Thursday, 12 September 2013

Who caused the global financial crisis? An inconvenient truth.

Guest post by Vinay Kolhatkar

Who caused the global financial crisis? You must surely have heard the wrong explanation, something that goes like this:

  1. American banks knowingly sold unrepayable home loans to a gullible public;
  2. Unregulated Wall Street greed resulted in poor investments being sold to retirement funds the world over;
  3. Credit derivatives, collateralised debt obligations (CDOs), and credit default swaps, were evil toxic securities created by banks which led to a huge loss of wealth;
  4. This house of cards collapsed, leading  to corporate insolvencies, stock market crashes, real estate value
    declines, and increased unemployment;
  5. If governments had not stepped in to rescue the banks and insurance companies, we would have had a
    depression that could have lasted decades;
  6. It proves once and for all, that in a system of unregulated capitalism, the greedy and the corrupt will take
    advantage of the simple and the virtuous;
  7. So we must now regulate the financial system even more to prevent this from ever occurring again, and rescue us, the people, from the current malaise—via ‘economic stimulus’ that the government alone is an expert at

There are almost no major media outlets anywhere—newspapers, television, radio, magazines, even Hollywood movies and television serials—that have not repeated a version of this mantra. Nevertheless, it is imperative that serious students of finance and economics maintain a critical perspective and look behind-the-scenes for what the true story may be.

For example, students of investment theory know that derivative contracts are zero-sum games in which wealth can neither be created nor destroyed. Explanations which merely lay the blame at  the feet of ‘financial instruments’ and ‘greed’ are either incorrect, or at least missing something crucial.

So what is the real story, and who has  been voicing it?

In recent times, some of the prominent voices of reason have been: George Reisman, Thomas E Woods and other economists associated with the Ludwig Von Mises Institute; Ron Paul, a libertarian ex-congressman and a candidate for the  Republican nomination for president in 2008 and 2012; Governor Gary Johnson, the Libertarian Party candidate for president in 2012; investment maven Peter Schiff; and the folks at the Ayn Rand Institute. In times past, the real story was narrated several times by Ludwig Von Mises, Henry Hazlitt, and Friedrich Hayek— some of the greatest economists associated with the Austrian tradition of economics, and also by an outstanding
exponent of free market capitalism— philosopher Ayn Rand.

The principles of the free market have long since been discovered. An Inquiry into The Nature and Causes of The Wealth of Nations was written by Adam Smith in 1776, and the principles were refined in the 19th century.
Those who follow the rules of logic, and are objective in their judgment, have not a shred of doubt as to the efficacy of the free market.

Wherever there is a systemic economic problem—collapsing asset prices, widespread unemployment, a cluster of insolvencies, inflation, depression, stagflation, or recession—the source of the problem is almost always that elected officials have not allowed the free market to work. Governments interfere with the market economy using various devices such as subsidies, tax incentives & other legal distortions, unwarranted regulatory burdens, price or volume controls, dictates about which consumers are to be served, or outright nationalisation. This is the generic form of the story.

The particulars of this story (the lessons of history wasted, yet again)

In his book Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse, Tom Woods, an Austrian economist, discusses the particulars of this story and the sticks and carrots thrown into markets by the Clinton and GW Bush Administrations:

The Clinton Administration revived legislation that was designed to ‘encourage’ banks to issue home loans to minorities. Even though Asian Americans were getting more home loans in percentage numbers than white Americans, an apparent lower rate of lending to African Americans and Latino Americans was taken as prima facie evidence of discrimination. The stick of reputation destroying discrimination lawsuits became quite ominous as regulators began to collect
data regularly from the banks. Later studies found that there never had been any evidence of discrimination when the data was adjusted for credit risk, but the media uproar drowned out the follow-up studies. The American dream was being denied to some on account of their race, said the media. The market, already tied up in subsidies and regulation,
was further nudged into an uneconomic direction.
    The fire ignited.
The Bush Administration then added carrots to the stick, and the financial party
morphed into an inferno. Far more capital was diverted into real estate construction than was
justifiable. Eventually there was glut of construction, and prices collapsed. Even though banks were packaging the risk of price downturns and selling them in the form of securities, they did hold significant portions
of it themselves, and their solvency came into question. In the thinly capitalised industry of banking, it was not easy to tell which of the banks were solvent and which were not, so banks grew wary of lending to each other. In
the modern economy, financial markets cannot function easily without financial intermediaries carrying large levels of risk to each other, and the contagion of panic spread.

So what were the Bush-era carrots?

