QE2, Credit Expansion, The Mortgage Bubble, and the

Future of the United States Economy

2/22/2011

Chris Marcus
chris.marcus@gmail.com
 The Status of the United States Economy in 2011
As the United States continues its effort to recover from the recent financial crisis
progress remains limited despite numerous legislative measures and support from the
Federal Reserve. On November 3rd 2010 the Fed introduced a new program commonly
referred to as QE2, which consisted of purchasing $600 billion worth of treasuries and
mortgage-backed securities in order to lower interest rates and stimulate economic
activity. Unfortunately QE2 represents a continuation of the same policies that caused
the credit crisis and will be similarly damaging, as it will exacerbate the problem it was
intended to solve while preventing a real recovery from taking place.

Many view the buildup and collapse of the mortgage market as a failure of free market
capitalism and a lack of regulation that allowed greed to run rampant and bring down the
financial system. However this explanation is based on the United States operating as a
free market absent government intervention which has not been the case. This leads to a
misdiagnosis of the cause of the crisis and is dangerous as these conclusions are used as
the basis for future decision-making. While the elements of greed and speculation have
always been present throughout the history of civilization the difference this time was
that changes in government regulation and monetary policy allowed greed and
speculation the means to corrupt the financial system. If greed represented pouring the
gasoline, the government intervention was the necessary match that distorted the free
market, skewed incentives, removed the fear of loss, and altered decision-making in the
private sector. These distortions caused by programs like QE2 and government
subsidization of industry have a very predictable and damaging effect on the structuring
of an economy and continuing to treat the problem with larger doses of the cause will be
met with similar results.

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 Expansion of Credit and the Monetary Base
Typically when the economy struggles one of the first responses by the Fed is to lower
short-term interest rates. The Fed does this by printing money and using it to purchase
assets such as treasuries and mortgage-backed securities (although it is not limited to
these) or it can lower the amount of reserves that banks have to hold against their loans
which allows them to make additional new loans (if they now have to hold only $90 of
reserves instead of $100 they can loan an additional $10). In both cases an expansion of
the money supply is used to create new credit. Money works like other goods in that
when there is a shortage the price goes up as you have to pay a premium to own it and
when there is an increase in supply the good becomes less difficult to obtain and the price
goes down. The price of money is represented by the interest rate which measures the
cost of borrowing. As the Fed creates new money the additional supply makes money
less difficult to own lowering the interest rate that borrowers have to pay. This inflation
of the money supply also dilutes the currency and reduces its value resulting in higher
prices being charged for goods.

Worth noting is the distinction between inflation, which is the expansion of the money
supply, and rising prices which are the effects of the inflation. The significance is that
the former is the cause while the latter is the effect. It is common to see the rising prices
referred to as inflation but the problem is that this leads people to try address the
symptoms rather than the cause. Austrian economist Ludwig Von Mises illustrates the
inherent problem that stems from this error in syntax.

There is nowadays a very reprehensible, even dangerous, semantic

confusion that makes it extremely difficult for the non-expert to grasp
the true state of affairs. Inflation, as this term was always used
everywhere and especially in this country, means increasing the
quantity of money and bank notes in circulation and the quantity of
bank deposits subject to check. But people today use the term
"inflation" to refer to the phenomenon that is an inevitable consequence
of inflation, that is the tendency of all prices and wage rates to rise. The
result of this deplorable confusion is that there is no term left to signify
the cause of this rise in prices and wages. There is no longer any word
available to signify the phenomenon that has been, up to now, called
inflation. It follows that nobody cares about inflation in the traditional
sense of the term. As you cannot talk about something that has no
name, you cannot fight it. Those who pretend to fight inflation are in
fact only fighting what is the inevitable consequence of inflation, rising
prices. Their ventures are doomed to failure because they do not attack
the root of the evil. They try to keep prices low while firmly committed
to a policy of increasing the quantity of money that must necessarily
make them soar. As long as this technological confusion is not entirely

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 wiped out, there cannot be any question of stopping inflation.

Look at the silly term, "inflationary pressures." There is no such thing

as an "inflationary pressure." There is inflation or there is the absence
of inflation. If there is no increase in the quantity of money and if there
is no credit expansion, the average height of prices and wages will by
and large remain unchanged. But if the quantity of money and credit is
increased, prices and wages must rise, whatever the government may
decree. If there is no inflation, price control is superfluous. If there is
inflation, price control is a sham, a hopeless venture.1

Yet despite the destructive economic effects of credit enhancement the premise that
expansion of the money supply is the correct strategy to employ during recession is
currently taken as a given and rarely even debated. Much like the once commonly
accepted belief that home prices could only rise, little time is spent discussing the cost of
these actions, the probability of their effectiveness, the impact of the inflation that is
being created, or the construction of a contingency plan should credit enhancement not
work. Instead the strategy appears to be to just do more the next time. More than two
years after the bankruptcy of Lehman Brothers and the unprecedented expansion of the
Fed’s balance sheet the stimulus provided displays little evidence of having any positive
effect. Commodities, food prices, and energy continue to rise while unemployment
remains high, municipalities now face risk of default as the effects of government
stimulus start to wear off, and the housing market begins the next leg of its decline.
Below is a chart of the United States monetary base using data from the St. Louis branch
of the Fed.2

1
http://mises.org/efandi/ch20.asp
2
http://alfred.stlouisfed.org/graph/?chart_type=bar&s_1=1&s[1][id]=AMBSL&s[1][vintage_date]=2011-
01-28&s[1][cosd]=2010-12-01&s[1][coed]=2010-12-01&s[1][range]=Custom&s[1][line_color]=
%230000FF&s_2=1&s[2][id]=AMBSL&s[2][vintage_date]=2011-02-04&s[2][cosd]=2010-12-01&s[2]
[coed]=&s[2][range]=Custom&s[2][line_color]=%23FF0000&chart_type=line&s[1]
[mark_type]=MARK_FILLEDCIRCLE&s[2][mark_type]=MARK_FILLEDCIRCLE

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In August of 2008 before Lehman Brothers declared bankruptcy the monetary base was
$872 billion. As of December 2010 the monetary base was over $2 trillion. Given the
lack of improvement in the economy despite all of the stimulus provided it seems
reasonable to consider whether this is indeed the correct strategy to be pursuing.
Comparing the effects of altering interest rates through credit enhancement via the Fed as
opposed to the way credit functions in a true free market begins to reveal a great deal
about why the approach has not worked and why a continuation will only create a bigger
problem that will be more difficult to address at a future date.

