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Archive for the ‘Economic Issues’ Category

– The NDP government of Nova Scotia collected $654 dollars more in tax per capita from Nova Scotians. The increased tax burden for a family of four: $2,616.

– 80 per cent of the NDP government’s “better than estimated” result is from higher tax revenues.

– Public Accounts Vol. 1 documents (page 43) say HST revenue is “higher than the prior year primarily as a result of the two percentage point increase in the HST rate that became effective on July 1, 2010.”

– The Finance Minister claimed the higher HST revenue came from increased consumer spending but consumer spending over the same period in Nova Scotia was flat: 0.1 per cent, the third worst retails sales number in the country (Source: StatsCan).

– The Finance Minister has said gas and diesel sales drop when prices are high but motive fuel tax revenues are up $7.2 million over the year before.

– The NDP government does not report how much of the $291 million in additional HST revenue came from gas and diesel sales.

BACK IN THE RED IN 2012

– The NDP government is estimating departmental spending will increase by $471 million in 2011-12, a six per cent increase over the previous year.

– Billion dollar swing: From a surplus of $569 million to a deficit of $390 million in 2012 is a swing of $959 million.

– In 2012, the debt will grow by $678.9 million, which is 3 times the reduction in 2011.

Progressive Conservative leader Jamie Baillie says the NDP government’s tax grab is hurting the economy and costing jobs.

“Contrary to the story that was spun for them yesterday, Nova Scotians know that higher taxes kill jobs and hurt our economy in the long run,” said Baillie.

http://www.pccaucus.ns.ca

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Unlike the Great Depression which occurred over 75 years ago, the current global recession is a mystery to most. The first point to understand is the housing bubble and its inevitable burst, as well as the different theories of what caused the bubble in the first place including sub-prime mortgages. Following that, mortgage securitization, the complexity of large insurance firms, and the lack of regulations surrounding capital requirements will be discussed. Finally, both the Canadian monetary and fiscal policies used in recovery will be analyzed. Putting it all together, one will see how the financial crisis started as well as the government’s actions used to combat the crisis.

The Housing Bubble – What Caused It?

In the past, the main cause of housing crises has been reduced demand due to declining domestic investment in the housing market. The short recession of 2001 in the U.S. was triggered by a sharp decline in domestic investment, mainly in telecommunications infrastructure. As a fall-out, the stock market assets of households declined, but housing assets held up, cushioning the normal decline in consumption that comes with recessions. This event isn’t that well known compared to what’s happening now, perhaps because it happened to be a minor issue or that it worked itself out. Unfortunately, it’s not the case with the current global recession.

The collapse of the housing market in the U.S. was the trigger to the global recession. A popular metaphor for crises of this nature is the “housing bubble” bursting. Consider an imaginary bubble that represents the housing market, with sub-prime mortgages (an extension of credit for non credit worthy borrowers) as the air inflating the balloon. Eventually, reality sets in and the bubble bursts. That being said, there are other factors as well depending on who you ask.

An interesting theory involving the housing bubble is called the Austrian Business Cycle Theory (ABC) which not surprisingly comes from the Austrian school of thought (Mises, Friedman, Hayek, etc.) This theory states that financial bubbles would not have even happened had the Federal Reserve not pursued their “easy money” policies, otherwise known as “loose” monetary policy. In other words, the Federal Reserve caused the housing bubble by creating unsustainable growth and is to blame for the financial crisis. Essentially, the Federal Reserve (hereby known as the Fed) kept increasing the money supply throughout 80’s and 90’s. Since 1984, money supply as measured by “money to zero maturity” rose by 390.1%, with an average annual growth rate of 10%. This significant increase in money supply caused interest rates to stay too low for too long, creating an era of mass consumption and rising prices.

The Austrian school of thought states that when central banks increase money supply like this, it causes market interest rates to fall below the rate that would exist otherwise; there is an artificial boom rather than a real one. Eventually, houses became over-priced forcing many first-time buyers to purchase sub-prime mortgages. As one can guess when interest rates eventually rise, many of these mortgages become unaffordable resulting in foreclosure and bankruptcy.

