Wall Street didn't cause crash

[the-rukh.livejournal.com]

Here is an interesting article by conservative author and economist David Frum. He rejects the idea that the issue was Wall Street's lack of regulation or greed, but instead a different issue: China and the lag between middle class income and cost of living.


Wall Street didn't cause crash of '08

Financial reform? Not exactly. The bill before Congress does nothing to address the fundamental background causes of the crash of 2008.

Wall Street may have been the instrument of the crash. But the crash was made elsewhere: in Washington's failed policies for middle-class families -- and in China's distorted rush for economic growth.

The story is not a simple one. But I hope you will pay attention to the details. If you don't, you may find that the pocket that has been picked is your own.

As you've heard, the crash begins with the huge excess load of debt built up in the last two decades by American households. Why did Americans borrow so much? Some like to tell a story of irresponsibility: We borrowed too much because we were self-involved yuppies who just could not deny ourselves the latest flat-screen doodad for our McMansions.

Maybe that describes some people. But many millions of middle-class families plunged into debt for a very practical reason. Their incomes were not keeping pace with the cost of crucial items of the middle-class lifestyle: housing, medical care, college tuition. At the same time as housing, medical care and tuition were jumping in cost, the cost of borrowing was dropping to historic lows.

Adjusted for inflation, the typical American family earned less in 2007 than that family had earned in 2000. Meanwhile, everyday necessities such as energy were becoming more expensive: By 2007, the typical American family paid more for energy than it did for clothes and entertainment combined.

As everyday bills piled up, families borrowed to pay extraordinary bills. Mom needs nursing care? Junior got admitted to Chapel Hill? The roof needs refixing? No worries -- just cash out with a cheap refinance deal.

In the 1950s, the total debt of all American households amounted to less than one-third the nation's gross domestic product. In 1980, household debt amounted to less than one-half. As recently as 1990, it was still under 60 percent. In 2000, it was under 70 percent. On the eve of the 2008 crash, total household debt had bulged to 96 percent of gross domestic product.

All this borrowing might look like the road to ruin. And in fact it was the road to ruin. But that's not how it looked at the time. At the time, it looked like a bargain. Between 1980 and 2008, the household debt load doubled as a share of the economy. Yet the interest cost to carry that debt rose much more modestly. In 1980, the average American family devoted about 13 percent of its disposable income to debt service; by 2008, the average family was spending about 17 percent of its disposable income to service debt.

Why was debt so cheap?

This takes us to another fundamental cause of the crisis: the growth of China.

Maybe you've heard that we bought a lot of goods from China and now we are deeply in debt to China. That's true obviously -- but the cause and effect are upside down.

China lent us a lot of money so that we would keep buying Chinese goods.

Export booms do not usually last very long. The exporting country accumulates more and more of the importing country's currency. Eventually the exporting country decides it wants to use some of that currency. It exchanges the importing country's currency for its domestic currency -- and that has the effect of making its exports more expensive. The boom bumps up against its own natural limits.

That did not happen with China. Desperately eager to create more and more jobs to employ the tens of millions of peasants flowing into China's huge cities, China not only accumulated dollars by the hundreds of billions -- it held them. Then it went into the foreign currency market to buy still more billions of dollars, sometimes $1 billion a day.

All that dollar buying prevented China's currency from going up in value, which would have increased the price of China's exports -- and that kept China's factories turning.

What do you "buy" when you buy "dollars"? There are only so many Benjamins in the world, nowhere near enough. Buying "dollars" means buying dollar-denominated debt, and far and away the biggest source of U.S. dollar debt is U.S. mortgage debt.

With China so eager to buy, U.S. bankers went to work to create mortgage paper to sell. It didn't have to be good-quality paper -- the Chinese didn't really care about that. Did you get a great deal on your refi in 2005? Thank the Central Bank of China.