First, the Government created or revitalized institutions that they owned to give them an appearance of government-supported credit risk. You may have heard of Fannie Mae and Freddie Mac, the colloquial names
used respectively for the Federal National Mortgage Association, and the Federal Home Loan Mortgage Corporation. These institutions were granted over USD 2 billion in a line of credit by the Department of Treasury. Moreover, their quasi-government status helped them to raise money cheaply. These institutions bought the worst of the risk, embedded in the form of securities, from the banks.

Government alone can counterfeit money

Further, Governments everywhere have allowed their central banks to create paper money out of thin air—so that they can spend money on vote-grabbing schemes without ‘raising taxes’, which is an electoral no-no. It
is a two-step process—governments raise money by issuing bonds, and the central banks boost the prices of those bonds by the money created out of thin air. The central bank may intend to reverse the price boost
down the road. This money creation exercise also creates a temporary illusion of prosperity,
a perfect device for getting re-elected when in power. In this case, it added fuel to the fire. The prosperity illusion, however, begins to fade. More money needs to be printed to kick the can down the road again. Eventually the problem gets too big to avoid, and the central bank can no longer reverse the price boost.

From 2003, and leading up to the crisis in 2007, the stick & carrot regime created an irresistible cycle of profit for the banks. The cycle began with unwarranted construction, followed by lending to the undeserving, who would then buy homes to keep the construction going, followed by the banks selling major portions of the risk to the Fannies, the Freddies, and anyone else who would buy it—and there were more of those when the illusion of prosperity was created, and finally, pocketing structuring fees for the CDOs so issued. The cycle took about a year from end to end. But at any given time, many such unfinished profit cycles would overlap. Thus when the bubble burst, the banks were left holding a lot of the risk.

To restore “equilibrium,” i.e., to allow the economy-wide structure of production to match up again with the economy-wide structure of genuine demand, malinvestments in one sector of the economy must be painfully liquidated, and capital redeployed. The problem cannot be cured by simply looking the other way, or by propping up with even more government handouts the sectors in  which malinvestment has occurred. In fact, the more the market is prevented from functioning normally, the longer it will take to cure the problem.

The cure is never costless.  But the longer it is postponed, the more it will cost.

The unavoidable inference

The U.S. Government, due to its desire to force its will on the market, was the primary culprit behind the large-scale malinvestment, and the consequential crisis that followed.

Why is this obvious truth hidden from the public?

As governments are in the business of getting re-elected, they and the economists in their lucrative employ generally do not wish to acknowledge, sometimes even to themselves, their principal causative role in the boom and
bust cycle.

In 1936, a mathematics lecturer by the name of John Maynard Keynes gave a vacuous scholarly credence to the notion that free markets do not work, and that governments, undoubtedly advised by utopian macroeconomists, must step in to ‘fix’ the market. This idea elevated the role of politicians, and opened the gates of fame and fortune to the macroeconomist government advisers. As Hunter Lewis amply demonstrates in his book Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Busts, this so-called treatise was mired in obfuscations, incorrect assumptions, and bad logic, but came replete with elegant and opaque prose, and equally elegant but dense and diversionary mathematical equations. With the publication of The General Theory of Employment, Interest, and Money, a quack was elevated to the level of a superstar.

Soon after, Keynes was duly anointed as the father of modern economics, and the science of money suffered so serious a setback that it has never recovered. With government control of curriculum in public and private education, hordes of future academics, newspaper columnists, elected officials, film & television producers, and even investment professionals and company presidents, have been trained to think in terms of the avarice myth (“markets left to themselves must necessarily reward avarice over conscientious work”), and the fixed pie
(“wealth is never newly created, it is always taken by the powerful from the vulnerable”).

In historic times, monarchs did dilute gold money to cheat their subjects but at least the classical economists (Adam Smith, David Ricardo, and John Stuart Mill) never pandered to the monarchs by offering a scholarly cloak
of respectability to this deceptive practice. Following the Keynesian era’s extraordinary intellectual regression however, fine-tuning the economy by creating money out of thin air to stimulate the economy, and arbitrarily
reversing this to slow down the economy, has been converted into a pseudo-intellectual art form. But in practice, the cumulative action over a decade or more in almost any part of the world is a savage level of net money
printing, which results in an inflation tax that governments do not ever acknowledge as being entirely of their own making. Productivity has a natural tendency to get better and will rarely decline—thus prices should in general be reducing, yet endless inflation is now a world-wide phenomenon.

Where to, next?

