The Housing Bubble Simplified
The Tip of the Iceberg
This is the story you might hear from a typical Right-wing pundit: Politicians, naively hoping to make housing affordable for everyone (hence, buying lots of votes), used the Community Reinvestment Act (CRA) to pressure banks into lowering their lending standards and making loans to low-income borrowers. Banks, responding to the normal market pressures, didn't want to take on too many risky loans and endanger their own solvency. They started to push back. The politicians stepped in and said, "Don't worry; we'll eliminate the normal checks and balances that would exist in a free market. Instead of gambling with your own money, you can gamble with the taxpayer's money! We'll just have Fannie and Freddie (the NGOs) buy up all the bad debt."
Here's where a small problem with a handful of poor people became a much bigger problem with every Tom, Dick, and Harry deciding that they were real estate investors. Once the banks didn't have to keep the risky loans on their own books, they saw dollar signs and started making lots of bad loans to any moron who wanted to flip houses or buy a vacation home. This increased demand quickly drove housing prices sky high- ironically making housing less affordable!
The Rest of the Iceberg
The preceding story is not entirely inaccurate, but it does not begin to explain the extent of the disaster. Below is the other part of the story, which gets a lot less attention, but deserves the lion's share of the blame. The government actions described above were only the spark. The problem quickly took hold throughout the private sector and spread far further than could be blamed on Fannie, Freddie, or the CRA. So what allowed it to go so far? Why did previously responsible lenders embark on such a long journey of economic stupidity?
Here's the part where Bush appointee, Alan Greenspan, added to the fun. Under a free market, the banks would have started to run out of loanable funds, driving interest rates through the roof. This would have put an end to the dangerous housing bubble, as people would have stopped borrowing. Unfortunately, Greenspan had a very different idea. He didn't want to deal with the crash of the "Dotcom" bubble from the Clinton years, so he kept pumping credit (i.e. new money in the form of reserves) into the market and artificially lowered the interest rates. This allowed the housing craze to spread throughout the entire economy. "Flipping houses" became an accepted investment strategy and various bundles of bad debt were traded and sold like worthwhile commodities. This was like throwing gasoline on the Democrats' brush fire.
It's important to note that this action by The Fed is the real culprit. If government intervention had not funnelled the money into housing, the newly created money would have ended up forming a bubble somewhere else. All of the normal free market signals, which would have discouraged dangerous behavior, were removed by government. This creates a "moral hazard" in which people engage in riskier behaviors than they would under normal circumstances. In the end, the people who caused the problem blamed "deregulation" and the free market, but you can't say that we have a free market or deregulation unless there is NO regulation. Imagine that the market is a car with four round wheels. Regulation is like replacing those wheels with square ones. What the government typically calls "deregulation" is when they replace one of the square wheels with a round one. Is it any wonder when the whole thing spins wildly in circles? You either free the market, or you do not. There is no halfway:
"Capitalism and socialism are two distinct patterns of social organization. Private control of the means of production and public control are contradictory notions and not merely contrary notions. There is no such thing as a mixed economy, a system that would stand midway between capitalism and socialism."–Ludwig Von Mises