Feeds:
Posts
Comments

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.

Advertisements

In the latest issue of the Dalhousie University student newspaper The Gazette, I came across this gem after seeing the name of a friend and fellow conservative writer: Ben Wedge of The Campus Free Press.

Ben Wedge needs balance

Ben Wedge is at it again. One of his latest articles, “How not to protest,” should cause concern among readers. His unprecedented far right bias is being allowed free rein in The Gazette, with no articles from a different perspective challenging his radical views. This letter is a modest attempt to correct that.

The Gazette is the perfect example of left-wing university newspaper. God forbid there’s a conservative among their staff. I may be a student of Saint Mary’s University, but I still read the Gazette and I come to expect issues obsessing over “sustainability” and an assortment of other stereotypical hippy garbage. Although I’m biased, I welcome the change of pace when it comes along every now and then. Guess it’s just me.

In his article, Wedge argues that the fundamental issue surrounding recent protests against government inaction on climate change is not government inaction on climate change but the protesters themselves. Indeed, Wedge concludes that “we should all take the time to view the footage (of the protest), to research what really happened, and form our own opinions.”
He says that recent allegations of police brutality are exaggerated, and he hopes that the police can be vindicated and the protesters can be sent “a strong message that theatrics will not be tolerated in protests.”

The problem is not the catastrophic consequences of inaction on climate change, but an alleged affront to the reputation of the police.

Did your readers see how Wedge completely avoided engaging the issue of climate change? For Wedge, the problem is not climate change. It is protesters challenging the powers that be.

Uh, yeah – that is the whole point of the article. Hence why it’s called “How not to protest” not “My opinion on climate change”.

I will concede that Wedge has been consistent in his articles in this respect: at root, his articles are always a defence of the rich and powerful, and always critical of non-elite groups promoting change, particularly change that threatens the established order. His argument is inherently antidemocratic and authoritarian. The incipient catastrophe of climate change is of secondary importance for Wedge when police officers are allegedly being slandered – no doubt a greater threat to humanity.

If Wedge supports action against climate change but does not support the protesters, where are his positive suggestions for effective political activism? So far as I can tell by reading this article, it is nothing more than an attempt to admonish the protesters for their excessive behaviour. Is that contributing anything other than doublethink into the discourse of climate change?

Gazette readers beware. Opinions Contributor Ben Wedge is propagating a radical vision of the world that is not clear upon a glance at his articles. The Gazette should refuse to publish his opinions without a response from someone who is not a Conservative Party sycophant.

– Kevin Johnston, second-year arts and history

Yikes. Apparently, if you are conservative, you must accompany your opinion articles with an opposing opinion, but if you’re left-wing you’re free to publish all the opinion articles you wish.

All conservatives I personally know enjoy and welcome debate – without insult. We’re not afraid of outside opinion. If anything, the opposition strengthens our arguments. It’s interesting seeing this trend of trying to stamp out right-of-centre individuals from journalism on campus. They will tell you they are not afraid, but if they are not, then they should welcome the article to flaunt all its supposed faults. Let the article speak for itself.

Sussex, New Brunswick

One of the best parts of the Maritimes are the beautiful small towns sprinkled throughout the region. One of these towns is Sussex, New Brunswick. A couple of my cousins and an aunt live there so I’m fortunate to visit Sussex at least once a year. What sets this town apart from the others (among other things) are the murals. Here are some pictures I took while in Sussex, as well as many I didn’t take that are still great.


You won’t find a friendly sign like this in Halifax…









More pictures of the murals can be found here.






View Part 1 here.

View Part 2 here.

View Part 3 here.

View Part 4 here.

View Part 5 here.

View Part 1 here.

View Part 2 here.

View Part 3 here.

View Part 4 here.

No Smoking
Poppies
Cat Sticker
Native Land
Bandana
Entrance

View Part 1 here.

View Part 2 here.

View Part 3 here.

Squirtle
Moose
Heart
Stop Sign
Public Gardens Statue
Graffiti

View Part 1 here.

View Part 2 here.