FINANCIAL THEORY AND VUK VUKOVIĆ: PRACTICE OF THE US FINANCIAL CRISIS 2007-2009

91 35 (1) 91-128 (2011) * 16 P 28, G

01, ** 316.334.2

G :

: Received: June 1, 2010 The author would like to thank two anonymous referees for their useful comments and suggestions. at London School of and Political Science, London at London School of Accepted: December 10, 2010 * ** Student at Master of Science program Student at Master of

UDC the US financial crisis US financial the JEL

[email protected] Political economy of economy Political Article

VUK VUKOVIĆ 2007-2009

. This crisis by now 1 uential economic analysts, nancial crisis nancial

nancial crisis the paper will focus on the political economy of the INTRODUCTION

According to NBER the crisis in the US started in December 2007 and finished in June 2009, but with ban- According to NBER the crisis in the US started in December 2007 and finished kruptcy of Lehman Brothers and the rising danger of further bank crashes the crisis culminated and became kruptcy of Lehman Brothers and the rising danger of further bank crashes the crisis culminated and became widely focused in September 2008. Its consequences are still present in many countries. 1 consequences. Governments throughout the world are using the panic as an excuse consequences. Governments throughout 1 of the public, the business world, poli- Since September 2008 the main emphasis global fi ticians and has been on the Abstract mortgage of the subprime economy political is on the this paper of The emphasis to it through contributed how the policy makers United States and crisis in the uence of the rising infl made under and , their “Great ” industry. The nance of the fi the lobbying activities groups and United States in the in the mortgage began as a bubble-burst of 2007-2009 to the of the US, and afterwards nancial market fi over to the entire that spilled up over the US real sector nancial market. The crisis sprang integrated world fi to the real in US , spread consequently and, due to the decline given for the publi- of the World. No sound has been economy of the rest the self-regulating free that the causes of the crisis lie within cly proclaimed idea of political power, of the crisis lie primarily in the activities market. The causes uence the strong infl government which has, under i.e. in the extensive nancial corporations, led to favou- the lobbying power of fi of interest groups and allocation. Regulation cient resource policies and ineffi ritism in macroeconomic government sponsored affordable housing through was enforced by stimulating and an increa- of the rating agencies, banking regulation enterprises, nance industry. the fi sing connection between government and economy, government regula- nancial crisis, political Keywords: United States fi tion, lobbying, political power called the “Great Recession” due to its strong and long-lasting effects resulted in called the “Great Recession” due to its parts of the world. Claims were made that social and political instability in various of the 1930s in its profound and lasting it would outmatch the to increase their relative size in the economy and strengthen their regulatory power to increase their relative size in the economy income. Infl and the interventionist redistribution of warning of the failure of the free market populist politicians and anti-globalists are and are calling for the end of globa- system, the end of the “neoliberal” economy protectionism. lization while contributing to the rising This paper will question the notion that the causes of the crisis lie within increa- sing deregulation and an unconstrained free market. Through analyzing the causes of the global fi crisis seen through the increasing impact of lobbyists and interest groups on poli- it tical and regulatory decisions. It is not a question of for or against intervention;

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93 35 (1) 91-128 (2011)

nancial ation tar- ation – which nancial indu- nancial cially created de- cially created ed banking regula- the growth ation upon which ve with help of the Taylor rule. CRISIS

THE

OF

of the fi uence of the political power BACKGROUND in the downward spiral were nancial institutions caught up

cient and risky decisions. The central government regulators induced decisions. The central government cient and risky of government policies. sector was fuelled were all consequences nancial aimed at punishing those who is being constrained by regulations cient market INTERNATIONAL

2 The international environment preceding the crisis was characterized by globally stable , growth of productivity and a low level of infl The banks and other fi The banks and other The desire of regula- of this paper revolves around that point. The main argument kind of decisions busi- from the system by determining what tors to eliminate risk investment incentives led to the creation nesses should make or by guiding their inherent to the society. of a high level of systemic risk that became perspective on the current crisis. The paper begins by introducing an international because of its central role in the It focuses around the United States in particular onto the rest of the world’s fi inception of the crisis which spilled over of the fi guiding them into. the government regulations were only following the decisions recession. Subsequently it endea- markets and so bringing about the worldwide the causes of the crisis. It continues with a vours to explain opposing views about rate mortgages and offers a perspective description of the mechanism of adjustable of the housing bubble and the spill-over on increasing bank risk-taking, the burst In chapter four the paper examines the effect to the real sector of the economy. the crisis. It covers the impact each of them political and regulatory inducements of why the policymakers instituted them. had on the economy and possible reasons enhancement of systemic risk by the These causes include the general regulatory on the bolstering of the crisis, the policymakers with the unintended consequences and the legislative solutions in housing role of government-sponsored enterprises agencies and intensifi policies as well as the function of rating policy had implications in creating the tion. An assessment on whether monetary chapter fi crisis and the housing bubble is given in Finally the role of the rising infl stry as possibly the decisive factor of the crisis is portrayed in chapter six. The reasons of banks’ risky behaviour do not lie in the deregulation of the banking the deregulation of do not lie in of banks’ risky behaviour The reasons and the artifi from overregulation they originate sector, rather now seek same politicians who created by those and mortgages mand for housing The free and and risk-laden. system got so corrupt to why and how the for answers effi made ineffi Extensive debt ac- housing and mortgage investments. the policies of affordable combined with house infl cumulation and risk-taking is a matter of political decisions that caused a distortion of the market that led to market that of the a distortion caused that decisions of political is a matter risk. systemic of accumulation was a primary result of policy changes by central banks focused on infl and geting. Short term interest rates were at historically low levels both in the US

09

08 1/10

07

1/09 Japan

06

1/08 05 Oil exporters

Japan

1/07 04

1/06 03

Euro area

02 1/05

01

1/04 Euro area

00 USA

1/03 Asia Emerging

99

1/02 98

USA

97 1/01 2 4 that a serious concern gure 3) and

showing remained weak, not gures 1/00 0 IGURE IGURE

4 3 2 1 0 ation rates among its member countries 0.015 0.010 0.005

-1 -2 -3 Real short-term interest rates (%) Real short-term interest F F Current account balances as shares of World GDP -0.015 -0.020 -0.005 -0.010

08

1/10 06

04

1/09

02

1/08 00 Japan

Japan

98 1/07 Asia Emerging

96 1/06

94

1/05 92

Euro area

Euro area 90 1/04 88

Reserve the US Federal in 2001 recession Due to the 1 and 2). gure

1/03 86

gure 2). gure

USA 1/02 84

USA

82

1/01 3 1

Advanced economies

80 1/00 IGURE IGURE 8 3 very low levels (fi was already at ation, which -2 7 6 5 4 3 2 1 0-4 23 18 13 Historically low infl ation rates worldwide, ation rates worldwide, Historically low infl ation, annual % change average infl F Nominal short-term interest rates (%) Nominal short-term interest F whereas the Fed does not. The ECB rate generated different whereas the Fed does not. The ECB monetary policy rate generated different real effects across the countries of the eurozone. Those countries that had negative The European (ECB) was less aggressive than the Fed due to the The European Central Bank (ECB) was less aggressive than the Fed due to fact that ECB has to deal with differing infl Source: IMF (2010). Source: worldwide (fi worldwide though rate. Even interest its target in a sharp decrease (Fed) introduced Board the economy, fi in the recovery of this resulted at least until of employment, growth or growth of a substantial GDP signs did not in in- were threats of a decrease recovery” there to this “jobless 2005. In addition fl the US might experience a recession decade, like that endured in Japan in the 90s. that endured in Japan decade, like experience a recession the US might rates still remained ra- of the monetary policy in 2004 real Even after tightening ther low (fi

FINANCIAL THEORY AND VUK VUKOVIĆ: PRACTICE POLITICAL ECONOMY OF THE US FINANCIAL CRISIS 2007-2009

94 35 (1) 91-128 (2011) FINANCIAL THEORY AND VUK VUKOVIĆ: PRACTICE POLITICAL ECONOMY OF THE US FINANCIAL CRISIS 2007-2009

95 35 (1) 91-128 (2011) t MARKET

ow of foreign ve. cit started to grow nancial market in de- FINANCIAL

nancial regulation and gove- AND

into the US brought about ows 4). This period is matched by gure institutions, companies and nancial . Excess in Asia were being in- nance current consumption rather than nance current consumption 3 HOUSING

nancing US investments and consumption. nancing US investments THE An empirical investigation of monetary policy investigation of An empirical

2 ned in two main categories; one, the (New) Key- ned in two ON

for was strong demand savings. There ected high world into the US. High infl ows CRISIS

ows were used to fi cit itself caused the housing boom, but there is evidence that housing boom, but there is evidence cit itself caused the ation and higher real policy rates such as Germany, did not did not Germany, such as rates real policy and higher ation THE

OF

was mainly used at the time being for the purchase of ow of foreign capital ORIGINS

For detailed information concerning this issue, see Shiller (2008), chapters 3 and 4. Low resulting in higher real interest rates was not the only reason why Germany did not experi ence Low inflation resulting in higher real interest rates was not the only reason why Germany did not experi 2 3 seeking in and the other, the free-market approach, blaming lax mone- seeking in Wall Street and the other, the tary policy leading to the housing bubble and extensive regulation that curtailed and sustained growth. The basic distinction is in the response to the crisis where the (New) Keynesians urge for more intervention, fi try rnment stimuli as the drivers of growth. On the other hand the free-marketers 3 as to the causes of the Great Recession. There have been many disagreements Opposing views have been defi nesian, which states that the crisis is to be blamed on deregulation and profi nesian, which states that the crisis is experience an asset bubble. experience policy rates, such as Ireland or Spain, experienced housing booms, while coun- while booms, housing experienced or Spain, as Ireland rates, such policy infl with low tries an asset price boom, but it was nonetheless one of the factors. vested into safe assets such as US government securities, which contributed to a vested into safe assets such as US government high level of capital infl fi excessive risk taking and exposed domestic excess savings towards assets increases households to exchange rate risk. Pushing in an appreciation of asset . This the demand for these assets which resulted as on total output. An infl put additional pressure on demand as well Low real interest rates refl Low real interest and expectations of constantly increa- savings, combined with low interest rates of an asset bubble in both houses and sing asset prices resulted in the creation securities. An increasing demand for assets motivated the fi (derivatives) whose main purpose was to veloping new instruments and securities diversify risks. safe assets from Asian and oil exporting countries that contributed to depress the that contributed to exporting countries from Asian and oil safe assets economies, the US securities issued by advanced yield on long term government assets from cur- US savings rate also contributed in steering in particular. A low countries into fi rent account surplus as a possible cause of the crisis will be addressed later in chapter fi will be addressed cause of the crisis as a possible However, capital infl defi assets. The US current account investment into productive uncontrollably by the end of 1998 and reached its highest level around 2006, whi- end of 1998 and reached its highest level uncontrollably by the countries experie- exporting countries and emerging Asian le at the same time oil in their current accounts (fi nced high surpluses is no proof that the in the US housing market. There the likewise high growth current account defi real-, adding to the housing bubble the infl