The Rate of Consumption and the Pricing of Interest Rates

When an individual earns money he has two choices. He can spend it now (consumption)
or he can save it (investment). By saving money it can be lent out for someone else to
use for business. Remember that capital is created when money is saved as for someone
to borrow money someone else has to save it first. The proportion of consumption to
investment is determined by the individual’s time preference, or the degree to which he
prefers to consume now as opposed to later. If he prefers a higher level of current
consumption relative to the amount saved than his time preference (rate of interest) will
be higher. The lower savings rate results in a smaller pool of savings which increases the
scarcity and is naturally reflected by a higher cost of borrowing. Lower amounts of
consumption relative to savings reflect a lower time preference meaning more money is
saved for future consumption. The amount of savings made available to business for
investment is what allows business to gauge the level of consumer demand. If consumers
demand more capital-intensive goods that require longer chains of production they will
have to forgo current consumption which will result in higher savings. That more
savings are available and the interest rate is lower naturally signals business of the
market’s demand for more capital-intensive goods. If an entrepreneur has forecast
successfully and can profitably meet that demand at the current rate of interest his profit
will be sustainable to the degree that he continues to accurately forecast any future
changes in consumer time preferences. Good forecasting is rewarded with profit while

5
poor forecasting is punished by loss. Whatever society’s time preferences may be,
allowing production to match the amount of savings made available will cause the correct
level of sustainable business activity to be undertaken.

The Central Bank Steps In

When a central bank decides to intervene and lower interest rates it expands the money
supply and the additional supply of credit lowers the rate banks can charge. The lower
rate caused by the intervention sends a distorted signal to business as it creates the
impression of demand supported by savings when it is in fact only the creation of new
money. Projects that would not have been undertaken at higher interest rates are now
started because they appear profitable with the lower borrowing costs. But there has been
no change in underlying productivity so the new business activities use the newly created
money to bid for the same pool of labor and resources. More money chasing the same
goods bids up the cost of these factors of production, which in turn raises end consumer
prices. This also changes the structure of the economy because resources are drawn away
from activities that were previously being funded with new savings to the new enterprises
created due to the lower borrowing costs. This cycle will continue as long as the
expansion increases but if the central bank ceases the expansion the lack of continued
new credit will lead to higher interest rates and many of the projects that were once
profitable will become unprofitable. At the same time businesses are experiencing an
increase in borrowing costs the lack of more newly created money exposes the lack of
savings to support the new goods that have been produced. Wages and prices fall as
unsustainable businesses have to scale back operations or be altogether liquidated. This
is the bust of the earlier boom phase.

Imagine a firm that has a break-even rate of 4% interest in that underlying demand is
great enough for the firm to be profitable if borrowing costs are below 4% but insolvent if
they have to pay above 4%. If a lender is willing to extend credit to a firm at 5% the
firm will decline the loan. Now the Fed in an attempt to stimulate the economy makes
credit available at 3% and same firm seeing this lower rate takes out the loan. The
government’s intervention in the market has altered private decision-making. The firm
sees the cheaper cost of credit and takes out the loan that it otherwise would not have.
But when the government exits its stimulative phase the business finds out that the actual
demand as represented by savings is insufficient to support the higher interest expense.
For a recent example one only needs to look at how mortgage borrowers started
defaulting when they couldn’t afford the higher payments associated with their loans as
they reset when the Fed began raising interest rates in 2004.

If the central bank instead continues expanding in order to avoid the bust phase the
stability of the currency comes into question and eventually the public will lose faith in
its value as Mises explains in the following excerpt.

The inflation and the boom can continue smoothly only as long as the
public thinks that the upward movement of prices will stop in the near
future. As soon as public opinion becomes aware that there is no reason

6
 to expect an end to the inflation, and that prices will continue to rise,
panic sets in. No one wants to keep his money, because its possession
implies greater and greater losses from one day to the next; everyone
rushes to exchange money for goods, people buy things they have no
considerable use for without even considering the price, just in order to
get rid of the money.3

This illustrates the danger of using credit expansion as a tool to stimulate growth without
a relatively quick reversal of the additional liquidity. The longer the expansion continues
the greater the amount of mal-investment created that will need to be liquidated later. As
the amount of mal-investment increases the amount of underconsumption that will be
required to rebuild the savings base also increases causing a longer and more severe
contraction when the liquidity is reversed. Another inherent problem with this strategy is
that it allows politicians the option of continuing to expand in hopes that a quick recovery
will allow the economy to skip the recession entirely (unfortunately the probability of this
decreases the longer the expansion continues). It allows an economic decision to become
a political one, which is dangerous in that the choice is usually made to continue
expanding rather than face the consequences of withdrawn liquidity. When this does not
work the original problem begins to snowball into a much larger one, which is
representative of the current situation in the U.S. economy. The recent decline in the
dollar and concern over the continued printing by the Fed is the fear that Mises warns of.

The Value of Recession

If the central bank ends a period of credit expansion the mal-investment is exposed and a
period of contraction begins as wages and prices fall. Just as the boom was a period of
increased activity and consumption due to the misleading signals sent by the new bank
credit the bust represents the reversal of these phenomena. However while the
contraction represents a period of sacrifice and underconsumption this is not something to
be avoided as the recession signifies a healing of the economy. The period of earlier
overconsumption is now being replaced with a period of underconsumption as the market
rebuilds the base of savings.