The ABC theory also states that the Fed’s “easy money” policies caused resources to be allocated in an unsustainable way. Too many houses were being built, and too many of those houses were larger and more expensive than they should have been. In conclusion, the Austrian school of thought looks at both speculation (people thought the boom was real when it was actually artificially created by the Fed) as well as real factors such as low interest rates (again caused by the Fed’s money supply policies).

Other theories about the housing bubble include Alan Greenspan’s view that the Fed did not cause the housing bubble, but rather complexity and weak regulations did. Greenspan even denied the existence of a housing bubble as it was occurring; only believing it when the financial system failed and he was in the hot seat. Even then, Greenspan published a report called “The Fed Didn’t Cause the Housing Bubble”, where he denies allegations that the Fed was at fault, stating:

It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.

Greenspan even blames the crisis on the fact that highly competitive markets are cyclical, and that “on rare occasions it can break down”. As for recovery, Greenspan calls for capital-requirement regulations and a more broad view of fraud in the real estate market, but emphasizes not bogging down the economy with heavy, controlling regulations. In short, this view involved real factors (complexity, regulations) but does not consider speculation as cause of the housing bubble.

Finally, there is the Keynesian view that speculation (or “psychological” factors) caused the housing bubble. In the late 90s, significant increases in overall stock prices made Americans wealthier. This increase in wealth led people to consume more, including new and expensive houses. By 2000, the average saving rate of disposable income fell to 2%. Basically, Americans felt wealthier than they actually were, and as one can guess during financial booms people tend to consume excessive luxury items including fancy houses; people are over-confident. The recession was made worse by the fact that Americans did not have the savings to cushion the blow of the recession. As well, the sharp decline in the stock market in the early 2000s triggered investors to shift investment away from the stock market and into the ever-growing housing market. All of this adds up to Americans enjoying artificial wealth. Keynesian economist Paul Krugman blames expectations (speculation) of capital gains for the inflating of the bubble:

[W]hen people become willing to spend more on houses, say because of a fall in mortgage rates, some houses get built, but the prices of existing houses also go up. And if people think prices will continue to rise, they become willing to spend even more, driving prices still higher, and so on…prices will keep rising rapidly, generating big capital gains. That’s pretty much the definition of a bubble.

With artificial wealth comes one of the main culprits of the housing bubble: sub-prime mortgages and speculation. Sub-prime mortgages occur when banks lend to un-credit-worthy customers – that is, handing out loans to people who want to buy a house that they can’t actually afford in the long-run. This may seem obvious to us all now, but at the time people of all types – bankers, potential home owners – were disillusioned by the notion of housing prices continuing to go up (people were speculating). The idea was that although it wouldn’t pay off now, when the owners are ready to turn the home over to new owners, the supposed increase in the value of the home would compensate for the lack of income needed to pay off the mortgage. As one can imagine, the idea was popular for both bankers and eager to-be homeowners alike. Bankers lend more (which means more return for them in the long-run if the market goes well), and average folks get a better house than they could have otherwise.

To make things worse, lenders often offered low down-payments, and some even lent out loans that exceeds the total price of the house. Many borrowers even took portions of their mortgage out to pay for other luxury items. Sub-prime mortgages also often came with higher interest rates than normal prime mortgages, as people with bad credit history have a greater chance of defaulting or having delinquent payments. With all of this adding up, the bubble filled up with lending amounts close to and exceeding equity (what one owes compared to what one owns), and eventually the market collapsed with many facing foreclosure and bankruptcy. As well, an over-supply of new houses made the high prices unsustainable.

Interestingly enough, according to Robert Shiller, housing prices stayed relatively the same for a century prior to 1995. As well, there was a 30% increase in house prices from 1995 to 2002 alone – before the housing boom was even off its feet. To Keynesians, this is more than enough evidence to suggest speculation was the main cause of the housing bubble rather than real economic forces such as interest rates and regulations, as other markets didn’t rise in the same manner.

To sum these theories up, the mainstream view held by Greenspan and other economists such as Bernanke blames “real” economic factors but ignores speculative factors as well as the Fed’s involvement in the economy. Keynesians such as Krugman blame factors such as speculation and the psychological aspect of the business cycle. Finally, the Austrian school of thought points not only to speculative forces, but also to “real” factors such as low interest rates and the Fed’s “easy money” policies of the late 90s and 2000s.

