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The Crisis in 10 Points
Posted By admin On January 1, 2009 @ 5:59 am In Money Watch | Comments Disabled
Thursday, January 1, 2009
The 2007–2008 financial crisis had its genesis in the United States housing markets, but it rapidly spread to other economies, first to the United Kingdom, but then almost everywhere else, including such unlikely spots as Iceland whose banking system collapsed.  Because events in the United States triggered the crisis, this essay will concentrate on the US causes although they had their many counterparts elsewhere.
There are at least three long-standing background influences that contributed to the financial debacle that dominated the US economy in 2008:
It is against this long term, more philosophic backdrop, that the following, more immediate issues, assumed greater importance.
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The financial crisis of 2007–2008 was a Ponzi scheme writ large. A Ponzi scheme, or chain letter, initially succeeds but eventually collapses, just as imprudent loans may at first succeed in their objectives but eventually the laws of economics come into play and expose the futility of the whole exercise. A pyramid scheme is always unsustainable for the simple reason that it is based on faulty principles and built on flawed foundations. Until too late, no one in authority (regulators, risk managers, senior bank executives, credit-rating agencies, investment analysts) asked the key question, namely, how on earth was it possible in the long term to make profits by lending money to people whose chances of paying it back were practically nil?  The issue was simply swept under the carpet because loans to deadbeats provided a better short-term return than did lower-risk debt instruments.
In summary, the essence of the subprime crisis is that money was lent (often through the agency of questionable mortgage brokers) at very low interest rates (courtesy of the Fed) to hundreds of thousands of people (all they needed was a credit score and a pulse) who could not afford to pay it back; and it was backed by collateral (a house) that was not properly valued.  Such assets, accurately described as “liar loans,” were then packaged into opaque securities, known as structured-investment vehicles (sponsored but not guaranteed by a respected and well-known name), which very few people understood. They were sold on to pension funds, banks, and others whose gullible investment managers also did not understand them and failed to carry out the rigorous analysis that their clients had a right to expect. 
Government encouraged all of this by supporting affordable housing (which was politically correct) and accusing banks of redlining (failing to lend to poor and black people in the same proportion as they lent to the rich and white). When the borrower, already maxed out on his credit cards, predictably failed to make payments, the scale of the problems eventually became apparent to somnolent regulators and financial institutions. Confidence and trust evaporated, because no one knew which institutions held suspect securities, how much the losses were, and who was ultimately safe. A financial system built on debt and excessive leverage was a financial system built on sand.
The errors and fallacies that weave and surround this awful catalog of errors could have largely been avoided by paying attention to a single sentence  written by Henry Hazlitt over 60 years ago:
The art of economics consists in looking not merely at the immediate but at the long effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.
  See, for example, an excellent analysis by Alex Brummer the city editor of the Daily Mail in his book The Crunch: The Scandal of Northern Rock and the Escalating Credit Crisis .
  Quoted in the European Wall Street Journal, November 6, 2008, page 15.
  Credit-default swaps proved to be too complex for risk managers at AIG whose computer models were not up to the task. See the European Wall Street Journal of November 3, 2008, page 1.
  Government action was centered around the Troubled Asset Relief Program (TARP), a boondoggle of gigantic proportions. How successful this will prove to be is beyond the scope of this article.
  See an excellent article by David Carr in the International Herald Tribune on September 30, 2008, page 17, entitled “How a Stupid Question Clarified Subprime Mess.”
  Sometimes a pulse was not even necessary as 23 dead people in Ohio were approved for loans. Ibid.
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 Mises.org: http://mises.org/story/3263
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 a single sentence: http://mises.org/story/3000
 blog: http://blog.mises.org/archives/009171.asp
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 The Crunch: The Scandal of Northern Rock and the Escalating Credit Crisis: http://books.google.com/books?id=aU1UJgAACAAJ
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 General Theory of Employment, Interest, and Money: http://books.google.com/books?id=dQD9o31F1N4C
 The Critics of Keynesian Economics: http://books.google.com/books?id=99MmAAAAMAAJ
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 book of the same title: http://books.google.com/books?id=xDc3AQAACAAJ
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