There was a recent daily show clip (link or embed to come) where Jon Stewart talks with a woman from CNN about the subprime crisis. The woman in general appeared to have almost no understanding of how financial markets operate, which was, let's say...less than ideal, given that she does a segment on finance. But what I found most annoying about the interview was that both of them seemed to agree that the government had caused this recession (assuming we are actually in a recession which we won't know for months blah blah) by not properly regulating the subprime lenders or by doing *something* wrong anyway.
Now. To the extent that the government caused the subprime mess, it is primarily the Federal Reserve that is to blame. The Fed has caused or at least significantly contributed to two bubbles in the past decade by keeping interest rates artificially low. The first time around, Greenspan was concerned that the Y2K problems were going to be a big drain on the economy. So, he cut interest rates to offset the effect of Y2K. Turns out, Y2K wasn't such a big deal, but since interest rates were super-low, we had the dotcom bubble. Sure, it may have happened anyway, but it went much longer and higher than it otherwise would have due to the super-low interest rates.
The dotcom bubble was completely burst by mid-2001. Then of course we had 9/11. After 9/11, the Fed lowered interest rates even further to make the recession as short and shallow as possible. Well, it worked - but then the low interest rates led to yet another bubble, this time primarily in real estate. The endgame of a bubble - in this case brokers telling buyers to lie about their income while everyone looked the other way and then everything was repackaged into CDOs which no-one really understood and banks kept off balance sheet but still put the profits in their P/L - is always the same. Cheap money means that there's lots of money out there, which pushes down returns, which means everyone is doing everything possible to get a higher return, and eventually it goes too far.
So now this bubble has burst, real estate prices are going down, and banks are writing down hundreds of billions from the bad debt that had on their books (albeit 'off balance sheet' but it was still there, it turns out). So who *caused* this recession? Well, stepping back for a second, the American consumer has been living for at least the past few years, if not for much longer, on borrowed money. Literally. Generally this borrowed money took the form of a home equity line or something similar. Now that housing is going down, there's no more borrowed money to be had, so people will have to go back to living within their means (or at least closer to their means). This is why there is a recession right now. People can no longer spend beyond their means, so consumer spending is declining. (Plus for related reasons the dollar is falling, which makes energy and imports more expensive)
My point here is that this had to happen at same point. If the Fed had kept interest rates higher over the past six years (and even raised them yet higher), then the recession that started in 2001 would have been longer and deeper, the real estate bubble of the last five years probably wouldn't have happened, and people wouldn't have spent the last five years living off of credit. Would the economy etc be in a better place right now? Probably, but it's hard to say. The key thing is that there is no free lunch. At some point the days of crazy credit were going to end, and we were going to have to start living within our means again, no matter how painful that might be.
Posted by Stephen Bronstein at January 28, 2008 12:00 AM