Government Did Not Cause The Recession

We are in the midst of the worst recession since the Great Depression. Economists and commentators alike are united in blaming the banks and the lack of restraint on them for driving us over the cliff. Yet there is a myth common on the internet that it was the government that caused the recession. Allegedly it was the government that forced the banks to lend extra and fueled the boom. There are three parts to this argument. It is claimed the government caused the recession by guaranteeing to bail out banks if they got in trouble, by forcing banks to lend more through the Community Reinvestment Act, Fannie Mae and Freddie Mac and by keeping interest rates artificially low. These arguments are unable to explain the timing of the crisis, its magnitude and the fact that it’s global effect. These claims simply do not stand up.

The first claim is the weakest. It is argued that all banks knew they were guaranteed by the government who would bail them out if they got into trouble. It was a case of heads I win tails you lose. It’s known as moral hazard and analogies are made with seat-belts making people drive faster. It is claimed this government protection made banks reckless and take gambles causing the crash. The problem is that bank failures were so rare that most people never thought it could happen. Failure was never on the mind of bankers. They presumed they would always be successful, that’s why they were so reckless. An Irish bank hadn’t failed since 1884 so it was presumed that banks simply didn’t fail.

When the financial crash did occur in 2008 the most striking thing about it was that nobody knew what would happen. There was complete confusion and uncertainty over what would happen. If government guarantee was a cause then everyone should have been calm as they were supposed to know what would happen.

The second point is that government forced the banks to lend more money through the Community Reinvestment Act, Fannie Mae and Freddie Mac. This is quite ironic because instead of laying the blame on the free market or the rich and famous, it blames poor minorities. The story usually goes that Barney Frank and his cronies used their powers to benefit Democratic voters and were funded by the banks themselves (this ignores the fact that Wall Street gave most of its money to Republicans). In this story, Republicans were the ones who bravely stood up to him and warned of future disaster but were not listened to. It is also the story most divorced from reality.

First of all the Community Reinvestment Act was first past in 1977 which makes it difficult to explain how it caused a boom that didn’t start until 20 years later. Secondly, it was far too small to have any impact on the market. An in-depth study failed to find any evidence that it was responsible. Only 6% of high risk loans were covered by Community Reinvestment Act. Thirdly, there was no federal incentive to force banks to give more commercial loans, yet 55% of commercial loans are underwater.

Finally, the story above ignores the fact that Republicans controlled Congress from 1994 to 2006 which makes it difficult to blame it on the Democrats. How could Barney Frank force his will on the nation when he was opposed by a majority in the House, the Senate and the President? It also fails to explain the boom in Ireland and Europe where there was no comparable law.

This argument is further ridiculed by the fact that during the boom conservatives were arguing the opposite. The Cato Institute argued that the Community Reinvestment Act was preventing minorities from buying houses and that more houses would be sold if things were left to the free market. The American Enterprise Institute likewise argued that the credit restrictions imposed by Fannie Mae and Freddie Mac were too strict and were stifling the free market.

Also subprime mortgages weren’t the only part of the crash, many commercial and housing loans defaulted, which rules out solely blaming the poor for the recession. While Fannie Mae and Freddie Mac were by no means innocent (no bank was) the facts don’t fit. They were actually withdrawing from the housing market in the early 2000. This is because there was tighter regulation due to the accounting scandals. They also can’t lend out subprime loans because by definition subprime loans are loans below legal standard. So they can’t be blamed for inflating a bubble they were pulling resources out of. The boom came from the unregulated financial sector. 84% of subprime loans made in 2006 were by private firms. This is a private made recession not a government one.

Ireland tells a similar story. It was not the large established banks that started the boom (they didn’t need to, by definition they were already doing well). It was the newer banks like Anglo-Irish Bank that broke the mould by taking big risks. Competition forced the main banks to follow suit or lose business. (Ironically competition, so praised by free marketers, made the situation worse).

The third and strongest claim is that interest rates were too low. There is certainly some truth in this as low interest rates did add fuel onto the fire. However they did not cause the boom and bust by themselves. One study estimates that interest rates are responsible for one quarter of the rise in house prices. Interest rates were lowered in Europe and USA in 2002 but they were raised again after 2004. If the low interest rate hypothesis was right, then the boom would have been at its height in 2003 before gradually easing off. Yet the property and stock market continued to boom even as interest rates were continually risen. A glance at history shows that there are numerous times where there has been low interest rates but no bubble (now for example). An examination of the chart would suggest that because the UK had higher interest rates throughout the period it should be least affected, yet it has been hit as hard as America despite America having much lower interest rates. Also look how America began rasing interest rates much sooner and higher than Europe yet they were both hit as badly.

