Economics of the Madhouse

Proving the disconnect between reality and the mindset of people who make the decisions that affect our lives, is the big problem. It is not enough to belly-ache about government. Nor are conspiracy theories sufficient, if we want change. The evidence on what went wrong leading up to the financial crisis is now emerging in Washington.

As the world’s largest economy, the US would exercise disproportionate influence over the global outcome of the boom/bust. Washington had a special duty of care beyond its own borders. the rest of the world would be affected by how they anticipated the economic trends.

It now turns out that the Federal Reserve was aware of the issues that would cause a crisis in 2007-08, with the housing market leading the way into the bubble that would have to burst. Five years ago, in the summer of 2005, the Fed discussed house prices and the unconventional – some would say dodgy – mortgages that were being spun by bankers.

The minutes of the meeting have now been published. We learn that the economic advisors to the Fed’s interest rate setting committee spelt out the details of the housing bubble. Prices were over-valued by about 20%. But they misrepresented the influence of mortgages targeted at low-income families. Furthermore, the economists lulled the committee into believing that monetary policy could respond effectively to a slump in house prices. They were spectacularly wrong.

In Ancient Days

The governors of the Fed who were members of the committee fell for the reassurance that a drop in house prices would not spill over into a financial crisis. One of them recalled what happened “in ancient days” which persuaded him that banks would not act recklessly.

And yet, the historical record is replete with evidence of how property booms lead to busts. And these were always accompanied by a melt-down in the banking sector, with savers losing their money as banks across America closed shop.

So why did the Fed governors fail to correctly assess the prospects the looming crisis from the vantage point in 2005? The explanation is philosophical and psychological: they couldn’t “see” the looming crisis despite the empirical evidence staring them in the face.

Compounding the Errors

One of those decision-makers was Tim Geithner. At the time he was President of the New York Fed. He focused on the degree to which the supervisory system was checking on the money-lending/risk-taking activities of the banks. His faith was pinned to the power of regulation.

Well, we also know that regulation cannot prevent asset bubbles once land speculators are involved in their get-rich-quick search for capital gains. Again, the history books provide all the evidence. We’ve had land-led boom/busts when there’s been no regulation, when there’s been weak regulation and also when there’s been very tight regulation.

So Geithner’s record shows that he is not qualified as the guardian of the economy’s welfare. Why, then, did Barack Obama appoint him as the US Treasury Secretary? Today, an estimated 5.5m American families area locked into mortgages that are at least 20% higher than the value of their homes. Their fate – as is ours – is in the hands of a man whose mindset is disconnected from the real world. Welcome to the economics of the madhouse.

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