Capital Requirements

After the financial collapse, many were left wondering where banks were getting all this capital that they were lending out. Simply put, many mortgages were packaged and sold as financial security instruments by banks to other institutions in exchange for additional capital the banks could then lend out (to those with bad credit, no doubt). The institutions that bought these packages benefited by being guaranteed repayment. If they don’t receive the repayment, they have the legal right to take back their capital or assets worth an equivalent amount. Since security is rarely seen as bad in any context, it seemed like yet another win-win situation. The fact that the American currency was the global common currency helped it make sense financially as well. Interestingly enough, the two lead buyers of these packages were government created organizations Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), created in 1938 and 1970 respectively. According to the Cato Institute:

Beginning in 1992 Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low- and moderate-income borrowers. In 1996, HUD, the department of Housing and Urban Development, gave Fannie and Freddie an explicit target: 42 percent of their mortgage financing had to go to borrowers with incomes below the median income in their area. The target increased to 50 percent in 2000 and 52 percent in 2005. For 1996, HUD required that 12 percent of all mortgage purchases by Fannie and Freddie had to be “special affordable” loans, typically to borrowers with incomes less than 60 percent of their area’s median income. That number was increased to 20 percent in 2000 and 22 percent in 2005. The 2008 goal was to be 28 percent. Between 2000 and 2005 Freddie and Fannie met those goals every year, and funded hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans made to borrowers who bought houses with less than 10 percent down. Fannie and Freddie also purchased hundreds of billions of dollars worth of subprime securities for their own portfolios to make money and help satisfy HUD affordable housing goals.

Also according to the Cato Institute “Freddie Mac and Fannie Mae grew to own or guarantee about half of the United States’ $12 trillion mortgage market”. It’s no wonder many began distrusting the government after the crisis hit, calling for more capital requirements and regulations.

Complexity & Capital Requirements

Another culprit in the creation of the crisis is complexity. Whether intentional or simply the result of mass bureaucracy, it’s often been at the root of many people’s problems: skimming over the fine-print. Those pesky security instruments were further packaged in complex ways as derivative security instruments such as collateralized debt obligations and adjustable-rate mortgages, or in simpler terms, credit insurance. In fact, some large insurance companies such as AIG insured the packages without enough capital to back them up, calling them “credit default swaps”. A credit default swap essentially involves one party (let’s say, party ‘X’) being insured against a different party (party ‘Y’) in the event that party ‘Y’ defaults. AIG for example would receive a premium in exchange for the promise of paying party ‘X’ if party ‘Y’ defaults. Since AIG was receiving premiums on something they expect wouldn’t happen anyway (mass default and bankruptcy), it was in their best interest as a profit-maximizing corporation to keep issuing credit default swaps. As expected, when the housing market collapsed, the packages ended up being worthless and the many foreigners holding these credit default swaps ended up losing big time – a large reason of why the American crisis turned into a global crisis. Luckily for the employees of AIG, the U.S. government bailed out the “too-big-to-fail” insurance company to the tune of $180 billion (U.S. dollars).

Although weak regulation in general was not the cause, the lack of regulation surrounding banks’ mortgage lending, banks’ capital requirements, and insurance “swaps” secured the collapse of the financial system, and can now be looked back upon when creating new policies regarding lending and capital requirements so that a crisis such as this cannot happen again.

Recovery in Canada: Monetary Policy

Although practically every industrialized country in the world dealt with the global recession through fiscal policy, there were other policies that were put into place as well.

Monetary policy plays a big role in helping to manage the economy and keep it on the right track, and that’s no different when dealing with a massive recession. When the recession hit Canada, the Bank of Canada chose to gradually lower the interest rate to the very lowest point of 0.25% beginning in April of 2009. Doing this helps stimulate the economy in the short-run by providing an incentive to consumers to purchase goods now rather than later (particularly big-ticket items such as vehicles and houses, as those industries fared the worse when the recession hit).

To add to this, households typically tend to save money in a recession as opposed to spending it, so low interest rates help encourage consuming sooner than later. Finally, lowering the interest rate helped push the deflation that occurred from June 2009 to September 2009 back to a positive rate.

