How Corporatism, Not Capitalism, Caused the Housing Crisis of 2008

by Kristin Knepper

When the housing bubble burst in 2008, big banks were blamed for being greedy, permitting high-risk home loans and then selling them as securities to investors. Everywhere, cartoons such as this depicted the responsibility:

“The banks were too greedy and the government wasn’t regulating them enough! They need to be punished for their reckless behavior!” were common phrases heard in 2008. Americans said this crisis highlighted the flaws of the capitalist system and the greed of corporations. Yes, banks taking on more risk than they could handle was a cause. However, economic pillar number seven: the “rules of the game” guide economic growth. The banking system was not the main cause of the housing crisis in 2008. It was the US government and their support of corporatism over capitalism.

Capitalism is the economic policy that’s classified by an open market with private ownership of goods and capital, with limited government. The United States has a mixed economy, because their government regulates the market and businesses beyond the definition of capitalism.

Corporatism is a structure in which the market is made up primarily of big businesses guided by governments’ regulation and incentives. Jordan Ballor explains, “Corporatism is distinct from socialism, because under corporatism the means of production (capital) remain in private hands. But the private firms are not simply free to respond to market signals. Instead, under a corporatist structure, the government directs firms in the ways in which they should employ their resources, sometimes through moral suasion, but more often through regulation, tax policy, and legal directives.” So what were these policies and legal directives that caused the housing crisis?

Affordable Housing Goals (Thanks, Bill)

In 1992, the Clinton Administration revived the Community Reinvestment Act. This act, first passed in the 1970’s, encouraged banks to approve more home loans to low and middle income families. It was believed that the current standards for home loans restricted ‘The American Dream’ of homeownership to just a small minority of wealthy people. The CRA created a new standard for banks to be evaluated by. This standard was the diversity of their loans, or how many subprime home loans they would approve to ‘benefit the community’s American Dream’. With the incentive to take on some risk, loan institutions increased their subprime mortgages until in 2008, half of all mortgages in the United States were subprime or nonprime. 70 percent of those were guaranteed by the government or government agencies (Wallison and Pinto, 2012).

Fannie Mae and Freddie Mac- “Too Big to Fail”

These government guaranteed loans were created thanks to Freddie Mac and Fannie Mae. Freddie and Fannie were federally mandated by these affordable housing goals to flood the market with subprime loans. Then, in 1995, the Department of Housing and Urban Development authorized Fannie and Freddie to purchase subprime securities, too! (Hensarling, 2009). Which the private sector was selling off left and right, because they knew these loans would not be repaid and they did not want to be liable! “Again, the incentive to approve the loan was much, much greater than declining it.  And if it wasn’t approved at one shop, another would be glad to come around and take the business.  After all, the loans weren’t being held for more than a month or so before they were the investors’ responsibility” (The Truth About Mortgage). The loans were guaranteed by the Freddie Mac and Fannie Mae standards, so they were perceived as high quality and, since they were backed by the government, ‘too big to fail’. This could not have been further from the truth.

The Feds Record Low Interest Rates

The third main factor that influenced the housing market crash was the Federal Reserve lowering the interest rate. “Following the 2001 recession, Fed chairman Alan Greenspan slashed the federal funds rate from 6.25 to 1.75 percent. It was reduced further in 2002 and 2003, reaching a record low of 1 percent in mid-2003—where it stayed for a year. This created excessive liquidity and generated a huge demand bubble” (White, 2009). By 2003, you could buy a house with a mortgage loan of zero percent down and 1 percent interest, encouraging people to buy and refinance their homes. The increase in demand for homes created an overdevelopment of new homes.

Boom… Bust.

