U.S. Home Prices
The price of homes had risen for the past generation, but as this chart above shows, that story of steady growth is a bit deceptive. If you adjust home prices for inflation, they have fluctuated in a narrow band between 1970 and 2000. But mortgages don’t rise with inflation. So if you borrowed $20,000 to buy a $25,000 house in 1970, by 2000 that house would be worth around $125,000 and you’d have paid off your mortgage. But $125,000 was not much more than $25,000 in real terms. You felt richer because the numbers were higher and because you had paid off your debt, but the truth was that home ownership was not a great way to create actual gains. On the other hand, the record showed that you were not likely to lose money either, and that gave lenders confidence. If worse came to worst, they could always seize the house and sell it, thus getting their money back.
With cheap money enabling more people to buy houses, demand rose, which meant that housing prices took off like a rocket in 2001, then accelerated further after 2004. Lenders kept looking for more and more borrowers for their cheap money, which meant lending to people who were less and less likely to repay these now “subprime” loans. The climax came with the invention of the five-year variable-rate mortgage, which enabled people to buy houses for monthly payments that were frequently lower than rent on an apartment. These rates exploded after five years, but if a buyer could not meet the new payments and lost the house, at least he would have enjoyed some good years and was simply back where he started. If housing prices stayed steady, he could refinance, so all in all, he didn’t seem to be taking much of a risk.
Nor did the lenders appear to be risking much, especially given that they made their money on closing costs and other transaction fees, then sold the mortgages (and passed along the risk) to secondary investors in what became known as bundles. In packaging these loans for the secondary market, lenders emphasized the lifetime income stream, which made the subprime loans appear to be the perfect conservative investment.
Everyone was making money and no one could get hurt—it was the oldest story in the book. And most people didn’t care or didn’t want to believe that the bubble could burst.
However, reality began to intrude. New homeowners who never would have qualified for an ordinary loan in ordinary times began to default, and as properties came on the market from forced sale or foreclosure, prices that had been counted on to keep going up began to fall. During the run-up, small investors had bought multiple houses, fixed them up a bit, and resold them for a quick profit. But as boom turned to bust and speculators were unable to “flip” the houses at profit, they rushed to unload them at whatever price they could, which drove prices further down. By 2007, the mild decline that had begun in 2005 became a rout. In truth, all that happened was that prices returned to the highest level within their prior historic range; the froth was disappearing, but the basic value was still there. Nonetheless, many of the people who had put money into these houses were devastated.
With the collapse of the housing market, the mortgages that had been bundled and sold to investors no longer had a clear value. Because these investors had believed that prices would never fall, they had never looked at what was actually inside their bundles. The more aggressive investors in bundled mortgages, investment banks such as Bear Stearns and Lehman Brothers, had leveraged their positions many times over, and by the time the loan payments were due, the value of the underlying assets was so murky that no one would buy them, or even refinance the loans. Unable to cover their bets, these big players went bankrupt. And since many of the people who had bought these supposedly conservative investments, including the commercial paper issued by the banks, were in other countries, the entire global system went down.
The story of the collapse often focuses on the United States, but the damage was truly worldwide. Residents of eastern Europe—Poland, Hungary, Romania, and other countries—who in normal times had never been able to afford a house had bought in. Austrian and Italian banks in particular, backed with European and Arab money, had wanted to provide mortgages, but interest rates in eastern Europe were high. So the banks offered these new, eager, and unsophisticated buyers loans at much lower rates, only denominated in euros, Swiss francs, and even yen.
The problem was that these homeowners weren’t paid in these currencies but in zlotys or forints. A Polish homeowner essentially paid for his mortgage by first buying yen, then paying the bank. The fewer yen a zloty bought, the more zlotys the homeowner had to spend and the more expensive his monthly payment became. If these zlotys rose against the yen or the Swiss franc, there were no problems. But if the zlotys fell against the yen or the Swiss franc, there were huge problems. Every month, more and more eastern Europeans were buying Euros and other currencies. As the financial crisis deepened, there was a flight to safety; and eastern European currencies plunged. Homeowners were squeezed and broken.
Major expansions always end in financial irrationality, and this irrationality was global. If the Americans went to the limit with subprime mortgages, the Europeans went a step further by enticing homeowners to gamble on global currency markets.
There is a constant refrain that we have not seen such a catastrophic economic event since the Great Depression. That is triply untrue, because similar collapses have happened three other times since World War II. This is a crucial fact in understanding the next decade, because if the financial crisis could be compared only to the Great Depression, then my argument about American power might be difficult to make. But if this kind of crisis has been relatively common since World War II, then its significance declines, and it is more difficult to argue that the 2008 panic represents a huge blow to the United States.
