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L. Neil Smith's
Number 539, October 4, 2009

"The Age of Authority draws to a close"

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by Ryan J. Swift

Article is special to The Libertarian Enterprise and, and can be found at


The financial crisis has many people to blame, look in the mirror, and chances are, you're one of them. (Did you buy a piece of real estate, hoping to ride a never-ending-price-inflation-palooza, to financial riches?) The media has identified scapegoats ad nauseum for the economic collapse, as well as the financial sector meltdown, and they have most of the issues right (but rarely complete):

Profit-driven lenders used creative mortgage products to lend money to unworthy, sub-prime borrowers. Once the loans were made, and loan fees collected, they were bundled and sold off to the next poor sap. While passing the risk exposure from the unsound loans to somebody else, the original lender simultaneously collected another cash stream from the mortgage bundles.

"Affordable housing" advocates bullied banks into making unsound loans (like chairman of the House Financial Services Committee, Barney Frank, community organizers like ACORN and quasi-private, government-hijacked Fannie Mae and Freddie Mac).

George W. Bush and company routinely pushed an "ownership society" mentality.

The American consumer obtained lines of credit they either knew they couldn't afford, or were not informed enough to make a decision about (and in some cases lied about income and assets to obtain).

All of these folks are major players rightly deserving some of the blame. Why, though, does the Federal Reserve get such a relative pass for their role in causing the collapse? For me, it's a colossal head-scratcher.

CNN's Anderson Cooper ran the series Culprits of the Collapse, where former Federal Reserve Chairman, Alan Greenspan, came in at number six. Who was CNN's greatest culprit? You. CBS ran a similar wanted list called 25 Financial Crisis Culprits (news networks are so creative with these names...); a person associated with the Federal Reserve didn't receive mention on CBS' list until number 18, where once again, Alan Greenspan had a share of the blame distributed to him. Said CBS: "Former Federal Reserve chairman (who) now admits that the markets don't regulate themselves." (1) (2)

On Capitol Hill last October, Greenspan submitted this mind-bending testimony:

"I found a flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak."

If financial institutions were greedy and joined the madness to make a buck, fine. If financial institutions were bullied by "affordable housing" forces to make some of these loans, fine. If the American consumer bought mini-mansions they couldn't afford, fine. These folks haven't been given a pass by either the government, or the media.

But where does a real estate bubble really begin? With low interest rates and additional cash to lend. Now, remind me again: who provides additional money and artificially low interest rates to "stimulate" the economy? That's right, the Federal Reserve. If the financial crisis, caused by toxic mortgages, derivatives, and credit default swaps, was a giant game, the first play was made by the Federal Reserve. Simply put, if there's no additional money to be loaned, and no artificially low interest rates to loan at, a real estate bubble doesn't occur. Speculative manias have to start somewhere. Without a steroid shot of demand, it's tough for too much mania to ensue.

Greenspan is a hyper-intelligent man. He was charged with the enormous task of managing the nation's, and in some ways, the world's economy. If he didn't think that years of artificially low interest rates, extra money to lend and an entrepreneurial, profit-driven economy would cause a few bubbles, then I've found a flaw in the model that I perceived is the critical functioning structure that defines how economists work, so to speak.

The Fed is the first iteration of the game, and they seem to get a gigantic pass from the media, and naturally, a Keynesian government. In fact, some people still believe the Fed fixes the economy and smoothes out business cycles. Yeah, sure.

As Peter Schiff puts it: "Wall Street got drunk, but the Fed liquored them up."

The United States is an empire built on debt. Budget deficits, financed by other countries like China and Japan, are not necessarily a bad thing, if the money is invested into productive capacities for future economic growth. But if the money is used to pay for goodies like big screen TV's from China, or to remodel homes, there is no infrastructure investment for future growth. The money is spent on consumption, while the debt liability remains. And servicing a debt liability, i.e., paying interest on a loan, is not a zero-sum game for the U.S. if the loan is owned by another country (zero-sum game references the idea that a dollar paid on interest, is, at the same time, a dollar earned from interest by someone else). If it were a zero-sum game, one could argue that the money spent on mortgage interest (debt), goes right back into the U.S. economy. It is true, though, that Fannie Mae and Freddie Mac own or guarantee about half of the $12 trillion U.S. mortgage market. (4)

The housing bubble occurred due to easy money policies. A monetary bubble followed the housing bubble when the Federal Reserve showered the markets with liquidity, including public capital. For those keeping score at home, that's two bubbles caused by the Federal Reserve, since 2000. Expansionary monetary policy, or expanding the amount of money in the economy to stimulate growth, was the Fed's cure to the economy's ails after the dot.comcrash, and the slight recession following September 11th. Well, that and George W. Bush telling us to go shopping. The federal funds rate bottomed out at 1.00% in June 2003, before the Federal Reserve began slowly bringing the rate back up to sustainable levels. By June 2006, the federal funds rate peaked at 5.25%. The three-year run allowed for a period of record mortgage rate lows. (3)

At it's peak, 5.25% was still a low rate of interest for most any lending activity, and it was far too late by the summer of 2006 to rein in the unsustainable demand for housing. The Federal Reserve attempted to fix a sluggish economy by inflating it, but they were unable to guess correctly as to when the extra money should be pulled out of the economy. The housing bubble was already out of control, and poised to burst by the summer of '06.

