A lot of crap has been flung around over the past couple months among people trying to assign blame to different actors in this crisis. Is it the loan officers? The homebuyers? Wall Street? Fannie Mae? There's a bit of blame for everyone to share here.
One of the biggies, though, is a large group of people blaming government in general and the Federal Reserve in specific for this crisis. According to them, if they had not acted so capriciously and created such easy credit, this crisis never would have been able to get off the ground. Hence, according to these people, the Federal Reserve should be eliminated...or at least have its power restricted.
So, is government culpable for this disaster?
The argument rests upon the creation of easy credit. By decreasing interest rates too much, companies and consumers start loading themselves up with debt. Interest payments are low, expected growth is high, so why the heck not? However, the "easy credit" also implies "irrational exuberance." The government is creating artificially strong business conditions, above where we could produce with a full employment economy. So, once the economy starts cooling down, a lot of the debt that looked good at the time...really isn't. Mr. Time Machine producer who took on a $1 million home equity loan is screwed because he has no market and all these interest payments to service.
In this example, government is the primary villain. By lowering interest rates and making the economy seem better than it actually was, they encourage the entire private sector to over-leverage, thus setting the economy up for a painful readjustment.
But, wait! There's a scenario where private actors make the mistake, and government acts perfectly rational. In this example, the private sector makes the mistake because they take the credit and do stupid things with it.
Consider the example where the government perfectly manages interest rates. The Federal Reserve has just the right Fed Funds rate and just the right amount of T-Bonds on the market, and the economy is producing exactly at full employment. All is well...right?
Well, Mr. Time Machine Producer still ends up getting a $1 million home equity loan, because some bank thought it was a good idea. That still doesn't change the fact that, objectively, his business plan doesn't work because his product cannot possibly exist. So he's going to default.
The point is that markets can still misjudge business ventures and the credit quality of borrowers, even if the economy is functioning perfectly smoothly and government has set interest rates perfectly. No matter if credit was tight, loose, or just right, the private sector would STILL be misallocating resources. And that means painful readjustment.
The questions here are two fold. The first is what size the bubble can possibly be. Many would assume that the bubble can't get very big. This, however, depends entirely on the private sector and its own interpretations. If it reads the market VERY wrong, it's going to misallocate resources VERY wrong.
The second question is one of adjustment. If markets have allocated resources badly, shouldn't they reallocate them very quickly, thus averting recession? That's a question of sticky prices, particularly ones involving the labor market, and therefore tough to answer.
But if the private sector reads the market wrong and the market is slow to adjust, we can be stuck in a long recession, even if the government did everything right.
What about the current crisis?
Well, in my opinion, we probably were overproducing. Unemployment was below 5% and inflation was higher than normal. That suggests an expansionary economy (IE, overproducing), meaning too easy credit, meaning the potential for an overall bubble.
But we've had expansionary economies before. This crisis, though, is the worst since the Great Depression. What gives?
It should be obvious: private failure. The failures have largely concentrated in the mortgage market, especially in the subprime market, which is in turn affecting credit. That means sectors of the economy related to finance and home building are hurting, but the rest of the economy is still chugging along pretty well. That suggest MASSIVE misallocation of resources by severely underpricing risk: a private sector failing by definition.