Much has been written about the meltdown of the financial sector beginning in late 2007 and reaching its black hold of despair in mid-2009. Most of what’s been written has been examined with political motivations, rather than from the perspective of economic reality. Now that most of the smoke has cleared, it may deserve a second look.

Who's Really to Blame?

Many people blame the 2008 financial crisis on "greedy capitalists," "the banks," or "the stock market" - or various other bogeymen who stand in the way of the government's "noble" goal to take care of everyone. And certainly, predatory lenders and crony capitalists bear their share of the blame. The truth is that the financial crisis was not only made worse by government overseers and regulators, but the blame for the very crisis itself can be laid primarily at the feet of the regulatory state.

In 1977, a U.S. federal law was passed called the Community Reinvestment Act (CRA). This legislation was designed to help poorer inner-city residents get home mortgage loans – a noble intention, to be sure. Over time, more and more people who couldn't afford a home were able to obtain home mortgages. We intentionally lured people into debt that we knew they couldn’t repay. The ability of so many people to buy a home without the ability to pay was one of the factors that gave rise to a housing bubble.

The U.S. dollar is nothing but an entry in a balance sheet

U.S. currency is created out of thin air when it is borrowed from the Federal Reserve. The banks pay a rate, known as the prime rate, to the Federal Reserve to borrow this make-believe money. The Federal Reserve manipulates this rate, to slow or quicken the pace of borrowing.

During the period leading up to the crisis, the Federal Reserve was keeping interest rates low. This caused these subprime (high-risk) loans to be even easier to get, which contributed to the housing bubble even more. Low interest rates also caused banks to make less money and seek ever more risky investments to obtain the same return. They sliced and diced the high-risk mortgages into abstractions called CDOs (collateralized debt obligations). They further abstracted them by dividing them up into "tranches" of varying risk. They passed these "derivatives" on to other institutions, who were unaware of the true risk they contained.

If that sounds complicated, it’s because it is. Nobody on any side of it understood what was happening, so almost nobody saw the impending crisis. Effectively, banks found a way to hide risk from themselves and from each other. A conflict of interest with the ratings agencies incentivized them to rate the CDO loan bundles with far higher ratings than they actually had. When the cascade of inevitable mortgage defaults began, the house of cards fell apart. Many major institutions were left holding the bag and a capricious government was left to decide who to save with our tax money with bank bailouts and who to let die. Crony banks were deemed “too big to fail” and given handouts, and the American people took the brunt of the economic hit.

It was a game of dominoes, and it was the welfare state that set them up. It doesn’t make any sense to blame one of the dominoes and give a pass to the finger that started the cascade. The regulatory state, in an effort to be magnanimous, arranged the set of conditions that created the meltdown. Government rewarded irresponsible lending to people who could never be expected to pay on their loan. Once the true nature of the market and its derivatives was known, it then picked the winners and losers, and destabilized market sentiment in doing so, consequently necessitating even more bank bailouts.

If we want to extend the opportunity of home ownership to poor Americans, we need to help them not be poor, rather than try to manipulate the free market with a maze of incentives, handouts, phantom loans, impossibly complex securitization techniques, and crushing regulation that makes the entire process too expensive to sustain. Otherwise we will continue to see these booms and busts indefinitely.

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