Soros and the economic crisis

John Cassidy has a review of George Soros new book about financial economics. While I don’t share Soros’ dim view of long-term American economic prospects, his analysis is certainly worth reading, as is Cassidy’s thumbnail of how we got here:

As house prices shot up between 2001 and 2005, credit standards deteriorated sharply. Rather than restricting their lending, mortgage financiers deluded themselves into believing that the collateral for the loans they were making would continue to rise in value. The very act of extending more and more credit, on easier and easier terms, kept demand for real estate buoyant, which, in turn, ensured that for several years the lenders’ optimistic expectations were validated. It was only when borrowers who had taken out loans they couldn’t afford started to default in large numbers that the housing bubble finally burst.

This is why I disagree with government intervening either to write down loan values or artificially propping up home prices. Even if banks are forced to sell off foreclosed homes at a loss, and even if many people who stay in their homes are temporarily in a negative equity situation, all that will be lost in general is the value accrued during the bubble. A substantial loss, certainly, but it is real — that is to say, these results will reflect genuine market conditions — and the sooner the economy is based on reality, the better.

Here is Soros:

Eventually, the US government will have to use taxpayers’ money to arrest the decline in house prices. Until it does, the decline will be self-reinforcing, with people walking away from homes in which they have negative equity and more and more financial institutions becoming insolvent, thus reinforcing both the recession and the flight from the dollar. The Bush administration and most economic forecasters do not understand that markets can be self-reinforcing on the downside as well as the upside. They are waiting for the housing market to find a bottom on its own, but it is further away than they think.

This mixes truth and falsehood. These homes are not worthless. If they were sold at auction, the winning bid would not be zero. There is a real bottom to the market, in other words. So why does Soros say the government “will” have to intervene in the market?

Government efforts to prop up housing prices are tantamount to taxing Americans in an effort to fool the market. No matter how far down the true bottom of the market is, the sooner we get there, the sooner recovery can begin. A swift, sharp recession — what used to be called a “panic,” where the market suddenly plummets to the bottom — would be more painful in the short term, but it would be more likely to avert the long, drawn-out misery we had in the ’70s, where government intervention brought about stagflation.

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