Root cause of the financial crisis
Several times recently, Treasury Secretary Paulson (and many others) have claimed that the "root cause" of the current financial crisis is "the housing correction." This is completely wrong--and unless policy makers realize that it's completely wrong, they're not likely to make the right policy decisions.
Just today, in his testimony before the Senate Banking Committee, Paulson said:
And that root cause is the housing correction which has resulted in illiquid mortgage-related assets that are choking off the flow of credit which is so vitally important to our economy. We must address this underlying problem, and restore confidence in our financial markets and financial institutions so they can perform their mission of supporting future prosperity and growth.
Now, first of all, the proposal doesn't address the housing correction--it addresses the illiquid mortgage-related assets (by buying them)--so it's still a step removed from what Paulson claims is the root cause. (Directly addressing the housing correction would involve buying houses, not buying loans.) But that's neither here nor there, because the root cause is not the housing correction. The root cause was the housing boom.
Roughly speaking, an average household needs to earn enough money to be able to afford an average house. You can adjust that a bit--smaller, younger, poorer households can be left out of the calculation if you assume that they'll rent rather than own--but after leaving them out, it's just not sustainable for the average house to cost more than the average household can afford to pay--who else is going to buy it?
Now, you can back things up yet another step in your search for root cause: How did house prices get too high? The answer to that question (which has mostly to do with bad interest rate decisions from the Fed interacting with bad public policy in financial market regulation) will help us prevent the next financial crisis. But for addressing this financial crisis, all we need to understand is that the correction is not the root cause. The root cause is that house prices got so high that the average household couldn't afford an average house. Once that happened, a correction was inevitable.
The way to address the root cause is to let house prices drop to where an average house is within the means of an average household. (Or, alternatively, boost the income of the average household to the point that they can afford an average house. But that's very hard. Letting houses prices go on falling, although painful for everyone who owns a house or who has lent money to someone who owns a house, is very easy.)
Now, some sort of bailout plan may be necessary to keep the financial system from simply collapsing under the weight of all that bad debt. But if that plan is focused on keeping house prices from falling, it's a hopeless plan. If you successfully kept house prices up, we would remain mired in this problem until incomes rose enough to make house prices affordable.