Imagine a person who makes $1000 per week in income and also has expenses of $1000
per week. This person is consuming all of his assets. One day his friends come over and
ask him to take a trip to the casino. He doesn’t have any money to gamble with but in
order to convince him to go his friends loan him $1000. Unfortunately he picks the
wrong hand of blackjack and loses his money. When he gets back home he has a few
options. He can default on his loan, try to borrow more in hopes of winning back what he
lost, or cut his level of spending and save money to pay back what he owes. If he
defaults on his loan that will likely hurt his reputation with his friends and they may be
unwilling to lend money to him again in the future in fear of further losses. If he borrows
more to gamble there is a chance he can win it back but the odds are in favor of him just
ending up further in debt. The most responsible option is to spend less than he makes to
compensate for the previous overconsumption as he saves money to repay what he owes.
3
http://mises.org/tradcycl/austcycl.asp

7
It involves the sacrifice of a lower quality of life as certain items are cut out of his budget
but that is the consequence of his earlier choices. When referring to an economy rather
than an individual the conditions associated with the last option are what we refer to as
recession.

Credit in a Simple Economy

The reason that no intervention is needed in a free market is that good investment is
rewarded with profit while poor investment is punished by loss. The desire for profit and
the risk of loss are the incentives for business to make smart investment and for lenders to
apply prudent lending standards and avoid predatory loans. All parties benefit through
joint productive trade as this arrangement leads to the maximum productivity in an
economy.

Imagine a simple economy consisting of three businessmen - a farmer, a doctor, and a

baker. Each of these craftsmen is capable of learning all three skills but choose to
specialize in the craft that they are most highly skilled at. The farmer is willing to work
nine hours in a given day and if he splits his time among the three tasks he could produce
$2 of farming value, $1 worth of medical value, and $1 worth of baked goods. Or he
could spend all of his time farming and produce $6 worth of farming value as opposed to
$4 of total value in the original scenario. If the doctor and baker have similar competitive
advantages and rates of production in their respective fields the benefit of each of them
focusing on their area of specialization is clear. If each person only performs the task in
which they are most efficient then the economy would have $6 of farming, $6 of medical,
and $6 of baked goods for a total GDP of $18. If they decide to each do their own work
and decline to trade they would each be producing only $4 of total value resulting in a
GDP of $12. This is the mutual benefit achieved through an efficient economy where
resources are allocated to their most efficient purposes and utility is maximized.

To study the effects of overly tight credit (when creditworthy borrowers are unable to
obtain loans) let’s introduce a lender into the example. Each business wants to expand
and needs $10 of additional capital to do so. For this example we will assume that each
of these businesses will repay the loan, these are the only investment opportunities
available to the lender, and the lender has $30 of savings giving him the opportunity to
grant anywhere from zero to three loans of $10 each. Under these conditions the lender
and the economy benefit by the lender extending credit to all three businesses. The three
firms benefit through their joint trade and the lender will be able to collect interest on his
entire pool of capital. However if the lender is too tight with credit and denies a loan to
one of the parties there is now less production in the economy and the lender is now
collecting interest on only $20 of his money while the remaining $10 is not used for any
productive purpose and generates no interest income. This is the economic loss to credit
being overly tight and denying creditworthy borrowers.

In the opposite case of credit being too loose or cheap the lender gives out a loan that he
should not have. In this case he will give out all three loans and we will assume that the
farmer will be unable to repay his. Now the lender loses his capital investment, the

8
farmer is insolvent, and the doctor and baker also lose out on the farmer’s production and
trade. This demonstrates how the productive capacity of the economy is maximized only
when credit is neither too tight nor too loose, and this equilibrium can be reached only
when the market is allowed to balance supply and demand without any outside distortion.

Government Direction of the Housing Market

The buildup of the mortgage bubble over the past decade involved mistakes and
shortsighted decisions by many parties involved. Investment banks that made lucrative
fees on mortgage products, rating agencies that profited on transaction volume while
seemingly forgetting to analyze the deal collateral, mortgage brokers who sought out
potential homebuyers even when it was clear borrowers could not afford the properties,
appraisers who intentionally inflated home values, and speculators who purchased
properties not as a home but in an attempt to profit under the belief that prices would only
rise as well as others all shared guilt and appropriately deserved blame. But the crisis
simply could not have occurred were it not for the intervention by the government
through its ideology of increased homeownership and the Fed’s cheap monetary policy.

The Origins of the Housing Bubble

When there is no outside intervention in the housing market home prices, like other
assets, are determined by supply and demand. Supply is represented by the homes
available and demand is what buyers are able and willing to pay. This system of balance
has predominantly worked for the period during which home pricing data is available so
the question is what caused the collapse of the market at this particular point in time.

Economist Robert Shiller compiles data for the Case-Shiller Home Price Indices and in
his book “Irrational Exuberance” points out that outside of the end of World War II and
the late 1990’s home prices have mostly been flat or declining in the period between
1890 and 2004. Even including these two periods of increase real returns on home prices
during the entire period are 0.4% per year indicating that housing generally tracked
inflation and illustrating just how unusual the enormous recent spike was. After World
War II there was a shift in the population as well as housing subsidies in the Servicemen's
Readjustment Act of 1944 to which a large degree of that price increase can likely be
attributed. In the more recent increase there appears to be little evidence of a housing

9
shortage that would explain the abnormal increase in prices but there were significant
changes in the structure of demand.

The Push for Home Ownership

In 1992 former President George H.W. Bush signed the Housing and Community
Development Act of 1992. This bill amended the charters of Fannie and Freddie to meet
the Congressional mandate that the government-sponsored enterprises (GSE’s) “have an
affirmative obligation to facilitate the financing of affordable housing for low- and
moderate-income families”.4 Two years later former President Clinton sent a request to
the U.S. Department of Housing and Urban Development (HUD) to begin work on a
program called National Homeownership Strategy (NHS) that was designed to further
increase home ownership.

The following is an excerpt from the HUD report about the creation of NHS.

At the request of President Clinton, the U.S. Department of Housing

and Urban Development (HUD) is working with dozens of national
leaders in government and the housing industry to implement the
National Homeownership Strategy, an unprecedented public-private
4
http://www.law.cornell.edu/uscode/uscode12/usc_sec_12_00004501----000-.html

10
 partnership to increase homeownership to a record-high level over the
next 6 years. The ideal of homeownership is so integral a part of the
American Dream that its value for individuals, for families, for
communities, and for society is scarcely questioned.5

One example of the impact of NHS can be found in revisions made to the Community
Reinvestment Act in 1995. Whereas bank regulators had previously been given the task
of measuring the solvency of banks, the revisions made in the 1995 amendment dictated
that banks were now rated also on the amount of low-income loans they made. A
description of the changes can still be found on the CRA website.

