What caused this financial mess?
President Bush spoke today about the financial crisis to the U.S. Chamber of Commerce.
I’m going to use the President’s speech as an opportunity to explain to a non-financial audience what the Federal government did this week and why. I will oversimplify in many cases, and will gloss over many details. I don’t claim that the description below is comprehensive. But it is, we think, a good starting point for discussion.
This is a story that evolves over time as we learn more, and will be debated by economists and historians long after we’re gone.
- We begin with a global credit boom. A dramatic increase in worldwide saving outside the United States, and especially in Asia and the Middle East, meant there was a lot of money to lend. Fed Chairman Ben Bernanke referred to this as a “global savings glut.” The U.S. has a productive economy and a strong legal framework that protects investors, so a lot of this capital was attracted to the U.S. This lowered interest rates here, creating abundant and inexpensive credit. This was particularly true for riskier borrowers – as the supply of loanable funds increased, the interest rates charged to these borrowers came down a lot, making it easier for them to get loans. In many cases this was a good thing – many low-income people who had previously been unable to buy a home were able to do so. At the same time, an economist would say that “credit spreads narrowed dramatically,” and many would say this led to an underpricing of risk. Lots of lenders seeking higher yields made increasingly risky investments.While most of the focus has been on housing, and I’ll use housing to explain the rest of the story, the underpricing of risk existed in other markets as well (e.g., commercial real estate). Also note that the credit boom was not confined to the U.S. – Australia, the U.K., France, and Spain also experienced housing or credit booms.
- We then look at a domestic housing boom. Cheap credit and low interest rates contributed to a building boom, soaring housing prices, and ultimately an excess supply of housing. Normally you’d expect about 1.6 million homes to be built each year. At the peak of this boom, about 2 1/2 million houses were being built each year. At a normal time, there’s about a 5 1/2 […]