Those who look busy in politics enjoy short term success. After Sept. 11, the majority were thirsty for blood and supported the Patriot Act and the invasion of two foreign nations. Now they are demanding that something be done by government to fix the economy.

It could be argued that politicians talked up the economy. It isn’t so much that they talked it up or down, but that they did them backwards. If they had tightened lending during the boom, we never would have been in the position to bust. Talking up the bust and down the boom makes me wonder if they wanted us to crash in order to boost U.S. manufacturing (see my conspiracy theory post), or if it was just straight corruption at the point where regulators choose who gets the money.

Our government is comprised almost entirely of investor-class elected officials. When times are good, they want to use their power to fuel growth and for their own profits and popularity. When times are bad, they feel the ire of the populace threatening their re-election and seek someone to blame in order to appear to be cracking down on the problem. We can see an example of this in the housing market boom and subsequent crash:

• In 1977 Jimmy Carter signed the Community Reinvestment Act, which went a long way towards giving government the right to force the banking system to lend to high risk borrowers.
• In 1982, Congress (with a Democratic majority) passed the Alternative Mortgage Transactions Parity Act, which allowed non-federally chartered housing creditors to write adjustable-rate mortgages.
• Bill Clinton put pressure on “Government Sponsored Entity” Fannie May to relax credit requirements in order to try to boost lending to low income buyers. HUD wanted them to keep 50% of their portfolios in loans to low income people.
• Bill Clinton threatened to essentially audit lenders and air their dirty laundry if they didn’t comply. Here is what realtytimes was saying back in the beginning of ’03: “Government policies encouraged riskier lending. They did this ‘encouraging’ with threats to step in with GSE reform legislation in response to accounting scandals, and other such methods.” There is clear evidence of both carrots and sticks being used by the government.
• George W. Bush continued and expanded these policies. In 2008, Government Sponsored Entities had extended over five trillion in loans, with a mere hundred million in total assets. They were able to do this via Fractional Reserve Lending, which is an outdated concept from back when banks didn’t want to have to hold on to large amounts of gold, and more recently is used as a way for central banks to regulate the money supply.
• Investors would flee if they saw the banks making such high risk loans, so the banks started bundling risky loans and selling them at bargain prices in order to keep profits up for investors.
• People saw great profit in real estate and started taking out as much debt as they could, figuring they could always just sell some if things got tight.
• A hiccup in the housing prices started a cascade. Housing prices began to drop, and people started to default on homes that were no longer worth as much as the loan.
• As the problem gained media attention, the politicians deflected the blame, blaming the banks for the government-pushed subprime loans. They assured us that they would fix the problem by regulating these wicked banks and doing away with their subprime lending.
• The inability of people to get loans or refinance demolished the housing market, making it even harder for those in trouble to sell, even at a loss. Foreclosures cascaded further. This tanked the housing prices and caused the very foreclosures they were intended to prevent. People who would have gladly sold their homes or refinanced were foreclosed on instead. The banks were nothing but a Ponzi scheme.
• George W. Bush realized his legacy was threatened, and that the collapse of the American banking system would be put at his feet. He abandoned any pretense of free market and crafted the largest corporate bailouts in history.

To unravel the above mess, you have to realize that government financial regulation is an illusion. It creates waste and assures that the booms and busts are larger, last longer, and affect everyone. The bottom line is that we had people borrowing fake money from the central bank, money which was backed up by the government, which is backed up by the people – people borrowed fake money from themselves to buy houses they couldn’t afford, and subsequently lost them. The free market balanced itself, via crash, despite the government meddling, but with a much greater magnitude than it would otherwise have had. Without government regulation, fractional reserve lending wouldn’t exist on a national scale, nor would subprime loans, and neither would the problem.

From the wiki: “fractional reserve banking benefits the economy by providing regulators with powerful tools for manipulating the money supply, interest rates, and government debt creation. From a Keynesian point of view this debt creation provides governments with much greater latitude to stimulate the economy through government spending.”

On the Federal Reserve: According to the wiki,  “The Federal Reserve System is subject to the Administrative Procedure Act. It is not “owned” by anyone and is “not a private, profit-making institution”. It describes itself as “an independent entity within the government, having both public purposes and private aspects””. The Federal Reserve was created in 1913, by a Democratic Congress and approved by Woodrow Wilson. The Chairman and Vice Chairman of the Federal Reserve are both appointed by the U.S. President.

The very creation of the Federal Reserve gave regulators both the power and the inclination to lengthen booms and then plunder private sector savings (monetize) to ‘stimulate’ our way out of the ensuing and ever larger busts.

Lack of oversight? There is a difference between no oversight and bad oversight. The government controls everything from taxes, to laws, trade treaties, tariffs, lending practices. If the regulators were pushing subprimes and Fractional Reserve Lending, then how would additional regulating been helpful? The only idea I’ve heard out of Washington lately is that we should borrow money to make a product we don’t want and then go buy it. We have a sinking boat with one party wanting to bail water out of the front of the boat into the back, and the other party wanting to bail water from the back of the boat into the front. It doesn’t help to shuffle the money around if you don’t earn it in the first place.

It isn’t so much the fault of the market or government, but at the point at which the two meld, where government decisions affect the flow of large amounts of money in the private sector, corruption is inevitable. The banking sector is a tough issue. The way I see it there are three main ways we can deal with this:

1. We can nationalize the banks. It wouldn’t be the first time. Obviously, the government has its own problems with inefficiency and corruption, and this essentially gives a competitive advantage to those banks which are subsidized by the government (as does our current meddling in which we have seen bailed out failures buy up successful competitors).
2. We can do nothing. This is high risk in the sense that if the banks fail, the government is obligated to pay for most of what the banks lose (FDIC guarantee of 250k per account), so if they fall, we pay anyway. As for if they will fail; deflation causes defaults, which causes bank failure; inflation higher than interest rates makes the banks lose money on all of their loans. Due to fractional reserve lending, this means they will fail if the economy is at all unstable. Seeing how we just doubled our money supply last year, this is pretty much going to happen. A failure of the banking industry impacts lending, which is central to the Ponzi schemes that are most modern businesses, and to the housing market. If everyone has to buy their houses with cash, the price is either going to fall a lot farther, or they are going to be bought by China.
3. We can do what we are doing now, which is leave them private and give them money, which they will abuse, both due to human nature and greed, and due to it being in the bank’s best interest to hold the money as long as the dollar is gaining value (which it has been until very recently), because using it causes inflation (if the dollar drops much longer, expect dramatic inflationary action by banks trying to drop dollars which are losing value). This is just meddling, and isn’t healthy for anyone.

The problem is that we are so deep in this Keynesian lunacy, that switching systems guarantees a crash. What are we to do?

I think this highlights a serious flaw in human nature. People have this unshakable feeling that there is a benevolent deity looking out for them, that everything will turn out fine in the end, and that there is a good solution to every problem, that when life gives you lemons, you get lemonade.

Sometimes every solution comes with pain and sacrifice. Sometimes the government can’t fix it, people die, wars are lost, retreat is the best you can do. Sometimes you just have to eat your damn lemons.

The longer you fight the tough decision, the worse the consequences get. We need to deal with the core issue, which is that every day we pay more regulators more money to regulate a shrinking industrial base. It’s time we let go of the micromanaging and let our good citizens keep the fruits of their labor so that they might afford to keep doing it.