The new regulations provide that a bank generally will be rated, in part,
based on its record of helping to meet the credit needs of its assessment
area(s) through qualified investment.6

In 2008 Sandra F. Braunstein, Director of Division of Consumer and Community Affairs

made the following comments to the Committee on Financial Services.

Under the investment and service tests, investments benefiting low- and
moderate-income individuals and neighborhoods, or distressed or
underserved rural areas are assessed, and services to the entire
community, including low- and moderate-income individuals and
neighborhoods, are reviewed. An institution's performance in making
investments and providing services each accounts for 25 percent of the
institution's overall rating. Examiners also weigh the innovativeness of
the institution's community development lending, investment, and
service programs and activities.

Institutions with assets between $265 million and $1.061 billion are
designated as "intermediate small institutions" and are evaluated on
their record of lending in low- and moderate-income areas and to
lower-income people in the institutions' assessment areas.

An institution with a Needs to Improve or Substantial Noncompliance

rating on the lending test cannot be assigned an overall passing grade
for CRA.7

In this case regulators are admitting under oath that banks were partially rated
on the degree to which they made loans to lower-income borrowers resulting in
loans being made based on regulatory rather than lending standards. The
revision effectively forced banks to make loans to people who could not afford
to pay them back. This is just one example of regulation being introduced that
forced lenders into making loans that they would have otherwise withheld.

5
http://www.huduser.org/publications/txt/hdbrf2.txt
6
http://www.ffiec.gov/cra/letters/letter_19950629.htm
7
http://www.federalreserve.gov/newsevents/testimony/braunstein20080213a.htm

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These are the types of non-performing loans that led to the failure of the
mortgage market.

In September of 1999 the New York Times published a story titled, “Fannie Mae Eases
Credit To Aid Mortgage Lending” describing how the government still wanted lending
standards further reduced.

Fannie Mae Corporation is easing the credit requirements on loans that

it will purchase from banks and other lenders. The action, which will
begin as a pilot program involving 24 banks in 15 markets -- including
the New York metropolitan region -- will encourage those banks to
extend home mortgages to individuals whose credit is generally not
good enough to qualify for conventional loans. Fannie Mae officials
say they hope to make it a nationwide program by next spring.

Fannie Mae, the nation's biggest underwriter of home mortgages, has

been under increasing pressure from the Clinton Administration to
expand mortgage loans among low and moderate income people and
felt pressure from stock holders to maintain its phenomenal growth in
profits.

In addition, banks, thrift institutions and mortgage companies have

been pressing Fannie Mae to help them make more loans to so-called
subprime borrowers. These borrowers whose incomes, credit ratings
and savings are not good enough to qualify for conventional loans, can
only get loans from finance companies that charge much higher interest
rates -- anywhere from three to four percentage points higher than
conventional loans.8

The impact of this cannot be understated as this again displays how the private sector’s
desire to make a profit is actually what prevented them from making loans that they did
not feel would be repaid. But the government intervened to pressure Fannie and Freddie
to buy bad loans that the private sector declined and these are exactly the type of loans
that helped contributed to the buildup of the crisis. The private sector did later join in
when given the choice of matching market terms dictated by the government or not
lending at all, but ignoring the impact of the government’s role that lead to that outcome
is a costly error.

By 2002 the warnings signals were emerging and evidence of the effects of this behavior
was clear enough that it even received mention in the 2002 Budget Report released by the
government.

The large size of some GSE’s is also a potential problem. Financial

trouble of a large GSE could cause strong repercussions in financial

8
http://www.nytimes.com/1999/09/30/business/fannie-mae-eases-credit-to-aid-mortgage-lending.html

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 markets, affecting Federally insured entities and economic activity.9

This hardly seems to support the need for more regulation. In this case the existing
regulation worked just fine as it caught the problem in plenty of time. The only problem
is that the government balanced this against its desire to expand homeownership and
chose the latter while ignoring the warnings. Like hitting the snooze button and then later
blaming the alarm clock for waking up late this wasn’t a case of insufficient regulation
but a lack of leadership. The government didn’t need to create any additional regulation
to prevent this. They just needed to stop making bad loans.

The Knockout Punch

With the housing mandate in place, the increased role of the GSE’s and other government
housing agencies buying more loans, and the banks, rating agencies, mortgage brokers
and appraisers eagerly waiting on the sidelines the elements for the boom were in place.
Following the collapse of the tech boom (which itself was preceded by a period of
expansion and collapsed shortly after an attempt to raise interest rates exposed the mal-
investment of that bubble) the Fed under Alan Greenspan began a series of rate cuts from
2001-2003 that left short-term rates at 1%. As seen in Shiller’s chart it is during this
period that housing boom really takes off.

All of the factors previously mentioned put the framework in place but it was the decision
to lower interest rates that removed the market’s last line of defense against the bubble.
The expansion of the money supply provided additional money to chase the same basket
of goods and bid prices higher. Without the new currency in circulation, bidding up
home prices would have required cutting back consumption somewhere else. Instead,
homes were bid up while other consumption increased. Providing a backstop on the
losses through the GSE’s in combination with other incentives like the mortgage tax
deductions gave the housing industry a subsidization that promptly directed the money
flows to the industry. Now that banks had a cheaper source of funding they were able to
offer low teaser payments on adjustable-rate mortgages to a level where low-income
borrowers could meet the initial payments. This element specifically was crucial to the
formation of the bubble because the fact that borrowers could not previously meet the
minimum payments was what had held home prices in check. With this barrier removed
the ascent began.

There might have been concern about borrower’s ability to meet higher payments when
the loans reset as the Fed raised rates but with housing being the recipient of the money
inflation the new cash was bidding prices higher and allowing borrowers to refinance
providing the cash to meet the higher payments. That the game had to end at some point
was of little concern to most of the parties involved because borrowers put nothing down
while lenders were able to pass the risk along to the GSE’s and other creditors who
confused money inflation for demand supported by savings. With treasuries giving
minimal returns investors seeking yield were forced into riskier alternatives which turned
out to be a costly mistake. While the Fed often blames the crisis on foreign inflows they
9
http://www.gpoaccess.gov/usbudget/fy02/pdf/spec.pdf

13
omit the role of the dollar as the reserve currency in absolving blame. With the dollar
serving as the international reserve foreigners looking for a return in a supposedly safe-
haven U.S. investment provided additional demand for mortgages. When the Fed finally
raised rates the whole scheme collapsed in the exact manner that can be expected after
any period of credit expansion.