Another monetary economic option the Bank of Canada took was selling government bonds at high prices and low yields (price and yield always have a negative relationship); making bonds a safe place for investors to park their money while the crisis fans out. That being said, investors make close to no money by doing this. Called “flight to safety”, this phenomenon does not exactly help the recovery of the economy because investors that would otherwise be pumping money through the economy (and thus stimulate demand) in higher risk, more profitable investments are now leaving their money in risk-free, low-yield securities. At the same time, the government uses the increased revenue to pay down the massive deficit it has accumulated due to mass government spending (part of the Economic Action Plan). However, as interest rates begin to rise as they have been this year in Canada, the bond market looks less promising to investors because of the lower prices.
Finally, even after the interest rate is driven to near zero, there is the case of open market purchases by the government such as purchasing foreign currency in order to increase the monetary base as well as the money supply. Other open market purchases include repurchase transactions with chartered banks. In short, the central bank buys securities from chartered banks and agrees to sell them back the following day, increasing the monetary base of the economy. In turn, the increase in liquidity helps stimulate the economy. Although fiscal policy is what’s mostly discussed when dealing with recessions, it’s clear that strong expansionary monetary policy is also a solid force in recovery.

This type of policy could have helped Japan in the late 90s and early 2000s when the interest rate fell to 0.25% and the Japanese central bank basically gave up. The central bank could have also announced a target inflation rate before the deflation occurred to promote price stability. Canada on the other hand was able to avoid a similar fate of bad deflation by keeping a tight grip and a close watch on monetary policy. As well, a combination of relatively solid chartered banks and a sustainable money supply growth allowed for Canada’s fiscal policy to work as well as it has.

Recovery in Canada: Fiscal Policy

As a reaction to the global recession that began in the U.S. in 2008, like most countries, Canada embarked on an expansionary fiscal policy called the Canadian Economic Action Plan. This policy simply means increased government spending (what’s known as stimulus packages or plans) and lowering taxes. Many people question whether this policy works or not, but Canada’s performance in terms of recovering from the recession is proof enough for many. Although our recovery is now modest, it’s quite a bit more stable and speedy than most industrialized countries. As well, where in the U.S. the effectiveness of their economic stimulus package is questionable, in Canada there’s evidence it works.

The Canadian Economic Action Plan states its goals as reducing the tax burden for Canadians, providing improved employment insurance to those who need it, supporting local commerce by protecting jobs that have been affected the most, providing new infrastructure projects to create jobs, and providing affordable housing for low-income residents. Finally, as we have seen with the signs out front of McNally, it helps universities and colleges with improvements and needed projects.

In its first year, the Economic Action Plan has created roughly 130,000 jobs and in July, 2009 the number had increased to 310,000. This doesn’t include the over 120,000 Canadians who participated in the work-sharing program. The Action Plan also added roughly 2% to Canada’s real GDP growth during the last three quarters of 2009. These facts combined with the statistics given above indicate that Canada’s fiscal policy response to the recession has helped cushion the fall as well as provide recovery.

Observations & Recommendations on Recovery

I was pleased by the performance of the Canadian government in its implementation of the stimulus plan in practically all aspects, but the infrastructure improvements impressed me the most. Not only does it create jobs, but it fixes things that wouldn’t have been tended to otherwise such as much needed road paving or overpass replacing. As well, the tax credits available to Canadians are welcomed in a land of high taxes. The report promises these as mostly being permanent decreases in the tax burden of Canadians, allowing for Canadians to hold more of their own money and decide how to spend or save it in their own ways. To illustrate how significant these tax decreases are, Canadian tax-to-GDP ratio is the lowest it’s been since 1961. The new tax-free savings account is also an impressive way to give incentive for Canadians to save more. Other organizations have expressed their opinions about Canada’s Action Plan, including the popular magazine The Economist, stating “the main reason for Canada’s resilience is that neither its financial system nor its housing market magnified the recession. The banks remained in profit. House prices held up fairly well and are now rising.” The IMF stated “Canada’s resilience bears testimony to its strong and credible policy frameworks that responded proactively to the global crisis.” The New York Times and the Wall Street Journal also have quotes of positive remarks concerning Canada’s economic efforts, among even more important organizations and people.

