Before the stock market crash of 2008, a series of financial events preempted its downfall. Starting in 2006 there was a noticeable drop in the price of homes after an unprecedented boom in the market. The boom was actually a colossal bubble created by the government in the early 2000s when they legislated away financial regulations that kept individuals from borrowing more than they could payback. This made homes more easily affordable to average citizens, but at what cost?
During the early 2000s, financial institutions slid by regulators and issued loans to people with no way of paying them back. The rouse was kept alive by a series of banking trades that allowed people to take out debt which long outweighed typical limitations in borrowing capabilities. Before the crisis, more and more individuals and companies took on debt to finance other debt which allowed the economy to keep expanding fast enough for debtors to pay the interest on their loans and keep the economy ticking.
The housing market bubble started to pop around 2006 when asset prices in the market hit their peak value. Markets were somewhat unnoticeably inflated for quite some time by what are known as “NINJA” loans. “NINJA” stood for “No Income No Job Approved” loans. Unethical lending practices in the housing market are believed to be the catalyst which tipped over the stock market in 2008 after banks couldn’t pay back their debts.
One of the main culprits of unaccountability in financial institutions was the practice of paying ratings agencies to rate packaged loans with letter grades based on their predicted ability to be paid back. The problem was that the ratings agencies had no obligation to be accurate in their findings. They were paid by financial institutions who did better when ratings were better. This perverse incentive led to grossly inaccurate ratings and in turn caused the housing market crash of 2008. When liquidity dried up the banks had to foreclose on loans.
Three economists, with overlapping theories may have grasped the nature of the events that occurred leading to the financial crisis of 2008. Thorstein Veblen, John Maynard Keynes, and Hyman Minsky each proposed theoretical models of sociological patterns in economics.
Thorstein Bunde Veblen predicted that as income inequality rises people are more willing to rely on credit to buy “positional goods”. This effect increases consumption even when debtors do not have the future earning potential necessary to successfully pay out the full term of the loan. John Maynard Keynes believed that an increase in aggregate demand would occur as an effect of what Veblen described would occur in the market. As long as there remained an increase in aggregate demand, he believed the economy would grow. Our third economic prophet delivers the knockout punch. Acknowledging the effects of an economy that is driven by Veblen’s social motivators, Minsky observed an inevitable pattern that would occur in the economy over time. As credit tightens debtors will take out less money in loans and the economy would begin to deleverage.
The observations of Veblen, Keynes, and Minsky all turned out to be true multiple times. As Steve Price noted in class “We are forgetful of previous panics (tulips in Holland in 1637, 1819, 1837, 1873, 1893, 1907, 1929, 2001, 2008)” (Steve Price 5:53 Ppt Chap 8) Interest rates have continually lowered overall consistently since the 1980s. More and more people have been willing and able to rely on credit to pay their bills. Now that interest rates have been so low for so long, many doubt whether the weapons wielded by the federal reserve will be strong enough to fight back against market stagnation during the next downturn. The federal reserve could lower interest rates again, but would they dare? If interest rates hit zero a currency crisis would ensue.
Of further concern, the effect of a U.S. currency crisis could hit the global markets. The United States dollar is the world reserve currency. This means the world’s many central banks almost always hold U.S. dollars in reserves in case of an economic emergency that could occur if their currency became unstable for any reason. Having United States reserves allows countries to have a short-term emergency money supply in the event that hyperinflation occurs with their own currency.
A good example of the resulting issues that arise during such a crisis would be the African nation of Zimbabwe. Zimbabwe was one of the most developed countries in Africa and at one point had a pretty efficient economic machine in place. Lead by a dictator, the country was riddled with corruption. In the end it printed so much of its own currency that it became virtually worthless on the global stage and even to its own people. It got so bad that my girlfriend’s grandpa who was a banker there his whole life once said to me: “The money is worth less than the paper it is printed on, and I would rather have toilet paper.” From there, oil prices shot up and as a result all other elements of the Zimbabwean economy slowed. They now use the U.S. dollar as their interim unit of exchange and conditions are not optimal to say the least.
A major problem with the Federal Reserve’s model of monetary policy is that it can’t control where inflation occurs. People who can afford goods and services by way of their income, savings, or other forms of collateral are now competing with those who were able to take out loans to afford things whether they can pay them back or not. Right now, inflation is most noticeable for the average person in the increased cost of housing, healthcare, and education. I will focus on education alone for this essay in the name of conciseness.
Education costs are rising rapidly. Most noticeably there is an alarming cost increase in education at the college level. Tuition fees have skyrocketed as many people have flocked to student loans as a way to postpone their entry into the labor market and attempt to advance their earning power through specialization. One reason for inflation in education costs is the increase in access to student loans that was made possible when the government passed a law guaranteeing student loan solvency. This meant even if the individual didn’t pay back the loan, the government would. Financial institutions were then incentivized to give out as many loans as possible since the very custodian of their currency would enforce its repayment. Nowadays man students are graduating only to find that jobs are in much more limited supply than they were expecting when they decided to pursue a four-year degree.
Given today’s financial conditions, we may be facing a global economic downturn in the near future. Adding to the currency situation, we are also faced with a slowing birth rate and a rise of populism in political movements around the globe.
Traditional economics tells us that economies operate with rational actors and yet as we can see people and governments will take out more debt than they can produce in profit to pay it off. This effect acts as a stimulant for the economy in the short run but sacrifices the value of the currency its tied to in the long run. Eventually, things like pensions, social security payments, and other entitlement programs will have been inflated away by an overly stimulated economy.
The federal reserve has a duty to burst these bubbles. If the federal reserve doesn’t burst the bubbles in stocks, housing, and elsewhere, we end up with an insolvent society. The average person spends very little time focusing on monetary policy which allows them to mindlessly spend money as if it actually grew on trees.
Best, Richard. “How the U.S. Dollar Became the World’s Reserve Currency.” Investopedia, Investopedia, 12 Mar. 2019, www.investopedia.com/articles/forex-currencies/092316/how-us-dollar-became-worlds-reserve-currency.asp.
“Shortcut from This American Life.” Shortcut from This American Life, shortcut.thisamericanlife.org/#/clipping/355?_k=al8x3x.
“Student Loans Owned and Securitized, Outstanding.” FRED, 8 May 2019, fred.stlouisfed.org/series/SLOAS.