Economist Peter Schiff, one of the few people to predict the mortgage crisis
well in advance of the collapse writes about the breakdowns that he saw years
earlier that lead to the bubble.

Just as prices in a free market are set by supply and demand, financial
and real estate markets are governed by the opposing tension between
greed and fear. Everyone wants to make money, but everyone is also
afraid of losing what he has. But over the past generation, government
has removed the necessary counterbalance of fear from the equation.
Policies enacted by the Federal Reserve, the Federal Housing
Administration, Fannie Mae and Freddie Mac (which were always
government entities in disguise), and others created advantages for
home-buying and selling and removed disincentives for lending and
borrowing. The result was a credit and real estate bubble that could
only grow -- until it could grow no more.10

10
http://www.washingtonpost.com/wp-dyn/content/article/2008/10/15/AR2008101503166.html

14
 The Private Sector Pulls Back While the Government Orders
Another Round
In response to the collapse private lenders tightened lending standards in order to avoid
losing their capital again. This was reflected by the difficulty for many in obtaining
credit in the past few years. However this is not a failure of free markets but evidence of
their effectiveness. Having been burned by making bad loans the private sector adjusted
its behavior and this time declined to match the Fed when it began lowering rates in
2007. Given that the crisis was caused by bad debt and irresponsible lending shouldn’t
an increase in lending standards and tighter credit be the desired outcome? Yet the
government criticizes the private sector for not lending while using taxpayer funding to
continue issuing these same types of loans, this time through the FHA.

A 2009 article in the Washington Post mentions how with the pullback from the private
sector, Fannie, and Freddie, the new source of low-income loans has become the FHA.
Changing the name on the government institution while committing the same mistakes
has not created a different outcome and the only surprise here is how rapidly these loans
are defaulting.

This decade's housing boom rendered the FHA irrelevant. Americans

raced to aggressive lenders, seduced by easy credit and loans with no
upfront costs. But the subprime mortgage market has crashed and
borrowers are flocking back to the FHA, which has become the only
option for those who lack hefty down payments or stellar credit. The
agency's historic role in backing mortgages is more crucial now than at
any time since its founding.

With the surge in new loans, however, comes a new threat. Many
borrowers are defaulting as quickly as they take out the loans. In the
past year alone, the number of borrowers who failed to make more than
a single payment before defaulting on FHA-backed mortgages has
nearly tripled, far outpacing the agency's overall growth in new loans,

15
 according to a Washington Post analysis of federal data. If a loan "is
going into default immediately, it clearly suggests impropriety and
fraudulent activity," said Kenneth Donohue, the inspector general of
the Department of Housing and Urban Development, which includes
the FHA.

The spike in quick defaults follows the pattern that preceded the
collapse of the subprime market as some of the same flawed lending
practices that contributed to the mortgage crisis are now eroding one of
the main federal agencies charged with addressing it. During the
subprime lending boom, many mortgage brokers and small lenders
milked the market for commissions and fees by making as many loans
as possible with little regard for whether they could be repaid.11

When the government blames the crisis on greedy banks and lack of regulation while
calling for bigger government are programs like the FHA, the Community Reinvestment
Act, Fannie and Freddie, and cheap Fed money the type of solutions we should expect?

The Government’s Financial Crisis Inquiry Commission

When the same parties most responsible for creating the problem with the GSE’s
(Congress and the White House) end up in charge of the effort to decide who was at fault
it is not really all that unexpected to see them not acknowledge their own role. This is the
equivalent of catching someone shoplifting but instead of punishing him asking his
opinion how to prevent the problem in the future and then following his recommendation
to get rid of the security guard. Should it come as a surprise that the ten member
Financial Crisis Inquiry Commission (FCIC) created by the government came back with
the following conclusion?

We conclude that these two entities contributed to the crisis, but were
not a primary cause. Importantly, GSE mortgage securities essentially
maintained their value throughout the crisis and did not contribute to
the significant financial firm losses that were central to the financial
crisis.”12

This is also untrue however. While the commission claims that these securities
maintained their value a report released by the Federal Housing Finance Agency only a
few months earlier details the losses already suffered by the GSE’s.

To date, the Enterprises have drawn $148 billion from the Treasury
Department under the terms of the PSPAs. Under the three scenarios
used in the projections, cumulative Enterprise draws range from $221
billion to $363 billion through 2013.13

11
http://www.washingtonpost.com/wp-dyn/content/article/2009/03/07/AR2009030702257.html
12
http://c0182732.cdn1.cloudfiles.rackspacecloud.com/fcic_final_report_conclusions.pdf
13
http://www.fhfa.gov/webfiles/19411/Projections_102110.pdf

16
Worth mention is that while the commission absolves the GSE’s and places blame on
investment banks that sold the deals the $148 billion GSE loss funded by taxpayers far
exceeds the amount of loss from the bailouts to banks and financial firms like AIG
combined.14 That the banks share blame is not in question, but to make the claim that
they were the problem while absolving the impact of Fannie and Freddie is hard to take
seriously. The GSE’s offered a way for multiple parties to earn transaction fees without
having to be concerned with the fear of loss. The government intervention altered private
decision-making and the result was quite predicable.

Additionally the scenario analysis conducted in the report was based on the three most
likely set of assumptions about the housing market as determined by Moody’s Investor’s
Service, the rating agency that not only initially rated many of these deals Aaa but
maintained these ratings even months after many of the deals had gone bad. Given the
fact that the government chooses Moody’s to create housing scenarios on which to create
a snapshot of potential future outcomes has to be interpreted either as a sign that they
have no interest in actually understanding the causes and correcting them, or that they are
simply not capable of conducting an intelligent investigation.

