September 28, 2008
My friends,
In the last week or two, I have heard frequently from you that the current financial mess has been caused by the failures of free markets and deregulation. I have heard from you that the lust after profits, any profits, that is central to free markets is at the core of our problems. And I have heard from you that only significant government intervention into financial markets can cure these problems, perhaps once and for all. I ask of you for the next few minutes to, in the words of Oliver Cromwell, consider that you may be mistaken. Consider that both the diagnosis and the cure might be equally mistaken.
Consider instead that the problems of this mess were caused by the very kinds of government regulation that you now propose. Consider instead that effects of the profit motive that you decry depend upon the incentives that institutions, regulations, and policies create, which in this case led profit-seekers to do great damage. Consider instead that the regulations that may have been the cause were supported by, as they have often been throughout US history, the very firms being regulated, mostly because they worked to said firms' benefit, even as they screwed the rest of us. Consider all of this as you ask for more of the same in the name of fixing the problem. And finally, consider why you would ever imagine that those with wealth and power wouldn't rig a new regulatory process in their favor.
One of the biggest confusions in the current mess is the claim that it is the result of greed. The problem with that explanation is that greed is always a feature of human interaction. It always has been. Why, all of a sudden, has greed produced so much harm? And why only in one sector of the economy? After all, isn't there plenty of greed elsewhere? Firms are indeed profit seekers. And they will seek after profit where the institutional incentives are such that profit is available. In a free market, firms profit by providing the goods that consumers want at prices they are willing to pay. (My friends, don't stop reading there even if you disagree - now you know how I feel when you claim this mess is a failure of free markets - at least finish this paragraph.) However, regulations and policies and even the rhetoric of powerful political actors can change the incentives to profit. Regulations can make it harder for firms to minimize their risk by requiring that they make loans to marginal borrowers. Government institutions can encourage banks to take on extra risk by offering an implicit government guarantee if those risks fail. Policies can direct self-interest into activities that only serve corporate profits, not the public.
Many of you have rightly criticized the ethanol mandate, which made it profitable for corn growers to switch from growing corn for food to corn for fuel, leading to higher food prices worldwide. What's interesting is that you rightly blamed the policy and did not blame greed and the profit motive! The current financial mess is precisely analogous.
No free market economist thinks "greed is always good." What we think is good are institutions that play to the self-interest of private actors by rewarding them for serving the public, not just themselves. We believe that's what genuinely free markets do. Market exchanges are mutually beneficial. When the law messes up by either poorly defining the rules of the game or trying to override them through regulation, self-interested behavior is no longer economically mutually beneficial. The private sector then profits by serving narrow political ends rather than serving the public. In such cases, greed leads to bad consequences. But it's bad not because it's greed/self-interest rather because the institutional context within which it operates channels self-interest in socially unproductive ways.
This, my friends, is exactly what has brought us to the mess we are now in.
To call the housing and credit crisis a failure of the free market or the product of unregulated greed is to overlook the myriad government regulations, policies, and political pronouncements that have both reduced the "freedom" of this market and channeled self-interest in ways that have produced disastrous consequences, both intended and unintended. Let me briefly recap goverment's starring role in our little drama.
For starters, Fannie Mae and Freddie Mac are "government sponsored enterprises". Though technically privately owned, they have particular privileges granted by the government, they are overseen by Congress, and, most importantly, they have operated with a clear promise that if they failed, they would be bailed out. Hardly a "free market." All the players in the mortgage market knew this from early on. In the early 1990s, Congress eased Fannie and Freddie's lending requirements (to 1/4th the capital required by regular commercial banks) so as to increase their ability to lend to poor areas. Congress also created a regulatory agency to oversee them, but this agency also had to reapply to Congress for its budget each year (no other financial regulator must do so), assuring that it would tell Congress exactly what it wanted to hear: "things are fine." In 1995, Fannie and Freddie were given permission to enter the subprime market and regulators began to crack down on banks who were not lending enough to distressed areas. Several attempts were made to rein in Fannie and Freddie, but Congress didn't have the votes to do so, especially with both organizations making significant campaign contributions to members of both parties. Even the New York Times as far back as 1999 saw exactly what might happen thanks to this very unfree market, warning of a need to bailout Fannie and Freddie if the housing market dropped.