ationary trap. ationary that ows into the US ed by a jobless recovery social ts and less on their inve- nancial market where the cient, too risky and irresponsible. cient, too risky and irresponsible. innovation through the secu- nancial nancial sector are all a consequence of their assets with mortgage-based secu- ll up as fi ate ts in good times. This is why government intervention is smissed as a cause because their low-rate policy was justifi smissed as a cause because to prove that more government and regulation are not the answer and can only and can the answer are not regulation and government that more to prove growth. stunting of further lead to and Shiller such as Akerlof of regulatory standards urge for tightening Those who point out that Bernanke (2010) Stiglitz (2010) and (2009, 2010), (2009), Krugman were not a way because they behaved in such Wall Street in general banks and were al- institutions. Banks from the government enough to controls submissive by some means could risks and the market did not (and lowed to take too many it was responsible for brought the system down as not) punish them. Deregulation enterprises to focus more on profi allowing government goals, which led them to behave like predatory lenders. Monetary policy is di- to behave like predatory lenders. goals, which led them in the post-2001 recession period, accompanied with fears of a defl period, accompanied with fears in the post-2001 recession market was due to large capital infl The bubble on the housing lending and home and increased incentives for mortgage lowered interest rates started to infl ownership. The bubble into new types of securities made ritization of mortgages and their repackaging were being underwritten, the bubble this possible. As more and more securities on the fi grew even larger. This led to further greed of and were inve- stors were led by “animal spirits”, instead psychological category was even more sting more than they should have. This it added to the instability of the markets. visible when the downturn occurred, as was a lack of regulatory oversight The only mistake of the monetary authorities effects. that could have prevented the recessionary this crisis and the bubble-burst of the hou- From this standpoint it is obvious that as it moves in cycles, in which, after sing market are inevitable in the economy of economic downturn arises. The long periods of economic success, a period who become too greedy and who causes are in the market itself and its participants seek extraordinary profi enough to stimulate the economy out needed as the government alone is powerful pre-crisis high growth levels. Without its of a recession and bring it back to its and demand would plummet, public unrest intervention would rise than it already is. causing the system to be even more vulnerable The free-marketers such as Cochrane (2009), Taylor (2009), Friedman (2009), Roberts (2010), Wallison (2010) claim the opposite. The market was being con- strained from punishing those who were ineffi The regulators imposed housing policies, tax cuts and bank capital restrictions The regulators imposed housing policies, tax cuts and bank capital restrictions that gave incentives to the banks to fi rities. Increasing leverage and risk-taking followed by an increase in home values which sustained the high growth of the fi government guided policies. The banks were making the decisions that the gover-

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97 35 (1) 91-128 (2011) nd t. They t. . 5 and it increased the 4 nancial institutions increased their credit nancial nancing. The lack of own sources was com- nancial sector. The intention is to identify and nancial sector. The TAKING

RISK

could not fi risk and how it was possible that the policymakers lled up with BANK The trend of lagging growth of real compared to the real GDP growth added to this increasing hou- The trend of lagging growth of real wages compared to the real GDP This was impossible to return Lehman Brothers borrowed 30 times more than the amount of its own capital. 4 sehold debt and a decrease of domestic savings. 5 Annual Report, pg. 29). in the case of a credit crunch in the housing market (SEC – Lehman The crisis originated in the United States in the housing and mortgage market The crisis originated in the United States in the hope of making a profi where people were buying and selling houses Until the 2000s the subprime mortgage market was relatively small in size and it Until the 2000s the subprime mortgage investment banks whose goal was to buy was carried mostly by commercial and them into mortgage-backed securi- these mortgages from underwriters, repackage backed by the payment of principal and ties (MBSs) and sell them further while were structured by classes with the same interest on the mortgages. These MBSs were later bought by whose collateral but a different level of risk. They payments on the mortgages paid by interest was the return in the form of interest the mortgage owners. 3.1 a proper response, the focus of this paper is not in explaining various views as to focus of this paper is not in explaining a proper response, the a political eco- Rather, its main purpose is to provide what created the recession. the policies responsi- the market crashed and on the nature of nomy view on why intention to explain or the market found itself. It has no ble for the state in which American fi analyse the complete decisions that guided market parti- demonstrate the correlation between political cipants and the causes of the recession. buying real-estate as the safest possible invested mostly borrowed into increasing. As an answer to this increased investment whose price was constantly demand on the housing market the fi and decreased their interest rates. This re- expansion, lowered lending standards sulted in two effects: it increased the debt of households Although both of these views offer an interesting examination of why the system views offer an interesting examination Although both of these got fi According to them, the idea of a global savings glut that led to low interest rates glut that led to low a global savings to them, the idea of According exu- full explanation. Irrational does not provide a the housing bubble and fuelled not crucial but they were present on the market, animal spirits were berance and Monetary and herd behaviour. to bubble growth what contributed in explaining to historically low le- role as the interest rates were down policy played a crucial way for too long. vels and remained this nment institutions were guiding them into. The area in which the free market the free in which The area into. guiding them were institutions nment was constrained. function could banks’ demand for other sources of fi pensated for by borrowing from other institutions until the amount of debt became unsustainable, i.e. when it could not be paid out of its own capital nancial nancial innova- nancial to engage in risk taking to engage in risk taking

ned as “increases of asset prices that have no Tax Relief Act or the Com- c measures (such as the nancial institutions who seem to be traditionally conser- nancial institutions who seem to be traditionally BUBBLE

and credit strength of households was compensated by the nancial ows of foreign funds fuelled a housing construction boom which led boom which construction a housing funds fuelled of foreign ows many investors, both from the US and worldwide, invested into the invested into the US and worldwide, both from the many investors, 6 HOUSING

cial policies of the Bush and Clinton administrations gave support to rising cial policies of the Bush and Clinton THE Recognized through the creation of various new financial derivatives such as mortgage-based securities Recognized through the creation of various new financial derivatives such as mortgage-based securities tion of securities and derivatives. The assumption for an asset bubble growth was tion of securities and derivatives. The assumption for an asset bubble growth was created. Speculative bubbles are defi 6 munity Reinvestment Act). The government was encouraging commercial and munity Reinvestment Act). The government its investment banks to give out mortgage loans by guaranteeing them through it government entities. This increased the scope of investing into real-estate; affected the growth of real-estate prices and led to a loosening of lending standar- ds for new subprime mortgages. This, in turn, opened space for fi 3.2 Offi of making sure every citizen had a household debt accumulation by their policies home. Lack of fi government through its specifi This lethal combination of easy credit and rising debt accumulation accompanied accompanied accumulation debt and rising of easy credit lethal combination This infl by large innovation to the rise of the US housing bubble. Based on these rising prices and fi these rising prices bubble. Based on of the US housing to the rise US housing market. As the prices went down, those who had invested in the boom who had invested went down, those market. As the prices US housing home values due to their ordinary investors, losses. In parallel, started reporting affected by started to be loans contracted, worth less than mortgage now being a downward spiral was created. foreclosures, and thus fi Banks and investment vative and cautious and who tend to act within their legal boundaries that suppress and who tend to act within their legal boundaries vative and cautious the opposite to their went into risk taking and acted quite irresponsible behaviour, The main cause of such willingness previous practices. had a “safety net” in framework for their activities. They was the new regulatory took out insurance wrong. By issuing home loans the banks case something went (CDSs). These instru- in terms of credit default swaps for their credit portfolio not insurance con- policies (although they formally were ments acted as insurance the banks in the case of foreclosure or an tracts) that guaranteed down payment to obtained in insurance companies such inability to repay interest. The CDSs were In the case of rising housing prices the as American International Group (AIG). in insurance instruments the banks safety net functioned well. Having a back-up did not meet the usual criteria, people started offering home loans to people who was based on a never-ending growth with low and irregular incomes. The system risk of potentially negative effects if the in housing prices notwithstanding the in the system led to the fall of prices suddenly started falling. The overheating on the housing market and the inability to real-estate prices, i.e. to a burst bubble to pay back the money borrowed from the loans. The banks were not able could not afford to compensate the losses other institutions. Insurance companies and the safety net proved to be an illusion. (MBSs), credit default swaps (CDSs) and collateralized debt obligations (CDOs).

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Population in millions

1,000 900 800 700 600 500 400 300 200 100 0

2020

2010 2000

in the United States

7

1990 1980

government cial decision of the 1970 1960

Building costs

1950

1940

1930

1920 1910

Home price index Population

1900

1890

5). The highest growth in housing prices in the given 120 year gure 1880 5 0 50

250 200 150 100 IGURE rate interest or Index The S&P Case-Shiller U.S. Home Price Index measures the values of single-family housing within the Uni- The S&P S&P Case-Shiller relative home price index S&P Case-Shiller relative 7 It uses the The index measures changes in housing market prices given a constant level of quality. ted States. in “repeat sales method” of index calculation which uses the data on properties that have sold at least twice, indices). order to capture the true appreciated of each specific sales unit (Standard & Poor’s Source: Shiller, 2006. Shiller, Source: housing prices Robert Shiller created an index of relative F rational economic explanation in which the market prices move quite the opposite quite the move prices the market in which explanation economic rational only temporary prices are The high conditions. market by when determined than a consistent rather than enthusiasm of investors, as an effect of the and they act bubble on The bursting of the (Shiller, 2006). of their real asset value” evaluation which of price movements, changing the direction in real terms means the market existed an market in the US there On the housing to their real value. are readjusted deviated from the “equilibrium” prices, which had growth of real estate irrational market forces. path determined by with a basis year being set as 1890, which shows the movement of house prices up with a basis year being set as 1890, which until today (fi the offi period took place between 1998 (right after matter what the price) and 2006. A house that everyone should have a home, no was worth $200,000 by the middle of that was worth $110,000 by the end of 1998 The prices were increasing up until 2006, presenting an 85% increase in prices. could not keep track of its high prices the point when the demand for housing of leading to a downward pressure on the prices, which started to fall by the end 2006.