14
http://money.cnn.com/news/storysupplement/economy/bailouttracker/

17
 More Stimulus Please
The ongoing debate as to how best to respond to the crisis has largely fallen into two
main views. The first is that the economy needs additional stimulus, we need to borrow a
little more now to get things back on track, expanding credit will promote easier
conditions that will help business and lead to jobs, and that the greatest fear we face from
a monetary standpoint is deflation. The Obama Administration and Bernanke Fed as
judged by their actions fit into this category. The alternate view representing the
Austrian School of Economics, the one economic circle that predicted the crisis, why and
how it would occur, and spoke out in attempts to prevent it, is that the crisis was caused
by too much debt, treating it with more debt will only enlarge the problem, the size of
government and spending is unaffordable and crowding out the private sector, and that
the real fear is inflation.

While there are several problems with the stimulus approach, one is that there seems to
be little if any thought ever given to deciding at what point it becomes counterproductive.
In the past three years the Fed has expanded credit in a variety of ways including
lowering interest rates, buying treasuries and mortgage-backed securities, backstopping
bank losses and consumer debt, and bailing out insolvent firms. At the same time the
President and Congress continue to borrow and spend the United States debt past $14
trillion (this doesn’t even include off-balance sheet commitments to Social Security and
Medicare with estimates ranging anywhere from an additional $50-$100 trillion15) while
government officials regularly warn of the ominous yet vague dangers of not going
further into debt. But is this approach really that dissimilar to the gambler going back to
the casino to double down? Given recent history is continued borrowing and spending as
opposed to saving and investing really the best approach of how to structure an economy?

After three years of stimulus it’s certainly hard to argue that there has not been a
substantial effort to support the economy with this strategy. So at what point do we begin
to consider that it might not be working? Is it possible that adding more stimulus and
debt to a problem that was caused by too much leverage is making things worse? Have
any of the decision makers in the current administration and Fed even considered the
irony of that question? And unless there is evidence to support that credit expansion is
guaranteed to work (there isn’t) has any contingency plan been developed in case it
doesn’t? These are the kind of questions and planning that are common in the private
sector and why reckless behavior is more easily held in check when people are forced to
make decisions with their own money. When the government is allowed to spend
endlessly without any repercussions these decisions are ignored just as they were when
the private sector was able to pass along mortgage losses to the government via GSE’s.
The discipline instilled by the possibility of losing money is a fundamental and essential
element of a productive economy and only when it is removed are the forces of greed and
speculation able to run amok.

Throughout the past three years new stimulus plans are rolled out on a regular basis with
the justification that now isn’t the time to stop. But if this were actually doing more harm
15
http://www.pgpf.org/Special-Topics/Hugh-Jidette-the-Challenge.aspx

18
than good how would we know? Has this been considered and if not is it any different
than selling a cup of lemonade for a dollar but not knowing whether the ingredients cost
more or less than a dollar? What if it turns out that the critics of QE2 are correct and at
some point the United States will be forced to acknowledge that the stimulus just made
the problem worse and now the unwinding of that liquidity is going to create a far more
severe contraction than what was experienced in 2008?

One hopes that President Obama, Bernanke, and Congress would at least agree that a cost
of stimulus does exist. Common sense tells us that it must because otherwise instead of
giving $8,000 credits to buy a house we could give out $80,000 credits at no further cost.
But considering the following comment from former House Speaker Nancy Pelosi (which
is not all that uncommon of the economic belief system that many of our lawmakers
practice) one cannot be certain.

Unemployment insurance, the economists tell us, return $2 for every $1

that is put out there for unemployment insurance. People need the
money they spend it immediately, for necessities. It injects demand into
the economy; it creates jobs to help reduce the deficit.16

Think about the logic behind that statement. If that were true then all the United States
would have to do is print money as fast as possible and the economy would thrive. In
Pelosi’s economy the United States could just issue $14 trillion in unemployment benefits
and in addition to funding unemployment the fantastic 100% return would eliminate the
national debt all without the entire country having to leave the couch. She actually
believes that borrowing foreign money (or printing it) to purchase foreign-made
consumer goods is what’s going to revive the U.S. economy. Shame on any economist if
this was actually the intended message but further shame on Pelosi and Congress for
taking a statement like that and using it as justification for policy. Obviously there is a
wide range of opinions by economists but at some point we are counting on elected
leaders to be able to listen to the choices and pick between “$1 of entitlement benefits
creates $2 of growth” and “printing money to monetize debt in response to a debt crisis is
a bad idea”. The fact that as a whole they choose the former represents great cause for
concern.

Ben Bernanke and QE2

16
http://www.examiner.com/conservative-in-spokane/tax-cut-extension-fails-senate

19
The Fed stated the reasoning behind QE2 was to lower interest rates which will create
easier economic conditions and foster growth. While there are a lot of things that are
likely to happen when a central bank prints currency to monetize their nation’s own debt
unfortunately creating economic growth isn’t one of them. This round of credit
expansion is going to have the same effects as the past ones except for one difference.
This time the economy was already in an incredibly fragile state when it began and with
the unprecedented expansion that has already taken place in the past three years, the
further expansion from QE2 is undermining confidence in the dollar and the entire U.S.
financial system.

Given that the goal of the program was to lower interest rates it was certainly surprising
to hear Bernanke’s recent assertion that QE2 has been a success. In the three months
since QE2 was announced the 10-year yield is up over 100 basis points and the 30-year
bond has risen by more than 60 bps. Most commodities have risen substantially with
many setting new record highs on an almost daily basis. Since October rubber is up 41%,
cotton 41%, wheat 21%, coal 36% and oil 13%. Just like any other inflation of the
money supply there are now more dollars chasing the same basket of goods and
commodity prices are rising accordingly. The only surprising aspect here is that this was
in some way expected to improve the economy and create jobs.

To project the impact of QE2 on unemployment is surprisingly simple. If input costs for
businesses increase, profit margins are reduced. At this point the business can respond in
one of two ways. It can sell the same number of units for less profit or it can raise the
price to pass along the increases to the consumer and sell fewer units at the higher price.
Unfortunately neither of these outcomes is going to incentivize any business to add
additional workers.

A recent article in the Wall Street Journal mentions the dilemma facing firms and how
they will have to choose between two unpalatable options.

