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The financial blame game

BY JUSTIN SUGG | OCTOBER 26, 2009 7:10 AM

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A global battle rages on — and I’m not talking about Afghanistan.

This is a battle of economics.

The financial crisis has prompted economists and politicians to call for increased regulation, while a chorus of free-market thinkers is countering such calls. A question of blame is at the heart of this debate. To answer this question, I’ll need to go over the financial collapse’s history.

The ’90s were a period of unparalleled prosperity for America. In 1998, the Russian government defaulted on its debt, much of which American companies owned. The Federal Reserve feared those companies’ collapse could trigger a panic, so it pumped more than $3 billion in the market by financing a failing hedge fund called Long-Term Capital Management.

Imagine a balloon being filled with a steady amount of air. Now, imagine the Federal Reserve taking a deep breath and blowing a whole bunch of air into that balloon because it thinks the panic will deflate it. The balloon hyperinflated at a fast pace and instead of deflating, the balloon popped.

The Dow Jones Industrial Average — which rose steadily to near 10,000 points in 1998 — shot straight to 11,000 in 2000, before crashing to around 7,000 in 2002. The Dow’s dive took the economy with it. The country’s growth rate dropped from 6 percent in the second quarter of 2000 to around .2 percent in the fourth quarter of 2002.

The Fed took drastic measures, whittling away interest rates from 6.5 percent in 2001 to 1 percent in 2003. The federal government also gave generous tax cuts to people buying homes. This combination kicked off the largest housing boom in U.S. history, according to a New York Times report.

Banks, unable to make any money from the interest rates off these loans, sold the debt to other banks, who then sold it to investment banks. These investment banks turned this amalgamated debt into a financial product called a derivative. People buying these would get a return based on the increasing housing values and mortgage rates. The cheap money and incentives did a good job of stimulating the economy. By 2004, the country was in full-fledged recovery.

It didn’t last.

The housing market went under in 2006, rendering the derivatives worthless and bankrupting financial institutions all over the world. Pro-regulationists argue the deregulation in the ’80s and ’90s — including Congress repealing the Glass-Steagall Act in the late-90s — caused the crisis. The Glass-Steagall Act prevented investment banks and lending banks from merging.

If banks couldn’t merge, they argue, then the housing crisis wouldn’t have spread to other parts of the economy. Sharers of this view also argue that if the government properly regulated the derivatives and required banks to keep cash reserves to cover potential losses, then the derivative market might not have collapsed.

This argument doesn’t address the root cause of the crisis, namely the Fed’s irresponsible actions. Not only did the Fed drastically lower interest rates, it kept them low. The Fed didn’t start to raise rates until around 2004 and didn’t even raise them back to 2001 levels. These low rates made banks super-dependent on derivatives.

Talk of regulating those products is also a knee-jerk reaction and smacks of 20/20 hindsight. The housing market was the most stable growth-driven market in the United States and wasn’t the only market that derivatives used. If the Fed and the federal government acted using free-market principles, they would’ve raised rates sooner and more aggressively.

Right now, pro-regulationists seem to be winning this argument. Congress earlier this year passed new credit-card regulations, and the president is championing more financial regulation.

But the government should regulate itself before regulating others.


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