The basic plot of what has happened in our financial system for the past few months is taken directly from a script of late 1920s vintage. If you understand the Crash of '29 and the Great Depression, you understand the "subprime crisis." It involves only some word replacement.

In the 1920s, people decided that stock prices would never go down (in the famous quote, they had "reached a permanently high plateau") and thus began speculating – buying heavily on margin (i.e., with borrowed money) and getting loans from financial institutions with stocks as collateral. Then, as overvalued stocks tend to do, the prices came crashing down. People could not meet margin calls because the assets they purchased with borrowed money were no longer worth anything. Loans defaulted en masse and banks subsequenty failed in droves. Capital-starved banks all but refused to make new loans or, more commonly, simply couldn't. We experienced deflation, which doesn't get the press of inflation but is in many ways much worse. The money supply sharply contracted because of all the "paper wealth" that disappeared with stock prices and loans made in real dollars that were repaid with defaults.

If you need to understand what is happening now, just replace "stocks" with "houses". Lenders completely abandoned lending standards not because they thought Joe Deadbeat could repay his $400,000 mortgage on an $18,000 salary, but because they convinced themselves that the underlying assets would never lose value. Just like 1929, only with different assets. Say some lender sees Ed's application (annual income: $15,000) and realizes he can't afford a $400,000 mortgage. They lend Ed the money anyway because they assume, crucially, that Ed will pay for a while and then, when he no longer can, he will simply sell the asset to someone else for $400,000. Heck, he might even make a profit since home prices always go up! Instead, of course, what happened is that people were given mortgages they couldn't handle and, when they finally could no longer keep up, they went to sell their $400,000 home and found out that it is worth $200,000. Hence defaults by the millions.

You can accurately point out subtleties and relevant points that the preceding oversimplification has omitted, but in essence this is what has happened. And now we diverge from the 1929 plotline.

This "bailout" ensures that, while deflation followed the Crash of '29, good old-fashioned inflation is our lot this time around. Where is $700,000,000,000 going to come from? The government is broke and will only get broker as incomes and tax revenues fall. Well, the Treasury whips out the printing press and makes $700 billion worth of obligations to sell to China. Thus vastly increasing the number of dollars in existence and further watering down our beleaguered currency.

A worthwhile experience, if you ever find yourself in Eastern Montana, is to visit Little Big Horn. One walks around and cannot avoid wondering, "What in the hell was Custer thinking?" The entire landscape and scenario were so obviously disadvantageous to him that his sanity is cast into doubt. In short, by the time someone said "Hey, I think I see some Indians" it was already far too late. The terrible decisions had already been made and subsequent efforts to extract himself from the situation were irrelevant.

Since the scenarios have played out so similarly in 1929 and 2007-2008, we have to ponder whether or not saying "Hey, this is what happened in 1929, let's do something to stop it" is futile now. Yes, we have the foresight of history, enough so that even the Hayek-humping knuckleheads in the White House realize that something very, very bad is about to happen. But the "bailout", as I read it, is an evasive action being taken well past the "I think I see some Indians" point and having little potential other than to exacerbate the already-precarious predicament in which the dollar finds itself. That Congress is hesitant to get onboard what could be a $700 billion albatross is unsurprising.

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  • Your analogy is right on, Ed! I've read through Galbraith's The Great Crash a few times and have been both entertained and stunned by the parallels between the Crash of '29 and the Crash of '08. I don't know whether to laugh or cry over it.

    Worse yet, it appears as though the government is determined to take the dumbest measures possible to deal with what is bound to be an awful recession/depression. Printing your way out of an economic crisis is a sure-fire way to absolutely dismantle your economy and potentially your law and order as well. Inflation can be the most radical revolutionary device if exaggerated by short-sighted moguls and policy wonks with a penchant for creating more fiat money.

    But I'm afraid it's already to late to try to keep the Fed from taking such measures. Bush already ignored the down vote on the bailout and approved $300bil.+ in new money to be used at the Fed's discretion. More dumb-ass welfare for the rich is, I'm absolutely certain, to follow.

    Kiss your job, your house, and your savings goodbye, John Q. Public! Welcome to the bread lines.

  • the other night i saw some conservative lackey saying that over-regulation was the root of the problem here, and that liberal ideology was holding up the rescue deal (which of course was a speeding silver bullet until the democrats arrived).

    i'm just waiting until we get to the point in the argument where they are not actually making words anymore.

    "guh… buh… sneh…"

  • I think it's also important to note that many, many defaults are not due to banks lending to unqualified borrowers (in your example) but banks lending to investors. I know people who got no-doc no-income-verification loans and owned a half dozen houses. Their income in no way supported that. But, like kiting checks, they could buy, spruce up, and flip. Those crazy loans that allowed you to "pick a payment" were designed for flippers. But, like kiting checks, eventually someone is left holding the bag. In places like Las Vegas, Miami, even Atlanta, there are condo developments that have over half the units in foreclosure. A friend of mine is stuck in a condo, with nobody paying HOA dues, the value is plummeting, and investors are walking away from condos that flipped 2-3 times before the building was even built, that have NEVER been lived in. If you're stuck with a 400K mortgage on a 200K asset… I'd probably just walk away too. Now my friend is trying to decide whether to keep paying his mortgage, and hope that in 20 years his value will come back up to what his paid for it… or just walk away.

    Culturally, we all got caught up in the hysteria. There are literally hundreds of television shows that are all about flipping houses and get-rich-quick schemes.

  • I think it is important to note as well that not all of the foreclosures are people who got loans they could not qualify for or made risky investments. This crisis has had a domino effect that has brought everyone else down too. We currently own a home, for which we have a very traditional, low interest rate, 30 year fixed mortgage that we were fully qualified for, that we now can't get rid of. Our house's value is less than what we owe because the foreclosures in the market have brought down the values of everyone's homes. We did not even buy in a market with a housing bubble, but the foreclosues have forced prices down none the less. Because of jobs we have had to move, so now we are forced with the decision of indefinitely throwing a substantial chunk of change out the window every month for our unsellable empty house, trying to get a substantial external loan for the difference between what we can sell it for and what we owe and pay that off for the next ten years, or simply foreclose and ruin our very good credit. I am not trying to paint us as victims, but simply to point out that the problem has moved beyond arguments of moral hazard in that a substantially larger group of people than those that made bad financial decisions will suffer the consequences of the housing market.

  • This was an admitted oversimplification, and I realize that not every mortgage involved was given to a deadbeat.

    I feel sorry for anyone who bought a home between 2000 and 2006. As Richard Salzman said about the Crash of '29, "Anyone who bought stocks in mid-1929 and held onto them saw most of his or her adult life pass by before getting back to even."

    That's probably going to be the case here as well, although the government seems intent on accelerating the recovery of housing prices.

  • Myconfidence says:

    And when the dust settles, the powers that had become be the powers that were, because power does what power does, same difference, same as it ever was…

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