In 2008, after 16 years of government-incentivized subprime loans, record low interest rates and zero-down mortgages, the bubble burst. “The housing bubble and its aftermath arose from market distortions created by the Federal Reserve, the government backing of Fannie Mae and Freddie Mac, and the Department of Housing and Urban Development and its Federal Housing Administration. Americans suffered through a severe recession in 2008 and 2009, a downturn unfortunately precipitated by perverse government policies” (White, 2009). Homes went into foreclosure because they were “underwater”, their mortgages were now much more than the houses were worth. Banks were blamed for approving these loans and greedily selling them off. The crisis was seen as a failure in government to regulate corporations, when in actuality it was the government incentives and regulations that led to these risky loans. Americans had tunnel vision of achieving the American Dream, and the government’s policies made middle and low income families think this was possible. The rules of the game were misguided, and the American people suffered drastically because of it.

Works Cited:

Ballor, Jordan. "Corrupted Capitalism and the Housing Crisis." Acton Institute. 15 Feb. 2012. Web. 05 Feb. 2016. <http://www.acton.org/pub/commentary/2012/02/15/corrupted-capitalism-housing-crisis>.

Hensarling, Jeb. "The True Causes of the Housing Crisis." POLITICO. 29 Apr. 2009. Web. 06 Feb. 2016. <http://www.politico.com/story/2009/04/the-true-causes-of-the-housing-crisis-021819>.

Wallison, Peter, and Edward Pinto. "Free Fall: How Government Policies Brought down the Housing Market." American Enterprise Institute. 26 Apr. 2012. Web. 06 Feb. 2016. <https://www.aei.org/publication/free-fall-how-government-policies-brought-down-the-housing-market/>.

"What Caused the Mortgage Crisis?" What Caused the Mortgage Crisis? Web. 09 Feb. 2016. <http://www.thetruthaboutmortgage.com/what-caused-the-mortgage-crisis/>.

White, Lawrence. "Housing Finance and the 2008 Financial Crisis." Downsizing the Federal Government. Aug. 2009. Web. 05 Feb. 2016. <http://www.downsizinggovernment.org/hud/housing-finance-2008-financial-crisis>.

 

Picture source: http://www.politicalcartoons.com/cartoon.aspx?id=cfecfd8f-3c1a-478e-8390-601ae8743ff3

Homo Non Economicus: An Essay on Behavioral Economics

by Kristin Knepper

“Economists aren't rational, because they assume people are” -Michael Fitzgerald

When I first heard that one of the pillars of modern economics is that “humans are rational”, I doubted that I could ever grasp economics. I know from my bar experience that there’s no such thing as a free drink, and I know that without ceteris paribus (all else held constant), economists would run in circles with “what ifs”. But humans, being rational? No way. Just watch some reality television.

This notion of rationality began when economists Adam Smith and David Ricardo wrote that people act in their own self interest and will pursue the option that leaves them "better off"; the optimal solution. This evolved into John Stuart Mill writing of an "economic man" or homo economicus, the theory that humans will maximize utility and businesses will maximize profit. While we would like to think we always make the best decisions for ourselves and our families, behavioral economics proves we do not.

Behavioral economics assumes that people have cognitive biases that prevent them from making rational decisions. Cognitive biases can be influence by the power of words. A “free” product has proven to be chosen much more than an item that is one cent. Biases can also be influenced by the necessity to make a decision quickly or with little thought.  By having knowledge of these cognitive biases, sellers can manipulate the behavior of consumers. For example, Apple started selling their latest iPhone at $600, and then reduced the price to $400. This made consumers think they were saving money. However, they probably would not have thought the same if the price started and stayed at $400 (Ariely, 2009). To be “rational” is to maximize utility. But are consumers’ really maximizing utility when they buy a $400 iPhone and think they are getting a bargain?

It is crucial that economists do not underestimate the power of cognitive bias and perception. People act in their own interest. When I buy that new Kate Spade purse, I’m not rationalizing that the money would be better spent on college tuition or 100 Starbucks cappuccinos. I’m thinking about how cute that purse would look on my arm. My interest, in this situation, is not to maximize utility and not to maximize my dollars towards necessities. My interest is to look good, as best explained by economist Frank Taussig:

“An article can have no value unless it has utility. No one will give anything for an article unless it yield him satisfaction. Doubtless people are sometimes foolish, and buy things, as children do, to please a moment’s fancy; but at least they think at the moment that there is a wish to be gratified. Doubtless, too, people often buy things which, though yielding pleasure for the moment, or postponing pain, are in the end harmful. But here ... we must accept the consumer as the final judge. The fact that he is willing to give up something in order to procure an article proves once for all that for him it has utility – it fills a want” (1912).

