The current financial situation is complicated (so we're told, and I tend to believe this), but boiled down to the basics, it seems to be based on two main things:  the housing "bubble", and bad loans, with an underlying theme of greed and failed free market policies.  In a previous post, I detailed how it was government policy, not the free market, that fueled the so-called "subprime contagion" — the bad loans.  But what caused the housing bubble?

First, a thought experiment.  Consider two investments with the original names of Investment A and Investment B.  Both investments have been solid over the long term, and in recent years both have been in a bull market.  If you invest in A, you will pay a 20% tax on all profit you make.  If you invest in B, however, you can make up to $500,000 in profit tax-free before paying that 20% tax.  Into which investment do you think the most capital is going to flow?

Now consider further:  if more money starts chasing a particular item, what happens to the price?  Economics 101 would say that the price would increase.  We saw this same phenomenon in the mid-to-late 1990s with the tech bubble — investors were throwing good money after bad at tech stocks, in search of the next Yahoo, WorldCom, Oracle, Microsoft, etc. without regard to whether or not the companies were solid and actually turning a profit.  Tech stock prices soared, and as long as investors were able to turn around and sell those stocks at an even higher price, the money was flowing.  But, like all speculative bubbles, nothing can go up indefinitely, particularly when the underlying fundamentals are missing; the tech bubble burst, leaving many investors high and dry, and a little bit lighter in the wallet.  Investors like Warren Buffet and Bob Brinker foresaw this and moved into other investment areas.

Now consider this:  in 1997, Congressional negotiators and the Clinton White House struck a deal that would enable a cut in the capital gains tax.  The compromise included a new $500,000 exemption on the profits from the sale of a home, with no such exemption for the profits from other investments.  Such an exemption played well to various factions:  realtors and mortgage companies favored it because it increased demand for their products; investors favored it because it enabled the cut in the capital gains rate.  The market distortion enacted by the exemption had no real opposition, as no well-organized special interest was immediately impacted — people didn't start losing money on their homes until nearly 10 years later, and it is difficult to measure the money that would have gone into other investments had there been no artificial disincentive.

As one might deduce from the thought experiment above, thus was triggered the housing bubble.  With the Bush tax cuts of 2001 and 2003, the capital gains tax rate was brought down further, from 20% to 15%, but the tax favorability of homes versus other investments stood, continuing to fuel the bubble.  But again, bubbles eventually burst, and with the subprime problems kicking in (also, as discussed in a previous posting, incentivized by government policy that distorted the market) the end to the housing boom was signaled.

So, we see that both main aspects to the current financial crisis — the subprime market and the housing bubble — were not failures of free market capitalism but rather the logical outcome of government policy, and bipartisan government policy at that.  Of course, we shouldn't worry:  the politicians are working on a fix; of course, it is a fix that depends not restoring the free market, but rather on government intrusion on the market meant to fix the problems caused by previous government intrusion.  Surely we can trust the politicians to get it right this time, right?