The Housing Crisis: Caused by the Bush Tax Cuts

I don’t know about you, but watching the markets get crazy has been great fun for me.  Once upon a time I wrote a book on the origins of the Fed, so every time I read about the “moral hazard” involved in bailing out insolvent lenders—or borrowers—I have to laugh.  This hazard lies in thwarting the logic of the market, according to the old-school economists and journalists who preach it. 

If you violate this logic—if you don’t let the market cleanse itself of imprudent investors, mere speculators, and the like—you have validated precisely what the market should be punishing.  You have not let the market do its anonymously moral work of enforcing a transparent relation between honest effort and legitimate reward.

In a corporate age of globally administered markets and prices, this is a pretty flimsy argument, of course, but it keeps surfacing in the Financial Times, and even in Paul Krugman’s op-ed of August 17 in the New York Times, where the distinction between speculative lenders and hard-working borrowers is pushed to its logical conclusion.  I still like the piece because he introduces a comparison between third-world debtors and strapped mortgage holders here in the good old USA; but the market is not a moral calendar, no matter how well-regulated.

The origins of this credit crunch—maybe even a crisis—reside, by all accounts, in the housing market.  Big banks bought up a lot of sub-prime mortgages, then bundled them into portfolios that could be sold downstream as reliably income-producing assets.  Thus mortgage debt was “securitized,” made into something hedge funds and private equity firms, and even stodgy mutual funds, could buy into as an investment, not as a side bet.  When the housing market flattened out, that is, when prices and construction began to fall and when foreclosure rates began to rise over the last two years—even with interest rates relatively steady—this mortgage debt suddenly looked dubious.

The bubble burst, in short, when everybody realized that the long-term inflation of residential real estate prices, which started about a decade ago, was over, maybe even in Manhattan.

Our questions should then be, why did this huge investment in subprime mortgages take place, and why should dismal forecasts on the housing/mortgage market affect all others?  The short answer to the first question is George W. Bush’s tax cuts—and this answer should give the Democratic candidates another reason to repeal them. 

The rationale for these cuts came from the supply-side arguments of the 1980s (personified by Dick Cheney).  It goes like this.  Investment, productivity, and employment will increase if you augment the incomes of those who do the saving and investing.  These already wealthy folks will acquire a new monetary incentive to invest in goods production if you raise their disposable incomes by cutting their taxes.  That investment will in turn produce larger payrolls and more taxable incomes, thus canceling the revenue-reducing effect of the original tax cuts.

Then as now, these supply-side arguments have two defects.  First, the history of the 20th century is the record of increasing productivity and output as functions of declining net investment.  Economic growth doesn’t require greater investment after 1919, in other words, so it certainly doesn’t need higher profits or executive incomes.  In fact, any shift of income shares away from labor and toward capital—any shift away from consumption and toward saving or investment—will be a cause of crisis, not of growth. 

For if higher profits aren’t needed for investment in goods production (the “real economy”), they will force their way, as unruly surpluses, into the available speculative sites, for example into the stock market of 1926-29.  Or into “high-end consumption.”  Or into subprime mortgage lending.  Whatever.

The recent private equity mania (“leveraged buy-outs” of publicly traded companies) exemplifies these three tendencies of overwhelming capital surplus, as Ben Bernanke often said before he took up his more taciturn duties at the Fed.

But the stock market has not been as reliable as long-term investors and short-term scalawags alike would want.  The dot.com bust still spooks everybody except me, but I’m the historian who compares it to the crash of 1901-02.  And how many yachts can a rich man steer toward his own private coast of utopia?  Where else to turn?  To the housing/mortgage market, of course, the available speculative site where prices were surging after 1995, even after the stock market tumble of the turn of the century.

Second, tax cuts have never, I repeat, have never caused increased investment—not in the 1920s, not in the 1960s, not in the 1980s, and not in our own time.  The empirical record is uniform: net investment keeps falling no matter what.  Don’t take my word for it.  Consult Peter G. Peterson, a co-founder of Blackstone (a private equity group just gone public), and a former cabinet member under Nixon and Ford. 

