Present Financial Crisis And Americans' Response

Introduction

The economic historian Anna Schwartz has described the recent housing bubble as a classic "mania." She observes that, while the details change in each historical episode, in this case as in others "the basic propagator was too-easy monetary policy and too-low interest rates."' In the housing boom, easy money and cheap credit financed an unsustainable increase in investment in residential real estate. Especially in the hottest teal estate markets, buying took on a frenzied aspect. Here, I will first present a brief history of the current economic crisis. Financial services ate highly regulated, yet the regulatory system failed. Then, I offer a diagnosis of the crisis, focusing on the issue of the capital position of banks and other financial institutions. Finally, I consider American's response and the way forward and the prospects for a return to a sound financial system and a healthy economy.

Origins of The Crisis

During the run-up in home prices, credit was easy, whether measured by its price or by its terms. The nation's central bank, the Federal Reserve System, pegs the Fed funds rate that banks charge each other for the overnight loans of deserves used to fund loans to the public. From November 2001 to December 2004 the Fed funds rate was at or below 2 percent. From June 2003 to June 2004 the rate remained at 1 percent. For much of this period, real (inflation adjusted) short-term tales of interest were negative. In other words, amounts of money to be repaid in the future would be worth less than what was borrowed due to inflation. It literally paid to borrow money, especially to finance an appreciating asset like residential housing in overheated markets in California, Nevada, Arizona, and Florida.

Professor John Taylor of Stanford University has argued that the Fed pushed short-term interest rates below levels predicted by an economic model of monetary policy based on historical patterns (the "Taylor Rule").- This episode of easy credit can also be put in historical perspective.

There was no central bank in the United States until 1913. But the Bank of England was founded in 1694. After the end of the Napoleonic wars and postwar economic recovery, Great Britain enjoyed nearly a century of peace and prosperity under the gold standard, free international trade, and free movements of capital. Ir was the Pax Britannica. Prices ended the period roughly where they began.

What was Britain's Bank Rate {the rough equivalent of today's Fed funds rate)? In June 1822, it was 4 percent, and on July 30, 1914, the eve of the First World War, the Bank Rate was 4 percent. At no point in this remarkable period did the Bank Rate ever fall below 2 percent.-^ For the Fed to have set rates so low for so long flew in the face of historical experience and common sense.

The boom phase ended when the Fed began raising interest rates. Housing prices first stopped rising in 2006 and then began declining. Mortgages started going into arrears, and homeowners walked ...