Briefing Paper No. 110

How Did We Get into This Financial Mess?

As policymakers confront the ongoing U.S. financial crisis, it is important to take a step back and understand its origins. Those who fault “deregulation,” “unfettered capitalism,” or “greed” would do well to look instead at flawed institutions and misguided policies.

The expansion in risky mortgages to underqualified borrowers was encouraged by the federal government. The growth of “creative” nonprime lending followed Congress’s strengthening of the Community Reinvestment Act, the Federal Housing Administration’s loosening of down-payment standards, and the Department of Housing and Urban Development’s pressuring lenders to extend mortgages to borrowers who previously would not have qualified.

Meanwhile, Freddie Mac and Fannie Mae grew to own or guarantee about half of the United States’ $12 trillion mortgage market. Congressional leaders pointedly refused to moderate the moral hazard problem of implicit guarantees or otherwise rein in their hyperexpansion, instead pushing them to promote “affordable housing” through expanded purchases of nonprime loans to low income applicants.

The credit that fueled these risky mortgages was provided by the cheap money policy of the Federal Reserve. Following the 2001 recession, Fed chairman Alan Greenspan slashed the federal funds rate from 6.25 to 1.75 percent. It was reduced further in 2002 and 2003, reaching a record low of 1 percent in mid-2003 - where it stayed for a year. This set off what economist Steve Hanke called “the mother of all liquidity cycles and yet another massive demand bubble.”

The actual causes of our financial troubles were unusual monetary policy moves and novel federal regulatory interventions. These poorly chosen policies distorted interest rates and asset prices, diverted loanable funds into the wrong investments, and twisted normally robust financial institutions into unsustainable positions.

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Lawrence H. White is the F.A. Hayek Professor of Economic History at the University of Missouri-St. Louis and an adjunct scholar at the Cato Institute. He is the author of Competition and Currency, Free Banking in Britain, and The Theory of Monetary Institutions.