2007

2005

2003

2001

1999

1997

1995

1993 1991

Change in housing prices, annual

1989

1987

1985

1983

1981

1979 Fed key interest rate 1977

6 1975 nancial industry was interlinked with these price movements by issuing by movements these price with was interlinked industry nancial prices, their a decline in country were to experience If one part of the cation. 5 0 IGURE -5 20 15 10 -10 -15 -20 -25 Source: Author’s own calculations; Board, 2010; and Standard & Poor’s Indices, & Poor’s 2010; and Standard own calculations; Federal Reserve Board, Author’s Source: 2010. The fi The of strong growth on the were based returns whose derivatives and other MBSs diversify risk that MBSs could sense at the time It was common housing prices. di- due to their geographical local misbalances were protected from because they versifi continued in in prices would be because the rise be jeopardized returns wouldn’t what would take into account expectations did not of the country. The other parts crash. country experienced a housing market happen if the entire prices and the Fed key look at the link between housing Figure 6 offers a closer in housing prices are 35 year period. It shows that changes interest rate in the last interest rates were the level of the Fed interest rate. When negatively related with rates started to fall the declined, and as soon as the interest high, housing prices lag, as the change in rise, although they did so with a certain housing prices would by roughly a one always precede the change in housing prices interest rates would started to rise rapidly In the last decade, the housing prices to two year period. rate. When the interest by a gradual decrease of the interest around 2001, followed increases were closing in on their peak. rate hit its lowest levels the housing price in 2004 again resulted in a lag on the The Fed’s decision to raise interest rates decrease until 2006. However, this sharp housing market as the prices did not rate. If it had been, the fall would not decrease was not all due to a rising interest had the same scope as the interest rate have been so severe; rather it would have latest drop in housing prices was not a movement as it did in previous years. This rate movement, although the interest rate complete consequence of the interest that led to a decline in home prices. The movement could have been the trigger rapid and robust lies in out-of-the-model answer to what caused the drop to be so created incentives to invest into housing, factors, such as political decisions that which will be dealt with later in the text. F Comparison of housing price changes and the Fed interest rate (%) Comparison of housing price changes and

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101 35 (1) 91-128 (2011)

ed by negative by negative ed CRISES

ected in decreasing private ected in THE nancial market, a decrease of

cient way of creating wealth. spread sector is rapidly nancial OF

nancial institutions. While no one SECTOR

nancial market is intensifi market nancial CAUSES

ected in the stock market. And vice versa, a ected in the stock market. RISK the sector. The crisis on for the private culties

REAL

THE

ts in the real sector is refl ts in the TO POLITICAL

SYSTEMIC

scal stimuli to bolster demand, revive production and turn AND cient answer, at least not in the long run. Empirical testing is cient answer, at least AND OVER

- cit, which cannot be balanced by levying extra taxes but only by cit, which cannot be balanced SPILL

ts and a loss of jobs. CRISIS REGULATION

REGULATORY

stren- contraction (due to risk increases and the nancial market caused by a credit nd an answer in fi Greed and corruption seem to be the most popular two causes that are being bla- med for the risky behaviour of banks and other fi 4 4.1 The crisis has strengthened the interventionist and regulatory powers of the gover- The crisis has strengthened the interventionist maintain political stability, may prove to nment, which in the short run, in order to in the long run this may prove to be be simulative of economic recovery. However, government for the market can a risky orientation. It is unlikely that substituting prove to be an effi needed to prove the riskiness of such a trend on future economic growth. It is essen- tial to restore the faith in the market as the most effi spill-over effects on the real sector. This is especially evident in the rising unem- evident in the This is especially effects on the real sector. spill-over market, In the integrated and political stability. which jeopardizes social ployment, fi fast, the risk on the effects act on which spill-over and beco- of loans decline crisis the amount other sectors. In a banking around to in diffi resulting me more expensive fi drop and conse- criteria) tends to lead to a real sector activity gthening of lending quently a fall in production and employment. A decrease in demand on the world’s and employment. A decrease in quently a fall in production 3.3 the fi stabilize to intervention Political additional debt accumulation. The growing public debt in the US has already rea- additional debt accumulation. The growing the risk of future instability and crises. ched unprecedented levels, which increase in the fi The reaction of governments to breakdowns around the unemployment trend. This increases budget expenditures and therefore around the unemployment trend. This increases the budget defi A fall in employment levels increases political pressures, and governments try to A fall in employment levels increases political fi largest market brings about a decline of imports in the US, a decrease of other about a decline of imports in the US, largest market brings production, growth of the US and consequently a fall in countries’ exports to the globalized world. a GDP decrease in most countries of unemployment and profi The fall of sales and which is refl sector net present value available, offers more market decreases the amount of money decline in the stock a fall in production fewer loans for the private sector, expensive loans, meaning and profi demand, growth of unemployment and exports, decrease of home and foreign of protectionist measures that can only consequently social turmoil often consists instability can result in the strengthe- deepen the crisis. Social turmoil and further and to further endangering of demo- ning of populism and authoritarian solutions cratic orders. - nan- Freddie ciency of ciency nancial insti- nancial ENTERPRISES

SPONSORED

uence of lobbyists and various in were behaving rationally ts. Investors GOVERNMENT

: MAC

FREDDIE

) and the Federal Home Loan Mortgage Corporation ( ) and the Federal Home Loan Mortgage AND

MAE

Fannie Mae ) both had a crucial role in creating the bubble on the housing market. Their ) both had a crucial role in creating the is being decreased with growing regulation bestowed upon it, nancial market FANNIE 4.2 the Federal National Mortgage Asso- Government sponsored enterprises (GSEs), ciation ( Mac banks on the subprime mortgage market. main goal was to purchase loans from full responsibility for it, receiving intere- Once in ownership of the loan they take the risks of default on the loan. Fannie and sts on a monthly basis and taking over these loans as a source of monthly reve- Freddie have the option of either keeping as mortgage-backed securities to inve- nue or repackaging them and selling them their loans to acquire new mortgage stors. The banks use the money from selling Mortgage prices rise as a source of addi- loans and the entire cycle is continued. in- tional creation from the banks selling them to the GSEs. “By creasing the demand for mortgages in the secondary market, the GSEs can reduce the interest rates the homebuyers pay on the mortgages in the primary market, fostering home ownership” (Levine, 2010) which was their main purpose created by the government. and Securities issued by the GSEs were marked as government issued securities were considered to be of a substantially low risk and hence low return. This was thus increasing its systemic risk. denies the existence of these motives, as they are always present, there is no evi- there is present, are always as they motives, of these the existence denies fi crisis. The caused the and in 2007-2008 culminated that they dence determined an AAA rating, as safest securities with into only the tutions invested risk with the minimum and rated as securities rating agencies by the authorised into low-risk to link investing It is questionable the lowest return. and therefore extra profi with greed for AAA securities bolstering into MBSs and hence investments The reasons for increasing this case. The policies of should be seen in regulatory policy decisions. the housing bubble the political goals of government were made for the legislative and with an increasing infl gaining voters. Combined risk for the fi resulted in the gradual creation of systemic interest groups this such as affordable risk was built in by regulatory decisions cial system. Systemic activities of govern- an oligopoly to rating agencies, housing policies, granting additional regulations on the mortgage market and by ment sponsored enterprises was not a consequen- Systemic risk created in this way imposed on banks’ capital. business activity it was concealed behind desires to reform ce of bad intentions; origin of increased eliminating risk and uncertainty. The by diminishing or even cognitive basis of regulatory decisions risk-taking lies in the informational and when they are spontaneously created by which have a much narrower effect than provision where market failu- market regulations. Even in the case of by the government is much more effi res do exist, the acquisition of public collectivistic economy. The effi cient in a market environment than in a the fi

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103 35 (1) 91-128 (2011) the uence of Mae and Freddie Mac mortgage loans owned by Fannie Percentage of mortgage loans with a repayment lower than 5% in total (in thousands of mortgage loans) by Fannie Mae and Freddie Mac a repayment lower than 5% owned Total amount of mortgage loans with 1 ABLE Year 2007 608.6 23 2006 390.0 15 2005 306.1 12 2004 268.7 11 2003 311.3 12 2002 214.4 8 2001 162.4 7 2000 106.3 5 1999 91.9 5 1998 75.6 4 Total purchases of mortgage loans by Fannie Mae and Freddie Mac with low loans by Fannie Mae and Freddie Total purchases of mortgage interest payments The Housing and Urban Department (HUD) instituted a set of housing policy The Housing and Urban Department (HUD) instituted a set of housing policy goals as a part of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992. The most interesting one concerned the Low-and Moderate-Income Goal that transferred the authority to the GSEs to purchase as many as these mor- Source: U.S. Department of Housing and Urban Development (HUD), 2008b; and Roberts, and Urban Development (HUD), 2008b; and Roberts, U.S. Department of Housing Source: 2010:29. T GSEs on that market. By the time the government took over their business in 2008 took over their business the government market. By the time GSEs on that newly issued three quarters of American MBSs and half of all they had acquired standards for had been lowering 1999 Fannie Mae (HUD, 2008). Since mortgages the MBS business banks who were favoured to “expand buying mortgages from to even get an ordinary whose credit rating is not good enough to those individuals with a low down The total amount of mortgage loans loan” (Friedman, 2009). in the period between and Freddie bought had quadrupled payment that Fannie the owners of a quarter 1). By 2007 Fannie and Freddie were 1998 and 2003 (table 5%. issued with an interest rate less than of all mortgage loans By the end of 1990s as the real estate market expanded, so did the infl estate market expanded, of 1990s as the real By the end due to the general notion that they would be bailed out by the government if they by the government bailed out would be that they notion the general due to problems. or liquidity solvency any experienced ts t, not so- ting from eco- ed by reaching the government targets resul- mortgage loans owned by Fannie and Freddie with mortgage loans owned a cially created market for these kinds of securities. “There 2 ABLE YearFannie MaeFreddie Mac 49.5 2000 49.9 51.5 2001HUD goals 2002 53.2 51.8 42 2003 50.3 52.3 2004 51.2 53.4 50 2005 51.6 55.1 2006 50 56.9 2007 54 50 55.5 55.9 50 56.1 52 53 55 Households with income less than or equal to median income. Households with income less than or equal to cial objectives – in effect; they were trying to catch up with private lenders” cial objectives – in effect; they were (Krugman, 2010). (HUD) the GSEs had acquired According to the Housing and Urban Department the market altogether (HUD, 2008). Their more subprime mortgages than rest of which meant that they had “no compe- advantage was funding at a very low cost buy” (Wallison, 2009). Their entrance into tition for any asset they were willing to the subprime mortgage market justifi position on that market. ted in their rapidly achieving the dominant market meant that more and more origi- The impact of the GSEs on the mortgage as nators of mortgage loans would strive to extend them to dubious borrowers, they now had an artifi was a huge frenzy at the originator level to produce the subprime and Alt-A loans that would then be sold to the GSEs” (Wallison, 2009). Because of their impact the market was growing. And the only way the GSEs were able to make profi was for the market to keep on growing. They were therefore benefi nomies of scale. The Fed also made a study on this matter that showed that “the GSEs were not even successful in reducing interest rates for middle-class home a U.S. Department of Housing and Urban Development (HUD), 2008a. Source: of the subprime mortgage market was However, certain claims say that the growth lenders like Countrywide, not by Fan- primarily underwritten by private mortgage for a sharply reduced share of the nie and Freddie. “Fannie and Freddie accounted the peak years of the bubble. To the extent home lending market as a whole during they were in pursuit of profi that they did purchase dubious home loans, tgage loans from low and moderate income borrowers as the goal determined goal determined as the borrowers income moderate low and loans from tgage Fannie by overachieved were being these goals how 2 shows 2008). Table (HUD, must buy HUD that the GSEs a policy through the The Congress set and Freddie. funding and made unlimited these mortgage loans amount of a pre-determined in Fan- This in turn resulted the political goal. them in order to attain available to market. in the mortgage high involvement nie and Freddie’s T respect to HUD’s goals (% of total low-and moderate-income mortgage loans) (% of total low-and moderate-income respect to HUD’s goals Low-and moderate-income:

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105 35 (1) 91-128 (2011) sta- ting from their lobbying ting from their lobbying nancing. the GSEs to the owing” from uence among Congress mem- if the GSEs were to nancial system (Green- their existence” for always claimed they cation . 8 . In addition to that both Fannie and Freddie were reliable sources of cam- both Fannie and Freddie were reliable . In addition to that and unsta- rst to be hit by this possible recession were the social groups with low ght against homelessness and poverty leads to election success, disregarding the Both of the companies were strategically giving large donations to those politicians who were sitting in the donations to those politicians who Both of the companies were strategically giving large 8 Fifteen of the 25 listed members of the House and the Senate that gained the boards regulating their industry. most campaign funds were either members of the House Financial Services Committee, the Senate Banking, Committee or the Senate Finance Committee. Senator Dodd, with the most gran- Affairs Housing & Urban the ted campaign funds, is the chairman of the Senate Banking Committee, while Congressman Kanjorski is Chairman of the Financial Services Subcommittee on Capital Markets, Insurance and Government Sponso- red Enterprises (Center for Responsive Politics, 2009). paign donations for mostly Democrats (table 3). Democratic candidates received mostly Democrats (table 3). Democratic paign donations for year period. Politi- as the Republicans in the twenty twice as many contributions and Freddie were mutually benefi cal elites and Fannie tus quo for the GSEs on the creating thus a privileged position and campaign donations mentioned lack of for the go- market. This resulted in the previously as their ease of fi vernment-protected companies as well Fannie and Freddie is worth noticing, The political implication in the story behind Fannie and Freddie has been neglected by as for some reason the need to reform GSEs infl the new regulatory bill in Congress. The bill (Senator Dodd and Congressman bers, especially on those who wrote the funds are “fl Frank in particular) is still intact as the Congress members The behaviour, however, did not go unnoticed in the political arena. The opposi- did not go unnoticed in the political The behaviour, however, regulation and supervi- 2001) were calling for additional tion Republicans (before accusing the Republi- while the Democrats responded sion of Fannie and Freddie, preserving the “affordable housing” for all Americans, cans of being against span, 2010). In addition to this warned the Congress in his testi- in the Congress warned Greenspan to this Alan addition 2010). In span, and Freddie effects Fannie the potential hazardous the US Senate of mony before and mortgage securitization warned of increasing upon the system. He could have for the US fi creating systemic risk a threat of (Greenspan, mortgage market share of the home large and gain a huge become too did nothing. many warnings and Congress neglected 2005). The buyers – the central justifi – the central buyers Fannie Mae and Freddie Mac were included in the political decisions of the Ame- Fannie Mae and Freddie Mac were included goal of expanding the availability of rican government for obtaining its political especially to low-income minorities. loans for buying houses to all social groups, by the dictate made by government poli- The risk was becoming inherent to them a recession or falling housing prices. The cies, which was to escalate in the case of fi demanded from Fannie and Freddie a re- ble incomes. The regulatory decisions from those who could not have made purchase of mortgage loans and securities to the pursuit of a populist government regular down payments. This was all due the policy – that everyone is entitled to a home, with no regard to their income, as fi long run effect.

36.5 55.4 USD) Funds (thousands ENCOURAGEMENT Party/State

Republican-VA 55.4 Republican-CA 33.0 Republican-NY 32.7 Republican-MO Republican-OH 34.7 Republican-UT 61.4 Republican-MO Republican-AL 55.3 Republican-AL 55.0 POLITICAL Christo- pher Gary Tom Deborah Robert F. Spencer Richard

9) Davis, Tom Bond, 10) 21) Miller, 21) Reynolds, 23) *Annotation: The numbers by the names of the representatives mark the rank of the amount of funds given for their campaign by Fannie Mae and/or Freddie Mac. Representative 20) Pryce, 20) 6) Bennett, Bennett, 6) Bachus, 11) Shelby, 12) AND

40.1 30.5 ACT 111.0

USD) Funds (thousands

HOUSING

REINVESTMENT Democratic- MA Democratic-NY 38.7 Democratic- MD Democratic-OR 28.7 Democratic- MA Democratic-IL 51.7 Democratic-CT 133.9

3 Carolyn Darlene Christopher AFFORDABLE COMMUNITY

ABLE 17) Maloney, 17) Hooley, 25) 3) Obama, Barack Democratic-IL 105.8 14) Reed, Jack15) Carper, Tom Democratic-RI Democratic-DE16) Frank, Barney 50.7 44.3 18) Bean, Melissa Democratic-IL22) Pelosi, Nancy Democratic-CA 37.2 24) Hoyer, Steny 32.7 Total Democrats 966.7 Total Republicans 419.6 8) Conrad, Kent Democratic-ND13) Emanuel, Rahm 58.9 Representative Party/State 1) Dodd, 1) 2) Kerry, John 4) Clinton, Hillary Democratic-NY 5) Kanjorski, Paul 75.5 Democratic-PA 7) Johnson, Tim 65.5 Democratic-SD 61.0 19) Blunt, Roy Source: Center for responsive politics, 2010a. Center for responsive Source: 4.3 OF One of the pressures on Fannie and Freddie to enter the subprime mortgage market in was the Community Reinvestment Act (CRA). Although it was legislated back in 1977 it was revised several times since, the most important revision arriving 1995 when the government changed the Act so as to “force the banks who issue mortgage loans to prove a more active contribution to lending towards unprivile- ged social groups within their communities such as minorities” (Niskanen, 1995). T Fannie Mae and Freddie Mac political campaign donations from 1989 to 2008 1989 to from donations campaign Mac political Freddie Mae and Fannie

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107 35 (1) 91-128 (2011) ts cial de- ) and they were the only ts. A large amount of institutional investors OLIGOPOLY

AGENCY

cial ratings to various market securities. They were set as NRSROs RATING

THE Nationally Recognized Statistical Rating Organizations The rating agencies were, like Fannie and Freddie, privately owned companies The rating agencies were, like Fannie that enjoyed large government benefi 4.4 such as retirement funds, insurance companies and banks were forbidden to pur- such as retirement funds, insurance companies BBB as determined by the recognized chase securities with a lower rating than hi- rating agencies. The regulator in certain cases allowed only the purchase of ghest AAA rated securities creating thus a favourable market for credit rating agencies. In 1975 a government regulating agency, Securities and Exchange Com- mission (SEC), gave an oligopoly status to three rating agencies in the US. Stan- to dard & Poor’s, Moody’s and Fitch became the only agencies that had the right give out offi ( mand on the housing market, leading to its further distortion. This was visible mand on the housing market, leading in the 90s the effects of which were not through a series of policy Acts instituted received outstanding privileges, benefi visible until 2006. The constructers also continued to when the supply shrunk and and reliefs for building a house (which to rising social injustice and due to their the people stopped buying houses). Due regulation led to even riskier loans policies of resource redistribution, government in an even bigger misallocation of the and poor investment decisions resulting Loan requirements were softened due to very resources they were to reallocate. only of how to win the next election the short run of politicians thinking idea proved to be a political trick and remain in power. The affordable housing with costly unintended consequences. The government, through encouraging homeownership, created an artifi The government, through encouraging The banks, along with the GSEs were following the government’s instructions. the GSEs were following the government’s The banks, along with lending standards thus lowering interest rates or their They weren’t deliberately behind the banks available to riskier borrowers. The reasons making them more homeowners lies who simply could not afford to become giving loans to people in increasing the governed decisions which only resulted primary in politically real estates and MBSs. risk of the banking sector in dealing with Stan Liebowitz from the University of Texas was investigating the policies regar- investigating the policies of Texas was from the University Stan Liebowitz these pointed out that “perhaps 1990 to 2006. He market from ding the housing with housing agency involved every government standards that weaker lending tried to that the presidency tried to advance, that the Congress tried to advance, the penitent banks ini- tried to advance – and with which advance, that the GSEs – might lead to high eventually supported with enthusiasm tially went along and (Woods, 2009). if housing prices should stop rising” defaults, particularly The regulator was even threatening suits against those banks who do not lend who do banks against those law suits even threatening was The regulator amounts. proscribed the legally in to minorities

ict of in- cant regulatory nancial industry as they ict of interest nancial market as the nancial market gure out that a certain The regula- nancial stability. nancial industry needed to comply. They also to comply. They industry needed nancial ts and would cause problems in the long-run. However, nancial institutions that need to serve the capital regulation terest. Companies prefer favourable ratings as this can lower their costs of capital. terest. Companies prefer favourable ratings rating. Since the rating agencies depend They care less about the accuracy of the who wish for the best ratings possible, the on revenue from the securities issuers, may result in sub-optimal ratings. desire of the agencies to please their customers ones good enough to comply with SECs regulatory requirements in order to eva- in order requirements SECs regulatory with to comply good enough ones of a security. the riskiness luate of the fi a large distortion brought about Such a decision impact of the decision had severe consequences on fi consequences on the decision had severe impact of tors restricted the supply of ratings, empowering only the NRSROs to provide only the NRSROs ratings, empowering the supply of tors restricted fi which the rest of the ratings to fi for rating agencies services as the entire increased the demand ratings in order to supervision had to use the NRSROs that was under regulatory also using the same requirements. The government was determine their capital its GSEs, were issued by the government, including ratings, as all the securities would not use the investment grade. Companies that rated with the highest The system became a limited market for their securities. NRSROs ratings faced on the role of the rating agencies. much too dependent signifi faced little market discipline, had no “The rating agencies and enjoyed a burgeo- from competition by regulators oversight, were protected 2010). In a situation with limited compe- ning market for their services” (Levine, to the market the agencies had no incenti- tition due to a restricted access of entry to reveal their credit making pro- ve to use up-to-date methods and no incentive There was no market-correcting mecha- cess creating thus a lack of transparency. agencies operated in a particular business nism to ensure accuracy. In addition, the Before the 1970s the agencies were model where the “issuer pays” for the rating. where if one agency was giving out bad operating in an “ pays” model the rating from one of its competitors. The ratings the customer would simply buy implies the problem of a confl new model of “issuer pays” automatically The rating agencies dismissed the idea that they were in confl The rating agencies dismissed the idea that that if investors fi rely on “reputational capital” meaning rating agency is giving out bad ratings (meaning that they are too high with res- rating agency is giving out bad ratings this agency would soon start losing repu- pect to the risk of an asset or company) in loss of clients as the issuers would tation. The loss of reputation would result now turn to different agencies for rating evaluation not wanting to lose potential investors in their securities because of the link to the bad rating agency. Issuers would reduce their demand for this agency and this would result in the reduction of the agency’s future profi in order for the reputational capital argument to stand, there needs to exist a wide im- variety of competitors to which the issuers can turn to. The NRSRO concept plies that all those fi standards of the SEC have to use the nationally recognized rating agencies. In standards of the SEC have to use the nationally recognized rating agencies.