Interest rates over the last decade in Eurozone, USA and UK

It is true that the boom could have been damped with higher interest rates but not altogether stopped. This is because interest rates affect the quantity not the quality of loans. Just because interest rates are high doesn’t mean banks will make safer loans. In fact the loans that are better able to pay back the higher interest rates are the more risky speculative loans. At the height property speculation was having returns of 30, 50%, how could interest rates have stopped that? Anglo-Irish actually charged the highest rate of interest yet developers choose it because they were guaranteed to get a loan. In a boom, everyone is making so much money that it doesn’t matter so much what the interest rate is so long as you got the loan. With asset prices rising so much you were guaranteed (so everyone thought) to get your money back.

Paul Krugman sums up the problem with these arguments very well.

This is actually a very broad problem with all accounts of the crisis that try to exonerate the private sector and place the blame on the government and/or the Fed: none of the proposed evil deeds of policy makers were remotely large enough to cause problems of this magnitude unless markets vastly overreacted. That is, you have to start by assuming wildly dysfunctional financial markets before you can blame the government for the crisis; and if markets are that dysfunctional, who needs the government to create a mess?

Conservative bloggers do not seem to realise that their argument relies on the idea that the economy is an extremely fragile thing that can be shattered by minor legislation. How can the free market be gloriously praised and in the next breath have it stated that slight government intervention will cause it to come crashing down? If the claim that 3 years of low interest rates will cause mass unemployment and the near collapse of the financial system isn’t an argument for socialism, then I don’t know what is!

Many people on the right have found the recession very difficult. For years they claimed that the free market is never wrong, that left to its own devices would solve all our problems. Governments believed them and let markets run wild only to see them crash. The greatest crisis since the Great Depression resulted. This caused a crisis of faith for all free marketers, but some fundamentalists still remain true. They still fool themselves into believing that their God has not failed, that the market is still the one and only true way, that the government caused the crash. They fail to see that government intervention was never large enough, that the bailout was never foreseen and that interest rates on their own cannot cause a crash. They believe because they want it to be true, not because it is.

4 thoughts on “Government Did Not Cause The Recession”

  1. “This is because interest rates affect the quantity not the quality of loans.”

    If an excess of money is supplied to banks, then they lend to those who would have marginally failed to qualify for lending otherwise. So it makes sense that a worsening of retail borrower creditworthiness would be one of the outcomes of a central bank-inspired credit boom.

    On another point, those of us who saw the crisis coming did not claim to know exactly when it would occur. The timing is always difficult, because the recession can be continuously delayed by policy. But the problems being incubated in the West had been serious for many years, if not decades.

    1. On your first paragraph. Not necessarily, as this low return investments may actually be safer. During a boom it is the speculative, high risk loans that have the best returns. These investments have no problem getting loans even if the interest rate was higher. For example the return on investment on property development during the boom was through the roof. Whereas a standard, safe, secure investment would have low returns and have difficulty getting loan approval.

      1. I think you are failing to distinguish between different interest rates: rates which a central bank charges commercial banks for short-term loans, interbank lending rates, and the interest rates which banks charge their customers.

        The rates which are decided by policy are generally the first two types of interest rate. The third type of interest rate is then a matter for commercial banks, and is a function of the first two types.

        You said in your post “It is true that the boom could have been damped with higher interest rates but not altogether stopped.” I presumed that you were referring to something like the Bank of England Base Rate or the Federal Funds Rate. These rates are lowered by increasing the supply of money in one way or another to commercial banks. This allows the banks to then extend loans to people to whom they would not otherwise have extended loans. It follows that the marginal loans will have lower expected risk-adjusted returns than the loans which would have been made anyway.

        If you were referring to the rates charged to their customers by commercial banks, then it suggests that you think governments can manually adjust commercial loan rates, which doesn’t seem very likely.

  2. Liked the post. I would tend to agree with GM on the interest rate story though. But you do raise an interesting point with that thought. If banks were forced to stick to a certain range within the Feds Funds rate, or if they had a ceiling regarding the interest rates spreads they could charge, they would end up giving out safer loans. Still, I’m not sure if what essentially amounts to price controls by the government is the right way to go.

    Scott Sumner is one of the bloggers I follow pretty closely, and I’m fairly sure you’ve heard of him. He’s definitely on “the right” and has a pretty interesting take on the issue – one that seems very reasonable. Didn’t find exactly the post I was looking for, but this gets close.

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