American homeowners borrowed because they could not earn enough. China loaned to keep its factories turning. Money flowed in a frenzied torrent across the Pacific. And somebody had to make it all happen: Wall Street. It created the debt instruments China wanted to buy and packaged the mortgages that Main Street felt pressured to sell. With trillions of dollars changing hands, even a small percentage fee could pay a lot of people a lot of billions in fees.

No doubt some of those fee-takers did abusive things. But the whole dynamic was abusive and dangerous. And so-called financial reform is a petty distraction from that larger, more important, and more urgent dynamic: raising American incomes so Americans borrow less, and redirecting Chinese trade to the home market so that the Chinese lend less. Until we achieve those two things, any recovery will only invite the next disaster.
End of article frum ... David
-----

I think it brings up some interesting issues, issues definitely worth considering. My main criticism though is that he rejects one cause for this other, and I don't think there's anything that explicitly causes one to negate the other. I think all these issues are real issues and aided in causing financial collapse and probably more than these too.

The things he covers are more the issues that set the stage: influx of money, people needing to borrow to maintain a normal life. Yes, this caused there to be lots of debt built up. If people remember, that has existed for a while though, the U.S. economy had been considered a debt economy even back into the 90's. The economy was built on plastic then too, and people were expecting collapse then too.

So in that sense, he's right that we have not addressed those underlying issues: people still are needing to borrow to live normal lives. Frum may not agree, but healthcare reform actually addresses the underlying cause of these problems probably more than finance reform does.

As far as the issues with China goes, I'm not going to address that. Many people have, and maybe some of y'all should, as China is not going away anytime soon and has been very proactive in leveraging their economic abilities and will probably continue to be a chief influence on our economic situation into the foreseeable future.

Lastly, I think Frum is wrong on ignoring the effect of deregulation in banking. The banking issues acted as a magnifier. The influence of Wallstreet pushed the deregulation of loaning and pushed the social acceptance of living in this massive debt economy, through lobbying and advertising they made easy credit a way of life. That can't be ignored in this cycle either. Perhaps the banking reform will help to reduce the reliance people have had on loans, which will make it necessary for middle class income to catch up with cost of living.

Even more lastly, something I thought of. Part of the problem with cost of living is that with our constant inundation of advertising, people often feel they 'need' a lot of things they really don't. What is considered middle class has a lot of pork attached on simply because its part of our social environment. How do we address that problem that is so fundamentally linked to our culture? We may see a reduction in the social acceptance of just borrowing to afford anything, but when that butts up with 'now people believe they are expected to have all these things that they now cannot afford' what is going to happen?

Comments

[reflaxion.livejournal.com]

Wait, is he saying that China bought our crappy sub-prime loans? Because I don't otherwise see the correlation.

[the-rukh.livejournal.com]

Well China has many impacts in the story.

1) Tons of cheap exports and holding U.S. currency, causing it to be artificially higher than normal because that currency isn't being traded

2) Buying U.S. currency to keep it high in order to keep exports going and their economic boom going, further artificially inflating our currency

3) Loaning money to the U.S., which basically is like transferring debt. If a person gets a cheap loan and the money came from China, they owe the bank money, the bank owes China money, China is taking on the debt that way

4) And yes, finally, China actually buying U.S. debts including mortgage debt, packed and bundled by the deregulated U.S. financial markets.

[weswilson]

Wait, if China owned all these bad mortgages, wouldn't they have suffered more from the collapse of the housing bubble?

[the-rukh.livejournal.com]

I'm not sure, that's a good question. I don't have any information either way on how it's affected them nor how they have either dealt with it, or perhaps avoided it, or why it did not.

[the-rukh.livejournal.com]

http://en.wikipedia.org/wiki/China_economic_stimulus_program

[eracerhead.livejournal.com]

In other words It isn't wall Street's Fault. Wall Street merely provided the means bring about the demise of the economy because there was no regulatory body to stop them.