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109 35 (1) 91-128 (2011) nancial

RULE

ll up their assets with ed for a lower capital RECOURSE

THE

: ce of Thrift Supervision in 2001 as an ed for the same lower capital require- ate ratings. That would free up bank capital for ts, because they did not have any competition to ts, because they did REGULATION

FINANCIAL

t-making investments.” (Bartlett, 2010). The reason why invest- INCREASING requirement. Normally, banks are required to have capital equal to 4 percent of the requirement. Normally, banks are required an implicit government guarantee, such value of mortgages held. But those with required capital equal to 1.6 percent of as securities issued by Fannie Mae, only asset value. Once AA rated, CDOs qualifi on ment that applied to quasi-government securities, putting even more pressure the credit rating agencies to infl additional profi ment and commercial banks engaged in buying MBSs instead of, for example re- Treasury Bills, considered to be the safest possible investment, lies in another gulatory decision – the recourse rule enforced by the Federal Reserve, Federal Deposit Insurance Corporation and the Offi American amendment of the Basel regulations. AAA rated securities. “Securities rated AA or better qualifi AAA rated securities. “Securities rated 4.5 of the link they have with existing Rating agencies errors are important because from banks to fi banking regulation standards that demanded The effect of the condition the rating agencies found themselves in is that, altho- themselves in rating agencies found of the condition the The effect they could use any techniques position, they due to their oligopoly ugh private, fi or an asset, “while their of a company evaluating the riskiness wished for addition to that there is not much competition in the ratings market especially market especially ratings in the competition not much there is to that addition similar incentives. and have methods similar agencies use all three when success did not depend on the outcomes of these techniques to produce a certain techniques to produce outcomes of these not depend on the success did If the rating agen- is willing to buy” (Friedman, 2009). something that someone signals to investors decisions and therefore sending wrong cies are making bad by their NRSRO for their actions as they are protected they can’t be held account sued due to wrong or to that the rating agencies cannot be status. In addition protected by the they only provide opinions and are therefore misjudged ratings as and bad evaluations the US . Their imprecision First Amendment of their profi could not have hurt to Friedman (2009) a poor job. For example, according punish them for doing on the American mort- its main statistical assumptions “Moody’s hasn’t updated the dynamics of an market since 2002. This means that gage-backed securities the mortgage market wasn’t taken into unprecedented growth on the housing and advantage of working in such a distorted account at all”. Rating agencies took full of Enron and Lehman Brothers whose environment. This was obvious in the cases days before . Also academic ratings held high up to only a couple of “lag stock price movements by about 18 research concluded that rating agencies could have been prevented in an open months” (Levine, 2010). Such behaviour imprecision and neglect in estimates competition credit ratings market in which reputation, clients and money. The regu- would have been punished by the loss of private agencies and allowed them to be lator did not allow this as it favoured ineffective and corruptive. uenced the subprime cient investments are being substituted with balances with what later proved to lled the banks’ nancial crisis was caused by regulation, or better yet nancial crisis was caused by regulation, t opportunity. Their investments and incentives were t opportunity. Their investments and for AAA mortgage-based securities. In order to satisfy the cial demand (Friedman and Kraus, 2010). This rule was designed to guide the banks to guide the This rule was designed and Kraus, 2010). (Friedman 9 nancial and housing market. cially created demand for MBSs could prove to be one of the explanations cially created demand for MBSs could prove to Meaning that by investing into MBSs they could use more money for further credit and deposit creation. Meaning that by investing into MBSs they could use more money for further credit and deposit creation. 9 According to this rule American banks were required to spend more capital on more capital to spend required banks were rule American to this According into asset-backed investing for less capital loans and corporate and commercial or were is- were rated AAA long as these securities such as MBSs, as securities, into for every $100 investment this rule implies that GSEs. Basically, sued by the to $5 for the compared in capital was required, securities, $2 mortgage-based commercial same amount in and $10 for the in mortgage loans same amount loans behind lower lending standards that made mortgage loans more available to low- behind lower lending standards that made income borrowers. government policies and government Regarding the fact that bank investments, decisions of market participants, it could sponsored enterprises were guiding the be inferred that the global fi funds into allegedly less risky assets, such as AAA MBSs issued by Fannie or less risky assets, such as AAA MBSs funds into allegedly securities were 93 percent of the banks’ mortgage-backed Freddie. “The fact that is exactly what the rule were issued by a GSE shows that this either AAA rated or 2010). It fi accomplished” (ibid, assets. be toxic and high risk may have been one of bank investments, the recourse rule In addition to steering The more MBSs were housing prices throughout the US. the causes of increasing capital standards, the by the banks that were following the bought and packaged demand. This crea- to be written so as to cope with the rising more mortgages had ted an artifi to underwrite asset-backed securities, of demand there was an increasing need as housing prices always increase. The which the safest were mortgage-backed, artifi market. It would be wrong to accuse the by failed government intervention on the too greedy in this case. They were simply banks of taking too much risk or being exploiting the given profi to investors that led to the distortion of mortgage market, sending wrong signals the fi It is not realistic that a central regulator can make better decisions on which types left of assets to invest in than a private investor. Every market participant is best alone in assessing its investment decisions as well as the riskiness of an invest- ment. When investment decisions are proscribed by law this brings about a distor- tion of the market, as potentially effi those determined by the legislator. This means that successful projects are being de- left out for the purpose of achieving politically determined goals. Regulatory guided into wrong assets by the policies set by regulators in order to avoid risk guided into wrong assets by the policies the behaviour of market participants in a taking. The regulators tried to change they negatively infl way that seemed optimal. By doing so

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111 35 (1) 91-128 (2011)

1/10

cial 8/09

3/09

10/08

5/08 12/07

cially created de- cially created

7/07

2/07 9/06

cial demand for mortgage- for cial demand

4/06 11/05

RESERVE

6/05 1/05

and then Iraq, and a se- rst Afghanistan

8/04

es as an open market operation maintained 3/04

FEDERAL

10/03 THE 5/03

ated housing bubble. Every artifi bubble. Every ated housing

OF 12/02

7/02

2/02 9/01

POLICY

4/01

11/00

7 6/00 1/00 MONETARY IGURE

6 5 4 3 2 1 0 7 The Fed key interest rate: FOMC overnight federal funds rate (%) The Fed key interest rate: FOMC overnight The overnight federal funds rate classifi by central banks as one of the key instruments of monetary policy. Open market as operations became the main instrument of developed nations’ central banks thethrough the movement of key interest rates one can draw conclusions on what is reaction or direction of a central banks’ monetary policy. As a response to the 2001 Source: Federal Reserve Board, 2010. Federal Reserve Board, Source: price growth and to privileging certain interest groups, assets or investments. assets or investments. certain interest groups, and to privileging price growth F 5 Board was leading the decade the American Federal Reserve At the beginning of the shocks that had hit monetary policy in order to alleviate a highly expansionary the dot-com boom, the the beginning of the decade (such as the US economy at by an invasion of fi 9/11 attacks followed policy is its reference interest rate. The key indicator of a central banks’ monetary rate determined by the Federal Open In the US this refers to the federal funds the overnight rate by which the banks Market Committee (FOMC). It presents lend funds to one another. mand which is based on political rather than market decisions leads to artifi decisions leads rather than market is based on political mand which the and throughout 2002). By increasing ries of corporate scandals the Fed prevented the interest rate to historically low levels lowering its reference the easy money the economy at the time. However, possible recession threatening for further effect as it created a favourable environment policy had a contrary mortgage expansion. cisions adopted preceding the crisis created an artifi created the crisis preceding adopted cisions based securities which further led to an increase of the demand for mortgage loans, mortgage demand for of the an increase led to which further securities based on the loans. the risk of default and an increase of of lending standards loosening was an infl The consequence a- (1) ation is justi- ation of 2003) rst half t

. t ation rate in a given period of ation rate in a given period of between the real and ation (difference = 2 * t r ation and output gaps. Both of the parameters = 1; parameters which describe how the interest rate = 1; parameters which describe how the =, a+b

 of time, ation in a given period 0,1 

parameters for infl b ∈ from their target and potential levels. ation and output deviations ation. ation rate) and output (difference of current output from the potential output (difference of current output ation rate) and and was a monetary policy such an expansionary 7). The reason behind gure , a, b ); difference between real and target infl ation and output. The same weight given to output and infl ation t a ∗ 0 ; output gap, difference between real and potential output in a given period ; output gap, difference between real and π in such as Japan a depression decade of experiencing ation and the possibility – ation is above its target level (π – π*) > 0 or when real output is higher than ation is above its target level (π – π*) > 0 or when real output is t ; long-run key interest rate, estimate ; real rate of infl t * ; recommended key interest rate for a given period in time, ; recommended key interest rate for a given t t ed by the fact that a stable and economic growth represented two ed by the fact that a stable price level recession, the rate decreased from 6.5% at the end of 2000 to 1.75% in December in December to 1.75% end of 2000 6.5% at the from decreased the rate recession, almost for it remained 2003 where 1% in June record low to a and eventually 2001 a year (fi at 6% in the fi (peaking with rising unemployment slow recovery with fears of 2%) combined (an average of less than GDP growth rate and a slow defl (Bernanke, 2010). the 1990s concerning the Fed’s on the current crisis has been One of the crucial questions One way of exa- whether it had an effect on housing prices. monetary policy and Taylor rule. This po- monetary policy effects is by using the mining the scope of of the University of rule was created by John Taylor (1993) pular policy guidance relating the overnight rule examines monetary policy by Stanford. The Taylor rate to tradeoffs in infl federal funds interest target infl output): Where: i π federal funds rate should be 2 plus the tion are equal to their potential rates, the level of infl va- An important thing to determine while calculating the Taylor rule rate are the lues of to should be positive and have a value of 0.5 giving therefore the same weight both infl fi main goals of central banks, an assumption that will be questioned later on. The Taylor rule anticipates a high interest rate (and therefore a restrictive monetary time of time a, b > reacts on infl funds interest rates should be higher when According to the Taylor rule the federal infl a long-term value of the federal potential output (y – y*) > 0. Taylor estimated shows that when output and infl funds rate to be around 2%. His rule basically (π r

