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Commentary

Back to Basics


     
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WASHINGTON—In 1993, the government of British Prime Minister John Major launched a campaign under a motto borrowed from the world of pop music—“Back to Basics.” As I watch the worldwide financial crisis triggered by the wave of mortgage defaults in the United States, I am reminded that at the heart of the problem is the departure on the part of the U.S. government and American consumers from basic economic principles.

Major’s campaign referred to moral rather than economic issues, but the association is still relevant. Considering the consequences suffered by many ordinary people, there is something immoral about having disregarded basic economic notions for quite some time.

In recent years, many people forgot that in order to consume and invest, one needs to save. This elementary truth was lost as millions of people responded to perverse government-generated incentives by living beyond their means. What we are seeing today is nothing less than the inevitable price of behaving irresponsibly.

As is often the case with a financial crisis, the original sin behind the current turmoil has to do with government policy. Since 2001, the Federal Reserve has kept interest rates absurdly low in order to prevent a recession. Between 2003 and 2004 the rate at which the Fed allowed banks to lend to each other overnight was 1 percent! This convinced people that there was abundant money for anyone who wanted it.

Easy money begets extravagance on the part of those who lend and on the part of those who borrow. So financial institutions came up with irresistible offers, including mortgages that required no down payment and adjustable-rate loans that charged low interest in the early years. Borrowers went wild, often taking out second mortgages or multiple consumer loans simply because they could.

The theory was that the days of saving were over. The “new economy” was supposed to rest on the creation of asset value as reflected, for instance, in the skyrocketing price of houses. In such a context, financial institutions came up with slick instruments by converting debt into securities. Those sophisticated instruments passed from one hand to another in a trading dynamic that was supposed to allocate risk efficiently. In fact, because the origin of these securities was in many cases bad debt, the whirlwind of security trading concealed the high risk involved.

Why should we save, many Americans thought, if foreigners are doing the saving for us? Government policy reinforced the economy’s irrational exuberance. Fiscal deficits didn’t matter, the authorities claimed, because there was plenty of foreign capital investing in U.S. assets. A short-term mentality drove many American consumers at the expense of long-term thrift—a mentality so resilient that even when the U.S. dollar started to depreciate, people continued to buy imports on a massive scale. Apparently, they were thinking that the price of their homes would continue to rise forever.

So here we are, in the midst of a financial crunch. I think the U.S. economy is so productive that the crisis will pass, thanks to an innovative segment of society that keeps inventing new ways of producing more with less.

But what is happening today is an indication that prosperity cannot be taken for granted. If those responsible for the current turmoil suffered the full consequences of their actions, perhaps the nation would get back to basics soon. Yet these sort of economic lessons are hard to come by because governments step in to bail the victims out. Even the European Central Bank, a supposedly inflexible monetary guardian, has thrown lots of money into the system, and Germany’s government has rescued IKB Deutsche Industriebank AG because of losses related to subprime mortgages—an illustration of how global this crisis has become.

Don’t get me wrong here. The explosion of sophisticated financial instruments has provided liquidity to many markets that would otherwise not exist, and private equity funds have boosted entrepreneurial activity in extraordinary ways. The spread of risk around the world through the international sale of debt instruments is also a very good thing. The problem is that those blessings can easily turn to tears when people lose sight of the basic principle that prosperity depends on the capacity to sustain investment and consumption in the long term—which in turn depends on the capacity to save for the future.

It is time, then, to go back to basics.


Alvaro Vargas Llosa is Senior Fellow of The Center on Global Prosperity at The Independent Institute. He is a native of Peru and received his B.S.C. in international history from the London School of Economics. His Independent Institute books include Global Crossings: Immigration, Civilization, and America, Lessons From the Poor: Triumph of the Entrepreneurial Spirit, The Che Guevara Myth and the Future of Liberty, and Liberty for Latin America.

(c) 2007, The Washington Post Writers Group

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