The disaster of 2008: why it can happen again.
CouNTLeSS CoMMeNTARIeS and articles are marking the tenth anniversary of the panic of 2008. Yet almost all ignore the root cause of the crisis: a weak dollar. A wobbly, volatile currency always begets economic upheavals. If we don’t grasp that fundamental lesson, we will inevitably get into trouble again, big time, in the future.
Moreover, these retrospectives overlook or downplay two other major blunders by the federal government. Here are the three. • Damaging the dollar. Precipitated by the popping of the high-tech bubble, the economy weakened in 2000 and went into a formal recession the following year. In response, the Federal Reserve started to cut interest rates. Then it and the Treasury Department (which by law is in charge of the dollar) began to undermine the value of the greenback.
That was a catastrophic mistake. The theory behind this move was that a gradual devaluation of the dollar would boost exports, which would help stimulate the economy. That theory is nonsense: Countries with unstable currencies always, over time, roundly underperform those with sound currencies. Compare Switzerland, which has had the bestmanaged currency over the past 100 years, with Argentina, which has had one of the worst. Switzerland has expanded impressively, while Argentina has stagnated, even though it was once a global economic powerhouse.
The reason for such a dramatic divergence is simple. Progress depends on investing, and productive investing is aided immeasurably when money’s value is stable, just as markets operate far more efficiently and fruitfully when there are fixed weights and measures for commodities. For example, the amount of liquid that constitutes a gallon doesn’t fluctuate. Money measures value the way a yardstick measures length.
Funny money distorts prices, which are the absolutely crucial conveyors of information—supply and demand—that enables free markets to function. Like a virus in a computer, a distorted currency corrupts the information. As the greenback was gradually gutted, commodity prices soared. oil gushed from $20 to $25 a barrel to over $100. Gold ballooned from under $300 an ounce to a peak of $1,900. When money becomes unreliable, people turn to hard assets. The most dra- matic, destructive example of that process was in the housing market. To one degree or another, other currencies followed the dollar’s bad example. Thus, the artificial housing expansion—and bust—became a worldwide occurrence.
• Washington’s inconsistency brings on financial market paralysis. The inevitable reckoning turned into a panic that nearly brought the financial system into catastrophic cardiac arrest. In the spring of 2008 Wall Street’s fifth-largest investment bank collapsed, loaded with junk mortgages and other questionable assets. Bear Stearns was hardly a linchpin institution, yet the Bush administration decided to bail out the firm’s creditors. The two politically powerful and recklessly run government-sponsored enterprises, Fannie Mae and Freddie Mac, which were bulked up with subprime mortgages, teetered during that summer. Washington came to their rescue. Then Washington let Lehman Brothers, a far larger and more important institution than Bear Stearns, fail. “No more bailouts!” was the message. And then the first money market ever created, having become overly aggressive, was hit with losses. A run on money market funds, which had over $2 trillion in assets, ensued. Simultaneously, AIG, the world’s largest commercial insurance company, needed a huge infusion of emergency cash.
Panic erupted as everyone clutched cash in desperation. Washington reversed course again, granting federal guarantees for money market funds and bailouts for selected banks. AIG and Citigroup were, in effect, nationalized.
• An accounting rule became a weapon of mass destruction. In 2007 regulators resurrected an accounting rule, dubbed “mark-to-market accounting,” that had been abolished during the Great Depression. Its effect was to constantly and relentlessly artificially depress the value of bank capital at a time when these institutions were in precarious condition.
The Bush administration was obstinately oblivious to the perniciousness of this decree. Finally, in early March 2009, thanks to the efforts of a handful of enlightened individuals, the House of Representatives held a hearing that made it sharply clear that this edict had to go. Regulators got the mes-
sage and effectively defanged the destructive rule that was threatening the very existence of our banking system. That put an abrupt end to the terrible bear market that had battered equity averages by almost 60%. The subsequent bull market has gone on to this day.
This whole sorry episode underscores an underappreciated truism: Governments, not free markets, cause economic calamities.