will prolong the unemployment as it delays the movement of factors (labour) to fields where jobs are available.

Why Has Recovery Been So Weak?

The recovery has still been slow largely because governments and central banks have been interfering with the readjustment process.

  1. The Federal Reserve has carried out $4trn of QE, which implies a clear expansion of credit, precisely what the Austrian school advises against.
  2. Congress launched a $700bn bailout. Instead, we should have let the banks fail and go into bankruptcy so that the readjustment process can begin.
  3. Congress voted to expand unemployment benefits to 99 weeks.
  4. The $787 billion stimulus in 2009 was a spending bill that aimed to stimulate demand in the economy via consumption. This is the exact opposite of what is supposed to happen in the readjustment process.

Role of Government in the Crash

The government, as well as the central bank, can set the stage for a bust. This is shown by the fact that housing was particularly affected. This is supported by the fact that Fannie and Freddie (backed by the government) and the Department of Housing and Urban Development were tasked with increasing home ownership for the poor. Consequently, this led to bad incentives. Banks were incentivized to give loans to people with poor credit precisely because they knew the poor would be subsidised and Fannie and Freddie would buy up the mortgages. As a result, there is a clear incentive for banks to give too many loans and hence encouraged more real estate.

Furthermore, in the 1990s Congress repealed the Capital Gains tax for the property above $500,000 and also introduced a larger home mortgage interest deduction for taxpayers. These deductions clearly favour people who own their homes and hence led to people wanting to secure a loan. When you add up tax incentives and the fact that Freddie was guaranteeing mortgages for the poor and that the Community Reinvestment Act requires lenders to serve under-served areas, there is a large government failure.

However, during the Bush administration, most Republicans called for regulation of the GSEs. However finance committee leader Barney Frank opposed it and a bill to regulate the GSEs died in committee. Consequently, if we were to play politics, it is actually the Democrats who are to blame for 2008, not Republicans. The Federal Reserve is a much bigger reason for why there was a crash, with Fannie and Freddie exacerbating it.

Glass-Steagall Would Not Have Prevented 2008:

In 1999 the Republican Congress repealed the 66-year-old law, which separated commercial banking and investment banking. This means that Bank of America couldn’t be a commercial bank and an investment bank at the same time.

Let’s say that B of A was only a commercial bank. Given that Freddie Mac was subsidising mortgages and the Community Reinvestment Act required lenders to serve underserved areas, meant that the perverse incentives still existed with or without the Glass-Steagall. As early as the 1960s commercial banks were allowed to engage in investment banking activities, so the law had little relevance anyway. And during the 1960s there were no major financial crashes.

Hence the B of A could have bundled loans and then sold them onto an investment who would them repackage them in the form of Mortgage Backed Securities (MBS) as well as Synthetic CDOs. As a result there still would have been a financial crash, which originated from a housing bubble.

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