Tuesday, September 11, 2012

Setting the stage for the Financial Crisis

"In 2003, my approval rating was above 60 percent for most of the year."

Let's set the stage. The year is 2003. The memory of September 11th still lingers. The social and economic impact still haunts American households. A not-quite double-dip recession caused by the popping of the internet bubble and the terrorist attacks have left certain industries in shambles. The best career prospects, at the time, appeared to be joining the military to be a part of the campaigns in Afghanistan and Iraq. The president is telling the American people that defeating the Axis of Evil will restore our place in the world like WWII did for the greatest generation.

At the same time, the adjustment period caused by free-trade agreements (like NAFTA) and the opening of the Far East is in full swing. Companies, instead of hiring people at home, have found it much less expensive and more flexible to move their operations to the shores of India, Thailand, and China. Outsourcing is in fashion. Work that needs to be done closer to home is shipped to the hellholes of the Mexican maquiladoras or the comfort of the clean Canadian factories. A strong dollar policy holds that the US has a preference for consumption over production. Additionally, recently passed capital gains tax cuts created a preference for capital investments over labor. The old American blue-collar worker finds himself out of work and wanting. The new economy has no place for him. Unemployment was stubbornly high, by historic standards, despite the fact that the economy continues to grow.

Maquildora factories were pit-stops for immigrants crossing the border. They earned just enough money at the factories to pay the coyotes to smuggle them across the border. 

The previous few years saw the banking and finance sectors become more deregulated than they have been in decades. New legislation in the latter half of the Clinton Administration, including the Financial Services Modernization Act and the Commodities Future Modernization Act, lead to a new wave of financial consolidation and innovation that has begun to play out. The rise of bank holding companies, such as Citigroup, laid the seeds for Too Big Too Fail institutions that are arguably too big to even manage. New financial products were being invented left and right, then packaged together into previously exotic Over-the-Counter (OTC) derivatives. There were warnings from a small minority of people that both these pieces of legislation would lead to a financial crisis of epic proportions, but systemic risk was not a term to be found in regulators' vocabulary before the crisis.

Though the economy wasn't great, there was no great cause for concern either. After being in the ditches for so long, the feeling was that the only direction that the economy could go was up. People felt that the 3.5% annual growth of the 1990s were bound to return any time now. The philosophy of laissez faire was a rare consensus opinion among some of the greatest economic minds of a generation; from Clinton's Treasury Secretary Larry Summers to Federal Reserve Chairman Alan Greenspan to Bush's Chairman of the Council of Economic Advisors Gregory Mankiw. Let the good times roll and they will come.
The philosophy these guys espoused actually made the world burn. Instead of putting out the fire, they just reset the timebomb. After the crisis, they have been instrumental in the re-regulation of the financial sector. 

The fall of communism and the outsourcing of manufacturing lead to unprecedented growth of the global economy during the 1990s and 2000s. Oil imports are enriching Saudi princes while Chinese industrialists have found great wealth by becoming the world's sweatshop owners. The Gilded Age is alive and well in places from Russia to Banana Republics. The new money in the third world were now looking for a safe place to invest their financial assets. The old West - America and Europe - still had the safest banking system around. Much more so than what they would find at home, especially after the setbacks of East Asia Financial Crisis and the Russian debt default. The safest investment in the world in the safest country in the world, U.S. Treasury bonds, could not be sold fast enough. Investors started looking for other AAA rated assets and stumbled upon the US mortgage market - a traditional safe-haven for investors.

The US was set to see a new housing boom. Every President since the Harry Truman has reinforced the idea that Americans have a God-given right to own their own home. Such a national goal was reinforced by the First time home-buyers tax credit and the Home Mortgage Income Tax deduction, as well as low interest rates set by the Federal Reserve; the economic incentives for the individual aligned to buy instead of to rent. It became a patriotic duty to be able to lay down your own white picket fence, preferably in the suburbs too.

The stage is now set.

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