Unsound mortgages were defaulting, and more were surely on the way as interest rates would re-adjust and the recession ate up jobs. The Federal Reserve swooped in to rescue the financial system. This was just as much a global play as it was domestic, as U.S. financial institutions had pooled most of the toxic mortgages together that had been made, and sold them abroad: meaning, the global financial system was at stake. Wall Street had also made bets on the housing market, and these mortgage-backed securities, in the form of derivatives, and credit default swaps. Without getting too deep into these financial instruments, let's just say they allowed Wall Street to become even more of a giant casino than it already was. Unfortunately, some of the bets went bad, and were making bank balance sheets sink fast.

What would the Federal Reserve do to save the world this time around? It's like a well-crafted superhero cartoon, with incremental perturbations, a climax and a resolution. Well, of course, the Fed figured they could solve this problem with more easy money policies. Forget the fact that those very policies caused the original housing bubble, and greatly contributed to the financial system meltdown.

Quantitative easing was instituted by the Fed, an extreme form of easy money, bringing interest rates down between zero and 0.25%, and increasing the money supply to unprecedented levels. If you want to know why the U.S. had $4.00 gasoline last summer, in the midst of a recession, look no further than the Federal Reserve. Yes, speculators manipulate short-term prices, while supply and demand ratios rule the day; but, remember, oil is priced in dollars. Devalue the dollar with easy money policies, and expect oil prices to be driven up.

The housing market has yet to stabilize. Don't let government tax credit incentives, or a general improvement compared to prior devastation, fool you. A weak economy, a weak job market and over-supply in housing brings one scientific sounding truth: there are way more houses than buyers right now. In order to get more buyers, we'll need more jobs and, probably, more people (immigrants...). The long-run trend on mortgage rates is up, as Treasury debt soars, and the Federal Reserve cannot continue to prop up an empire of debt with more debt (or, in this case, by purchasing mortgage-backed securities).

Meanwhile, as real estate crashes and burns, the financial sector is shaky and as the Fed uses easy money policies to save the day, the stock market is booming! The S&P 500 has increased 34% since March 9th. This is either because investors expect a significant improvement in the discounted future cash flows of the American economy (in layman's terms, we'll just consider this to be profits), or because there's been another speculative mania. I'll bet that it's much more due to the latter, than the former. The increased money supply has not materialized into a lot of new credit, such as lending to small businesses. The majority of it has remained in bank coffers to help stem future expected losses. No, it seems having so much extra money in the economy, and investors scrambling around to preserve their wealth, has created this recent asset bubble in stocks.

For those keeping track at home, that's three bubbles the Federal Reserve has had a hand in.

Some say the Fed's intervention into the financial sector was necessary, to shore up a banking panic. Fed chairman Ben Bernanke is dancing around in Jackson Hole, Wyoming this week, taking credit for preventing a global depression. (5) I, however, am not quite as convinced that we're all better off. I recognize that fallout from a failed Bear Stearns, AIG, Citi and other financial institutions would have been awful. But it's hard to convince me that propping up banks and companies with taxpayer money, and inflationary policies, really helps the plight of the everyday American. Certainly, money could have been borrowed, taxed or printed, to make sure FDIC insurance was available, (expanded, if necessary), for depositors at these financial institutions. That would've helped individual depositors who were getting screwed by the Fed's easy money policies and a liquored up Wall Street making unsound loans, and bad bets. I'm also not convinced that a bank run, followed by a bank panic, would play out in our modern internet world, the same way it did in the 1930's. The capacity for public hysteria hasn't changed, but the ability to disseminate reliable information, instantly, has. What if banks were allowed to go under? How long would it have taken for banks to become insolvent? What if the bankruptcy process was sped up? (This could have been a useful government intervention at the time.) If people were informed about FDIC policies, which banks were having trouble and how the problem was to be handled...would it have been such a disaster? Perhaps. But maybe insolvent banks, backed by reliable public information, would have gone insolvent much faster once some of their depositors rushed to pull their money out. The depositor's action to pull money out would be out of fear and a rational response to reliable information. The banks that were solvent may not have had an epidemic of withdrawals. Now, almost a year and half removed from the initial Bear Stearns bailout, the financial system might be up and running again, healthy as ever.

If we had a banking system that required more than a 10% reserve ratio, bank runs wouldn't be so scary. The first question I always consider whenever the government intervenes: does the intervention help the many, or the few? The second question: does the intervention hurt the many, while helping the few?

Propping up bad debt and poorly ran institutions is anti-capitalist, a turn in the wrong direction from the watered down pseudo-capitalism we have been practicing. The productive capacities and assets of these firms could be utilized, after emerging from bankruptcy, by firms who haven't driven their companies into the ground; and the toxic debt could be liquidated from the economy. Instead, we have a Fed chair parading around in Jackson Hole, patting himself on the back for doing the exact same thing that caused, or assisted, three previous bubbles within the decade. While this hurts my capacity for Double Bubble jokes, that's okay, in the interest of candor.

(1) — Anderson Cooper 360: Blog Archives — Ten Most Wanted: Culprits of the Collapse

(2) — 25 Financial Crisis Culprits

(3) New York Federal Reserve — Historical Changes of the Target Fed Funds Rate

(4) — Fannie, Freddie Tumble on Bailout Concern, UBS Cut

(5) — We Saved the World from Disaster, Fed's Bernanke Says

Ryan J. Swift writes for, a site offering "economic wit in a stuffy world".


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