Interest Rates, Caffeine and Fuzzy Signals: Intervention and Recession Nikolai G. Wenzel, Ph.D. Broadwell College of Business & Economics Fayetteville State University

Overview Initially a housing bubble …then a financial crisis …and now an economic recession What happened Overinvestment in the housing market Risky investments… and risky loans But HOW could it possibly happen? And WHAT NOW?

Outline Theory A Contrarian History of the Crisis of 2008 III. Prospects for Recovery Conclusion

I(1). Theory: The Dynamics of Intervention Intervention in one market leads to intervention in other markets Intervention as distortion of price signals Examples: milk, medical services, etc. First proposed by Ludwig von Mises

I(2). I, Pencil Specific Lessons: General Lessons: “not a single person on the face of the earth knows how to make me” Inputs from multiple countries… and multiple skills A pencil is made by millions of people who have never met… …and don’t care about each other – or pencils! General Lessons: Markets = cooperation without coercion Knowledge is dispersed; markets make use of “local knowledge of time and place” Price mechanism communicates limited knowledge and coordinates interests

I(3). Moral Hazard If you’re protected from the consequences of risk… you’ll engage in riskier behavior Examples include: Insurance Antilock brakes Airbags and seatbelts

II(1). Housing and Monetary Policy The Federal Reserves controls the money supply A higher supply means lower price of money… or the Fed can simply lower “the” interest rate The interest rate is simply the price of money The money market then effects the market for loans

II(2). Housing and Monetary Policy 2001 (January): 6% 2003 (January): 1% 2005 (January): 1.25% By 2006: 5.25% Cheaper money = more loans More loans = increased demand/prices

II(3). Housing and Fuzzy Signals Caffeine versus sleep The evil leprechaun TA Crossing a desert in a bus: speed or AC?

II(4). Housing and Fuzzy Signals Interest rates reflected Fed policy… …but not the real price of money! Artificially low prices meant overinvestment… …followed by a necessary crash!

So… why did all that easy money end up in housing?

II(5). Housing and Regulatory Policy Specific background Bush, Clinton and the ownership society Home ownership 64% to 69%, 1990s to 2000s General background Federal govt support of housing since New Deal Federal govt support of housing since 1970s

II(6). Housing and Regulatory Policy The Federal Housing Administration (FHA) Lower downpayment requirements Incentive to spend more (ΔD) Freddie Mac and Fannie Mae Federal insurance on housing loans Moral hazard and downward-sloping demand Private profit… backed by taxpayers

II(7). Concluding the History Remember the theory: Dynamics of intervention Institutions and information Institutions and incentives Artificially cheap money: Downward-sloping demand Massive quantity increase (housing bubble) Overborrowing, overbuying, new financial instruments Moral hazard and regulatory policy Overinvestment in housing, generally Overpurchasing, specifically Bailouts: privatize profit, socialize risk (more moral hazard!) The housing bubble… and the bursting bubble Unsustainable… like a caffeine high Feeding frenzy… and irresponsible behavior

III(1). Long Run Production and Recovery In sum, my concern is not so much about short-run macroeconomic conditions Questions about long run: Economy’s productive capacity, given regulatory environment Regime uncertainty

III(2). Regime Uncertainty Higher taxes during a recession? Fundamental regulatory change? Health insurance, energy, unions Property rights and regulation: TARP and executive pay caps Chrysler bondholders Govt management Who gets a bailout? Lehman Brothers, AIG, Bear Stearns…

III(3). More Fed Shenanigans

Conclusion 1. Dynamics of Intervention Was this really a market crisis? What’s next? Always difficult to predict future, anyway Especially difficult with regime uncertainty Optimism about American spirit

Feedback and comments welcome. nikolaiwenzel@gmail.com Thank you! Feedback and comments welcome. nikolaiwenzel@gmail.com