One year after the beginning of the modern credit crisis, Randall Forsyth , writing in Barrons, provides an fine round-up of what caused this mess to begin with. His theory is that the problems began when statistical modeling of mortgages replaced old-fashioned credit reports when it came to valuing mortgage loans.
“With statistical modeling, no longer was it necessary to collect and verify information about borrowers. Put everybody in the pool and everything would even out, statistically speaking.... From that, Wall Street made the leap to taking those loans and structuring them into securities. Since financiers knew, with statistical certainty, how many loans in the pool would default, they sliced the loans into tranches.”
He blames the advent of modeling for creating the illusion that loans were just another form of security, and he correctly dates the beginning of the problem from “somewhere in the 1970s,” but he seems to miss the critical ingredient that made all of this possible. The final elimination of the dollar’s tie to gold is what unleashed the illusion that we never again had to worry about whether there was enough money. The Fed cast a spell over the financial markets that risk was a thing of the past, having been reduced to one slight factor among many that is used to assess the market price of load/securities. The element of risk itself was considered to be separate from an actual borrower’s ability to pay and became merely an aggregated statistical construct divorced from human action.
He urges us to keep markets functioning as the best means to solve the problem but he seems to miss the critical point--and this is not just his mistake but a near universal issue--that an essential part of free markets is the sound money that emerges from market exchange. The money we use has been distorted and destroyed in order to make possible a fiat money world in which scarcity and risk no longer play a role -- or at least this is what we believed. By all means, let markets clear but the core problems will never go away until money resumes its role not as an infinitely available grease for economic expansion but as a scarce and finite good that merely facilitates sound economic development.
Two new books are crucial here. First, there is Hayek’s amazing writing on the business cycle, which links macroeconomic phenomena to the quality of money. Second is George Selgin’s demonstration of the historic capacity of markets alone to make and guard money.
