What Ails the Economy

Amid calls for Obama to "go big" on a new jobs bill, we need to understand what caused the Great Recession in the first place and why these efforts will not work.

It all started with real estate. For decades, house prices have been growing faster than inflation. During the 2000s, that trend kicked into overdrive as a result of several factors. The first is the traditional market reaction to scarcity. As cities grew, their more desirable sections became more valuable.

A new factor entered the market when the Clinton administration decided to increase minority home ownership. There were allegations that banks "red lined" minorities - drawing red lines on a map marking areas that they would not give loans to regardless of the potential borrower's finances. As a result, banks loosened up traditional requirements for down payments and monthly payment to monthly earnings ratio. The Bush administration continued these policies.

The Fed kept interest rates at historic lows in order to promote economic growth.

All of these factors together combined. People who previously would not have been able to qualify for a home load suddenly could. Low interest disguised rising house prices. These fed back into loans as people were encouraged to refinance in order to get lower loans. At the same time, they financed the new value of their house, treating their homes as low-interest credit cards. To keep monthly payments low, these loans were variable-rate interest. A lot of consumer spending was generated by these loans. Event the Obamas engaged in it.

Some Wall Street geniuses noticed that high-risk borrowers (AKA sub-prime borrowers) weren't really that high a risk. They paid higher interest rates and, if you bundled them together and added a little mortgage insurance, they were almost as safe as AAA bonds but they paid much better return.

The thread that held all of this together was rising home values. If anyone got in trouble, they could sell their house at a profit.

Then oil and food prices rose. The Fed worried about inflation and raised interest rates to try to slow things down. Suddenly, all of those people with variable-rate loans had to pay more. Many people could not afford the new payments and had to dump their homes. The bottom dropped out of the market. Millions found themselves "under water" where they owed more on their house than it was worth. Many walked away from their loans, turning their houses over to the bank (or whoever currently owned their loan). That put more downward pressure on house values as banks tried to dump seized houses.

At the upper financial level, the income from mortgages turned into a drag. At the lower level, people could no longer borrow against the rising value of their house. In its final months, the Bush administration bailed out some of the top banks but failed to do anything about real estate values in general. Enter the Obama administration.

In the book A Connecticut Yankee in King Arther's Court, the main character has advance knowledge of a natural event which will occur (a solar eclipse) and takes advantage of it. On his fourth voyage, Christopher Columbus did this in real life with a lunar eclipse. The idea was to make people think that you ended the eclipse when it actually happened on its own.

The Obama Administration tried to do something like this. They predicted that the recession would end during the Summer of 2009 and be followed by a steep recovery. They mainly based this on the recession from the early 1980s. Accordingly, they figured that they could do almost anything, call it a stimulus, and claim credit for the natural recovery.

Unfortunately, as Japan showed in the 1990s, a recession generated by a real estate bubble takes a long time to recover from. The only solution is to wait until the economy grows naturally to the point where land values match the inflated ones. That means that Obama should have focused his efforts on rebuilding land value.

He didn't. A small part of the stimulus was focused on first-time buyers. It helped a bit but not much.

Obama also announced a program to help people who were in danger of losing their home. This was worse than useless. Only a small fraction of possible beneficiaries actually had their homes saved. Others found themselves worse off after applying for the program and being rejected. Worse for Obama, the impression that this was one more bail-out of people who acted irresponsibly led to the first Tea Party protests. A program that fails to help people and galvanizes the opposition sets the bar for an epic fail. In the meantime, real estate prices are still falling and home seizures are rising again.

So where does that leave us? We know some things that will not work. Japan tried traditional stimulus packages. They failed and left Japan with the highest debt ratio in the world. Keynesian insist that Japan needed a much greater stimulus and urges President Obama to "go big". This is playing with fire. If it fails then the additional debt will ruin the US economy for decades and possibly pull down the rest of the world with it.

One thing that we should not do is eliminate the mortgage deduction from the income tax. That would just make things worse. If anything the government should be offering tax incentives to make home ownership more desirable.

Something like the Cash For Clunkers could be done with the government buying and demolishing some of the surplus housing. Otherwise, the flood of seized property will continue to depress the real estate market and the economy in general. Or there could be something like the programs that pay farmers for not planting crops. The government could pay people to leave houses vacant.

Until the real estate market is shored up, the economy will not improve.