So as the credit markets slow to a crawl and foreclosure rates soar, two questions come to most everyone's minds: What caused this mess? And what can we do so it doesn't happen again? A great variety of answers have been proposed for these questions. If you will grant me a moment of your time I shall present one of my own.
First we must understand the root cause of the breakdown. In order to do this one must realize that nobody who was involved really benefits from the present situation. Homeowners obviously face un-affordable mortgage payments and foreclosure. Mortgage brokers and lenders, while they made a pretty penny during the boom, are now having to tighten their belts as demand for mortgages has dried up along with the availability of credit. Lenders are also being put in a tough spot by having to balance calls by the Government and others to make allowances towards borrowers against their contractual obligations to investors. The investors who purchased investment vehicles backed by the mortgages are now facing billions in losses as the mortgage backed assets they hold massively depreciate in value.
If nobody gains from this situation, why did they all allow it to develop? It's tempting to just chalk it up to greed and leave it at that. But greed, being a part of human nature, is a fairly uniform and constant force in the economy. Greed may have made the situation worse, but by itself it cannot account for what first triggered the bubble since it was in every part of the market long before the bubble ever formed.
If not greed, what was the root cause of the housing bubble? To find the answer we must, as the saying goes, follow the money. It was the investors who provided the money that fueled the bubble. And now, on an individual basis, they face the largest losses. Some investment banks have already lost billions. So what drove them to throw so much money into such a risky market? Some blame the credit rating agencies for overrating the safety of mortgage backed investments. But prudence dictates that one should look for more than just an agency's seal of approval before investing billions of dollars into an unfamiliar market. If investors had actually examined the substance of what they were buying they would have found a tangled mess of consumer dept of questionable quality. That should have thrown up red flags but it didn't, investors either didn't look or didn't care. Why didn't they? Because they were desperate. The market was flooded with money. With so much of it being invested, returns on known safe investments dropped to unfavorable levels. This left investors desperate for something which promised a decent rate of return, even if it took them into new and uncharted territory.
Why was there so much money in the market? Fortunately this is an easy question to answer. The United States Federal Government has granted a single entity central control over the money supply: The Federal Reserve System, more commonly known simply as The Fed. In the wake of the dot-com crash in the early 2000s Fed chairman Alan Greenspan took the drastic measure of reducing the federal funds rate to a mere 1%. This had the effect of dramatically increasing the money supply. The extra money served to largely counteract the negative effects of the dot-com crash. But as the famous saying in economics goes, there's no such thing as a free lunch. While Greenspan was able to blunt the impact of one bubble collapsing, he did so at the expense of creating another. Picture trying to press the air out from under a tarp only to have it pop up somewhere else and you get a good idea of the relation between the dot-com crash and the housing bubble.
If The Fed caused the bubble, what can we do about it? The easiest answer is to just make sure the central banking authority doesn't make the wrong decision again. This can vary from just trusting The Fed to learn from it's mistakes to eliminating The Fed and placing monetary control directly in the hands of the Federal Government. Unfortunately there is a common problem with all of these solutions. It is known all too well that humans are fallible. Whether working for The Fed or the Federal Government, the people in charge of the money supply will make mistakes.
This is usually where people chime in and suggest a return to the gold standard or some other form of hard currency. This solves the problem of human fallibility but it introduces another. If the supply of the hard asset backing a currency grows more slowly than the market's demand for that currency, deflation will result. Those who have taken a class in macro-economics should understand why this is dangerous. Put simply, deflation encourages people to stash away their money rather than invest or spend it. This causes a viscous circle to develop known as a deflationary spiral. The Great Depression is the best known example of what can happen when a deflationary spiral grips an economy. Any monetary system that cannot dynamically adjust the money supply in reaction to the demand for money is thus doomed to failure.
This leaves us in something of a catch-22. We need to be able to change the money supply in response to demand, but we cannot trust it to a human because he is fallible. One might suggest some form of mathematical model. But the fallibility of the human would simply be extended to the design of the model. So what can we possibly do to remedy the problem of human fallibility?
At this point it becomes helpful to view the situation in terms of risk. The chances of a monetary authority making a mistake is a risk to all those who hold the currency he issues. The classic method of managing risk in the market is simple: diversify. By spreading your assets around you minimize the damage that a drop in value of any one holding can do. The same principal can be applied to currencies and the economy as a whole. By having many currencies issued by many independent authorities, one can minimize the damage done by any one of them making a mistake.
There is a name for a system which allows such diversification, it is called free banking. With free banking, private banks are allowed to issue and manage their own currencies and accept other's as they see fit. Put simply, it is the free market applied to money itself. Historically there has been a very strong argument against free banking. That is that having to frequently perform currency conversions significantly increases the overhead of commerce. Fortunately, we now have a monetary system which is almost entirely electronic. Thus performing currency conversions posses little impediment as the necessary exchanges can be performed automatically as part of a transaction.
With free banking we would no longer have to entrust our currency to a single central controller. When a bank mismanaged it's currency it would only directly effect those holding that currency. Thus holdings would naturally gravitate towards the currencies of banks that have a proven track record of sound monetary policy. That is not to say the system would be perfect. Humans are, after all, still as fallible as ever and even the most competent banks' currencies would sometimes falter. But when such an event happened the consequences would be far less dire than what we are currently facing with our central monetary monopoly.