There is no cause-effect correlation between lower taxes and greater investment because, again, economic growth no longer requires, or even allows, increasing net investment.  At the macro level, we can improve productivity and output just by replacing and maintaining our existing capital stock—we certainly don’t have to make any additions to it.

So to cut taxes for the wealthiest individuals is to invite them to place their augmented incomes in the hands of people who have no choice except to bet this new money on the available speculative site, in this instance on the housing/mortgage market.  There’s no place else to put it if they want to get a return better than a savings account or a stodgy mutual fund.  It was a “liquidity driven bull market,” as David Rosenberg, the chief economist at Merrill Lynch, puts it (FT 8/16/07).  And it has regulated all others because the bulk of the surpluses generated by tax policy went there.  When it turned, everything else did.

The housing bubble was part of economic growth in the last six years, don’t get me wrong.  But notice that it was first driven by “high-end consumption,” then by subprime consumption of housing, not by an original investment in goods production.  It created employment in the building trades and put demand on industries that fabricate construction materials because consumption as such had long since become the leading edge of economic growth.

But what is to be done?  Yes, let’s repeal the Bush tax cuts and shut off the “high-end” source of the speculative boom in housing/mortgages—also the source of the boom in mergers and acquisitions, the bread and butter of private equity.  And yes, let’s subsidize “low-end” consumption of housing (among other things), to begin with by mobilizing Fannie Mae and Freddie Mac on the Gulf Coast.  In view of its pathetic performance in the real world, why not reverse the vector of the supply-side argument and start writing loans the way we write history, “from the bottom up”?

Meanwhile, however, can we leave this crisis in the hands of the bankers?  It all depends on which bankers we’re talking about.  Also when.  One of the architects of the Federal Reserve System, Paul Warburg of Kuhn-Loeb & Co., declared—this is in 1910—that “money making and the maintenance of a safe proportion between cash and cash obligations are at times distinctly opposed functions.”  Translation: if you let the banks scramble individually and competitively for liquidity in times of financial crisis, in the name of the profit motive at the micro/firm level, you destroy the system; at that point nobody gets to be motivated by the possibility of profit.

People like Warburg still populate the global financial system—think of Joseph Stiglitz, who fought the good fight at the World Bank, and who now writes bracing books about globalization and its discontents.  Better yet, think of William Poole, the president of the St. Louis Fed, who has been quoted repeatedly in the last few days as an old-school, “moral hazard” kind of guy.  In the front page, lead story in the Financial Times last week, for example, Poole is quoted as saying that only a “calamity” would justify an interest rate cut before October, when the official subcommittee of the Fed is to meet (his remarks were later disavowed by a Fed spokesperson, which means rates fall in September).

Poole is clearly the go-to guy when you want to talk about the “moral hazard” central banking entails.  Let the market do its cleansing work, he seems to be saying, let the losers take their losses.  But then you re-read Martin Wolf’s curmudgeonly column in the FT of August 16, and you wonder what planet St. Louis is on—it can’t be capitalist America.  Wolf, an erudite economist with a great sense of humor, says he loves the business cycle because it purges the system of the imprudent and the speculative investors; the market, he insists, needs fear of falling to keep it honest.  Then he quotes Poole approvingly as follows.

“When William Poole, chairman of the St. Louis Federal Reserve, said that ‘the Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment or when financial market developments threaten market processes themselves,’ I give a cheer.”

Me, too.  Three cheers from me.  This is Warburgian rhetoric on the melodramatic level of opera written by Brecht.  Poole is saying that we need to use the central bank’s full powers when financial crisis threatens market forces as such—forces he knows are already administered.  And notice the two “fundamental objectives,” normally construed as antithetical goals on the supply-side of town.  In this conspectus, the market is far from an anonymous set of forces to which we must submit for our own good.  Instead it’s something we manipulate in the name of social goals such as “high employment.”

Like the Dude, who unwittingly foiled the venal plans of the Big Lebowski, a loud-mouthed neo-conservative, socialism somehow abides in our America, even where finance capital has taken up residence.

So if my retirement account is at risk just now, I’m not that worried.  Markets have been socialized to the point of—oops—no return, by the very people who still believe in their moral contents and imperatives.