Daniel Sanchez
4/23/08
The Housing Crisis: What Not to Do
Since 1913, the ’ economy has seen many booms and recessions, and an occasional depression. The booms are caused when the money supply is inflated by The Federal Reserve which causes money to flow throughout the economy. Of course, the money supply is manifested in US Dollars and, according to the economic law of supply and demand, if more money is available in an economy, the more money the consumers in the economy are willing and able to pay for goods and services. The recessions, however, are more complex. Recessions may be caused when the money supply is contracted and consumers have less money to spend. Also, inflation of the money supply causes prices to rise in every sector of the economy. This is what happened in the as the housing market boomed. Prospective home-buyers were willing and able to pay more money for houses, but this boom caused booms in other sectors. There was and continues to be a larger demand for other goods and services and this caused and causes prices to rise. Eventually, when homeowners found themselves in a situation where they could not afford the house they had recently purchased, the housing market began to collapse. However, government intervention was a major factor in causing the housing boom that eventually became a bust. Furthermore, it has always been government intervention that has created artificial booms and their eventual busts. Government intervention caused the boom of the Roaring 20s and the eventual Great Depression. Likewise, the same is happening today in the housing industry. The current mortgage crisis will be exacerbated if the federal government intervenes. The federal government cannot solve the current mortgage crisis and the free market must be allowed to solve the mortgage crisis.
Section I – Contributing Factors
Many factors contributed to the boom and eventual bust of the mortgage industry including artificially-low interest rates. At the beginning of this century, The Federal Reserve System (The Fed) lowered key interest rates. “From Jan. 3, 2001, to June 25, 2003, The Fed reduced its overnight interest rate from 6.5 percent to 1 percent” (Samuelson). This allowed banks to borrow money at artificial interest rates. These interest rates are artificial because they are not set by the market; rather, they are set by an organization created by the United States Congress in 1913. When The Fed lowered interest rates, the interest rates were below the rate of inflation. This meant that banks could borrow money and, once the loans matured, the interest they paid plus the principal had a real value of less than what they had borrowed.
Since banks could borrow money at low interest rates, banks were able to lend the money they borrowed to their customers at artificially-low rates. In other words, prospective homebuyers could obtain a home mortgage with an, otherwise, low interest rate. This allowed more prospective homebuyers to enter the housing market and compete with existing prospective homebuyers because monthly mortgage payments would be lower than with an, otherwise, higher interest rate. During the boom, “from 2000 to 2003, bank lending rose about $1 trillion” (Samuelson). Since there was more demand for houses, existing homes sold at an increasingly higher number per month.
Mortgage lenders complimented low interest rates with laxer lending standards. These lax lending standards included not requiring homebuyers to place a down payment toward the purchase of a house. This meant that prospective homebuyers did not have to save money equal to the 20% of the price of a house. Previously, banks required a 20% down payment as a safe-guard against foreclosures. For example, if a house foreclosed, the lender that issued the mortgage could sale the house at 80% of the sale price of the house and would not lose any money. Another lax lending standard was not requiring borrowers to prove their stated income. This allowed borrowers to falsely state higher incomes and, therefore, qualify for higher amounts of money in the form of a mortgage. According to the February 24, 2007, article “Lax Lending Standards Haunt Mortgage Lenders — Who’s Next?”:
As the housing market soared, lenders trotted out adjustable or teaser rates to woo potential applicants with shaky credit records, and let them borrow with no money down. They often did this without vetting financial backgrounds.
This allowed borrowers to purchase higher-priced homes and drove the price of existing houses upward.
Since the average price of houses increased dramatically during the housing boom, speculators began to buy houses. A speculator could finance the purchase of a house by obtaining a low-interest mortgage. The speculator figured that the house would appreciate more than would be spent on interest to the lender. For example, a speculator could purchase a house for $200,000 with a 5% interest rate. If, after two years, the house appreciated to $250,000, the speculator would have profited about $30,000 ($50,000 in appreciation of the house minus approximately $20,000 of interest). This business model was simple, easily implemented, and included tax benefits. However, speculators competed with first-time homebuyers and other prospective homebuyers seeking to purchase a house. The increase in demand for houses and the relatively low supply of houses lead the price of houses to sky rocket.
What allowed and encouraged banks and other lending institutions to make risky loans is simple. Government intervention, according to professor of economics Walter E. Williams, is the culprit:
The Community Reinvestment Act of 1977, whose provisions were strengthened during the administration, is a federal law that mandates lenders to offer credit throughout their entire market and discourages them from restricting their credit services to high-income markets, a practice known as redlining. In other words, the Community Reinvestment Act encourages banks and thrifts to make loans to riskier customers.
As is obvious, the federal government encouraged to lenders to make unwise decisions.
