Since the 2008 financial crisis, Wall Street has been the perpetual whipping boy for the ensuing recession that has rocked the global economy. In the United States, Manhattan bankers relied too heavily on subprime mortgages, the story goes, sparking the crisis -- in bureaucratic jargon, what is dubbed a "regulatory oversight failure." In Europe, the debt crisis -- which struck again last week when the credit-rating agency Standard & Poor's stripped France of its AAA rating -- is often blamed on the fact that eurozone governments maintained outsized debt-to-GDP ratios, thereby breaking the rules laid down in the Stability and Growth Pact they signed when they joined the currency union.
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U.S. President Barack Obama has laid the blame at the feet of Wall Street "fat-cat bankers," and he finds himself in the company of Federal Reserve Chairman Ben Bernanke. Even Republican presidential hopeful Mitt Romney criticized Wall Street for "leverag[ing] itself far beyond historic and prudent levels" in his 2010 book, blaming its "greed" for contributing to the crisis. The concept of runaway European profligacy, epitomized by 35-hour work weeks and gold-plated pension programs, is also firmly lodged in the popular imagination.
But these explanations for the twin crises in the United States and Europe simply ignore the facts. Subprime mortgages with exotic features accounted for less than 5 percent of new mortgages in the United States from 2000 to 2006. It is therefore highly unlikely that they were solely responsible for setting off the housing boom that ultimately went bust. The explanation offered for the crisis in the eurozone overlooks the fact that Spain and Ireland -- two of the weak links in Europe today -- were actually paragons of virtue in terms of the Stability Pact. Both countries boasted budget surpluses in the years leading up to the crisis, and both had debt-to-GDP ratios of roughly 30 percent, or only about half the level that was permitted under the Stability Pact.
The immediate cause of the housing bubbles in the United States and the eurozone periphery was not regulatory oversight failure, but the precipitous drop in interest rates in the early 2000s. And the country that bears partial responsibility for depressing interest rates is a traditional punching bag in the American political arena, one that has somehow avoided most of the blame in this round: China. The ascendance of the world's most populous country in the global economy not only changed the terms of trade, but it also had a considerable impact on the world's capital markets.
The chain of events that led to the current economic breakdown began in 2000, when the Federal Reserve began to lower the Fed funds rate, its main policy lever, to stave off a recession following the bursting of the dot-com bubble. The Fed slashed the rate from 6.5 percent in late 2000 to 1.75 percent in December 2001 and then down to 1 percent in June 2003. It then kept the rate at 1 percent for more than a year, even though inflation expectations were well above the Fed's implicit inflation target and the unemployment rate was down to nearly 5 percent, which is considered the natural rate of unemployment. All the while, the Federal Reserve dismissed warnings about a nationwide housing bubble, with then Federal Reserve Chairman Alan Greenspan even denying that it was possible to have such a thing.
The low interest rates initially sparked the refinancing boom -- or as commentators liked to say, Americans used their houses as ATMs. Between the first quarter of 2003 and the second quarter of 2004, the time when the Federal Reserve held its main policy rate steady at 1 percent, two-thirds of mortgage originations were for home refinance. Americans got themselves indebted up to their eyeballs and went on a prolific spending binge with their newly acquired cash. Spending out of home equity extraction amounted to $750 billion, or more than 4 percent of GDP, in 2005 alone.
Fed policymakers generally looked favorably upon remortgaging as a source of personal consumption expenditure. In his now infamous 2005 Sandridge lecture, Bernanke, then a Fed governor, boasted of the "depth and sophistication of the country's financial markets, which … allowed households easy access to housing wealth."
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