This is the same concept that explains why a majority of people do not save enough for retirement. If they were perfectly rational, people would save more than enough. But consumers misspend. They are on the fast track for the pursuit of happiness. They would much rather spend now than later (hyperbolic discounting). These decisions must be accounted for in the study of economics.

By being more realistic about the human condition, economists can better predict and analyze economic scenarios. “We are finally beginning to understand that irrationality is the real invisible hand that drives human decision making… companies now see how important it is to safeguard against bad assumptions. Armed with the knowledge that human beings are motivated by cognitive biases of which they are largely unaware (a true invisible hand if there ever was one), businesses can start to better defend against foolishness and waste” (Ariely, 2009).

Works Cited:

Ariely, Dan. "The End of Rational Economics." Harvard Business Review. 01 July 2009. Web. 25 Jan. 2016. <https://hbr.org/2009/07/the-end-of-rational-economics/ar/1>.

Fitzgerald, Michael. “Irrational Economics.” CBS News. 20 March 2008. Web. 25 Jan 2016. < http://www.cbsnews.com/news/irrational-economics/>.

McFadden, Daniel. "The New Science of Pleasure." National Bureau of Economic Research. Jan. 2013. Web. 25 Jan. 2016. <http://www.nber.org/papers/w18687.pdf?new_window=1.

Picture source: http://mu-peter.blogspot.com/2012/03/evolutionary-economics.html

               

Price Gouging: The Associated Press' Biggest Fallacy

It's just equilibrium people!
by Kristin Knepper

 I’m not a seasoned economist, but I know enough to become furious when news outlets report on the cruelty of price gouging. With the recent snow storm that dumped more than two feet of snow throughout the east coast, price gouging has been reported by the Associated Press. News sources claim that businesses related to natural disasters (lumber and building supplies, technology such as generators, etc) have been unreasonably and unnecessarily raising prices on goods they know consumers need. What these news outlets need is a simple lesson on the law of supply and demand.

Ready kids? OK.

When the quantity demanded for a product goes up, and the supply is constant, the price must go up.

I repeat, when the demand increases, the price increases. Price is equal to value. When people value something more, the price reflects that increase in value. My favorite article on this subject, titled “Price Gouging Doesn’t Exist, And You’re An Idiot”, explains:

Here’s the problem. A customer who’s worrying about Hurricane Sandy goes into Office Depot[to buy water], happens to be the first one in the door, sees the $5 price, and immediately buys the entire display of 100 packs. Can’t be too careful, right? It’s an emergency! $500 might be a bargain if there’s no water available for weeks.

And now, no one else can buy water. It’s all gone.

So the retailer sets a limit. 5 packs per customer, whatever. So instead of all but 1 person going without bottled water, now, all but 20 do.

But knowing that there’s going to be increased demand for bottled water, what if Office Depot were to quadruple its price?

When a case costs $20, people start thinking.

• Do I really need all this water?
• Could I economize, maybe get along with as few bottles as possible?

So here, price is an incentive. If you raise the price during a disaster, consumers will have the incentive to buy less, or buy what they need. That leaves more for other consumers or the ones who really need it.

Another example from Dr. Boudreaux’s microeconomics class (Econ 102, come on Associated Press) is the example of Hurricane Katrina. During and after Hurricane Katrina, the price of lumber rose dramatically because everything had to be rebuilt. This helped accomplish two things. The first is that only the people who really needed lumber bought it. Those with minor damage thought “well my damages can wait until the price lowers to fix it”. The people with major damages said “well I have to fix this now so I have to pay that price”. The second effect was creating an incentive from lumbers’ in nearby states to enter the market. Lumber yards in Georgia, Alabama, and Northern Louisiana brought lumber to sell at the higher price. This created more supply, which was great for those in need!