My recommendation to the Canadian government concerning their efforts with its economic policies is simply to continue with the way they have been doing things financially since the global recession. As finance minister Jim Flaherty has been saying recently, Canada is recovering at a modest pace and should continue to do so until the world economy is stable once again.

Conclusion

As we can see, the global recession that we’re recovering from now was caused by a severe housing bubble. The Chicago school of thought and supply-side economists believe “real” factors such as complexity in the market and weak capital requirement regulations are to blame for the bubble, whereas Keynesian theory points to psychological factors and downplays “real” economic factors such as regulations or interest rates. The Austrian school of thought believes that both speculation as well as “real” factors such as unsustainable low interest rates and high money supply caused by the Fed’s manipulation of monetary policy. Other government involvement in the crisis includes the lending behaviour of Freddie Mae and Freddie Mac. In general, sub-prime mortgages, complexity, and weak regulations relating to capital are also partly to blame for the housing bubble. In terms of recovery, Canada’s economic policies show that expansionary monetary and fiscal policies are viable options for dealing with the financial crisis.

References

 

Websites:

http://www.fin.gc.ca/pub/report-rapport/2010-6/index-eng.asp
http://www.fin.gc.ca/pub/report-rapport/2010-09-27/index-eng.asp
http://www.bankofcanada.ca/en/rates/interest-look.html
http://www.bankofcanada.ca/en/rates/bond-look.html
http://www.rateinflation.com/inflation-rate/canada-historical-inflation-rate.php?form=canir
http://www.fin.gc.ca/pub/report-rapport/2010-6/pdf/cgel-lemc-eng.pdf

Scholarly Sources:

Mishkin, Sertletis (2007) “The Economics of Money, Banking, and Financial Markets: Third Canadian Edition”: Pearson Education Canada.

Shiller, R. (2006) Irrational Exuberance (2nd edition): Princeton University Press.

Baker, D. (2008) The housing bubble and the financial crisis. Real-World Economics Review, issue no. 46. Center for Economic and Policy Research, U.S.

Thornton, M. (2008) The Economics of Housing Bubbles. America’s Housing Crisis: A Case of Government Failure: Ludwig von Mises Institute, U.S.

Greenspan, A. (2009) The Fed Didn’t Cause the Housing Bubble: Wall Street Journal, U.S.

Government of Canada, Department of Finance: Canada’s Economic Action Plan: A Sixth Report to Canadians – September 2010. Web.

Government of Canada, Department of Finance: Canada’s Global Economic Leadership: A Report to Canadians – July 2010. Web.

H. White, L. (2008) How Did We Get Into This Financial Mess? Cato Institute Briefing Papers, no. 110: Cato Institute, U.S.

J. Schwartz, A. (2009) Origins of the Financial Market Crisis of 2008. Cato Journal: Cato Institute, U.S.

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With every industrialized nation struggling to survive the Great Recession, government focus has shifted back to the idea of protecting their respective economies. Up until the recession, focus seemed to be global economic interdependence ended up creating a large portion of nations’ wealth. That being said, it was and still is of the best interest of nations to trade with others. This is due mostly to the idea of comparative advantage; for instance, let’s say Country ‘A’ is able to produce wheat at $5 per unit, while Country ‘B’ can produce the same unit of wheat for $7. On the other hand, Country ‘B’ is able to produce steel at $10 per unit, while Country ‘A’ can only produce it at $15 per unit. Assuming there are little to no trade barriers between the two countries, it benefits both equally to trade with each other: Country ‘A’ sells their wheat to Country ‘B’, and Country ‘B’ sells their steel to Country ‘A’ (let’s say $6 per unit of wheat and $12.50 per unit of steel). Both countries receive profit from one good and gets another good for a lower cost than if they were forced to produce it themselves.

It’s easy to see that this simple concept is a timeless idea, but it’s not so easy to understand why some governments, particularly now, create policies that go the opposite way and hinder comparative advantage. Besides the fact that currently it’s often a matter of economic survival, it’s important to understand the various arguments or reasons why protectionism still exists in an age of mass economic globalization.

