In this post, I will try to paint in broad strokes my understanding of what caused the 2007 economic downturn and what I think it should mean for the future of the finance sector in the United States.
Starting in the 1990s and continuing into 2006, housing prices increased steadily and substantially. Variable rate mortgages and other sub-prime loans were riskily extended to those with relatively low credit ratings. Buyers assumed they would be able to pay the higher interest rates that kicked in after a designated time period because they thought their careers would progress or, in the alternative, they thought they could just sell their house for a profit. Overconfidence in the stability of the rising housing market prompted speculators to purchase, flip, and develop real property with little hesitation. The housing bubble grew until it burst in late-2006 and 2007. In most of the country, home prices initially only stalled. However, in markets like Florida, Nevada, Arizona, and California where there was an especially pronounced oversupply of housing, the prices dropped abruptly. The other states followed suit.
Then, in 2008, Bear Stearns, a giant investment bank was pulled into the red by its failing hedge funds that were heavily composed of investments in mortgage backed securities. Government sponsored enterprises Fannie Mae and Freddie Mac, dealers in mortgage backed securities, were both collapsing. The U.S. government took over management of Fannie Mae and Freddie Mac and bailed out AIG, a reinsurer of mortgage securities that was on the brink of failure too. By March of 2009, the Dow Jones had dropped from a high of 14,000 in 2006 to a mere 6,547.
Other financial industry giants were also failing. Lehman Brothers filed for bankruptcy and Merrill Lynch sold out to Bank of America hastily to avoid the same red-lettered fate. With other banking institutions like Citigroup teetering, the Legislature passed a $700 billion (yes, billion; as much as the entire GDP of Indonesia) bailout called TARP. They bought billions of dollars worth of stock in banks like Citigroup and guaranteed billions more dollars in loans. Taxpayers might still be Citigroup's largest shareholder. And yet, they cannot pass the government stress test even today.
The manufacturing industry suffered as a result of the crisis too. So the government poured billions of additional dollars into General Motors and Chrysler in addition to the TARP bailout. But both automobile companies and numerous other manufacturing companies went bankrupt anyway.
These problems affected the entire economy, making for fewer American jobs. In an effort to raise the unemployment rate, Congress provided a $787.2 billion (although the encumbered nature of some of the "investments" probably raise the true price to above $1 trillion) Economic Stimulus Package. Near the same time, Congress guaranteed billions more dollars of loans to failed banks.
The economic downturn has engendered a lot of anger (often directed at the finance industry and politicians) and even more finger pointing. Most likely, the combination of low mortgage interest rates and deregulation was the primary cause, although financial globalization, global imbalance of debt surplus and deficit, executive compensation, and credit cards among other factors likely contributed to the problem. The blame game is futile. What is important is learning from the past and moving forward instead of backwards (although perhaps something we did in the past is better).
We should not be mad at finance as a whole. The finance sector and many of its innovative financial instruments have enabled socially beneficial enterprises that were unimaginable before stock markets, mortgages, loans, bonds, swaps, options, micro-loans, crowd funding, etc. Therefore, the solution to the economic downturn caused by the housing crash is not to hastily restrict the size and inventiveness of the finance and business industries. Rather, regulations should be thought-out and designed to channel financial creativity in ways that most benefits the ability of small businesses and huge corporations to capitalize, grow, innovate, and succeed on the world stage.
One challenge faced by legislatures and economic policymakers is the fact that innovations in finance often help society; but, innovations in finance make finance more complex and harder to predict and understand thus making them more risky. Perhaps the price for the benefits of big and complex finance instruments is occasional bubbles and economic downturns. But, perhaps the cost is worth it. On the other hand, repentance is often harder than not messing up in the first place. Perhaps getting out of the economic ditches does take longer than not getting in them in the first place. I don't know the answer. But, I bet it is somewhere in the middle. Nations that are slow to innovate in finance and who make it hard to buy and sell risk lag behind other nations in political stability and economic growth (e.g. compare Ghana and S. Korea who had similar political and economic situations in 1960. Other factors played a role too [fertility rates, Ghana taking IMF loans, South Korea's linguistic and cultural unity, etc], but it is far-fetched to deny that S. Korea's financial acumen played no role).
The replacement of faith with moral relativity and cynicism also contributes to economic downturns. Without unifying belief in post-death consequences, there is no forceful constraint on behavior when there is pressure to act selfishly. My careful observations confirm that faithful people have more of a stomach to do what is right when nobody is looking. As the priority of religion dwindles in America, I predict that business and finance leaders will be less and less bound by morals and they will have more need of being restricted by economic regulations and criminal laws that will, in turn, burden the full potential of businesses and the finance sector to do good for society. Although a strong moral education and ethical character among leaders will not solve all the complex social risks of finance innovation, it is certainly an important part of the solution.
In short, I would say that the proper course for the United States vis-a-vis the finance industry is two-fold. First, complexity and innovation in finance should be encouraged, but not to such a degree that regulators, shareholders, and legislators can't understand reflect on the implications of the develpments. Regulation should be efficient and not overlapping or over-broad. Second (and the government's role is limited here), religion and traditional values need to have a stronger presence in the lives of Americans. This starts in the home.
