Did the Free Market Cause the Current Crisis? - Part I

I've decided to join the blogosphere (as if you couldn't tell...). I'm an environmental, behavioral economist who enjoys politics, legal issues, and, of course, economics. I think my position on various issues will become apparent as I go along.

I will begin by addressing a series of questions I often hear from my students: "is a carbon tax or a cap-and-trade system better" "what role should the Fed play in our economy?" "should we return to the gold standard?" "how can we lower healthcare costs?" "how accurate is economics when it is based on the provably false assumptions about rationality?" I would like to post daily, but time will tell whether I adhere to my goal.

The first question I attempt to answer is, "Did the free market cause the current crisis?" My short answer is "no," but the free market certainly played a part. Without government intervention, the recession would not be nearly as bad as it currently is. In this and future posts, I will try to lay out my view on this complex subject.

The current crisis is a direct result of the bubble in the housing market. Without the bubble, there would be no crisis, no recession, and no 9.4 percent unemployment. The bubble (and thus the recession) was caused by the confluence of three factors: the Fed dropping the interest too low for too long, the federal government's encouraging of an ownership society, and banks taking excessive risks. I’ll address the Fed in this post.

Factor #1: The Government - The Fed:

In the wake of 9/11, the Fed, under the direction of Greenspan, lowered the interest rate (technically, the target federal funds rate). The Fed typically lowers the interest rate when it is worried about a drop in production and consumption. Lower interest rates encourage businesses to borrow money to expand their operations (at least in the short run) because money is cheap. Low rate also encourage consumers to buy goods and homes on credit.

The economy was already struggling when terrorists attacked the Twin Towers; it was recovering from the bursting of the dot-com bubble. Because the economy was doing poorly and because many feared that the terrorist attack would further erode consumer confidence, the Fed acted wisely in lowering the interest rate. The Fed acted unwisely, however, in keeping rates so low for so long. The Fed didn't really begin raising the interest rate until 2005 - long after recessionary fears had passed

With extremely low interest rates in the early 2000s, banks offered home mortgages at low rates (especially on adjustable-rate mortgages, where borrowers often paid only one to two percent for the first two years). Home-buying became even more attractive than it already was. Plus, low interest rates made it easier for banks (including investment banks) to borrow money from the U.S. Treasury. It became profitable for banks to borrow tons of money from the Treasury, then lend most of that money to consumers through mortgages. These two factors together made money widely available.

Thus the first factor that caused the huge spike in demand for homes (and thus the bubble) was not the free market, but the government created central bank.

I'll address the other two factors in my next posts.