The first and most common argument involves the labour force; labourers from foreign countries that produce the same goods are often paid less than those in high-income countries like the U.S. or Canada, where the cost of business is higher. Because of this, some governments are worried companies (in other words, jobs) will move overseas to reduce the cost of operation. As we all know, wages and benefits are huge expenses for Western companies. Although most governments these days are at least partially in support of free trade, there are occasions where countries are losing jobs at an alarming rate. Governments will understandably be skeptical of the advantages of free trade if the one disadvantage out-shadows all else.

The second argument worth mentioning focuses on emerging domestic industries. In particular, governments of developing nations sometime set up tariff policies in place to protect “infant” industries; developing industries that are not yet stable and productive in comparison with the industries of more industrialized nations. These advanced economies have stable, mature industries which would otherwise crush the common industries of developing countries in a free trade situation.

Developing nations often have the lingering worry that if they allow completely free trade in the cultural industries, then the most commercially successful companies will dominate. This has the possibility of the cultural values of the developing country to erode away, replaced by the dominant culture. It’s a no-brainer that many will chose to sell American films if they far outsell films from the their home country, and America happens to have the most viable entertainment industry in the world. Unfortunately one of the most disliked countries in the world also happens to be America.

Finally, there is the case of countries deciding that another country’s trade policies unfairly discriminate against them. In retaliation, a common response is to impose similar barriers against the discriminating country. Although retaliatory tariffs and quotas can provide an incentive for negotiations (not a positive one at that), it can also lead to escalating trade wars, making both sides worse off than the original situation.

It’s now easy to see that these policies, though detrimental in the long-run, are tempting to nations desperate to survive the Great Recession. Whether they help, or whether they are morally and economically justifiable, will depend on who you ask. In the end it’s best to at least understand these anti-free trade practices, even if we don’t like them; especially if we don’t like them!

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Unlike the Great Depression, which occurred over 75 years ago, the global recession is a mystery to most. It’s understandable, as the Great Recession is happening now, taking away the hindsight the Great Depression now provides us. Even still, many people falsely blame ideology for these financial crises, when it is many reasons that all tie into each other, none of which lay claim to any particular ideology. Some reasons are “conservative” or even libertarian, while others are “liberal” and left-leaning. In the end however, one can only blame humanity and accept – and learn from – this event. The first point we need to understand is the housing bubble and its inevitable burst. From that come mortgage securitization and the complexity of large insurance firms that fooled the banks and subsequently the world. Finally, the lack of regulations surrounding foolish financial activity was the green light for the Great Recession. In a darkly hilarious manner, even the U.S. government, for better or for worse, helped speed up the Great Recession. Clearly it was for the worst. Putting it all together, one will see how the term “bad” in macroeconomics is not very subjective, and that it’s that way for a reason. Macroeconomics is not about theory or ideological origin – it’s about using history and our amazing capability of reason to our advantage to predict the future of the worldwide economy and to educate how it works. Why is this fact overlooked in most aspects of every day human life? In the end, it’s not about who to blame but how it really happened and why we must fix it. Never creating a severe recession would be a bonus, but humanity is far too short-sighted for that.

In the past, the main cause of housing crises has been reduced demand due to declining domestic investment in the housing market. This time, while that effect is still there, it’s a minor issue compared to the latest housing market collapse, which kick-started the Great Recession. Congressman Ron Paul (R-TX), among others, has been warning against and predicting this exact crisis for several years, perhaps even for more than a decade. Of course, the media payed little attention and so the public knew little of the matter. The short recession of 2001 in the U.S. was triggered by a sharp decline in domestic investment, mainly in telecommunications infrastructure. As a fall-out, the stock market assets of households declined, but housing assets held up, cushioning the normal decline in consumption that comes with recessions. This event isn’t that well known compared to what’s happening now, perhaps because it happened to be minor or that it worked itself out. Unfortunately, it’s not the case with the Great Recession.

