Frenzies: the Bad and the Not-So-Bad
The dot-com frenzy was bad, no question. The NASDAQ fell, what, eighty percent? The Dow fell a lot too. Recovery took years. The frenzy was an investment bubble without much debt on the table. It was all equities. The initial public offering market hasn't really recovered yet. There was a recession yes, but not like this one.
What makes this recession different (Lowenstein, 26)? House prices doubled, but that was nothing like the dot-com growth in stock values. However, and there is a big however, there was one big difference. The dot-com bust relied on the growth of stock values and their ultimate bust. The mortgage debacle was based upon risk alright, but not consumer risk. It was lender risk. Lenders figured out how to risk more and more money on loans that didn't ever pencil out. There's a ratio you want to watch, the ratio of capital a bank has to the amount of loans a bank has. Have to many loans with no capital and you are going to have a problem. Something like the Great Recession. Banks were allowed to carry too many loans without enough equity to balance them and the banks got caught. Now here is the good part: it will happen again, guaranteed, unless the regulators do something. All the derivatives allowed the banks to hide loans and make their ratios look far better than they were. So, regulators need to figure out how to measure debt ratios at banks and keep the banks from increasing their leverage too much ever again. That's the simple solution: reduce risk in lenders by making them play by more conservative rules. That's the solution. There's an ugly word here, however, and even moderate Libertarians will watch carefully. That word is regulation. Supposedly, capitalism is self-regulating. Well, this time around, we proved that capitalists make errors. Our job is to make sure they don't make the leverage mistake again.
Reference
Lowenstein, Roger. First, Slap Limits on Bank Leverage. The fight over a financial consumer protection agency misses the point. What fueled the crisis was bank debt. Bloomberg BusinessWeek. 22 and 29 March 2010. 26. http://www.businessweek.com/magazine/content/10_12/b4171026575784.htm