Investment practitioners should not assume that market events are so unforeseeable that diversification across asset classes is the only rational avenue to pursue in an increasingly volatile world. It is befitting to try and
understand the macro causes of why asset prices and economies as a whole are volatile, and why markets appear to fail. Modern finance theory does not illuminate the practitioner in this regard.

If classical and Austrian perspectives are correct, various world economies are headed for a severe downturn when the music stops for unrepayable levels of government debt. Keynesian solutions to print even more money and to recklessly divert capital to economically unprofitable election promises are dangerously in play in the U.S., the U.K., Japan, China, in some Eurozone economies, and in Australia.

Regulation of the finance sector has increased. Meanwhile, subsidies to the finance sector abound in terms of increasing government bond prices—through money printing for which the banks are the first beneficiaries, and prop-ups of the banks’ severe illiquidity & outrageously low levels of capital via the central bank’s lender-of-last-resort credit facilities. Yet these subsidies are not even reported by the mainstream media, much less fought against.

Vast numbers of politicians are untrained in Austrian or classical macroeconomics, and are ill-advised, often by advisers who are themselves similarly untrained. Thus, many who carry the courage of their convictions, could be taking ill-informed decisions, unaware of the deleterious longer-term effects of their policies.

There is no substitute for thinking, and a bit of quiet reflection. Read widely, ponder, and decide for yourself.

Here is a collection of readings that may help:

  1. Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Busts by
    Hunter Lewis
  2. Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse by Thomas E Woods
  3. Capitalism: The Unknown Ideal by Ayn Rand
  4. Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economics by Henry Hazlitt
  5. The Government Against the Economy by George Reisman
  6. How an Economy Grows and Why It Crashes by Peter D Schiff and Andrew J Schiff
  7. The Frankenstein Candidate: A Woman Awakens to a Web of Deceit by Vinay Kolhatkar

Image of Vinay KolhatkarVinay Kolhatkar is a Sydney-based writer and finance professional, and non-resident fellow at Contraditório Think Tank, Portugal. He has a Masters in finance from the University of NSW, and wide-ranging experience in the financing of large infrastructure projects. He was the founding Chairman of the Great Energy
Alliance Corporation. He is the author of
‘The Frankenstein Candidate: A Woman Awakens to a Web of Deceit,’ a political thriller novel available on Amazon, Kindle, Book Depository, and various other online outlets.
This article first appeared at the website of the
Contraditório Think Tank.

[Hat tip Dale Halling]


  1. So black and latino people should not be lent money because they welsh on the deal - is that basically what you are saying?

    If money had only been advanced to 'decent white folks' all would have been well - is that about right?


    If the borrower is black the buggers will spend all their money on fried chicken, crack cocaine, hip-hop CDs - *wink wink* - don't we all just KNOW what these people are like?

    50 years ago the KKK and Strom Thurmond and others warned us, we never listened and goddammit! now we are in deep doo-doo!

    Is that about right Mr Kolhatkar?

    I imagine you would get cheering and a standing ovation at the various 'freedom' (*snigger*) conventions of the American Conservative Union and other bastions of 'freedom [for people like us]' organisations; afterall they were warning everyone about those pesky black people back in '64 weren't they?

    I wonder if you could take your hand off your cock for a moment, Mr Kolhatkar, and give us some numbers of defaults on mortgages and personal loans broken down by ethnic groups?
    Would there really be a large disparacy? would such figures really prove your assertions?

    I cannot believe anyone is taking this rubbish seriously.

    Next you will be telling us Bill Clinton and George W. had a cup of coffee and actually planned it all.

    Funny how when black and latino people buy houses it is 'malinvestment' but 'prudent' when you do it; god forbid anyone black buys a house to become a stakeholder in their community, or to provide security for their family.

    No doubt next week we will hear about the Maoris in NZ and their mortgages.

  2. "So black and latino people should not be lent money because they welsh on the deal - is that basically what you are saying?"


  3. At the beginning of this piece, seven concise points are listed representing the popular but wrong explanation. Then we get 20-some meandering paragraphs of the right explanation. The wrong explanation is winning in large part because it is being conveyed in brief bullet points rather than long-winded digressions.

    Condense! Outline! Essentialize! Counter the seven points with seven points of your own. THEN go into detail and let the reader decide if he wishes to spend the time exploring your justification for your seven points.

  4. Mr Lineberry - To my eye Vinay looks like he has a bit of "latino" in himself, so calling him racist makes about as much sense as calling you homophobic!

