THE CAUSES OF THE FINANCIAL CRISIS
The Debt-Based Money System Slams Into
Greed and Peak Oil

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.

Effects of the financial crisis:
Looking broadly, I see at least five broad economic trends affecting the clean energy market over the next few years.

The credit crunch. Banks are having a hard time of it right now. This is an unequivocally bad thing for the clean energy sector. Clean energy projects typically entail massive up-front capital outlays, followed by relatively low ongoing costs. Banks provide the money for those up-front expenditures in the form of loans.

Except that right now, banks have retreated into their pillow forts. One analyst projects that, by 2020, the clean energy sector in Europe will require about 85 billion euros per year in financing to meet EU goals. Given the current pace of lending, debt finance will fall about 21 billion euros short. I’d put very low confidence in these specific numbers, but they are illustrative of the problem faced by energy developers who need cash to turn blueprints into megawatts. A secondary likely effect of the credit crunch is consolidation in the clean energy industry, as financially healthy energy developers (especially in Europe) snap up sound-but-cash-strapped counterparts.

Fossil fuel prices. To simplify: dirty energy competes with clean energy. High fossil fuel prices make clean energy projects look more attractive.

There are people paid much more money than to me predict the direction of fossil fuel prices, and I won’t pretend to have any special insight here. Based on my own analysis, which involves drawing a supply and demand curve on piece of graph paper with a crayon, I predict that fossil fuel prices will continue to gradually rise for years to come, while also exhibiting high volatility. The underlying upward trend in fossil fuel prices will be positive for clean energy development, but the volatility will blunt some of the benefit by injecting a high degree of uncertainty into the market.

Supply chain constraints. Whatever the state of the present economy, clean energy has been booming for several years now. One inevitable consequence of the growth is that manufacturers are having a hard time keeping up with demand for basic infrastructure, such as wind turbines. This situation should eventually right itself, but it will remain a brake on growth in the near term.

Global carbon policy. In fits and starts, governments worldwide are putting a price on carbon. And though the shortcomings of these early attempts have been well noted, in aggregate policymakers are stumbling in the right direction. These efforts are helpful, even if they aren’t anywhere near enough.

The economy. Although it is very difficult to make predictions about the direction of the economy, it appears likely the current downturn will continue for some time. Which is bad for the climate, mainly because of the way that a weak economy interacts with the other items on the list.

For example, slow growth saps the political will for dramatic action on climate change. Some legislative efforts, such as California’s AB32, are probably too far along to be at major risk for derailment. RGGI in the northeast is also pretty far along, but not so far along that New York Governor David Paterson wouldn’t consider bolting from the agreement. And, of course, federal legislation continues to lurch zombie-like around the halls of congress. The next president will have to expend a lot of political capital to pass a national carbon cap even under the best of circumstances. These are not the best of circumstances.

So the scorecard on macro trends in the clean energy sector reads: credit crunch, very bad; high fossil fuel prices, very good; supply chain constraints, bad but self-righting; global carbon policy, nascent but directionally correct; overall economic malaise, generally dampening.

Related posts:

1. The effects of the financial crisis on “stock market”
2. Effects of Global Financial Crisis of 2008–2009
3. (US) Financial Crisis in America