The fact is that such events are common. In the 1970s, for instance, there was a significant threat to the municipal bond market. Bonds issued by states and local governments are especially attractive because they are not subject to federal tax. Such bonds are also considered all but risk-free, the assumption being that government entities will never default on their debts so long as they have the power to tax. In the 1970s, however, New York City couldn’t meet debt payments and couldn’t or wouldn’t raise taxes. If New York defaulted, the entire financing system for state and local government would devolve into chaos, so the federal government bailed out New York, making it clear that Washington was prepared to guarantee the market.
During that same period there was a surge of investment in the Third World, primarily to fund the development of natural resources such as oil and metals. Mineral prices were rising along with everything else in the 1970s, and investors assumed that because minerals are finite and irreplaceable, the prices would never fall. Investors also assumed that loans to the Third World governments that usually controlled these resources were safe, given the perception that sovereign countries never defaulted on debt.
In the mid-1980s, the belief in rising prices and stable governments, like most comfortable assumptions, turned out to be misguided. Mineral and energy prices plunged, and the extraction industries predicated on high prices collapsed. The money invested—much of it injected as loans—was lost. Third World countries, forced to choose between defaulting and raising taxes (which would further impoverish their citizens and trigger uprisings), opted to default, which threatened to swamp the global financial system. This prompted a U.S.-led multinational bailout of Third World debt. Under George Bush, Sr., Secretary of the Treasury Nicholas Brady created a system of guarantees, issuing what were called “Brady bonds” to create stability.
And then came the savings-and-loan crisis. Savings-and-loan institutions, which had been created to take consumer deposits and generate home loans—think Jimmy Stewart in It’s a Wonderful Life—were given the right to invest in other assets, which led them into the commercial real estate market. This appeared to be only a small step beyond their traditional residential market, and the expansion carried the same “conventional wisdom” guarantee that prices would never fall. In a growing economy, or so it was
thought, the price of commercial real estate, from office buildings to malls, could only go up.
Once again, the unimaginable happened. Commercial real estate prices dropped, and many of the loans made by the S and Ls went into default. The size of the problem was vast and cut two ways. First, individual depositor money was at risk on a large scale. Second, the failure of an entire segment of the financial industry, which had resold its commercial mortgages into the broader market, was poised for catastrophe.
The federal government intervened by taking control of failed S and Ls—meaning most S and Ls—and assuming their liabilities. Mortgages in default were foreclosed, and the underlying property was taken over by a newly created institution called the Resolution Trust Corporation. Rather than try to sell all this real estate at once, thereby destroying the market for the next decade, the RTC, backed by federal guarantees that potentially could have risen to about $650 billion, took control of the real estate of failed savings-and-loans.
The crisis of 2008 was based on the same desire for low risk, and on the same assumption that a certain class of assets was indeed low-risk because its price couldn’t fall. It was met with a similar federal government intervention to bail out the system, and, just as before, everyone thought it was the end of capitalism. What is important to note is the consistent pattern, including the overstatement of the consequences. To some extent, this is a psychological phenomenon. With pain comes panic, and the management of panic is a question of leadership. Consider how it was managed in the past.
Both Franklin Roosevelt and Ronald Reagan came to power amid economic crises. Roosevelt, of course, faced the Great Depression. Reagan faced the stagflation that overtook the economy in the 1970s—high unemployment combined with high inflation and high interest rates. The economic problems both presidents encountered were part of global economic dislocations, and both posed a profound crisis of confidence in the United States. The crisis in the 1930s prompted Roosevelt’s famous line, “We have nothing to fear but fear itself.”
Roosevelt and Reagan both understood the psychological element in financial crises. The anticipation of economic hardship causes people to rein in their buying in order to protect themselves. The more they cut back, the worse the economic problems become. As an economic crisis deepens, it calls into question the integrity and leadership of elites, which can create political instability and destabilize society itself. That social uncertainty can in turn make it impossible for a country to act decisively in the world. Roosevelt faced the rise of fascism; Reagan came to power facing what was generally believed to be the growing power of the Soviet Union. Neither could afford the destabilizing consequences of a severe economic crisis, yet neither knew with any certainty how to solve the problem through economic policy. Both attacked the psychology of the problem, trying to create the sense that, most of all, something was being done.
In retrospect, Roosevelt’s frantic one hundred days of legislation had little effect on the Depression, which was ended by World War II rather than by his economic policies. Reagan also promised actions, although in the end the solution rested not with the president but with the Federal Reserve. Nonetheless, describing the times as being “Morning in America,” a phrase that was part of his 1984 campaign, Reagan, like Roosevelt before him, tried to change the expectations of the public, stabilizing the political situation and buying time for the economy to heal without weakening the state.
Both Roosevelt and Reagan understood that the real threat of an economic crisis would be its political impact, with the misery that piled up wrecking the entire system. They understood that their job as leader was not to solve the problem—the president really has little control over the economy—but to convince the public not only that he has a plan but that he is altogether confident of that plan’s success, and that only a cynic or someone indifferent to the public’s well-being would dare to question him on the details. This is not an easy thing to pull off; it takes a master politician, which is to say a master of illusion. Roosevelt certainly saved the country from serious instability and, in spite of the lack of recovery, positioned it to fight World War II. Reagan saved the country from the sense of malaise that the Carter administration was known for and set the stage for the reversal of fortunes with the Soviets.