Just ask McDonald's. Or paints and plastics giant DuPont. Or Kleenex

and Huggies maker Kimberly-Clark. Or 3M. Or Coach. These
companies, and many others, have warned in recent days that they're
getting squeezed by rising costs. They'll either eat the costs, which will
hit the stock, or pass them on.17

Evidence of the choice being made is not hard to find. In Macy’s earnings report the firm
mentioned how they plan to handle the rising input costs.

Macy's faces the same sharply rising cotton and labor costs as other
retailers and CFO Karen Hoguet warned that some price increases can
be expected this year.18

17
http://online.wsj.com/article/SB10001424052748704013604576104351050317610.html
18
http://online.wsj.com/article/SB10001424052748703529004576160091783830046.html?
KEYWORDS=macys

20
Rising energy costs are causing airlines to raise their prices as well.

Airlines are attempting to raise their ticket prices at a rate unseen since
the fuel crisis in 2008, according to data from FareCompare.com.19

And look at the sign recently placed in the store window of one Carvel’s Ice
Cream shop.20

To anyone who cares to look, examples like these are not hard to find. Yet Bernanke
remains unable or unwilling to notice this trend. This much is clear based on the
following comments he made before the House Budget Committee on February 9th.

Indeed, prices of many industrial and agricultural commodities have

risen lately, largely as a result of the very strong demand from fast-
growing emerging market economies, coupled, in some cases, with
constraints on supply. Nonetheless, overall inflation is still quite low
and longer-term inflation expectations have remained stable. To assess
underlying trends in inflation, economists also follow several
alternative measures of inflation; one such measure is so-called core
19
http://www.marketwatch.com/story/airline-stocks-plunge-as-jet-fuel-prices-rise-2011-02-22
20
http://www.europac.net/pentonomics/housing_and_inflation_0

21
 inflation, which excludes the more volatile food and energy
components and therefore can be a better predictor of where overall
inflation is headed.21

If he does not expect consumer prices to rise based on higher input costs then wouldn’t he
have to at least acknowledge that profit margins will decrease? And if so is that what’s
going to ease financial conditions for business and create job growth?

To see the chief economist in charge of monetary policy of the world’s reserve currency
come to that conclusion is concerning to say the least. Part of the problem is that
Bernanke is looking at metrics that measure price increases over the past year rather than
connecting the evidence to extrapolate what is likely to occur going forward. Does he
really think that because CPI tells him that price increases over the last year were
minimal that skyrocketing commodities don’t offer any meaningful clues about the
future?

Another problem is in the CPI itself. To inflation hawks that the CPI is a heavily biased
measurement comes as no surprise but to those unfamiliar a recent Wall Street Journal
article summarizes some of the flaws in the measurement.

Over the past 30 years, the federal government has made a lot of
changes to the way it calculates inflation. It's taken place under
presidents of both parties. Each change in methodology has come with
plausible-sounding justifications. But, as if by magic, each change has
had the effect of flattering the numbers. Funny, that. According to one
rogue economist, John Williams at Shadow Government Statistics, if
we still calculated inflation the way we did when Jimmy Carter was
president, the official inflation figures would look about as bad as they
did when ... Jimmy Carter was president. According to Mr. Williams's
calculations, if we counted inflation under the old system the official
rate wouldn't be 1.5%. It would be closer to 10%.22

Bernanke also mentioned how he excludes volatile food and energy prices to get a better
reading on inflation. Think about the irony of that. Excluding the two most essential
categories that people spend money on to get a more accurate measure of prices. And of
course even the reasoning behind that is flawed as well. Bernanke claims that the food
and energy prices are volatile on a month-to-month basis, but these are annualized
numbers. In comparing monthly figures perhaps a case can be made, but if prices are
rising over a year isn’t that a trend? Especially when one looks at these prices over even
longer periods of time it becomes clear that this is not short-term noise.

Inflation is Too Low

Amazingly one of the main arguments given by the Fed as they began contemplating a

21
http://www.foxnews.com/politics/2011/02/09/bernankes-remarks-house-budget-committee/
22
http://online.wsj.com/article/SB10001424052748704013604576104351050317610.html

22
second round of asset purchases has been that inflation is dangerously low and not
consistent with the Fed’s mandate. The following is a comment from Bernanke on
October 15th a few weeks before the formal announcement of QE2.

FOMC participants generally judge the mandate-consistent inflation

rate to be about 2 percent or a bit below. In contrast, as I noted earlier,
recent readings on underlying inflation have been approximately 1
percent. Thus, in effect, inflation is running at rates that are too
low relative to the levels that the Committee judges to be most
consistent with the Federal Reserve's dual mandate in the longer run.23

Looking however at the Fed’s own mission statement one can see a goal of “stable
prices”24 listed in the first bullet point. This raises the obvious question of what mandate
Bernanke and the other Fed governors are referring to. Wouldn’t stable price be defined
as prices that are stable rather than rising at a 2% rate? Does it seem odd that while India,
China, and Australia are raising rates to fend off inflation that Bernanke thinks the U.S.
needs more? The fact that Fed officials talk casually about 2% inflation as if it were a
preordained law of nature is a costly oversight. Yet even if this were somehow a goal
worth achieving is Ben Bernanke implying that he can fine tune the economy with
enough precision that $600 billion is the exactly correct number of bonds to purchase that
will tweak prices up by exactly 1% but not any further? The idea that Bernanke is going
to monetize debt while keeping prices in check given the way the Fed’s balance sheet has
expanded in the past few years is hard to believe.

He denies any link between his policies and the food shortages that are being experienced
throughout the world. He says the uprising in Egypt is due to Egypt’s own loose
monetary policy. But this conveniently ignores the fact that the dollar is the world’s
reserve currency and when other nations back their currencies with dollars our inflation is
exported. And if he feels that the problems in other countries are caused by loose
monetary policy what conclusions are to be drawn from the incredibly loose policy that
he has promoted here? Do the laws of economics apply differently to Americans?

We Can Raise Interest Rates in 15 Minutes

The problem going forward is that Bernanke has backed himself into a corner and has no
escape route. He claims that he can raise interest rates in “15 minutes” but the problem is
he won’t. He states he is “100% confident” he will know the right time to reverse course
but one only needs to look at his track record to have great skepticism that his confidence
is misplaced.