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113 35 (1) 91-128 (2011) (2) (Taylor, 10 rst quarters of ation are the main ation cially measures the

) t y : the In pressures. ationary – t ) + 0.5(y * t π in an point should result ation by 1 basis + t π + 0.5( t π ation are at their expected levels. The voters often see the US, used in the calculation, revolved ation rate for ce (CBO, the institution that offi ce (CBO, the institution interest rate did not fall below 3% in gure 8). The Taylor = 2 + t i ation is above its target rate or when output is above its full is above output rate or when its target is above ation mone- rst quarter of 2006 the Fed was conducting a restrictive ation and output gaps are given in table A in the appendix. By ation and output gaps are given John Taylor explains his rule in the following way: if inflation rises by 1% the proper answer would be a Taylor John 10 policy) when the infl when the policy) employment level. This would result in a decrease of infl in a decrease result This would level. employment opposite scenario it anticipates a low interest rate so as to stimulate output. Accor- so as to stimulate output. a low interest rate it anticipates opposite scenario of infl Taylor rule an increase ding to the than one basis point rate by more the nominal interest increase of raise of the interest rate by 1.5%. This increase doesn’t always have to be 1.5% but it is crucial that it were This increase doesn’t raise of the interest rate by 1.5%. answer would drop by 1% with respect to its potential growth level, then the right above 1%. If the GDP would be to lower the interest rate by 0.5%. For more see [http://www.econtalk.org/archives/2008/08/john_ taylor_on.html]. The long-run Fed target infl The long-run Fed target 1993). were taken from the used for calculating the potential output around 2%. The data Offi Congressional Budget is that output and infl The main assumption of the Taylor rule potential output for the US). By inserting the mentioned variables in the Taylor the US). By inserting the mentioned potential output for is obtained: model the next equation The data for infl the quarter rates for the values of the variables in equation (2) putting in the given obtained. Between the fi suggested Taylor rule interest rate were 2002 up until the fi low in comparison with the real economic tary policy and the interest rate was too conditions at the time (fi was locked down at 1%. The Taylor rate the period when the federal funds rate an increase of the federal funds rate. even rose to 4 and more percent suggesting economic activity at the time, to The market was sending signals of an increasing its interest rate. According to this which the Fed should have replied by increasing signals and continued with an expansio- analysis the Fed disregarded the market boost to the growth of the housing nary monetary policy giving an additional bubble. Fed’s main policy goals are stable prices, policy goals of the Fed. However, the interest rates, which should even- maximum employment and moderate long-run levels. Up until the 1990s the levels of tually lead to a stable output and growth with output growth, but in the recent high employment were highly correlated lag behind economic recovery, hence the recession employment levels started to Fed goals are now slightly detached term “jobless growth”. The once interrelated if employment is not at its maximum as the Fed experiences political pressures level, even if output and infl unemployment as the best yardstick to conclude whether the current government unemployment as the best yardstick to conclude whether the current government is doing a good job or not. This creates additional political pressure on the ruling party in Congress as they need to satisfy voters before the election making them

Q3/09

Q1/09

Q3/08

Q1/08

Q3/07

Q1/07 gure 6 in chapter 3.2) Q3/06

Federal funds rate

Q1/06 Q3/05

ation were at stable levels and that Q1/05

ed. However, it remains a fact that low

Q3/04

Q1/04

Q3/03

able at the time. Nonetheless the rates were low

Q1/03

ability of using the Taylor rule in assessing monetary Q3/02

Taylor rule interest rate Taylor Q1/02

Q3/01 Q1/01

uence the justifi Q3/00

8 Q1/00 gure 6). From this it can be inferred that the Fed did not have a crucial role in IGURE 7 6 5 4 3 2 1 0 8 -1 -2 there was no need for low interest rates (at least not for so long). From this pers- pective the low rates might have been justifi low rates contributed to the expansion of the housing bubble. Therefore, although rates had an effect on rising housing prices (as was seen in fi they cannot be construed as the only cause of the bubble bursting (as is also shown on fi the crisis as its rates were justifi enough to create a favourable environment for the bubble growth, but had little to enough to create a favourable environment for the bubble growth, but had little policy, as the employment level and the deviation from its potential level rather policy, as the employment level and the while determining whether the Fed was than output have to be taken into account If the Fed was following the full employ- making the right policy decisions or not. its policy rates from the market determi- ment level goal which caused it to alter was due to political pressure. Due to the ned ones, one could presume that this the reason behind low policy rates jobless recovery in the post-2001 recession was not following the output growth. could have been the fact that employment infl The Taylor rule suggested that output and Source: Federal Reserve Board, 2010 (appendix table A). 2010 (appendix table Federal Reserve Board, Source: This may infl believe that they indeed can handle the economy. The Fed doesn’t answer to the answer Fed doesn’t The the economy. can handle indeed that they believe a stable maintains it or whether policy the monetary it is governing on how public create poli- Thus Congress can to the Congress. but it does level of employment, focus on one independence, to the Fed’s huge on the Fed, despite tical pressure goal in particular. F Comparison of the federal funds rate determined by FOMC and the suggested funds rate determined by FOMC Comparison of the federal by the Taylor rule (%) interest rate as determined

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115 35 (1) 91-128 (2011) gu- nancial ts of around nancial sector nancial ts in relation to GDP (fi nancial sector as part of the nancial sector is known as a nancial transactions reaching of the fi tability SECTOR World GDP nancial industry (the

nancial sector gave the bankers great was even more nancial sector growth FINANCIAL tability at the time was fuelled by the fi

THE

– a rise of the share of the fi OF nancial sector had a share in total US profi

nance industry and its lobbyist and political power in the nance industry and its lobbyist and the crisis was that preceded and bursting. The process ation POWER

and other securities. This nancial transactions concerning derivatives fi nancialization fi POLITICAL nancial sector there was a growing gap between the real economy and the total nancial sector there was a growing gap between the real economy process of sector growth. A trend in which there is a decrease of investment into the real sector growth. A trend in which there into the fi sector as against an increase of investments re 9). In the years preceding the crisis the fi re 9). In the years preceding the crisis the credit available in the system it is possible impulsive and due to rising amount of that the real sector growth in profi The enormous wealth accumulated by the fi The enormous wealth 6 into riskier bigger investments was set for even oversights a scene With regulatory bubble infl deals, asset fi the expansion of the 80s and the 90s. time (1907) a banking biggest since J.P. Morgan. During his political power – the all the bankers in the stopped only by a coordination of panic could have been strong enough to pro- there wasn’t any government body private sector, because been suspended by The age of banking oligarchs has vide an effective solution. the Great De- various new regulatory measures following the establishment of between the 1980s as the Glass-Steagall Act). In the period pression of 1933 (such toward profi and 2002 there was an increasing trend do with its rapid bursting and the fact that the demand on the housing market rose market on the housing demand that the and the fact bursting its rapid do with policy decision- areas of lies in other demand increasing cause of The so rapidly. paper. presented in this as the ones already making, such whilst the real sector experienced a decrease of its profi whilst the real sector experienced a decrease gap developed to a ratio of 1:4 in favour of the fi gap developed to a ratio of 1:4 in favour GDP. In the 1970s the fi 21 and 30% whilst just before the Great 17%, in the 1990s this grew to in-between to this increase of the scope of the Recession it reached a level of 41%. Parallel fi value of all fi value of all fi being around 50 trillion dollars and the around 200 trillion dollars) (IMF, 2009). rm, and vice ts as share of GDP rm Cerberus Capital rm Cerberus Capital Real sector profi between Wall Street and ow of individuals POWER

ts as share of GDP ts as share of GDP POLITICAL

nd jobs in public services after they leave the fi AND

Financial sector profi more support and trust at the national nancial industry gained more and 9 LOBBYING 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 02 04 06 08 80 82 84 86 88 90 92 94 96 70 72 74 76 78

IGURE 1 0 5 3 2 4 6.1 The US fi sector industries had had before. “Once level, which matched the support the real good for the country. Over the past deca- what was good for General Motors was good for Wall Street was good for the de, the attitude took hold that what was had gained political power due to their country” (Johnson, 2009). The bankers into much more than mere interest groups rising economic power and developed those of the government. as their interests became identical with Simon Johnson draws attention to the fl Washington that only emphasises the linkage between newly empowered bankers Washington that only emphasises the linkage co-chairman of Goldman Sachs was the and the government. , the and after his political career en- Treasury Secretary in the Clinton administration CEO of Goldman Sachs, was appointed ded up in Citigroup. Henry Paulson, the Paulson’s predecessor John the Treasury Secretary in the Bush administration. large private fi Snow later became the chairman of a Management, while Alan Greenspan, a long-time Chairman of the Fed became a Management, while Alan Greenspan, a international bond market companies. consultant in Pimco, one of the strongest Such connections are even bigger at lower bureaucratic levels in the last three presidential administrations which have further increased the strong bonds al- between Washington and Wall Street. For Goldman Sachs employees it was most a tradition to fi versa – after a career in the public sector they were always welcome back to their versa – after a career in the public sector they were always welcome back to their position on Wall Street (Johnson, 2009). F US private sector profi ts as share od GDP (%), annual od GDP (%), as share ts profi sector US private Source: Government Printing Office, 2010. Government Source:

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117 35 (1) 91-128 (2011)

AIG ve banks by the size of ve rst fi =0.7132 2 R Citigroup JP Morgan JP more evi- becomes institutions nancial it still doesn’t justify nancial system, but ve banks with the most lobbying expenditures, Goldman Sachs Lobbying expenditures 2008, million USD Bank of America Bank of Morgan Stanley of bailout funds the amount is a correlation between gure 10 there Wells Fargo Wells Lehman Bros. 0 2 4 6 8 10 12 10 8 2 4 6 0 10

