This article examines the nature of the current financial crisis and the urgency of the government’s role in curbing the economic blight.

Let brokers, not government manipulation, set prices

By now, it’s obvious to all that something has gone terribly wrong with the American economy. Comparisons are made to past recessions in hopes of divining the end-by date for the current one. The only problem is that what now masquerades as a recession to the mass media is, in fact, not a recession.

A recession is an economic event triggered and controlled by the federal government, primarily the Federal Reserve, to keep the growth of a nation’s economy in check. It is part of a normal economic cycle, an adjustment in interest rates, taxes, and government spending in a triumphant effort to prevent a nation’s rate of growth from deflating the value of its money, called inflation. While certainly not a desirable state of affairs, recessions are a necessary evil periodically orchestrated and borne by all governments to foster a healthy economy and human progress.

The current dilemma facing the American economy is not simply a matter of a rough adjustment to controlled growth of the nation’s goods and services. It is a calamitous break-down of the financial structures of an economy, a state known in economic circles as a financial crisis. A financial crisis is an economic downturn brought about by the failure of financial and government entities to regulate and adjust to changing market conditions.

The future and bleak numbers

According to The Economist, research performed by economists Carmen Reinhart and Kenneth Rogoff on financial crises across the globe showed that the effects of a financial crisis are more detrimental and endure longer than those of a simple garden-variety recession. On average, gross domestic product (GDP) per person — the nation’s output of goods and services such as construction and brokerage —drops by more than 9% from peak levels. Unemployment rises by 7% on average and remains high for at least 4.8 years.

Real estate prices during a financial crisis drop on average 36% from the peak to trough. California has seen worse in the real estate price tiers that have already adjusted. High-end properties with “sticky” seller prices are yet to get the revaluation message and attract buyers.

The research shows that since the 1930s, all countries suffering through a financial crisis saw depressed property prices continue for anywhere from 4.5 to 5.5 years from the price peak — with little variation in length from recession to recession. For the United States (and California) in the current financial crisis, prices peaked during the first quarter of 2006. By that measure, and despite some sunny forecasts reported by the media, property prices will not bottom out until 2011 or beyond.

Government action to lift prices

According to Reinhart and Rogoff, the financial crisis will take a hefty toll on the nation before it is over. Some states such as California, Nevada, Arizona, and Florida will suffer disproportionately more since property prices there accelerated more quickly during the Millennium Housing Boom. However, the eventual upturn will not simply come about of itself. Personal and corporate finance have the capacity to grow much worse, should the steps yet to be taken by the Federal Reserve and Treasury be wrong — as happened in the mid-1930s to bring about the Great Depression.

In their paper entitled “The Current Financial Crisis: What Should We Learn from the Great Depressions of the Twentieth Century?”, Timothy Kehoe, an economist from the Federal Reserve Bank of Minneapolis, and Gonzalo Fernandez de Cordoba of the Universidad de Salamanca, compare and contrast the government reactions to depressions against the extent of financial damage done to their respective nations.

Great depressions, the economists argue, are the result of a government mishandling a financial crisis. They cite as examples two sets of very recent financial crises by nations:

  • the 1980s financial crises of Mexico and Chile; and
  • the 1990s financial crises of Japan and Finland.

During the 1980s crises, the Chilean government did not support ailing banks, but instead took them over, liquidated them and set up tighter banking regulation (something the US has not yet done). Chile then privatized the seized banks within three years and allowed the market to determine just what interest rates and credit allocations (loan amounts) would be available to borrowers. While this brought on a sharp drop in GDP in the short-term, Chile’s economy has grown rapidly since coming out of their crisis. (These rapid corrective actions were helped along by the fact that Chile was a military dictatorship and thus faced few political bars to proper monetary regulation.)

Similarly, the Finnish government during the 1990s allowed the market to determine how and to whom credit was granted (loans). Finland likewise suffered a few years of sharp decline but has since grown at an excellent pace.

In contrast, the Mexican and Japanese governments bolstered the larger failing banks by offering them favorable interest rates to remain in business, although they were otherwise insolvent (actions parallel to bank bailouts undertaken by the Troubled Asset Relief Program (TARP) in the US). This policy was, as now in the US, applied unequally, resulting in a large economic disparity between the favored big banks and those smaller banks which were ignored. Mexico and Japan also implemented massive financial stimulus programs which financially supported unsustainable employment and investment (asset) values without creating parallel private sector growth (something the US has not done).

Both these nations suffered decades of slow growth and economic stagnation following their respective financial crises. Japan’s present real estate values are, on average, only 50% of their 1990 values.

California’s real estate microcosm

It is clear from the reading of the economists’ arguments that the US government’s reaction to the current financial crisis is beginning to go the way of politicization permitted by the Mexican and Japanese governments. The worrying trend of demanding regulation and government interference past the regulatory stage now pervades all parts of our economy.

Similar to the financial crisis facing the nation at large, California is feeling the strain of a nigh-collapsed pricing in the housing market in the face of the sub-prime (and increasingly, prime) mortgage meltdown with income property mortgage deterioration now taking on alarming levels. Also similar to the federal government, the government of the state of California insists upon over-regulating the housing and mortgage industries to the detriment of the denizens of the Golden State.

Since the beginning of the current downturn, California has enacted at least two blanket moratoriums on mortgage foreclosure to support the continuation of extensive financially insolvent homeownership. As was seen in the previous examples of nations facing economic peril, supporting inflated asset values — real estate prices — only serves to weaken and prolong recovery of the resale market.

But for real estate speculators and builder subsidies (undesirable elements at any time in the real estate market), the current mid-2009 robust trend in sales of cheap, low-end housing would be flat or negative, with prices still declining to converge with their historical trend values (after 30 years of distortion). Both elements will adversely disrupt sales as increasing numbers of “momentum speculators” snap up cheap property, hold it, then flip or dump it, and builders add yet more inventory.

As in the examples of Chile and Finland, California needs to differentiate those homeowners who are solvent and willing to make their mortgage payments from those who are insolvent and not able to sustain the financial burdens of homeownership. Unless the state intends to individually support each and every person in the insolvent homeowner category, it must allow lenders to simply foreclose on those homeowners and return them to the status of renters and their properties to the market. Real estate brokers and their agents know exactly what to do with prospective tenants and property listings.

Then, the quickest way to fix the situation of the solvent-but-distressed homebuyers is to cram down their loan balances to equal the property value to give this huge portion of Californians a fresh start going into the recovery. Supporting asset values through government intervention always produces adverse long-term economic results.

It is unsettling, but unsurprising, to note that there is marked resistance to both these cures. California’s government, much like the governments of Mexico and Japan during their financial crises, refuses to take the hard but necessary steps to quickly push the California real estate economy once again towards solid, long-term growth that develops from unsubsidized builders, well-regulated lenders, and recapitalized homeownership — something feasible only once the marketplace has been cleared of the massive excess of more than 500,000 vacant single family housing units.

While myopic politicians cry foul before a public largely ignorant of proper medicine for what has been a distant and remote financial crisis, and reference the inequities of rewarding wayward homeowners who got in over their heads — ignorant of the fact that lenders also got in way over their heads — the state housing market will sputter and stall for the reason that their policies are supporting past housing prices.

If past financial crises are any indication, this quibbling will lead to the sort of half-step fixes that are the harbingers of an economic depression and, in parallel, a stagnant California housing market for many additional years — which could be avoided if the powers that be have the wherewithal to make the correct adjustments now.

Time to consider settling in for a long, bleak recovery. The current structure of politically-advantageous short-term policy fixes suggests nothing better.