Now flip the coin. The government enacts “anti-gouging” laws. Everybody buys lumber, even the man with the silly minor damage to his front door because, hey, the price is the same pre-disaster. The lumbers’ from the nearby states don’t sell in the disaster market because there’s no price raise and therefore no incentive for the extra profit.

There’s no more lumber in the market, because the price did not reflect the scarcity, nor did it create an incentive for the people. Or there is lumber, but because the government-enforced price does not fit the value, a black market is created. Let me tell you, that black market price will be far more than the price it would have been if the price ceiling weren’t enacted.

In conclusion; my message to the Associated Press: Stop reporting on price gouging! It is tricking consumers into believing that “big business” is using tragedy to take advantage of consumers. This is a complete fallacy. The rise in price is merely a reflection of scarcity and a natural process of reaching equilibrium between supply and demand.

Works Cited:

"Price Gouging Doesn't Exist, And You're An Idiot." Control Your Cash: Making Money Make Sense. N.p., 2 Nov. 2012. Web. 01 Feb. 2016.

Picture source: http://shsapeconomics.blogspot.com/2012/11/price-gouging.html

6 Tips for Your First Credit Card

by Kristin Knepper

If you're a high school or college student, it's not a bad idea to start building your credit. Credit scores are boosted by the length and diversity of credit history, so a credit card is a great place to start. Here are some tips for how to select and manage your first credit card!

1. Research
Credit card companies offer a broad range of credit cards with enticements like travel rewards and low interest rates. Research what rewards you think you would benefit from most. I chose a Bank of America Cash Rewards card. A lot of companies have cash rewards, usually with two or three percent back on things like groceries and gas.

Start by taking a look at what types of credit cards your current bank is offering. You can also research other banks and retail merchant cards. If you do not have an amazing credit score, you may need to apply for a student credit card or a credit card which requires a minimum security deposit. A retail merchant credit card such as Target or (my personal favorite) J Crew is another option for establishing credit, but beware: retail merchants usually charge higher interest rates. Which brings me to my next tip...

2. Read between the lines
Read all the terms and conditions. Even that boring gibberish that you don't think you'll understand. That gibberish is meant to trick you.
Personal example: I received a credit card offer in the mail. The pamphlet said "Zero annual fees". Great! However, while reading that boring gibberish, I was suddenly aware of a paragraph that spoke of an "$80 annual membership fee, divided into monthly payments of $6.60 a month". Hmmm.... so zero annual fees.... but an annual fee divided into a monthly fee.... I caught you, Capital One.

3. Do not apply for many cards at the same time
Applying for too many cards in a short time span actually damages your credit score! Banks can see what cards you've applied for and when, and they may decline you for too many inquiries.
Start by applying to one or two, and wait to hear back from them. If you're denied, look at student or credit-building cards.

4. Only spend what you can afford
When that shiny new piece of plastic comes in the mail, you may be tempted to overspend. DONT.
Starting out, only spend what you know you can pay off right away. Interest rates or (god forbid) late payments can slowly make a big pile of crippling debt.
Until you can better budget or have higher and more dependable income, pay off your balance each month and save yourself stress and interest.

5. If you don't follow rule 4...
OK if you really needed that new Kate Spade bag that was on sale and you're not getting paid for two weeks but you just had to have it and couldn't risk that gorgeous bag selling out.... then please, for the love of all accessories: Make the minimum payment!! Most minimum payments are $10-$30, there is no excuse to miss a payment.

6. Remind yourself of monthly payments
For a foolproof way to never miss a payment, make sure you have a reminder. Many credit card companies will e-mail or text you when your payment is due, if you sign up for their alerts. Put notes in your phone, Lily Pulitzer agenda, Palm Pilot, whatever. Just don't forget.

If you follow these basic tips, you'll improve your credit score and be purchasing that dream home before you know it!

Picture source: http://stylemeswanky.blogspot.com/2011/01/clueless-muffs-and-five-question-friday.html