There is plenty of blame to go around, but the main culprit is the Federal Reserve. In late 2002 Ben S. Bernanke, then a Fed governor and now the chairman, persuaded Alan Greenspan, then chairman, that the U.S. was in the grip of deflation. In consequence, the Fed pushed down on the monetary accelerator. By July 2003 the Fed funds rate had been squeezed down to 1%, where it stayed for a year. This artificially low interest rate set off the mother of all liquidity cycles.
The Fed’s laxity stimulated the economy and pushed final sales to an unsustainable growth rate of 7% in nominal terms, i.e., before inflation adjustment. (Final sales, defined as gross domestic product plus net imports minus inventory buildup, is a measure of goods and services absorbed in the U.S.) At the same time, the lax monetary policy encouraged investors to take undue risks chasing high yields. To make the most of tiny yields, leverage became the flavor of the day. Carry trades—borrowing in low‐yield foreign currencies and investing in higher‐yield ones— also became popular. Borrow, borrow, borrow. I watched this top‐heavy structure go up with amazement and terror. It had to crumble. It did.
The Fed’s policy blunder also weakened the dollar and thus stimulated commodity price inflation. When the dollar goes down relative to other currencies, the price of wheat, corn, rice and oil all go up in dollar terms. The currency began its downward course early in 2002, thanks in large part to Fed policy, and it bottomed out in mid‐July 2008, having declined 44% against the euro in that period. At the same time, the price of a barrel of oil climbed sevenfold, from $20 to $146. About half of that climb was a function of rising demand (such as from India and China); the remainder can be laid to the weak dollar. The same happened with other internationally traded commodities such as rice and soybeans.
Congress played its part, too. In 2003 and 2004 Fannie Mae and Freddie Mac, the government‐sponsored mortgage buyers, were engulfed in accounting scandals. To get Congress off their backs, they became more committed to financing homes for families with low incomes. The ploy worked like a charm. Congressman Barney Frank, who now chairs the House Financial Services Committee, turned a blind eye to their accounting shenanigans and praised their newfound zeal. That was typical. Fannie and Freddie became the largest purchasers of subprime and borderline (Alt‐A) mortgages in the 2004-07 period with a total exposure of $1 trillion and thereby contributed mightily to the housing bubble as well as their own later collapse.