Econ 101: Do We Need a New Theory of Market Stability?
In a recent Newsweek article, senior editor Michael Hirsh quoted Larry Summers who said: “Large swaths of economics are going to have to be rethought on the basis of what's happened.” Summers is correct that the recent credit crisis and recession has generated books and papers galore in attempt to provide an explanation for the crisis and suggest remedies.
Hirsh went on to indicate that the efforts of liberal philanthropist George Soros to “take back the economics profession from the champions of free-market zealotry who have dominated it for decades, and to correct the failures of decades of market deregulation” is a significant advance. The thrust of Hirsh’s story is that a new paradigm needs to be discovered because markets have proven themselves to be unstable.
The idea that economists are in disagreement on macroeconomic policy is, of course, not new. In 1992, Gregory Mankiw published a noted article entitled, “Macroeconomics in Disarray.” Yet Hirsh’s article states that the economics profession and many of its journals are controlled by free market thinking. That is not the case, at least in the field of macroeconomics. Pick up nearly any introductory or intermediate macroeconomics textbook and you will find it is dominated by Keynesian theory of unstable labor and product markets and the necessity for government intervention through fiscal and monetary policy.
What is needed is for economists to explain how we got in the fiscal crisis. Was it government intervention and meddling in the economy or a case of fundamental instabilities in the market process? Hirsh argues it is the latter, but a very good case can be made that it was unstable regulatory and monetary policy that caused the problem. Rather than looking to a new theory of irrational and exuberant markets, which Soros has been promoting for at least a decade, we should examine the Austrian business cycle theory as an explanation for what happened. This theory was put forth by Ludwig von Mises in his Theory of Money and Credit (first published in German in 1912) and in the works of Nobel Laureate Friedrich Hayek.
The Austrian school argues that an excess of credit from actions of the Federal Reserve is the fundamental cause of most business cycles. The latest recession would be no exception. The Federal Reserve lowered the federal funds rate from 6.4 percent in December 2000 to 1.83 percent by December 2001. When the rate reached 1 percent the Federal Reserve maintained that rate for a year, until June 2004. During this time the housing bubble took real form. The Federal Reserve then began raising interest rates until the federal funds rate hit 5 percent in June 2006. At this time the housing bubble began to burst.
Why did the bubble occur in housing? While there is not room to detail the argument here, in short, government policies enticed resources into housing through a myriad of federal programs, such as Fannie Mae and Freddie Mac, the Community Reinvestment Act, and tax incentives for home ownership.
In addition, housing is a highly leveraged investment. With interest rates very low, it is difficult to get a return on investment without leverage. After Fannie Mae and Freddie Mac had developed the market for mortgage-backed securities leverage in housing became easier with less apparent risk. Between 2005 and 2007, 58 percent of the mortgages of Fannie Mae and 67 percent of the mortgages of Freddie Mac were subprime. Banks were heavily enticed to originate mortgages for low income or even no income buyers through the Community Reinvestment Act and its amendments.
Other regulations added to the problem. There are large barriers to entry into the ratings agency market, and government regulations require the capital in financial institutions the meet certain ratings requirements. The ratings agencies are paid by the borrower to rate their debt. This created a problem for the plethora of mortgage based securities and other debt obligations that were a response to the credit expansion.
The use of mark-to-market accounting in the capital requirements of financial institutions is extremely pro-cyclical and some economists, such as Brian Wesbury, make a strong argument that much of the credit crisis stems from this government regulation. In March of 2009, William Isaac testified before Congress that when he was Chairman of FDIC in the 1980s and 1990s we would have had to nationalize all the banks had mark-to-market accounting been required.
University of Chicago professors John Cochrane and Luigi Zingales argue persuasively in the Wall Street Journal that the real credit crunch came Sept. 23, 2008 when Federal Reserve Chairman Ben Bernanke and Treasury Secretary Paulson testified before Congress that the financial system was about to collapse if they weren’t given $700 billion immediately. This was followed the next day by President Bush’s speech to the nation where he said “our entire economy is in danger.” After that the Libor-OIS spread (a measure of risk in the financial industry) jumped and the S&P 500 began to collapse.
There are a myriad of explanations for the recent credit crisis and the most logical of them point to government failure, not market failure.
Hirsh is correct that we should be using the crisis to formulate a more accepted and correct theory of the macro economy. This effort will be more successful if we look to the writings of the Austrian school, examine the 1920-21 recession that was shortened by the absence of government action, and look at the more recent histories of the Great Depression, such as the one written my colleague at