Posted by PrestoPundit on 07/15/2008

explain the current economic crackup:

The U.S. economy is in the midst of an old-style credit crunch
brought on by a combination of bad policies and incredibly lax
underwriting standards at financial institutions. The biggest policy
failure was the decision by Alan Greenspan’s Federal Reserve to hold
interest rates too low for too long. That led to a tsunami of credit
that inundated the economy with cheap money. Mortgage lenders in
particular were flush with funds and searched for deals wherever they
could be found. Heretofore unqualified borrowers suddenly “qualified”
as underwriting standards relaxed and then disappeared.

Egged on
by statements from Chairman Greenspan, market participants came to
believe the era of low interest rates would last indefinitely. But the
era did come to an end as the Fed was forced to begin raising interest
rates. Faced with the prospect of paying higher rates on their
mortgages in the future, borrowers began defaulting. First home prices
stopped rising, and then home prices began dropping–precipitously in
some overheated housing markets. Now we are approximately six months
into a new cycle of lower interest rates, but with no end in sight to
the crunch.

At least two other factors stoked the crisis. First,
many exotic financial products were issued whose value was tied in one
way or another to home prices and the value of the securities into
which home mortgages were bundled, such as collateralized mortgage
obligations. The pricing of these financial products was the product of
complex economic models, not the outcome of market transactions. As the
value of the underlying homes and mortgages declined, pricing of the
financial exotica became nearly impossible. As we learned in the
collapse of Long Term Capital Management, these pricing models fail
precisely when their accuracy is most important–in times of financial
turbulence. The inability to price the financial products has
exacerbated losses among the firms holding them.

There is a
wonderful parallel here to the collapse of the Soviet Union. As the
great Austrian economist Ludwig von Mises argued almost 100 years ago,
central planning inevitably fails because there are no market prices to
allocate resources. Market prices can only be the outcome of actual
market transactions among buyers and sellers. Planners used
mathematical formulas to value resources, especially capital. Now Wall
Street wizards have imported Soviet thinking to allocate financial
capital. Is it any wonder that it failed?

What should be done?

The Fed needs to understand it is facing a capital crisis, not a
liquidity crisis. The very low interest rates on safe assets show there
is ample liquidity in financial markets. The Fed should not supply
capital. That is the job of markets, and they are doing it.


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