March 28th, 2007 – Ben Bernanke: "At this juncture . . . the impact on
the broader economy and financial markets of the problems in the
subprime markets seems likely to be contained."

23
http://www.federalreserve.gov/newsevents/speech/bernanke20101015a.htm
24
http://www.federalreserve.gov/aboutthefed/mission.htm

23
 May 17th, 2007 – Bernanke: “While rising delinquencies and
foreclosures will continue to weigh heavily on the housing market this
year, it will not cripple the U.S.”

June 20th, 2007 – Bernanke: (the subprime fallout) ``will not affect the
economy overall.''

October 15th, 2007 – Bernanke: "It is not the responsibility of the

Federal Reserve - nor would it be appropriate - to protect lenders and
investors from the consequences of their financial decisions."

February 29th, 2008 – Bernanke: "I expect there will be some failures. I
don't anticipate any serious problems of that sort among the large
internationally active banks that make up a very substantial part of our
banking system."

June 9th, 2008 – Bernanke: Despite a recent spike in the nation's

unemployment rate, the danger that the economy has fallen into a
"substantial downturn" appears to have waned,

July 16th, 2008 – Bernanke: (Freddie and Fannie) “…will make it

through the storm”, "… in no danger of failing.","…adequately
capitalized"

After his diagnosis of the past crisis are we supposed to have confidence that this time he
will get it right even as he continues to miss what should be some very clear evidence of
a serious problem? The unfortunate reality is that he has already gone past the point
where it’s possible to have a smooth unwinding. In 2003 Alan Greenspan lowered short-
term rates to 1% for a year and when the Fed later tried to unwind that liquidity it brought
down the global economy. Given that FHA loans are already defaulting what does he
think will happen to housing once he starts to try and sell the book of MBS securities he
has on the Fed’s balance sheet? That Bernanke has held rates at 0% for over two years
and counting and has a balance sheet of almost $2.5 trillion25 yet doesn’t recognize any
signs of trouble is great cause for concern.

25
http://www.reuters.com/article/2011/02/10/us-usa-fed-discount-idUSTRE7197SJ20110210

24
 The Road Ahead
Like one of those high-speed car chases where the criminal in the getaway car has
already been caught for the original crime but adds a few more years onto his sentence
because of the chase the delay in acknowledging the mistakes that have been made and
taking action to address them is building a bigger problem that will be much more painful
to address in the future. The possibility of the economy growing its way back to
prosperity on a foundation of stimulus and cheap credit has long since passed. The
unfortunate reality is that great damage has been done to the economy and that the
reparation of that will require a great period of sacrifice by all Americans. Insolvent
firms must be allowed to fail rather than being subsidized. Bad loans must be processed
and written off. Government intervention and central planning in the economy must
cease and allow the market to function. This process will represent a difficult period for
all Americans as it will result in a recession more painful than what was experienced in
2008. But while the short-term pain will be significant, embracing a return to the
economic conditions that allowed America to thrive over the past two centuries is the
only way the country will ever return to prosperity. Each day that the insolvencies of
Social Security and Medicare are not addressed increases the cost of these programs and
reduces the possibility of a restructuring that will save any recovery value. Failure to
accept that we made promises we cannot keep only insures that eventually there will be
nothing for everyone. Each day that the $14 trillion dollar debt is increased with more
spending rather than reduced with cuts pushes our credit profile closer to complete
insolvency. Each government program designed to increase consumer spending and debt
will compound the leverage that is burdening our economy and preventing it from
growing. Anything short of accepting this guarantees a complete collapse of the entire
U.S. financial system.

Bernanke was correct about one thing in his testimony to the House Budget Committee.
Despite denying his role in enabling the process he did correctly summarize the
seriousness of the situation.

The CBO's long-term budget projections, by design, do not account for

the likely adverse economic effects of such high debt and deficits. But
if government debt and deficits were actually to grow at the pace
envisioned, the economic and financial effects would be severe.
Sustained high rates of government borrowing would both drain funds
away from private investment and increase our debt to foreigners, with
adverse long-run effects on U.S. output, incomes, and standards of
living. Moreover, diminishing investor confidence that deficits will be
brought under control would ultimately lead to sharply rising interest
rates on government debt and, potentially, to broader financial turmoil.
In a vicious circle, high and rising interest rates would cause debt-
service payments on the federal debt to grow even faster, resulting in
further increases in the debt-to-GDP ratio and making fiscal adjustment
all the more difficult.26
26
http://www.federalreserve.gov/newsevents/testimony/bernanke20110209a.htm

25
The result of all of the mistakes made over the past decade and especially in the last few
years is that a new bubble is being inflated in the government debt market to fund the
overconsumption of America and it threatens the financial solvency of the U.S. The
credit crisis and all of the bad debts were never fully processed but instead assumed by
the government and now the loans that would have represented losses to creditors have
been assumed in the form of treasuries. And with foreign appetite for treasuries waning
(many of our major creditors have spoken publicly about a growing reluctance to lend
further to the U.S. and China was actually a net seller of treasuries in November27) the
clock is ticking rapidly.

That the situation with the government’s debt is in many ways similar to the mortgage
bubble makes sense given that it really is just a continuation. And just as homebuyers
borrowed at low rates and defaulted when rates rose the majority of the government’s
debt is also short term and will have to be rolled over at higher rates. This will happen
whether Bernanke raises rates of whether the market does it for him.

As of late last year, roughly 43 percent of U.S. debt needed to be rolled

over within 12 months, the highest proportion since the mid-1980s.
The relatively short maturity of outstanding Treasury debt, coupled
with the increased reliance on foreign creditors, puts the U.S. at greater
risk of sharply higher borrowing costs should risk perceptions change
abruptly in credit markets.28

Risk perceptions are changing rapidly and time is running out. Hopefully our elected
leaders see this and begin to understand the danger of their actions. The future of the
nation depends on it.

27
http://online.wsj.com/article/SB10001424052748703954004576089722696015118.html
28
http://budget.house.gov/UploadedFiles/debtthreat27may2010.pdf

26