[the-rukh.livejournal.com]

I feel like that's sort of what he said, and I disagree with that.

[devil-ad-vocate.livejournal.com]

Ben Stein had an interesting take on it; he describes the Wall Street players as a 'bunch of drunken frat boys':

http://www.cbsnews.com/stories/2010/04/25/sunday/main6430581.shtml

[reality-hammer.livejournal.com]

There were regulatory and oversight agencies. They were watching porn and telling Americans there weren't any looming problems with Fannie Mae, Freddie Mac or the mortgage industry in general.

[ddstory.livejournal.com]

This article is kind of dumb. He takes a perfectly valid premise, China demanded large quantities of dollar-denominated assets. And then makes an illogical leap, China caused the crisis. Huh?

China didn't force Bear, Lehman, AIG, or any of the other large financial institutions into real estate. They did it all by themselves. That was what caused the financial crisis. So yes, it really was Wall Street's fault.

[the-rukh.livejournal.com]

Well, like I said, we shouldn't reject one set of causes for another. I think China did help set up the environment, but I don't think you could say they did it on purpose, or were the sole motivators, not even close.

Its like the Earthquake in Haiti. We can talk a lot about the lack of housing standards leading to so much death and destruction, but you can't say the earthquake itself had no part in it.

In the same way, the U.S. *should* have been working hard on keeping these issues in line, lots of people knew what would happen, but it was just so much more fun for people with the money and influence over lobbying and such to make mad money, despite their face.

Cheap debt

[reality-hammer.livejournal.com]

People may have attempted (or not) to justify their borrowing, and I am suspicious of some of Frum's economic examples but the simple fact is that cheap debt is a siren song all on its own.

You put 4-5-6% loans out there when people are making more than that in other investments or simply watching inflation out pace the loan rate and there's little to stop someone from borrowing now to (perhaps) pay back later with inflated dollars and/or investment returns.

There are a number of reasons for the cheap debt, of course. It was Fed policy, White House policy (over three administrations) and the (former) reputation of mortgage-backed securities as being proof against any and all sorts of economic maladies. Demand from China was "a" factor but before them it was the Japanese and British and...there will always be demand for US debt as long as we have a history of repaying it without significantly devaluing our currency.

If the federal government wants to continue to play in the mortgage game it should drop the zeros (zero down, zero interest, zero docs...) and require 10% down payments and proof of income sufficient to pay the principal, interest, real estate taxes and have enough left over for other debt financing/living expenses.

The government ruined the S&Ls with horrible regulations and oversight and almost did the same thing to the mortgage industry. How many times does it have to fail before it realizes that politics and banking don't mix?

All this will fall on deaf ears in the Obama administration, however. He's cut from the ACORN/lawsuit/forced loan cloth that helped cause the mortgage crisis. The third verse will be very much like the first two verses only the US taxpayer will be on the hook more than ever before.

Re: Cheap debt

[the-rukh.livejournal.com]

I don't think you said what you meant to say by 'politics and banking dont mix'

Re: Cheap debt

[politikitty.livejournal.com]

That said, it looks like while the mortgage crisis might have been inevitable and had political implications, it only became a larger financial crisis because it sparked a bank-run in the shadow-banking industry. Bank-runs are inevitable in any system unless you actually have some politics involved in the issue.

[htpcl.livejournal.com]

Can you really call Frum an economist? According to Wikipedia, the correct title would be economic speechwriter. That's close... kind of. But not exactly.

Indeed, he used to write the economic speeches of GWB but that still doesn't qualify him as an economist, and still leaves his competence in question.

Still, much like you (probably) I'd be more interested in people actually addressing the message, rather than trying to bring the messenger down.

[the-rukh.livejournal.com]

He knows a thing or two, and he spends his time talking about economics, I think he can be called an economist.

