Who caused this recession?
I’m a regular reader of Karl “Ticker Guy” Denninger’s blog. If you aren’t familiar with Ticker Guy, he’s a very outspoken, very angry, fairly vulgar, but shocking accurate guy that writes about the economy. I learned more from spending 15 minutes reading Karl’s blog than I did from two semesters of college economics.
Because of his and other blogs, I was able to avoid any major investment losses from this recent downturn. Needless to say, I’m a big fan. :-)
I’d been doing research and taking notes on the causes of our current recession. Yesterday, Ticker Guy posted his list and findings. His list is a superset of mine and reached the same conclusions.
Fundamentally, the government caused this recession. Here’s how:
1) Gramm-Leach-Bliley Act
The Gramm-Leach-Bliley Act repealed part of the Glass-Steagall Act of 1933. Glass-Steagall enforced a separation of investment and commercial banking in order to prevent the over leveraging that led to the Great Depression.
Given that we have a fiat monetary system and fractional reserve banking, this was basically corporate welfare: investment banks could use fractional reserve banking to create money which they used in leveraged investing.
2) Removal of Leverage Limits
Leverage is a financial mechanism that encourages investment banks to borrow money, invest it, and pocket the spread. The spread is the difference between what the investments earn and what the bank owes. So the investment bank borrows (sells bonds) at 4% and then invests the money to earn 10%. The investment bank pays the lender 4% and keeps the difference of 6%.
It used to be that 12:1 was the limit of leverage a company could have (it owes no more than 12 times its worth).
But in 2004, the Bush adminstration’s SEC removed the limits due to strong lobbying by Henry Paulson. This let companies over-leverage. And unsurprisingly each company that failed was leverage at more than twice the previous limit. Freddie and Fannie were running at roughly 80:1 when they failed.
3) Bankruptcy Reform
Normally if a bank loans money to someone that can’t pay it, the bank has to eat the loss. There’s a clear incentive for the bank not to make stupid loans.
Recent bankrupcy “reform” prevents people from discharging their debt through bankruptcy and makes it easy for the banks to get money through mechanisms like wage garnishing. So now even if you go into bankrupcy, you have a limited ability to recover. Those home loans and student loans will be with you forever.
With the drastically reduced disincentive against making bad loans, it’s actually profitable for the banks to lend money to people that can’t back their loans!
In summary, government actions encouraged banks to create money (fractional reserve banking with no leverage limits) and lend it to people that can’t afford it (bankruptcy “reform”).
Which, of course, is the root cause of the mess we’re in.
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