700

This is my 700th post. Since the number 700 has been so closely associated with the financial system bailout in the last few weeks, I figured that I would talk about that. There are two real dangers in such a topic. The first is that it gets too academic and boring. The second is that it gets too political. I will try to avoid both.

It's been an interesting ride watching different perspectives on how the country got to its current point. If you know anything about economic history, though, this issue followed the normal pattern, which I will lay out below. I am sure that a lot of other intelligent people picked up on this pattern as well.

1. A financial opportunity presents itself. In this case, real estate was made more attractive through cheap money (low interest rates).
2. Large numbers of people start noticing that the first people to the party have already made a lot of money. In this case, people started noticing that home prices were going up fast. Rather than thinking that this indicated that real estate's best days were behind it, a lot of people decided to stretch to buy a house even though it was financially wiser for them to rent.
3. Since all the people joining the party in step #2 inflate prices over a period of time, caution is thrown to the wind. Since prices have gone up for this long people assume that they will continue to do so indefinitely. This is where everyone gets stupid. No one in their right mind should ever conclude that five years of price run-ups indicate a long-term indefinite trend, but usually it becomes accepted as gospel truth. It helps that the people preaching it have already made a ton of money. In this case, a lot of people who didn't otherwise know much about real estate started thinking that flipping houses would be a good idea because house prices only go up, and because they watched too much TLC and HGTV. On the investment bank side, derivatives that were essentially outsized insurance policies against bad mortgages were created and traded in droves under the bad assumption that prices would continue to go up. Hedge funds also magnified things by making the same bad investments as everyone else, but largely with borrowed money.
4. Reality sets in. In this case, foreclosures started increasing as peoples' ARM interest rates increased. This created a vicious cycle of house devaluations and increasing foreclosure rates that we are still trying to work our way out of. Almost regardless as to the cause of the cycle (dot-coms, bad mortgages, etc), the key phrase you are going to hear a lot is "excess inventory." The cycle will not be complete until excess inventory is removed, and that can cause a large percentage of the pain in the next two steps.
5. People overreact during the aftermath. A bad situation is made worse because fear grips those who just had their dream world ripped away from them. There is mass selling. Companies layoff or refuse to hire due to a similar fear of the unknown. In this case banks, who are gripped with fear, have decided to sit on the money that they do have, thus presenting a very real threat to short-term economic progress.
6. The government implements a fix. The fix may or may not be effective. The title of this post is obviously in reference to the current $700 billion fix (no one really knows how much the fix will ultimately cost, but that is beyond the scope of this post). In the Great Depression the fix was the New Deal, which created such things as Social Security and (believe it or not) Fannie Mae. The low interest rates that spawned the current crisis were part of the government fix for the recession created by the dot-com bust.
7. Repeat. How long it will take until the cycle is repeated, I don't exactly know. The Great Depression required over a decade, serious deficit spending, and a world war to end. Most recessions, however, are less than two years long. I do know that we will see all of these steps again, regardless of whether the Republicans or the Democrats are running the show.

Now, I have just a few thoughts about the proposed solution. I don't like it, but I agree with the analysis that to do nothing is to invite another depression. The Great Depression was caused by a failure of the banking system, so the banking system as a whole absolutely cannot be allowed to fail. As someone who believes in free markets, it hurts a little to take that position.

I have noticed that Democrats tend to blame a lack of regulation and Republicans tend to blame the push in the late 1990s to make loans much more available to higher risk recipients as a root cause of the problem. They are probably both right to some extent. I don't really know who is more right. At the moment neither is a pertinent problem, though, because we are still working through the overreaction stage of the crisis. Addressing either of those five to ten years ago would have helped, but now they don't do too much.

If I had to guess what the focus of the next cycle will be, I'd bet on alternative energy. That has a ton of potential to produce an irrational bubble, because the very few alternative energy winners will make a ton of money. People usually forget that there usually are many more losers than winners. We are actually already in the middle of a small ethanol production bubble burst, so it would make sense that we would repeat this whole process on a larger scale.

I hope what people get out of the whole situation, though, is an understanding that these stages are completely propagated by human stupidity. Irrational exuberance and overwhelming fear drive overreactions in both directions. To me my house is worth the exact same as it was worth a couple of years ago, when taking into account the changes I have made to it in that time. It is only the market's opinion that has changed. The sun will come out tomorrow. The only real question is whether tomorrow is next year or a decade from now.