9 8 7 6 5 4 3 2 1 0 ts for further business activities (such as acquisitions of Bear Sterns and ts for further business activities (such as acquisitions of Bear Sterns -1 Share of received bailout funds in total assets total in funds bailout received of Share IGURE hroughout the decade. Perhaps allowing AIG to declare bankruptcy would have Perhaps allowing AIG to declare bankruptcy hroughout the decade. Bailout funds and lobbying expenditures in 2008 Bailout funds and lobbying Washington Mutual by JP Morgan Chase or Merrill Lynch by Bank of America). Washington Mutual by JP Morgan Chase or Merrill Lynch by Bank of America). Their lobbying activities did not allow the Lehman Brothers scenario. Although they were also companies full of “toxic” assets they ended up acquiring new banks and expanding their business activity. The fi Banks such as Citigroup, JP Morgan Chase or Bank of America spent a lot of Banks such as Citigroup, JP Morgan avoid bankruptcy and acquire additional money on lobbying activities so as to benefi Source: Author’s own calculations (data – see table 4). Author’s Source: assets are at the same time the fi the taking into account the last 10 years as well as 2008 (table 4). In both cases only one that stands out is AIG which has in the last 10 years, as well as in 2008, The system of power accumulated by the fi power accumulated of The system dent when looking at bailout funds and by what principles were they redistributed. they redistributed. were principles and by what funds at bailout looking dent when to fi According and the company’s lobbying expenditures and campaign donations. For example, donations. expenditures and campaign lobbying and the company’s size of as- according to the to be redistributed bailout was supposed although the in the size not the biggest clear that AIG, although company it is sets of a certain for that the bailout. The reason most money from got arguably the of its assets in 2008 as well as AIG had the most lobbying expenditures could be the fact that t F the disproportion in the bailout funds received by AIG and all other banks, where the bailout funds received by AIG and the disproportion in No other bank re- approximately 8% of AIG asset values. the bailout funds were 4). of more than 2.5% of its total assets (table ceived bailout funds proven to be highly destabilizing for the fi proven to be highly nancial nancial USD) (million Lobbying 1998-2008 expenditures USD) 2007-08 (million donations Campaign nancial institutions that nancial institutions c 4.10 2.662.27 26.7 1.10 15.5 9.575.52 0.33 0.95 90.9 84.5 5.46 0.802.50 52.8 0.80 25.9 3.39 0.94 19.8 0.55 0.62 1.9 USD) (million expendi- Lobbying tures 2008 h - 0.60 0.55 8.6 . (%) 1.82 assets 11 of total as share Bailouts b g 987 1.01 268 1.12 691 Total assets USD) (billion 1,817 2.48 1,0222,050 8.32 2.20 2,251 1.11 1,371 1,082 0.92 a 45 85 45 funds USD) bailout (billion Received

f e 4 d Source: U. S. Department of the Treasury, 2008. U. S. Department of the Treasury, Source: 2010. Federal Reserve Board, Source: politics, 2010b. Center for responsive Source: Troubled Asset Relief Program (TARP) in 2008. JP Morgan, Wells Fargo, Morgan Stanley, Stanley, Morgan Fargo, Wells Morgan, in 2008. JP (TARP) Asset Relief Program Troubled AIG, Citi and the TARP. through funds only received Goldman Sachs and Bank of New York America had additional sources. Bank of Failing Institution Program. This was expanded by the $43.5 billion AIG got from the Federal AIG got from This was expanded by the $43.5 billion Failing Institution Program. from allowed to take up to $60 billion, reduced which they are Facility (from Reserve Credit which they are line (from credit the Treasury the initially $85 billion) and a $1.5 billion from Source for lobbying expenditures and campaign donations (final three columns). and campaign donations (final three for lobbying expenditures Source ABLE Perhaps the fact that Lehman Brothers borrowed significant amounts to fund its investing into MBSs in the Perhaps the fact that Lehman Brothers borrowed significant amounts to fund its investing into MBSs in Financial institution JP Morgan Chase 25 Morgan Stanley 10 AIG Citigroup Bank of America Wells Fargo 25 Goldman Sachs 10 Bank of New York 3 Lehman Brothers - 11 a – Bailout funds are taken as the amount of preferred stock purchases received through the the through received stock purchases as the amount of preferred taken funds are Bailout – a given. as total assets in 2008, i.e. at the time the bailouts were Measured b – c – Significant the Systematically through was initially given $40 billion by the Treasury AIG – d spent the most money on lobbying. The lobbying policies of AIG correspond with correspond of AIG policies The lobbying lobbying. money on the most spent fi other than any more funds two times given AIG was funds. its bailout not invest was left to fail did the only big bank that Lehman Brothers, company. other fi campaigns as lobbying and political as much into found themselves in similar problems found themselves T expenditures of assets and lobbying and political campaign Bailout funds, total bailout funds the recipients of the years preceding the crisis raising its leverage ratio to 30:1 (SEC, Lehman Annual Report, 2007) made it too years preceding the crisis raising its leverage ratio to 30:1 (SEC, Lehman out. vulnerable to the housing market downturn thus making it impossible for the government to bail them also found themselves in problems having their assets filled with MBSs, but were other big banks However, exposure to bankruptcy risk is needed so as to broader analysis of each company’s A bailed out nonetheless. in February 2009, almost 6 months after the conducted a stress test Treasury The make a stronger conclusion. Lehman bankruptcy to determine how much more money was needed to salvage the biggest bank holding furt- companies. Maybe this test came too late for Lehman, but it would be interesting to view the results of her bailout funds and compare them to lobbying expenditures in the coming years.

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119 35 (1) 91-128 (2011)

st nan- ) based on nancial institutions met , 2008) had assets worth $662 , 2008) had assets worth st uence. Before the purchase ow of funds is most likely an nancial industry basically gives it a Troubled Asset Relief Program Troubled . In 2009 they spent 2.9 million dollars, . In 2009 they spent 2.9 million dollars, nancial reform that doesn’t match its se- 12 2008, the further outfl st nancial industry has shown substantial lobbyist power in the redi- scal stimulus as well as a fi Source: Federal Reserve Board, 2010. Federal Reserve Board, Source: billion. account. was taken into of Wachovia the purchase before allowed to take $30 billion). AIG received a further $49.5 billion later in 2009 through Federal 2009 through later in $49.5 billion a further AIG received billion). to take $30 allowed bailout funds as only the account taken into but these weren’t Purchases, Securities Reserve as bank assets. as well considered, in 2008 were expenditures lobbying from resulting Citigroup received $25 billion through the TARP (more precisely through the Capital Purchase the Capital Purchase through precisely (more the TARP $25 billion through received Citigroup 31 billion on December an additional $20 2008. It received CIP) in September Program, 2008 as a part of the Targeted Investment Program (TIP). Both programs were governed by governed by were Both programs (TIP). Investment Program of the Targeted 2008 as a part Department. the US Treasury Bank of America received initially $15 billion through the TARP (i.e. through the CIP) in the CIP) in (i.e. through the TARP $15 billion through initially America received Bank of $20 billi- the CEP) and by an additional $10 billion (again through September 2008 followed in January 2009. TIP the on through Among which the recipients were mostly the in-office Democrats holding key positions in the Congress. One the recipients were mostly the in-office Among which h – The share of bailouts in total assets would be 3.78%, if the original asset size of Wells Fargo Fargo be 3.78%, if the original asset size of Wells of bailouts in total assets would share The h – e – f – 31 (December of Wachovia the purchase before Fargo Wells – g 12 Wells Fargo is another example of buying political infl Wells Fargo is another of Wachovia Bank, the size of the Wells Fargo assets was approximately the same the size of the Wells Fargo assets was approximately of Wachovia Bank, given more than or the Nonetheless, Wells Fargo was as that of Lehman Brothers. Wells Fargo’s money as much larger banks. However same amount of bailout during the crisis left them in an even clever investments in political campaigns bank spent over a million dollars to fi better position than before. In 2008 this ce Congressmen’s political campaigns example is the House Speaker Nancy Pelosi, a second in line of presidential succession, following Vice-presi- example is the House Speaker Nancy Pelosi, a second in line of presidential succession, following member of a series Another example is Democratic House Representative Carolyn Maloney, dent Joe Biden. of of Committees on Financial Services and Oversight and Government Reform as well as the Chairwomen the Joint Economic Committee of the US Congress (U. S. House of Representatives, 2010). The American fi is threatening to repel or distort any reco- stribution of TARP funds and for now it very act or fi the size and value of a bank’s assets (the bigger the assets the bigger the bailout the size and value of a bank’s assets (the in comparison to zero dollars for Leh- funds), 25 billion dollars for Wells Fargo that non-economic and/or political criteria man Brothers increases the possibility bailout funds. A further examination of were determining the allocation of the as well as the relative size of MBSs in bankruptcy risk of both of these companies conclusion as to how the bailout total assets is needed so as to reach a complete funds were allocated. act of appreciation to the politicians that made this deal possible (Center for Re- act of appreciation to the politicians that mentioned fact that the bailout sponsive Politics, 2010). Due to the previously ( funds were to be assigned by the TARP lective criteria. The increased power of the fi lost right of veto on public decision making, even in the times when they have public support. Simon Johnson emphasizes that in March 2009 a group of CEOs from the nation’s thirteen most prominent banking and fi while in 2010 the amount was 2.3 million dollars. As the purchase of Wachovia while in 2010 the amount was 2.3 million was closed on December 31 -

ts of bailouts and dence. The bailouts scal costs) of a large BAILOUTS

dence towards the banks ON

(Lehman was rather nancial institutions INFLUENCE

Washington, but their ultimate victory uence in could still roll out their nancial crisis, the banks nancial crises. They estimate them to be only a POLITICAL

OF

with more con- scal stimulus have indeed provided the system did not receive any bailout funds at all. The stimulus package rms that IMPLICATION

them so as to make the system far scal costs. Banks can very likely misuse THE of the fi cials... In the aftermath

short-run stabilization and liquidity. In a dence and were crucial in restoring the 6.2 hoping that this would bring about Many voted in favour of the stimulus however, its much needed confi to a more stable system returning to it combined with a fi fi of public confi system of rising systemic risk and lack bigger loss of jobs and production, fi triggering a possible bank run and an even with President Obama in hopes to get the government on their side and insure side and on their government get the hopes to Obama in President with (John- themselves for guarantees government money and more of taxpayers’ even more poli- accumulated even as though the banks 2010). It seems son and Kwak, a built-in was generated from the crisis, and power since the onset of tical power of large fi further belief that cause irre- JP Morgan) would Citigroup or to Bank of America, small compared are likely to concept). The banks “too big to fail” (bringing in the parable damage with even more taxpayer money and favourable use this fear to grasp bailout funds as soon Bank of America received new Washington. For example, As soon as they would not be able to purchase Merrill Lynch. as it declared that it possible. “Campaign (through TIP) the acquisition was were granted the funds sector and government revolving door between the private contributions and the banks infl service gave Wall Street the point where their wisdom in their favour, to lay in shifting the conventional and administration seemed self-evident to congressmen lobbyists’ talking points offi be more than welcome. Deutsche Bank scal stimuli and bailouts could prove to (in terms of direct fi Research has pointed out that the costs conventional weaponry – campaign money and lobbyists; but because of their – campaign money and lobbyists; conventional weaponry were won in advance” (Johnson and ideological power many of their battles Kwak, 2010). to be much smaller than anticipated and government intervention may turn out much smaller than in previous fi 2% even in countries most hit by the small fraction of the GDP unlikely to exceed pointed out the benefi crisis (DB, 2010). Many others have also have been much more severe and that stimuli in a sense that the recession would higher levels. The system, if it were left unemployment would have reached even into a long lasting recession. The com- to self-correct would lead the entire world parison was somewhat reminiscent of the Great Depression of the 1930s. its The threat of a further stimulus to the banks which they would use to distort effects still stands. Bailouts can prove to have huge indirect costs that transcend mere fi to more dependent on them than it already is. Also, little attention has been given all those fi a is given either to large, over-sized, too-big-to-fail private enterprises, while