A popular metaphor for crises of this nature is to call it the “bubble bursting”, and for good reason. In this case however, the balloon works much better. Consider the imaginary balloon represents the housing market, and sub-prime mortgages to be the air inflating the balloon. Sub-prime mortgages occur when banks lend to un-credit-worthy customers – that is, handing out loans to people who want to buy a house that they can’t actually afford. This may seem obvious to us all now, but at the time people of all types – bankers, potential home owners – were disillusioned by the notion of housing prices continuing to go up. The idea was that although it wouldn’t pay off now, since houses and property are long-term assets, when they are ready to turn the home over to new owners, the supposed increase in the value of the home would compensate for the lack of income in the household. As one can imagine, the idea was popular for both bakers and for eager to-be homeowners. Bankers lend more (which means more return for them in the long-run if the market goes well), and average folks get a better house than they could have otherwise – a win-win situation right? So the inflation of the balloon begins, filling up with lending amounts close to and exceeding equity (what one owes compared to what one owns), and eventually the rubber wears thin enough to burst.

So now you’re wondering “Where did the banks get all this capital that they’re lending out from?”. The answer is one that’s overlooked but played a crucial role in the development of this recession. Simply put, many mortgages during this time of ballooning credit were packaged and sold as financial security instruments by banks to other institutions in exchange for additional capital the banks could then lend out (to those with bad credit, no doubt). The institutions that bought these packages benefited by being guaranteed a repayment. If they don’t receive the repayment, they have the legal right to take back their capital or assets worth an equivalent amount, hence the use of the word “security”. Since security is rarely seen as bad in any context, it seemed like yet another win-win situation. The fact that the American currency was the global common currency helped it make sense financially as well. As icing on the cake, the two institutions that were the lead buyers were Fannie Mae and Freddie Mac, created in 1938 and 1970 respectively, were government created.

These institutions weren’t the only thing the government created in the 1900s. In the early 1980s the government deliberately created a severe (relatively speaking) recession to control inflation using contractionary monetary policy. In other words, the money supply was reduced and interest rates were increased in order to reduce aggregate demand in the economy. A decline in demand means a decline in prices. At a time when inflation was on the run, the result was prices staying more or less the same while the nation’s output and income dropped. It’s bad, but the fear of hyper-inflation, which was a legitimate fear, would have been worse. An economy that as a whole is generally strong, for example the U.S. economy, is able to recover from the recession along with slowly lowering interest rates speeding the recovery up. Although not necessary, increased government spending and tax cuts (expansionary fiscal policy) could have also sped it up – which it probably did considering in 1986 the deficit rose to be well over 5% of national GDP. Believe it or not, that was considered a huge deficit at the time. Currently, the U.S. deficit created to end the Great Recession is about 12% of national GDP, and don’t think for a moment that it’s going to stop growing any time soon. Either way, the “severe” recession of the 1980s focused on expansionary monetary policy.

This time, strong expansionary fiscal policy is being used worldwide as it is much faster and more effective than the monetary policy used in the 80s. It leads to staggering deficits which are never good, but it does lead to a strong enough increase in aggregate demand to ride of the recession without the world coming to a screeching halt. Milton Friedman is probably turning in his grave, especially with the mass amounts of bailouts to major insurance companies and banks – many of which created this mess in the first place. The bailouts were accepted by policy makers much easier than in the Great Depression of the 1930s. They let the banks fail and the money supply contract. At a time when a 100% free market was extremely popular amongst major economists, it’s understandable why the government let them fail. In an ideal world, the free market should have corrected it all itself, but in a world full of foolish people, it just didn’t happen. This is not a defense of government bailouts, especially to the culprits of the Great Recession, but simply an explanation of why they were done. It’s interesting when people pay attention to certain aspects of history and ignore others – selective attention anyone? It must also be said that the wrong monetary policy was used during the Great Depression. Unlike in the 1980s where contractionary monetary policy worked, in the 1930s it was a total failure by the Federal Reserve. Milton Friedman named this decline in income, prices, and employment the “Great Contraction”, as much of this was caused in the tight contraction of the money supply. Like the 1980s recession however, the government at least partially created this recession as well. At the very least the government ensured that the recession turned into a depression. Interesting enough, current Federal Reserve chairman Ben Bernanke has been quoted as saying:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton [Friedman] and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

