“This crisis resulted from government reluctance to regulate the unbridled greed of Wall Street.”

Democrats have taken this mantra and used it as an unprecidented opportunity to institue their socialist ageneda. But, was the Free Market the problem, and is bigger governement and record defecit spending the answer?

To quote Peter Schiff, a genius economist and investor:

Absent from such conclusions is the central role the government played in creating the crisis. Yes, many Wall Street leaders were irresponsible, and they should pay. But they were playing the distorted hand dealt them by government policies. Our leaders irrationally promoted home-buying, discouraged savings, and recklessly encouraged borrowing and lending, which together undermined our markets.

Peter makes an excellent point about moral risk. The point is clear, just as price is managed by supply and demand in free markets, financials markets are governed by the opposing forces of fear and greed.

Houston, We Have A Problem

Which brings me to the most important point made by Mr. Schiff, a point that I can’t believe has not been addressed, and, in fact has been doubled down. The federal government, by way of social engineering and the socialist notion that everyone deserves a home, has introduced a moral risk to the markets by removing financial risk. I know this sounds confusing, but it is really simple. Read on…

The Federal Housing Administration, Fannie Mae, and Freddie Mac were created to encourage lending by allowing primary lenders to turn their long-term risk over to the government. Financial risk was now replaced by moral risk. You see, lenders could now lend money without risk, thus underminding the established best practices for loan approval, and increasing the amount of risky lending; including pay option ARMS, 0$ down loans, and document free loans. Absent of the risk of losing money, the natural market force of fear (the fear of losing money) was removed from the equation.

The result was the creation of false wealth based on credit, and an enormous real estate bubble that would eventually pop.

Many people credit the Clinton administration with creating a fantastically strong economy, as well as handing that economy to the Bush administration. The facts couldn’t be further from the truth.

Everyone knows the term the “dot com bust.” The economics that allowed the metoric rise of the economy during the Clinton administration were based in companies that had no product, no customers, and no assets, yet were valued at millions of dollars! Move forward to 2007, and you can see, the free markets demanded that business be based on real earnings, and real profits.

Sadly, the Bush administration and Alan Greenspan didn’t pay attention. Interest rates contributed the most to creating the housing boom. After the dot-com crash and the slowdown following the attacks of Sept. 11, 2001, the Federal Reserve took extraordinary steps to prevent a shallow recession from deepening. By slashing interest rates to 1 percent and holding them below the rate of inflation for years, the government discouraged savings and practically distributed free money. There was no real financial risk in barrowing money, so lenders and barrowers alike had no system of checks and balances.

Real Estate prices are based on a function of rents. Common sense dictates that if it costs you less money to rent a nice home than to own a run down old home, that people would want to rent! Sadly, home buyers ignorantly believed that home prices could contine there baseless, metoric rise of 20%+ per year almost indefinitely. Home prices moved well beyond rents, and people were willing to own “income” properties that didn’t turn a profit because they believed that “appreciation” would outpace the losses. Of course, this was not the case, and never will be the case. Rather than allowing interest rates to rise, and home values to gradually fall to more reasonable levels, artificially low interest rates invigorated the market for adjustable-rate mortgages and gave birth to the teaser rate, which made overpriced homes appear affordable! Alan Greenspan himself actively encouraged home buyers to avail themselves of these seeming benefits. As monetary policy caused houses to become more expensive, it also temporarily provided buyers with the means to overpay. Cheap money gave rise to subprime mortgages and the resulting securitization wave that made these loans appear safe for investors. What a terrible mistake!

To quote Mr. Schiff.

And even today, as market forces deflate the credit bubble, the government is stepping in to re-inflate it. First came the Treasury’s $700 billion plan to purchase mortgage assets that no one in the private sector would buy. Now it has recapitalized banks to the tune of $250 billion, guaranteeing loans between banks and fully insuring non-interest-bearing accounts. Policymakers say that absent these steps, banks would not be able to extend loans. But given our already staggering debt burden, perhaps more loans are not the answer. That’s what the free market is telling us. But the government cannot abide solutions that ask for consumer sacrifice.

Real credit can be supplied only by savings, so artificial steps to stimulate lending will only produce inflation. By refusing to allow market forces to rein in excess spending, liquidate bad investments, replenish depleted savings, fund capital investment and help workers transition from the service sector to the manufacturing sector, government is resisting the cure while exacerbating the disease

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