The world's finance officials will huddle this weekend in Washington to deal with the worst financial crisis since the Depression. Many leaders have already decided that the source of global fears lies in the US economic model. But which part of that "model" really needs fixing?
The German finance minister predicts the US will no longer be the "superpower" in global finance. The French president said the model of laissez-faire economics is "finished." Russia's president said the dominance of the US economy "has been consigned to the past."
Indeed, this crisis can be traced to US financial institutions taking on borrowers who signed mortgage contracts they could not afford. Those loans were then passed up the food chain to investors worldwide with little oversight over whether the home buyers might default if prices fell.
The housing bubble – caused in part by these iffy loans – did finally burst, revealing the false hope that foreign investors had placed on an ever-rising US housing market.
Who gave them that hope? It did not arise primarily from a lack of regulation. Rather, it was the wrong kind of regulation – the kind that tries to redistribute wealth by forcing private financial institutions to fulfill a government goal of providing inexpensive homes. US laws such as the 1977 Community Reinvestment Act and those that support government-backed Fannie Mae helped push banks and mortgage brokers into the business of handing out loans on easy credit.
The result? Too many subprime loans were given to too many people with inadequate income. A market fear was planted that home prices were not based on the real American model of letting markets determine the worth of assets.
The aggregated risks of these "bad" mortgages were seen as so high that they were then bundled with good mortgages and sold like bonds to investors in hopes they might not notice the flaws, or on the myth that government would never let housing prices fall.
This shell game of obscuring risk, which is not the American model, created a climate of distrust in the global financial system that officials are now trying to address. But how can governments restore trust and transparency in the market pricing of these wobbly mortgages and help restart credit flows?
The first reaction has been to rescue banks by lowering interest rates, buying up assets, providing loans, and guaranteeing deposits. The US has moved faster than a splintered Europe. But more needs to be done to prevent a global recession.
Investors need renewed faith that US mortgages no longer come with the toxin that they were sold under government pressure to unworthy buyers. New attempts to keep risky buyers in their homes will only prolong the crisis and prevent house prices from stabilizing.
The good news is that some banks, such as Wells Fargo and Bank of America, are buying up financial institutions burdened with bad mortgages – with a clear eye on the real value of those loans. And with the government takeover of Freddie Mac and Fannie Mae, those institutions face radical reform.
And to reduce financial complexity, more mortgages need to remain locally owned, with banks that know their customers. Human beings, not computer models, need to track a loan's worth. Such steps will lower risks and lessen fears.