Back to the present, one might now be wondering “Well, why didn’t the banks know of the huge risks of securitization?” Great question! Complexity is the culprit; whether intentional or simply the result of mass bureaucracy, it’s often been at the root of many people’s problems: skimming over the fine-print. Those pesky security instruments were further packaged in complex ways as derivative security instruments and sold again to other financial institutions, including back to the banks themselves. In simpler terms, these are bought for lower levels of risks such as interest rates or to help determine whether underlying prices will increase or decrease. This occurred because of foreigners trying to exchange cash for American securities (negotiable items that represent financial value), allowing banks and other buyers to increase returns. That was what was thought any way, but some large insurance companies such as AIG insured the packages without capital backing them up, calling them “credit default swaps”. As expected, the packages ended up being worthless. When this creates a ripple throughout the entire world in terms of mass amounts of assets going bad, we know this isn’t a normal old recession that’s expected to occur every once and a while. Although weak regulation in general was not the cause, the lack of regulation surrounding banks’ mortgage lending, banks’ capital requirements, and insurance “swaps” secured the collapse of the financial system, and can now be looked back upon when creating new policies regarding lending and capital requirements so that a crisis such as this cannot happen again.

Of course, not all of this happened spontaneously. Recall that foreigners bought up a lot of those security instruments because the U.S. dollar was so stable and strong. When the mortgages went bad, the security instruments that were held globally also went bad. The huge amount of bad assets in the bank’s financial books ceased the credit market, resulting in an unusually large recession that was and still is felt worldwide. From here, it can be said that asset prices normally decline in a recession as a result of the wealth effect (less household income, less consumption, and vice versa). This fact certainly doesn’t help fix the problem – if anything, it makes it worse. The real reasons – sub-prime mortgages, securitization, complexity, and the lack of regulation – pulled the world down into a severe recession. The government policies used to curb recessions (and those that help create them) differ from the past, mostly because of the sheer severity of this problem. Hopefully the world will learn from its many mistakes and get past this human flaw of over doing things; hopefully we understand more, look at the long-term more, and listen more. As Edmund Burke wrote over two centuries ago, “[e]very thing human and divine sacrificed to the idol of public credit, and national bankruptcy the consequence”.

[Cross-posted at the Campus Free Press]

This is the first draft. Feel free to edit and send back if needed. Help is always appreciated!

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This is an old article I wrote in the summer of 2007. Although the information may be out dated, I believe the underlying point of it still holds true.

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In response to Hugh MacIntyre’s earlier Shotgun post on why “Rodney MacDonald deserves to lose this election“:

I have never been a huge fan of Nova Scotian politics, and I live here. That changed with this article by the Chronicle Herald that explains Premier Rodney MacDonald’s promise to cut taxes. Now, while I’m sure this is common in the West, it’s not every day I hear of Maritime politicians taking traditional conservative stances and publicly declaring them. MacDonald said the personal tax exemption would increase by another $1,000 by 2014. In 2006, MacDonald committed to adding $250 to the exception limit every year for four years. Over the four years, on average about $200 will be added to the pockets of Nova Scotians.

“I’m a believer that people should have the opportunity to decide where they want to spend their money.”

Mr. MacDonald is a true conservative and it appears it’s not only the PCPO candidates that are staying true to their roots but the NSPC candidate as well.

I also applaud MacDonald’s ability to keep the exemptions like he promised even in tough economic times: “This speaks to what we stand for–we make a commitment, we stand by it, and we live within our means to pay for it,”.

On the other hand, there’s Darrel Dexter. Dexter is the leader of the Nova Scotia NDP and of course holds a seat in Cole Harbour where he, and I, live. Common to socialists, he insists on throwing taxpayer money at something that has failed time and time again: our socialized system of healthcare. Beating a dead horse comes to mind, but for the NDP, campaigning means making people unable to refute the things he wishes to pour money into. What common person, especially in the left-wing world of the Maritimes, is going to refute keeping ERs open? After all, if you don’t support his proposals, you appear to be a heartless individual or a “right wing extremist” according to the Left. For Dexter, it’s a win-win situation.

Perhaps it’s just my perception, but to me the NDP is continuing their tradition of emotion baiting and failed logic. In contrast, the Progressive Conservatives have been campaigning on solid, sound ideas that are simple: tax cuts are good for businesses, good for the working class, and good for the economy. With the current state of the economy, the choice seems clear.

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