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With no one denying the obvious fact that America is in a deep slump anymore, the discussion has instead shifted to why it happened. The Austrians (including me) who predicted these problems based on Greenspans low interest rate policy know of course that the main cause was that low interest rate policy, with his numerous bailouts of failed financial institutions also creating a moral hazard that encouraged risky behavior.

But non-Austrians who for various reasons seem determined to exonerate the central bank have instead offered various other explanations. I will not here answer them all, and will instead simply comment on the most common alternative explanations and the various arguments used explicitly for the purpose of exonerating Greenspan.

From the supply-side Republican establishment who until 2007 and in some cases well into 2008 denied the existence of any serious problems the blame is cast on Fannie Mae and Freddie Mac and the Community Reinvestment Act (CRA). Despite having been so wrong, they are closer to the truth than other deniers as the factors they blame did. Surely the fear of being accused of violating the CRA made some lenders more willing to lend to some low-income and minority households that really werent credit worthy. And surely, the role of Fannie and Freddie in buying up many of the mortgage-backed securities and then selling them on with their guarantees helped increase such lending.

But there is little reason to believe that either of those factors was more than something that aggravated slightly the crisis. After all, both Fannie & Freddie and the CRA had existed for decades without causing anything similar to this. And most sub-prime loans were issued by institutions not covered by the CRA, and the act itself isnt really that draconian as it says that lenders arent compelled to make loans that are likely to be unprofitable. Similarly, lending not covered by Fannie & Freddie expanded rapidly too during the bubble.

One argument that particularly left-wingers have advanced is that "deregulation or "lack of regulation" is the cause of the problems. Rarely do they specify exactly what regulations they refer to. (I suspect that many simply have such great faith in government that there must be some lack of regulation that causes any problems. What regulation is unimportant to them) Often it is said that securitization, and lack of regulation of it after the repeal of the Glass-Steagall Act, is the problem.

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January 3, 2009

The Best of Stefan M.I. Karlsson