Every crisis has in its official response an implicit official explanation of why the crisis began. As he took office at the trough of the Great Depression in 1933, President Franklin Roosevelt banned the private possession of gold. In doing so, he gave weight to his argument that gold “hoarding” had played a major role in the collapse in consumer spending that had attended the economy during its seize-up over the previous four years.
In our own Great Recession, we had Dodd-Frank. This omnibus bill of summer 2010 carpeted the financial industry with regulations. The very existence of Dodd-Frank has allowed its advocates in Washington to presume that a lack of regulation caused the panic of 2008. As Treasury Secretary Timothy Geithner wrote earlier this month, as he cited Dodd-Frank, “The failure to modernize the financial oversight system sooner is the most important reason why this crisis was more severe than any since the Great Depression, and why it was so hard to put out the fires of the crisis.”
From a logical perspective, it is a fallacy to identify in a response to something an explanation of its cause. Responses to things might be done for all sorts of reasons. But they have no good claim to being diagnostic tools into the things that prompted them in the first place. In fact, they have weak claims as such. If you want to discover what caused something, you shouldn’t root around in what came after, but in what had come before.
Clearing away all the background noise of how the crisis was responded to from 2008 to 2010 — setting aside TARP, Dodd-Frank, Quantitative Easing, stimulus spending, budget deficits — setting all of that aside, let us ask the question: what caused the crisis?
The most obvious problem with the economy during its mild boom from 2003 to 2007 was sectoral. There was way too much investment in things like housing, energy, and commodities.
Here are the stats. The Case-Shiller housing index blew past its usual secular peak of a 15% increase and went up by 90%. Oil did even more, retracing the upward march to $35 a barrel it had made in the 1990s, this time not stopping till it crashed through $100. And gold, which had been parked at about $300 an ounce for two decades, kept lifting its head up after 2003 such that it was brushing $1,000 by crisis time.
Otherwise nothing too unusual was going on in the economy. Unemployment and inflation were low, GDP growth was mild but respectable, budget deficits were within reason.
Given this lay of the land, you want to ask one question. Why the mad dash on the part of capital for housing, energy, and commodities?
Traditionally, activity of this sort will mean one thing: people aren’t trusting the dollar. Housing (which is to say land), energy, and commodities are all classic hedges against superfluous dollar production. Since these investment categories are limited in supply by geology, they cannot match any unnecessary dollar production with corresponding increases in their own supply; the only thing they can do correspondingly is to increase in price.
So there is highly suggestive evidence of a run on the dollar on account of fears of its devaluation, in spades from 2003 to 2008. Were any of these fears justified?
Again, the stats. After falling by a typical 8% against major currencies from 2000 to 2003, the dollar bounded all the way down by 30% against these currencies by 2008. You might call this the Treasury Department’s share in things, in that in its own trading operations Treasury strives to control the dollar’s exchange rate.
As for the Federal Reserve, it kept the federal funds rate mightily low through the 2000-03 sluggishness, at just over 1%. Then it lowered that rate into the recovery of 2003, so that it was nearly three percentage points below what conventional models, such as the Taylor Rule, said it should be. This status quo was maintained until 2007.
A relationship becomes clear. Cause: comprehensive devaluing of the dollar on the part of its masters in the government. Effect: major investment shifting into hard assets corresponding to fear for the dollar’s soundness.
Again, we have covered up all the activities that occurred after the crisis started in 2008, because these activities have no logical claim to be viable tools of diagnosis into what had come before they even existed.
In this light, the exposure in 2008 of the financial sector to currency-hedge instruments, especially to those in land, is clearly but a symptom of the root cause. As the flight from the dollar proceeded from 2003 to 2008, the financial sector was prevailed upon to provide products and insurance commensurate with the major development.
This it did. To mistake credit default swaps, subprime mortgages, easy loan approvals, and all the rest with the fundaments of the crisis is to fail to ask why markets for these things suddenly materialized out of nowhere from 2003 to 2008. It would be news if these things had developed outside of major dollar devaluation. But since they in fact developed in the face of major dollar devaluation, the real story cannot be the financial sector’s accommodation of the new dollar weakness, but rather the fact and origins of that weakness itself.
Surely one of the reasons that public officials have been keen to scattershot blame for the crisis across the real sector is cover. The government in its role of guarantor of the currency caused this crisis, and the crisis turned out to be a major one. So we hear from public officials that it was lack of regulation, the rise of income inequality, Ronald Reagan’s tax cuts of thirty years ago (!) that cased the crisis, in that these things either put the cause of the crisis in the ex-governmental portion of the economy or find government’s culpability in the ancient past. One of the reasons we got Dodd-Frank is to help make the rhetorical case that government was not responsible for this crisis.
Real leadership requires calling things as they are and taking responsibility for past actions. In this election year, and as our great economy still only pokes along, it is time to get serious and admit that the major economic arms of the federal government, the Federal Reserve and the Treasury, mismanaged the currency, and concede that because of it the nation had to endure not only the mildness of the 2003-07 boom, but the brutal Great Recession as well.
This article was first published in Forbes.