Section II – Intervention’s Boom & Bust
Intervention by the government has made and will make economic and financial troubles worse. In 1913, the 63rd United States Congress enacted The Federal Reserve Act. The Fed created the liquidity that caused the boom during the 1920s. According to Murray N. Rothbard’s, America’s Great Depression, the monetary supply increased by “61.8 percent increase over the eight-year period” (93) from 1921 to 1929. The price of stocks, commodities, and many other assets in the soared during the 1920s and many speculators become instant millionaires. However, once the stock market crash of October 29, 1929, began, the signs of a recession in the were obvious. Once the severe recession set in, President Hoover implemented many socialistic programs to revive ’s economy. This included the “bolstering of wage rates and prices, expansion of credit, propping up of weak firms, and increased government spending” (Rothbard 186). However, as President Hoover left office, the United Sates was at the “depths of an unprecedented depression, with no recovery in sight after three and a half years, and with unemployment at the terrible and unprecedented rate of 25 percent of the labor force” (Rothbard 186).
As the Dot-com boom began to collapse at the beginning of the 21st century, The Fed began to lower key interest rates and Congress implemented a $1.35 trillion tax cut and increased spending to stimulate the economy. These actions by The Fed and the federal government are what started the housing boom. According to Peter D. Schiff’s, Crash Proof: How to Profit from the Coming Economic Collapse, “now flush with renewed spending power, Boobus Americanus looked around for places to put money. Much was spent on consumption, mostly goods imported from the ” (117). Schiff continues:
Enticingly low mortgage rates were drawing attention to real estate, initially encouraging mortgage refinancing, which was adding further to spending power. Renters were discovering that low interest rates made it feasible to own, and so they began buying. (117)
The expansion of the money supply caused inflation and the tax cut left taxpayers with more money to spend, therefore, as the average price of homes rose, the price of commodities such as wheat, oil, cattle, and natural gas rose as well. The rise of prices is explained and supported by the economic law of demand and supply. In other words, prices rose because Americans were willing and able to pay more money for everyday necessities. What can be surmised is that the recession that was coming because of the Dot-com bust was postponed by the beginning housing boom.
One major problem with the rise in prices in the economy during the housing boom was that Americans spent a higher percentage of their income than before. Americans spent more on gasoline to dive to work, spent more on food for their families, spent more on healthcare, spent more on education, etc. However, incomes did not rise proportionately to spending and Americans lived on ever tighter budgets. Americans had less money saved for emergencies and the money that they did have saved had less purchasing power. What eventually happened is that when adjustable-rate mortgages and sub-prime mortgages reset, many homebuyers with these instruments could not afford the new monthly-payment amount. The increase in the monthly-payment amount eliminated any room that the homebuyers had in their budgets and, eventually, homebuyers would have to extract any credit and savings that they had in their credit cards and savings.
Since many homebuyers lived paycheck to paycheck, any sudden rise in spending or decline of income would mean that the homebuyers could not afford the lifestyles they enjoyed during the housing boom. Furthermore, many jobs were created because of and are tied to the housing boom. According to Schiff:
A stunning 43 percent of the increase in private sector jobs between 2001 and April 2005 were housing related, and these jobholders are themselves homeowners and consumers. But furniture, landscaping, appliances, municipal governments, and nearly everything else depend, directly of indirectly, in one way or another, on real estate. (116)
What this means is that if the housing sector collapses, then other sectors of the economy will suffer as well. Consumers will spend less and many retail-dependant jobs will have to be eliminated by retailers. Also, the demand for houses will fall because prospective homebuyers will not be able to afford to purchase homes and the supply of houses will increase because many homebuyers will foreclose and their houses will have to be sold.
If the federal government attempts to save homebuyers that are on the brink of foreclosing, the problems of the current economy will not be solved. The federal government can ask the The Fed to prop-up homes or increase the money supply so homebuyers can maintain their monthly payment. However, any increase in the money supply will cause prices to rise. Therefore, although homebuyers will be able to stay in their homes, their costs for food, energy, education, healthcare, etc. will increase dramatically. These increases would be symptoms of hyperinflation and will create bubbles in the commodities markets, precious metals markets, and energy markets. The value of assets will appreciate in terms of US Dollars. However, Charles P. Kindleberger points out that “by definition a bubble involves a non-sustainable pattern of price changes or cash flows” (1).
The housing boom was also a bubble and, by definition, had to implode. However, what caused this bubble was government intervention in the economy and intervention by The Fed. A house of cards was built and simple economic fundamentals would bring it down. The results of the collapse are already showing. Many retailers have gone bankrupt as sales diminish, airlines have gone bankrupt because of the soaring cost oil, homebuilders have stopped building homes and have had to reduce work force, financial intuitions have seen double-digit decreases in profit as they write-down bad loans and have reduced their work forces, and hundreds of thousands of homeowners have foreclosed on houses they could not afford. Other results have been violent as reported by a Los Angeles Times article:
In what appears to be the latest symptom of the nation’s mortgage meltdown and credit crisis, insurers, law enforcement officials and state agencies nationwide report a jump in home and automobile fires in the last year believed to have been set by owners unable to pay their debts. (Besinger)
The price of real estate will drop dramatically as reported in the March 2007 article, “Top investor sees U.S. property crash”, Jim Rogers is quoted as saying that “it’s going to be a disaster for many people who don’t have a clue about what happens when a real estate bubble pops,” and continues that “real estate prices will go down 40-50 percent in bubble areas. There will be massive defaults” (Kaban). The effects of the bursting of the housing bubble are tremendous and may continue for years.