  5. Hello Mr Lineberry,

    There is no way I would advocate a system in which people of colour (which includes me and my family, by the way) would be discriminated against. Each and every time we get a result that does not conform to demographic percentages, we cannot play the racism card. It does happen now & then. But Govt action to force quotas is not the answer. Sometimes it discriminates against minorities. Refer
    As the argument in the GFC article makes it clear, both GW Bush and Clinton had little idea of just how damaging their actions were. Ignorance is not bliss. But I think we agree on one point. We want to end elitism. On my part, I would like to see elitism replaced with meritocracy. The nexus of Wall Street and the Federal Reserve supports elitism. High inflation will not hurt the entrenched rich who have hundreds of millions in assets.

  6. Hello Anonymous,

    Why 7? I will give you 1. All persistent economic problems in developed economies result from Government interference in the economy.

  7. Hi Vinay, sorry for the delay in replying but I was in Sydney on business for a week or so and can never seem to get near a computer in that fine city.

    I never said you were racist, but merely singling out one group of easy targets and giving a massive 'wink' to the crowd who have experienced 5 years of financial turmoil in their lives: "your problems in life are caused by __________ and we all know what they are like"; much easier to explain the deep doo doo if you can put a stereotype face to the name.

    I also find the obsession with blaming the least little thing on the purchase of real estate just silly as most people purchase a house to live in and raise a family.

    In answer to your question "where to, next?" I think the answer is simple - hard work.

    Stop blaming people and politicians and who did what to whom about the thing at the place - and encourage your readers to start working. A novel concept.

    If everyone had their own business and reinvested their profits making it larger; then larger, then larger still - the problem would be solved fairly quickly; ie: seeing how quickly you can double your turnover and profits will make you a lot wealthier than anything else.

    But to play to an audience of middle class white people who are earning half what they used to, who have lost their house, who have had several years of financial pressures - by dog whistling about Government mandated lending to "minorities" in order give them a straw to grasp of the "oh well you can't say it out loud these days but at least I now know who is responsible for my problems in life" variety, is beneath you Vinay.

  8. the drunken watchman23 Sep 2013, 18:44:00


    just ignore him

    his comments usually involve some sort of personal attack

    I dont think straight talk will work with him

  9. Oh hello watchman, didn't notice you there - I see you are lowering yourself to the occasion again.

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  11. 1. In response to bank lobbying, Gramm-Leach-Bliley was enacted by politicians to reverse Glass-Steagall, enabling banks to gamble with depositor funds;
    2. Due to government use of both carrot (Freddie/Fannie guarantees) and stick (anti-discrimination lawsuits), American banks knowingly sold unrepayable home loans to a gullible public;
    3. A crony ratings system (see Egan Jones denied the right to compete) resulted in poor investments being sold to retirement funds the world over, rated at AAA;
    4. After several years of ridiculously mismatched profits with risk due to feedback from expansion of credit, banks started to believe that these risks were actually good, and gamble on them too;
    5. To allow greater leverage (return on gambling), risks were marked as 0 if they were insured by an AAA rated entity (e.g. AIG);
    6. The required exponential growth hit some form of wall, and a small fraction of loans that could never be paid back defaulted;
    7. The house of cards built with derivatives and leverage, built using depositor funds, started to crumble;
    8. To allow the shell game to continue, mark-to-market was suspended and banks were allowed to fall to negative real reserve ratios - i.e. if they weren't banks they'd be bankrupt, but because they can make money, they did;
    9. Unenforced regulations for the elite (see IndyMac) allowed for those with friends to get away with this for as long as required;
    10. With all banks at negative real reserve ratios, the situation was still highly volatile. The choices were:
    A) Bankruptcy for the banks, massive wealth loss for (some of) the elites and a severe but brief depression as the market reallocated capital
    B) A massive wealth infusion to the elites via the banks from the middle class and an ongoing malaise until 1-7 are all re-run
    12. B was decided upon, and a sales pitch was presented up to and including the threat of tanks in the streets
    13. To sell that the problems were caused by inaction rather than action they let one domino (Lehman) fall, caught things quickly and said "never again";
    14. It proves once and for all, that in a system of concentrated power, people will abuse that power;
    15. So now we must give those who abused their power before more power through creating more laws and bureaucracies, because this time they will be used for good not evil;

  12. I forgot one - probably in before #2, since it's groundwork that has "always" been there:
    Required by government regulation, the FDIC socialized risks across banks by charging a fixed percentage of deposits. Banks taking small risks now could not profit at all, while banks taking large risks or already near closure could easily woo depositors with huge interest rates that came with no risk attached.

  13. Vinay Kolhatkar19 Nov 2013, 22:01:00

    Thank you for that input, Martin.


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