[meus-ovatio.livejournal.com]

My understanding of the situation has absolutely no connection to the way Frum has framed it. I have no idea what he is going on about. As for his analysis of the debt-cycle, Americans don't borrow because they don't have enough money: they just leverage what money they have into more borrowing. If we made more, we'd just borrow more, get bigger houses, nicer cars and all that. The most financially stable households are the moderate to low income households who have simply decided to not leverage their incomes to insane heights of consumer borrowing.

[the-rukh.livejournal.com]

That's kind of why I tacked on the last paragraph, I'm not sure how much is that people can't afford a reasonable lifestyle and how much is the 'more more more!' attitude that we're constantly fed by people who have something to gain by us having that attitude.

[mahnmut.livejournal.com]

I suppose American financial institutions leveraging themselves 40 to 1 is China's fault as well. Along with the massive amount of money manipulation carried out by the wall street firms, the housing bubble, sub prime lending, too easy to get credit, predatory lending, deregulation, increased debt burden, the commodity bubble, and other systematic interviews.

Really, I don't think we should be pinning this on China, when quite clearly Wall Street fucked a lot of things up.

And then the same pundits who praised free-for-all market and are now screaming SOZIALIZMUZ!!!1!1 at one or another's effort to clear up the whole mess, are also mocking small countries like Iceland for going totally kaput for the same reasons. That would've even been funny if it wasn't so sad.

[root-fu.livejournal.com]

A different perspective:

Goldman executives cheered housing market's decline, newly released e-mails show:

http://www.washingtonpost.com/wp-dyn/content/article/2010/04/24/AR2010042401049.html (http://www.washingtonpost.com/wp-dyn/content/article/2010/04/24/AR2010042401049.html)

[mahnmut.livejournal.com]

Damn I think my eyes went asplode. ;-(

re-post

[root-fu.livejournal.com]

There is so much bs revisionism being circulated right now.

1st, banks ARE regulated.

The central bank's purpose is to supervise and regulate the US banking system and dictate policy. Its listed on the Federal Reserve's website:

What are the Federal Reserve's responsibilities?Today, the Federal Reserve's responsibilities fall into four general areas:

conducting the nation's monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices

maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

http://federalreserve.gov/generalinfo/faq/faqfrs.htm#3 (http://federalreserve.gov/generalinfo/faq/faqfrs.htm#3)

Banks ARE regulated.Therefore, what we're talking about isn't a lack of regulation, but rather a failure of it.

Of course, people being the un-educated sheep they are, they immediately jump on the "we need to regulate banks -- because banks aren't regulated" train.

If government regulation of banks, failed, causing this mess. What makes people think things will be any different with increased government regulation?The consensus fails, here. Then again, it often does.

+1

[zebra24.livejournal.com]

yes.

Also the reason for this wasn't greed itself.
Usually greed cause people to work better and not to spend money irrationally. (for some people to commit crime)

Here is just example of hand-made situation when caused by regulation situation moved natural managers behavior from earning to stealing.

[stewstewstewdio.livejournal.com]

It's as simple as this. We used up and exported all our equity at the personal, business and government level.

[allhatnocattle.livejournal.com]

I grew up watching David's mom read me the news every night. This is all I have to say about this post.

(1)

[abomvubuso.livejournal.com]

From Frum:

"We borrowed too much because we were self-involved yuppies who just could not deny ourselves the latest flat-screen doodad for our McMansions."
"Their incomes were not keeping pace with the cost of crucial items of the middle-class lifestyle: housing, medical care, college tuition."

I dont think there's as much difference between these two "causes" of borrowing, as Frum likes to pretend.