Section III – Free Markets Triumph
Since the founding of the to the depression of 1920-1921, the free market had always corrected and solved economic troubles. The federal government had a laissez-faire attitude towards the economy and hardly intervened when troubles arose. The first example is “’s first great depression, 1819, when the federal government’s only act was to ease terms of payment for its own land debtors” (Rothbard 186). Another example according to Rothbard:
In the 1920–1921 depression, government intervened to a greater extent, but wage rates were permitted to fall, and government expenditures and taxes were reduced. And this depression was over in one year—in what Dr. Benjamin M. Anderson has called “our last natural recovery to full employment”. (186)
Depressions and recessions were solved not by government intervention, but by sound choices that Americans made during the recession.
However, since the great depression of 1929, government intervention has exacerbated and prolonged recession and depressions. As Rothbard explains:
Propping up wage rates creates mass unemployment, and bolstering prices perpetuates and creates unsold surpluses. Moreover, a drastic cut in the government budget—both in taxes and expenditures—will of itself speed adjustment by changing social choice toward more saving and investment relative to consumption. (186)
If businesses are forced to pay high wages, costs could outweigh revenues and the businesses could go bankrupt. Likewise, if producers are forced to keep prices high, consumers will be shut out of the market and surpluses will abound. Therefore, the free market must be allowed to reign, although jobholders may lose their jobs. However, if the jobs are not eliminated, ultimately, those jobholders will lose their jobs once their employers go bankrupt.
During a recession, excesses are eliminated which may mean that consumers will spend less and companies will cut their expenses. What this means is that prices will fall and former jobholders will be able to use their savings to survive until the economy revives. Furthermore, any intervention to prop-up house prices so that homeowners can stay in their homes will socialize the mistakes that speculators and other homebuyers made. According to Williams:
The Bush bailout, as well as Federal Reserve Bank cuts in interest rates, is a wealth transfer from creditworthy people and taxpayers to those who made ill-advised credit decisions, and that includes banks as well as borrowers.
This is another reason why government intervention will makes housing problems worse and will spread to anyone smart enough to not make a bad decision. Furthermore, the free market will allow those homebuyers who bought houses they could not afford and speculators who used bad business models to take responsibility for their actions and suffer any consequences they brought to themselves.
Conclusion – It Affects Everyone
Ultimately the free market will solve the current mortgage crisis. The free market allows people who make correct and wise decisions to prosper while allowing people who make bad and terrible decisions to take responsibility for and suffer the consequences of their actions. What is apparent with the current housing crisis, however, is that the free market is not allowed to clean up the mess. The Fed has reduced key interest further and has helped financial institutions that used flawed business models to stay afloat. This has created bubbles in other sectors and has made the cost of living more expensive for anyone holding US Dollars. Likewise, if the federal government freezes interest on sub-prime mortgages, it will undermine contract law and will encourage further risky and unwise practices.
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My hope is that our government will allow the free market to sort out the current mess we are in. The mess, although, may become worse before it becomes better. However, I am certain and history has shown that government intervention will make situations worse. Our only solution for the coming economic collapse is to protect ourselves from disastrous government actions and hope for the best.
Works Cited
Besinger, Ken. “Arson to Avoid Foreclosure?” Times. 21 Apr. 2008 http://www.reuters.com/article/idUSL1470530620070314
Kaban, Elif. “Top Investor Sees Property Crash.” Reuters.com. 17 Mar. 2007 http://www.reuters.com/article/idUSL1470530620070314
Kindleberger, Charles P. and Robert Aliber. Manias, Panics, and Crashes: A History of Financial Crises. : John Wiley & Sons, Inc., 2005.
“Lax Lending Standards Haunt Mortgage Lenders — Who’s Next?” TheKansan.com. 24 Feb. 2007 http://thekansan.com/stories/022407/business_20070224023.shtml
Rothbard, N. America’s Great Depression. : D. Van Nostrand, 1963.
Samuelson, Robert. “Crutch of Cheap Credit” WashingtonPost.com. 19 May. 2004 http://www.washingtonpost.com/wp-dyn/articles/A38009-2004May18.html
Schiff, Peter D. Crash Proof: How to Profit from the Coming Economic Collapse. : John Wiley & Sons, Inc., 2007.
Williams, Walter E. “Taxpayers Should Not Finance Subprime Bailout.” Examiner.com . 24 Jan. 2008 http://www.examiner.com/a-1176842~Walter_E__Williams__Taxpayers_should_not_finance_subprime_bailout.htm