The Liberty Papers

I’ve been one of the doomsayers regarding America’s economy, with the impending collapse of the subprime lending market (which I think will create a nasty recession). As with any economic downturn, the government and the media will be looking for someone to blame. Ron Paul suggests that we place our sights directly on the Fed.

When the bubble finally bursts completely, millions of Americans will be looking for someone to blame. Look for Congress to hold hearings into subprime lending practices and “predatory” mortgages. We’ll hear a lot of grandstanding about how unscrupulous lenders took advantage of poor people [ed: Chris Dodd is already doing it], and how rampant speculation caused real estate markets around the country to overheat. It will be reminiscent of the Enron hearings, and the message will be explicitly or implicitly the same: free-market capitalism, left unchecked, leads to greed, fraud, and unethical if not illegal business practices.

But capitalism is not to blame for the housing bubble, the Federal Reserve is. Specifically, Fed intervention in the economy– through the manipulation of interest rates and the creation of money– caused the artificial boom in mortgage lending.

The Fed has roughly tripled the amount of dollars and credit in circulation just since 1990. Housing prices have risen dramatically not because of simple supply and demand, but because the Fed literally created demand by making the cost of borrowing money artificially cheap. When credit is cheap, individuals tend to borrow too much and spend recklessly.

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Unless and until we get the Federal Reserve out of the business of creating money at will and setting interest rates, we will remain vulnerable to market bubbles and painful corrections. If housing prices plummet and millions of Americans find themselves owing more than their homes are worth, the blame lies squarely with Alan Greenspan and Ben Bernanke.

Paul also points out the use of Fannie Mae and Freddie Mac to offload risk (which many investors consider to be implicitly guaranteed by the US Government). He doesn’t mention the use of derivatives to slice-and-dice the risk and further offload it onto the market, but his point still stands. The Federal Reserve has flooded the market with money, and that money has been chasing returns. Housing has been the “hot” asset class, creating an unsustainable bubble. When that bursts, it will be a lot worse than the tech stock bubble, because it actually hits people right at home.

Much debate on this blog has gone on (and will again soon with the Point/Counterpoint feature) regarding the Federal Reserve and the money supply. Whether you believe in a backed currency or not, it is generally assumed that the quantity of money in a economy should be based on the productive ability of that country. If the money supply has tripled since 1990, I think this is far in excess of any productivity growth we’ve seen since then. Thus, we have inflation.

You flood the market with money, and you see what happens. The rich, who have the ability to move money around chasing these asset classes, get richer. They buy second homes or investment properties to ride the appreciation wave, increasing demand. The poor and middle class, who are just trying to get ahead, struggle to keep their incomes constant or rising relative to the cost of goods. And when housing becomes the asset class bubble, they get priced out of homes and lenders must resort to “creative” financing to allow them to buy. Then, when the returns on investment start drying up, the demand of speculators and investors dries up, and home prices collapse.

The bubble is bursting. The particular nature of the housing market, as a relatively illiquid asset, is making this occur more slowly than a stock bubble would occur. But it’s occurring nonetheless. Blame can be spread around, of course, especially to some of those subprime borrowers who purchased homes they cannot afford. But Ron Paul is right, it is clear that the Fed’s loose money policy created this bubble, and they deserve a great deal of blame when it bursts.