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121 35 (1) 91-128 (2011) nd ts ei- ned by nancial as defi nancing. creative destruction creative in which the decisions nancial crisis nancial industry. It is more likely that nancial industry. It institutions and the government. nancial nancial giants do not leave a black hole in the credit nancial giants do not leave a black hole nancing) is the shattering of the competition. If one is the shattering of the competition. If nancing) some of the biggest fi nancial markets. Although they test of whether have no market-driven entities that t organizations: nor does it justify the increasing spread of government nancial institutions this paper has presen- nance industry on the government. In the light of what CONCLUSION The bailouts, despite their short-run stabilization effect, complete the picture of a The bailouts, despite their short-run stabilization fi growing partnership between the largest Schumpeter (1975). Shattering this process with favouritism of certain companies Schumpeter (1975). Shattering this process is not likely to be a way out of a recession. institutions from failure as the stability of The government stands to protect the thus increasing moral hazard and encou- the system is far too dependent on them, by the government will certainly not raging lack of responsibility. Such actions fi decrease the accumulated power of the for further instability and dependence of they will enhance it, creating conditions the fi fi ted so far, this can only result in yet another policies and credible promises of of the banks will again be steered by regulatory hazard problem and creating a new asset future bailouts thus furthering the moral instability. bubble and a new dose of uncertainty and institutions were close to bankruptcy, overall the data at the time were not sugge- stive of a worldwide crisis, rather of a process of creative destruction – the driving force of capitalism. These fi market; rather they are being quickly replaced by other, smaller and healthier companies who offer a more conservative form of fi 7 va- The very existence of a recession does not justify the enormous subsidies to rious fi intervention all over the fi spending increase to fund social security or infrastructural programs benefi programs infrastructural or social security to fund increase spending as the drivers of sized businesses have often been recognized Small and medium small businesses that the data indicate that there are a lot of growth. Even when a yearly basis as well. more businesses survive and grow on fail every year, even projects until they fi to invest into various business Entrepreneurs will continue company gets money from the government while its competition doesn’t, it has from the government while its competition company gets money the others. clear advantage over are creating or destroying value via the rationalization of invested capital” (Grant, of invested capital” via the rationalization or destroying value are creating resour- are left without stimulus businesses small and medium-sized 2009). The of certain pri- bailout or any kind of government favouritism ces. The result of a high lobbying activity is always a result of that company’s vate companies (that fi and/or political campaign ther the public sector or the large companies who lobby their way into getting the into getting their way who lobby the large companies sector or public ther the plan “a large a stimulus project. Through certain government-funded job for a and local governments will go to state governments, the allocated funds portion of non-profi process of constant dynamics of entrepre- a project that will result in success. This possible solution for them as well as for neurship that eventually yields the best of the entire economy is known as the process This crea- cials. nancial crisis. The government was government The nancial crisis. of the hand created the dependency on the other nancial industry nance generated the current fi current the nance generated The political power of government institutions and its connection with the corpo- with the connection and its institutions of government power The political of fi rate world behaviour of it guided the impulses through which a series of involved through The fi businesses. government offi cohesion with them resulting in rising system on in a rising protection resulting acquired political in which the banks ted a system regulators thus increasing. The systemic risk was problem where moral hazard thus contributing to to invest into non-standard home loans encouraged the banks policy further bubble. Through an expansive monetary the growth of the housing market contributing and liquidity was drawn into the asset impulses were created Freddie Mac the re- bubbles. Through Fannie Mae and to housing and securities contributing to the the HUD’s housing objectives thus gulators were reaching balances because selection. The increase of MBSs in banks’ creation of adverse effect of mispla- standards had been reached was yet another the required capital will be paid for by the Finally, the government failures ced regulatory decisions. to learn an important or better yet the voters were able taxpayers. If the taxpayers further misconduct of present a substantial limitation to lesson from this it would political institutions. capitalism because the success of capitali- This crisis does not present a failure of It is based on free markets. Economic sm is not based on unregulated markets. correlated with market freedoms. The growth and wealth accumulation are highly of capitalism or free markets but the fai- crisis therefore doesn’t present a failure yet markets regulated by narrow interest lure of overregulated markets, or better power. groups with a substantial level of political outcome of the crisis is the possibility that The biggest risk that could occur as an public in general start to believe that the even more politicians, economists and the the crisis, diverting thus the public opinion free market is to be blamed for causing result in not only a decrease of economic against the . This would an endangerment of the fundamental prin- freedom and economic growth but also individual freedom. ciple on which a society can succeed –

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123 35 (1) 91-128 (2011) f rate FOMC e ) t (i rate Taylor d gap Output b Par ) t ∗

c π a- – t tion gap Infl (π a Par b ) t a- π ( tion infl Rate of

a ) * t r ( rate Long- run int.

A PPENDIX ABLE 2005/4 2 3.4 0.5 -1.4 0.5 1.4 5.37 4.16 2005/3 2 4.7 0.5 -2.7 0.5 1.2 5.95 3.62 2005/2 2 2.5 0.5 -0.5 0.5 0.6 4.55 3.00 2005/1 2 3.1 0.5 -1.1 0.5 0.6 4.85 2.63 2004/4 2 3.3 0.5 -1.3 0.5 0.0 4.65 2.16 2004/3 2 2.5 0.5 -0.5 0.5 -0.4 4.07 1.61 2004/2 2 3.3 0.5 -1.3 0.5 -0.7 4.31 1.00 2004/1 2 1.7 0.5 0.3 0.5 -0.7 3.52 1.00 2003/4 2 1.9 0.5 0.1 0.5 -0.8 3.55 1.00 2003/3 2 2.3 0.5 -0.3 0.5 -1.0 3.65 1.01 2003/2 2 2.1 0.5 -0.1 0.5 -2.0 3.05 1.22 2003/1 2 3.0 0.5 -1.0 0.5 -2.2 3.40 1.25 2002/4 2 2.4 0.5 -0.4 0.5 -1.8 3.30 1.24 2002/3 2 1.5 0.5 0.5 0.5 -1.1 3.20 1.75 2002/2 2 1.1 0.5 0.9 0.5 -1.0 3.07 1.75 2002/1 2 1.5 0.5 0.5 0.5 -0.6 3.45 1.82 2001/4 2 1.6 0.5 0.4 0.5 -0.7 3.45 1.82 2001/3 2 2.6 0.5 -0.6 0.5 0.0 4.31 3.07 2001/2 2 3.2 0.5 -1.2 0.5 1.5 5.35 3.97 2001/1 2 2.9 0.5 -0.9 0.5 1.6 5.25 5.31 2000/4 2 3.4 0.5 -1.4 0.5 3.0 6.20 6.40 2000/3 2 3.5 0.5 -1.5 0.5 3.2 6.35 6.52 2000/2 2 3.7 0.5 -1.7 0.5 4.0 6.85 6.53 2000/1 2 3.8 0.5 -1.8 0.5 2.9 6.35 5.85 Year/ quarter Data used to obtain the Taylor interest rate compared with the federal funds rate with the federal interest rate compared to obtain the Taylor Data used T A f rate FOMC FOMC e ) t (i rate Taylor Taylor d gap Output Output b Par ) t ∗

c π a- – t tion gap Infl (π . Real output data available at Economic Report of the of the . Real output data available at Economic Report a Par b ) t a- π ( tion infl Rate of Rate

a ) * t r ( rate Long- run int. run int. Output gap as determined by the difference between real and potential output. According to Taylor to Taylor According and potential output. between real Output gap as determined by the difference (1993) this is calculated as: Inflation gap determined by the difference between real inflation and its target level of 2% as inflation and its target between real Inflation gap determined by the difference set by the Federal Reserve Board. Official federal funds rate as determined by the FOMC (Federal Reserve Board, 2010). Official federal funds rate as determined by the FOMC (Federal Reserve Board, Year/ quarter 2006/12006/2 22006/3 2 3.42006/4 2 4.32007/1 0.5 2 2.12007/2 0.5 2 -1.4 2.52007/3 0.5 0.5 2 -2.3 2.82007/4 0.5 0.5 2 -0.1 2.2 2.72008/1 0.5 0.5 2 -0.5 2.2 5.80 2.82008/2 0.5 0.5 2 -0.8 1.9 6.25 4.59 4.12008/3 0.5 0.5 2 -0.7 1.8 4.99 4.99 4.02008/4 0.5 0.5 2 -0.8 1.9 5.17 5.25 5.02009/1 0.5 0.5 2 -2.1 2.1 5.33 5.25 4.92009/2 0.5 0.5 2 -2.0 2.2 5.42 5.25 1.12009/3 0.5 0.5 2 -3.0 2.6 -0.4 5.51 5.25 2009/4 0.5 0.5 2 -2.9 2.0 -1.4 6.30 4.94 0.5 0.5 2 2.2 0.9 -1.3 6.00 4.24 0.5 -0.2 2.4 0.5 6.60 2.61 2.0 0.5 0.5 3.4 -2.0 5.30 2.00 0.5 -4.0 0.5 3.3 1.81 2.50 -6.4 0.5 0.80 0.16 0 -6.9 -0.90 0.16 0.5 -1.10 0.25 -6.0 0.15 1.00 0.12 President: 2010 [online] www.gpoaccess.gov/eop/tables10.html. Potential output data available: Potential output data available: 2010 [online] www.gpoaccess.gov/eop/tables10.html. President: Budget output data available at Congressional Government Printing Office, 2010; and potential Office, 2001. e – Suggested Taylor rule interest rate; rule interest e – Suggested Taylor f – . a – Long-run interest rate estimated by John Taylor to be 2% (Taylor, 1993). 2% (Taylor, to be John Taylor rate estimated by a – Long-run interest 2010). Board, as the headline CPI inflation (Federal Reserve Measured b – c – d –

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