The Crisis of Keynsianism

Almost everywhere you turn today, someone is citing John Maynard Keynes, the British thinker who turned big-state activism into an accepted economic policy tool. The common refrain is that three decades of free markets and deregulation have led us to this moment of crisis, necessitating a return to government activism. But what if the conventional wisdom is wrong? What if our problem isn't too little Keynesianism, but too much in the first place?

Keynes made his name in a world of economic gluts. The First World War caused the U.S. economy to grow at an unnatural pace, with nominal GDP doubling to more than $80 billion in just four years. Prices fell steadily after the war and pretty soon the country had too much of everything: Too much steel, too much oil, too much food and too many workers. By 1929, ten years of localized recessions had merged into one giant depression.

Keynes understood the imbalance between supply and demand and knew the economy on its own wasn't creating enough jobs for people to become consumers. He diagnosed the problem as a lack of "aggregate demand," which made sense given all the spare capacity sitting underutilized after the war.

Following the Keynesian model, Washington undertook ambitious programs like the Hoover Dam and Tennessee Valley Authority, which visibly employed armies of workers. But the most important and lasting measure was an embrace of homebuilding as an engine for economic growth. Housing was seen as a way to increase demand for materials and labor, which would hopefully create a positive feedback loop of rising wages, consumption and investment.

The government began insuring individual mortgages under the National Housing Act of 1934, and created Fannie Mae four years later to buy and sell the loans. These programs successfully pushed banks to lend more money relative to a home's price and extended payment periods from five years to 30 years.

The new standards made it easy for veterans to buy houses after WWII and ushered in a golden age of suburbanization. By 1959 Federal Housing Commissioner Julian Zimmerman boasted "The FHA experiment has been brilliantly successful... It has helped give us the greatest 25 years of progress we have ever had in housing."

During this first stage of meddling, Washington merely encouraged private banks to ease standards and lend more. Most of the mortgages were still made by local savings banks and held on their balance sheets.

During this time, Washington also spent billions indirectly subsidizing housing by building highways and promoting industries in the increasingly suburban Sunbelt. Countless aspects of the tax code also encouraged people to speculate on rising home prices.

The second chapter of intervention began in 1970, when Fannie Mae and Freddie Mac were charged with creating a secondary market for all conventional mortgages. By the mid-1980s, these two creatures of Keynesianism had literally taken over the industry. Latin American debt crisis? Savings & Loan meltdown? U.S. homebuyers never felt the pain because both times Fannie and Freddie kept the waters smooth in the mortgage market. The spikes in the chart below illustrate these moments when the GSEs stepped up to support the market.

Source: Federal Reserve

The GSE's have also been tireless advocates of ever more promiscuous lending terms. In 1989, borrowers were allowed to reuse their original appraisal and provide less income verification when refinancing mortgages. In 1993 and 1994, efforts were made to reduce down payments and increase lending to lower-income borrowers -- a decade prior to the subprime bubble.

Years before AIG sold its soul insuring bad loans, the GSEs were providing "credit enhancement" to trillions of dollars in mortgages and easing lending standards. Long before Bear Stearns, Fannie and Freddie were making securitization the norm. This gave Americans almost direct access to the multi-trillion dollar bond market and provided steady access to home financing even if their fellow citizens hadn't tucked the money away in a bank. This coincidentally allowed our savings rate to fall to an unnaturally low level below 1% of personal income at the height of the frenzy.

The chart below shows how the GSEs dominated mortgage lending for two decades before the credit bubble formed.

Source: Federal Reserve

Fannie Mae and Freddie Mac might have acted like private corporations, but they never ceased to be government agencies. Their entire business model was based upon frequent access to the capital markets as "super safe", AAA-rated quasi-government issuers. That's why foreign central banks were comfortable buying more and more of their debt since the mid-1990s.

Source: Treasury Dept.

These institutions represented a kind of shadow government spending that didn't visibly add to the deficit or require frequent votes in Congress. But the country's obligations still increased: Between 1984 and 2004, the GSEs' mortgage holdings more than tripled from 9% of GDP to 32%. Using Fannie and Freddie's "private" status as a screen, Keynesian housing crusade did an end run on Uncle Sam's balance sheet.

Companies like Bear Stearns and Countrywide finally took over the mortgage madness, but only after seven decades of government support. While they deserve plenty of blame for irresponsible lending, private-sector companies merely capitalized on an opportunity deliberately created by politicians. The bubble wasn't the work of Wall Street. It came from seven decades of public policy, all of which was faithful to the teachings of John Maynard Keynes.