He's simply moved the viewpoint half way to "self-involved yuppy" and then describes what are luxuries as "crucial items". If a BIG new house is seen as "crucial" to the middle-class lifestyle, necessarily they'll be paying more for housing. If college tuition has become more of a "crucial item" through the 90s and 00s and capacity has not increased, then prices for tuition will of course rise.
Medical care is the one factor which has increased most in cost. Is it for the same reason: increasing demand but lagging supply? I think there are other factors: the synergy between medicine and the law, which makes it risky to use anything but state-of-the-art equipment, or to prescribe an older and cheaper drug which has a higher level of risky side-effects. Introduction of, or increasing use of new treatments (huge increase in medicating children, explosion in the use of CAT and then MRI scans, HIV treatment, surgery and medication for the increasingly long-lived elders, oh etc etc over twenty years).

Frum may not agree, but healthcare reform actually addresses the underlying cause of these problems probably more than finance reform does.

Addressing it is good. We shouldnt pretend that increase in cost is going to level out though. People in developed nations may just have to lower their expectations of whether they can afford whatever-it-takes from medicine to save their lives. Even if its an insurance company paying, or a government fund paying, there comes a point where the years of life saved is not worth the money. We're just going to have to tolerate it, that a small section of the population can afford to be perfectly healthy, and for everyone else staying alive is the most they can ask. Thats the situation for the time being.

As far as the issues with China goes, I'm not going to address that. Many people have, and maybe some of y'all should, as China is not going away anytime soon and has been very proactive in leveraging their economic abilities and will probably continue to be a chief influence on our economic situation into the foreseeable future.

A lot of debt is concentrated in that one place, to the point where its a strategic liability. But the cause of it, the trade deficit the US has with China, is just a fraction of the trade deficit situation.

The US-China deficit began to rise steeply in 2004, rising to $268 billion in 2008. Source (http://www.census.gov/foreign-trade/balance/c5700.html#2010)
The US-World deficit in 2008 was $696 billion. Source (http://www.census.gov/foreign-trade/statistics/historical/exhibit_history.pdf) (.pdf)

(Those sources both include figures for 2009, showing a sharp drop due to the GFC. But since Frum is talking about the origins of that crisis ...)

Exactly the same mechanism of exporting-debt applies to the sum figure as applies to Chinese held debt. By Frum's argument, the Chinese should hold no more than 40% of foreign held US debt...

(2)

[abomvubuso.livejournal.com]

Lastly, I think Frum is wrong on ignoring the effect of deregulation in banking. The banking issues acted as a magnifier. The influence of Wallstreet pushed the deregulation of loaning and pushed the social acceptance of living in this massive debt economy, through lobbying and advertising they made easy credit a way of life. That can't be ignored in this cycle either. Perhaps the banking reform will help to reduce the reliance people have had on loans, which will make it necessary for middle class income to catch up with cost of living.

A trade deficit makes a country poorer. Its that simple. Middle class Americans have at least kept up, if not increased, their expectations of what is "crucial" to their lifestyle, and making such cheap loans available to them was not at all in the interests of the country as a whole. But then, government doesnt control the financial sector, does it?

Even more lastly, something I thought of. Part of the problem with cost of living is that with our constant inundation of advertising, people often feel they 'need' a lot of things they really don't. What is considered middle class has a lot of pork attached on simply because its part of our social environment. How do we address that problem that is so fundamentally linked to our culture? We may see a reduction in the social acceptance of just borrowing to afford anything, but when that butts up with 'now people believe they are expected to have all these things that they now cannot afford' what is going to happen?

Yeah OK.

[mikeyxw.livejournal.com]

A whole bunch of things caused the crash, all the money China had looking around for something safe was one necessary ingredient. The Fed keeping interest rates low, thus making T-bills an unattractive investment was another. Lots of people's willingness to take on a bunch of debt they shouldn't have was yet another. Wall Street packaging of these loans into bonds which nobody could understand was yet another. The bond rating agencies giving these a high rating, yet another. This is an incomplete list.

As much as I don't buy that it was all Wall Street's fault, I certainly don't buy that it was all China's fault, or the Fed's. There was plenty of greed and very little foresight all around.

To answer your question, nothing will adjust people's expectations about what is needed faster than not having the money to buy it or the ability to charge it.