Learning from history requires a thoughtful analysis of what actually happened, not endlessly parroting a politically convenient slogan.  The current economic crisis is not a repudiation of free markets, nor is it a repudiation of deregulation.  Such an “explanation” is simply Barack Obama and the Democrats peddling their same discredited elixir under a new label. 

The causes of the current economic crisis are complex, and many people are at fault.  Focusing on the housing bubble, the housing crisis will define the Bush II economy just as the technology boom and bust of the 1990’s defined the Clinton economy.  While bubbles developed during both periods, from a fundamental economic perspective, the two experiences have important differences.  The lessons we need to learn from the current housing bust come from understanding these differences.

Rising wealth across the globe has increased the supply of money available for investing.  During the 1990’s, the investment funds were put to good use – funding the Internet and information technology revolution.  The investment in information technology transformed our economy.  While the real annual long-run GDP growth in the U.S. is believed to be around 2.5% - 3.0%, from 1996 through the first half of 2000, real average annual GDP growth accelerated to 4.5%.

The technology boom led to an unrivaled and sustained acceleration in productivity for the average worker.  As the productivity gains increased the effectiveness of workers, income levels for all Americans rose.  When coupled with the capital gains tax reductions of the 1990’s, the result was the late-1990’s economic boom.

Like many transformational technology revolutions – such as the railroads of the 1800’s or the automobile industry of the early 1900’s – the information technology boom was associated with financial excesses.  The life altering potential of information technology created a euphoria that was unsustainable.  The result was the boom and bust of the stock market and with it the rise and fall of many early Internet companies and icons.

Importantly, the 1990’s boom was rooted in the creativity of individual entrepreneurs.  Worldwide capital flows supported the dreams and visions of these entrepreneurs, all to the benefit of businesses and consumers worldwide.  This was not the case for the 2000’s housing boom.

During the late 1990’s, Congress, guided by “socially responsible” visions, wanted to extend the American Dream to more people.  To achieve this goal, the government unleashed Fannie Mae and Freddie Mac – as well as Community Reinvestment Act and Department of Housing and Urban Development regulations – to divert more money toward housing.  In so doing, a housing bubble was all but inevitable.

Certainly, flaws in the private sector significantly heightened the risk (and ultimate cost) of the housing bubble.  Poorly structured securitization left banks with “no skin in the game” when they extended mortgages.  This, along with poorly executed ratings from the ratings agencies is problematic and needs to be addressed.  But, it was the government that created the incentives to over-invest in the housing sector in the first place.  Without the government incentives, the housing bubble would not have developed.

Since 1970, residential construction activity has been typically around 4.5% of overall economic activity.  Due to the government fostered housing boom, residential construction’s share of the economy swelled to an unprecedented 6.3%.  Greater investment in housing replaced investing in other assets – including the accelerated technological investments that drove the 1990’s boom.  The implication of this change was dramatic. Continued...