A catalogue of errors

Economic slowdowns are time to play the blame game, and there's plenty of culpable parties this time around

The credit crunch has exposed flaws in the financial system that four years ago seemed improbable. Blame has been more than forthcoming with Alan Greenspan, regulatory bodies, mortgage lenders, banks, ratings agencies and the market itself all coming in for criticism. But what is to blame for the credit crunch, a financial crisis that Alan Greenspan himself says is the most wrenching since the end of WW2?

According to George Soros, a man well qualified in financial crises, there has been nothing to match the events of the past nine months since the Great Depression. The situation is that household savings rates have fallen to zero in the US, and up to two million Americans are set to lose their homes. The outlook is little better in the UK with personal debts at higher ratios than the US. Banks have little idea of the extent of their problems, and perhaps most tellingly, JP Morgan recently had to purchase its suffering rival Bear Stearns. Amongst a catalogue of errors, one event was at root-the raising of interest rates by the Fed in June 30th 2004.

The raising of interest rates by the Fed in 2004 was the spark that led to the housing bubble that sustained the US economy. Alan Greenspan certainly did not help matters by adding fuel to the housing boom by suggesting that “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed rate mortgage”. With this encouragement, banks began to offer huge mortgage balances, with low monthly payments, and house prices skyrocketed as a result.

The valuation of housing stock in the US on future capital gains proved to be a risky move. As the boom continued, there was no reason to suspect that prices would drop, and consumers continued borrowing money the banks had made so readily available. However by August 2005, higher borrowing costs started to unwind the housing bubble-the default rate of sub-prime mortgages loans increased significantly. Thus began the credit crunch.

What is clear from this is that the Fed played a key role in this crisis by stimulating house prices and releasing a flood of liquidity. Regulators then played their own pivotal role by looking the other way as bad loans were made and debt became excessive. As Joseph Stiglitz rightly pointed out in a recent article in the Guardian, the housing bubble masked deeper problems in the US economy, namely the impact that the Iraq war and soaring oil prices were having on US finances-as the housing bubble continued, “hundreds of billions of dollar in mortgage equity withdrawals offset the war’s adverse effects”. Thus capital that could have been used to stimulate the economy in the current crisis, was instead being used on a contentious war.

Whilst globalisation has benefited the global economy through making it more integrated, it has also multiplied the possible pathways for the contagion of financial risk. Deregulation, financial innovation and the increasing role of the financial sector in the economy have all been key drivers in making the management of financial risk extremely difficult. The fall out from the US sub-prime mortgage crisis serves to demonstrate the global domino effect that can result from regulatory bodies not keeping up with financial innovation.

So who is currently facing the flak for this problem? In the US a number of lenders are currently facing investigation for fraud, including the US’s largest mortgage lender, Countrywide Financial. In the UK, Gordon Brown and Alistair Darling have suggested that it is the UK banks who are responsible, and Brown has urged banks to be more transparent about the scale of their bad debts. Ben Bernanke, charged with the thankless task of saving the US economy blames the ratings agencies, the investors in sub-prime securities who believed them and inappropriate incentive structures.

Whilst all of the above “villains” deserve their share of the blame for this catastrophe, it is clear that it is the US Fed and the UK government that doth protest too loudly. In an act of admirable confidence in the multiplier effect that rising house prices were supposed to generate throughout the economy, these authorities naively believed that the party would continue indefinitely, whilst giving no thought to, and taking no precautions for, what would happen if the bubble burst. In those halcyon days of cheap credit, encouragement rather than censorship was the accepted policy-we are now paying the price.