Roosevelt and Reagan did one other thing that was in their power to deal with the crisis. They shifted the boundary between public and private, state and the market. Roosevelt dramatically increased the power of the federal government. Reagan decreased it. The problem they were addressing wasn’t the economic crisis itself, but a fundamental political crisis. In the 1929 depression, the financial elite had lost the confidence of the public. They appeared not so much corrupt as incompetent. Under Hoover, they were permitted to play out their hand, but then the situation got worse. Roosevelt intervened, shifting some of the power that had been in the hands of the financial elite to the political elite. Had he not done so, the sense that all the country’s elites had failed might have prevailed, a sentiment that led to fascism in places such as Italy and Germany.
The reverse happened under Reagan. In the 1980s, the political elite was perceived to be behind the economic crisis, and the public blamed the structure of “big government” left behind by Roosevelt. Reagan shifted the balance between the state and the market back the other way, weakening the state to strengthen the market.
Part of rebuilding confidence has to do with understanding which part of the elite—political, corporate, financial, media—is to be held responsible for the crisis. By essentially putting one set of elites or another into receivership, transferring their authority in many ways to other elites, Reagan and Roosevelt gave the public the sense that the president was acting decisively and taking power away from those who had failed. This eased the sense that everyone was helpless, and indeed cleared the way for at least some reforms that didn’t hurt, might have helped, and certainly were needed symbolically. In the end, the crises worked out both because of the underlying power of the United States and because of the resilience of the modern state and corporation, which cannot live apart, yet have trouble living together.
Neither Bush nor Obama was able to manage the national psyche as Roosevelt and Reagan had. Bush lost control of the war and was blindsided by the financial crisis. He fell behind the curve after Iraq and never caught up. Obama created expectations he could not fulfill, then failed to create the illusion that he was fulfilling them. But of course Reagan ran into similar problems at first. The issue that is unknown but that will affect the next decade deeply is whether Obama can recover and lead. Can he understand that when Roosevelt spoke about fearing fear, he meant that the president’s job is to appear to be effective whether or not he is? If Obama doesn’t learn that, the nation will survive. Presidents come and go, but this is a fragile time, with the legitimacy of the presidency and the country itself caught between the demands of republic and empire.
When we talk about shifting the boundaries between corporate and political elites and between the state and the market, this inevitably raises ideological issues. For the left, strengthening the corporate elite and the market threatens democracy and equality. For the right, strengthening the political elite and the state threatens individual freedom and property rights. It is an interesting debate to watch, save that the problem is not moral or philosophical but simply practical. The great distinction that prompts such heated ideological debate just isn’t there.
The modern free market is an invention of the state, and its rules are not naturally ordained but simply the outcome of political arrangements. The reason I say this is that the practical foundation of the modern economy is the corporation, and the corporation is a contrivance made possible by the modern state. The corporation is an extraordinary invention. It creates an entity that the law says is liable for the debts of a business. The individuals who own the business, whether a sole proprietorship or a huge publicly held entity, are not held liable for those debts personally. Thei
r exposure can be no greater than their initial investment. In this way, the law and the state shift the risk from the debtors to the creditors. If the business fails, the creditors are left holding the bag. Nothing like this existed before the birth of “chartered companies” in the seventeenth century. Before that time, if you owned a business, you were liable for all of it. Without this innovation, there would be no stock market as we know it, no investment in start-ups, little entrepreneurship.
But this apportionment of risk is a political decision. There is nothing natural in the idea that the boundaries of individual risk are drawn where they are. Indeed, over time, these boundaries shift. The corporation exists only because the law created it. The political decision to create corporations also means that corporate law, not the law of nature, defines the precise boundaries of risk and liability. There may theoretically be some sort of natural market; but a market dominated by limited liability corporations, from the Fortune 500 to the local plumber, is inherently political.
Since 1933 and the New Deal, the issue of corporate risk has been bound up with the issue of social stability. The structure of risk has been built around the social requirements. During the Roosevelt administration, the boundaries of state control expanded. Under Reagan, they contracted.
What the 2008 crisis did around the world was redefine the boundaries between corporations and the state, increasing state power and the power of politicians, reducing market autonomy and the power of the financial elite. This had minimal impact on China and Russia, where the system was already tilted toward the state. It had some effect on Europe, where state power has always been greater than in the United States. It had substantial effect on the United States, where the market and the financial elite had dominated since Reagan. It also kicked off a political brawl between left and right over whether this shift was justified. In the United States in particular, the boundaries are always shifting and the argument is always couched in moral terms. In spite of variations, the strengthening of the state will be one of the defining characteristics of the next decade globally.
George Friedman Page 6