Complicating matters further was the 1994 renewal/revision of the Community Reinvestment Act of 1977. The CRA requires banks to to make a certain percentage of their loans within their local communities, especially when those communities are economically disadvantaged. In addition, Congress explicitly directed Fannie and Freddie to expand their lending to borrowers with marginal credit as a way of expanding homeownership. What all of these did together was to create an enormous profit and political incentives for banks and Fannie and Freddie to lend more to riskier low-income borrowers. However well-intentioned the attempts were to extend homeownership to more Americans, forcing banks to do so and artificially lowering the costs of doing so are a huge part of the problem we now find ourselves in.
At the same time, home prices were rising making those who had taken on large mortgages with small down payments feel as though they could handle them and inspiring a whole variety of new mortagage instruments. What's interesting is that the rise in prices affected most strongly cities with stricter land-use regulations, which also explains the fact that not every city was affected to the same degree by the rising home values. These regulations prevented certain kinds of land from being used for homes, pushing the rising demand for housing (fueled by the considerations above) into a slowly responding supply of land. The result was rapidly rising prices. In those areas with less stringent land-use regulations, the housing price boom's effect was much smaller. Again, it was regulation, not free markets, that drove the search for profits and was a key contributor to the rising home prices that fueled the lending spree.
While all of this was happpening, the Federal Reserve, nominally private but granted enormous monopoly privileges by government, was pumping in the credit and driving interest rates lower and lower. This influx of credit further fueled the borrowing binge. With plenty of funds available, thanks to your friendly monopoly central bank (hardly the free market at work), banks could afford to continue to lend riskier and riskier.
The final chapter of the story is
that in 2004 and 2005, following the accounting scandals at Freddie, both
Freddie and Fannie paid penance to Congress by agreeing to expand their lending
to low-income customers. Both agreed to
acquire greater amounts of subprime and Alt-A loans, sending the green light to
banks to originate them. From 2004 2003 [corrected on 10/19/08] to
2006, the percentage of loans in those riskier categories grew from 8%
to 20% of all US mortgage originations. And the quality of these loans were dropping too: downpayments were getting progressively
smaller and more and more loans carried low starter interest rates that would
adjust upward later on. The banks were
taking on riskier borrowers, but knew they had a guaranteed buyer for those loans
in Fannie and Freddie, back, of course, by us taxpayers. Yes, banks were "greedy" for new customers
and riskier loans, but they were
responding to incentives created by well-intentioned but misguided government
interventions. It is these interventions that are ultimately responsible for the risky
loans gone bad that are at the center of the current crisis, not the "free market."
The current mess is thus clearly shot through and through with government meddling with free markets, from the Fed-provided fuel to the CRA and land-use regulations to Fannie and Freddie creating an artificial market for risky mortgages in order to meet Congress's demands for more home-ownership opportunities for low-income families. Thanks to that intervention, many of those families have not only lost their homes, but also the savings they could have held onto for a few more years and perhaps used to acquire a less risky mortgage on a cheaper house. All of these interventions into the market created the incentive and the means for banks to profit by originating loans that never would have taken place in a genuinely free market.
It is worth noting that these regulations, policies, and interventions were often gladly supported by the private interests involved. Fannie and Freddie made billions while home prices rose, and their CEOs got paid lavishly. The same was true of the various banks and other mortgage market intermediaries who helped spread and price the risk that was in play, including those who developed all kinds of fancy new financial instruments all designed to deal with the heightened risk of default the intervention brought with it. This was a wonderful game they were playing and the financial markets were happy to have Fannie and Freddie as voracious buyers of their risky loans, knowing that US taxpayer dollars were always there if needed. The history of business regulation in the US is the history of firms using regulation for their own purposes, regardless of the public interest patina over the top of them. This is precisely what happened in the housing market. And it's also why calls for more regulation and more intervention are so misguided: they have failed before and will fail again because those with the profits on the line are the ones who have the resources and access to power to ensure that the game is rigged in their favor.
I know, my friends, that you are concerned about corporate power. So am I. So are many of my free-market economist colleagues. We simply believe, and we think history is on our side, that the best check against corporate power is the competitve marketplace and the power of the consumer dollar (framed, of course, by legal prohibitions on force and fraud). Competition plays mean, nasty corporations off against each other in a contest to serve us. Yes, they still have power, but its negative effects are lessened. It is when corporations can use the state to rig the rules in their favor that the negative effects of their power become magnified, precisely because it has the force of the state behind it. The current mess shows this as well as anything ever has, once you realize just what a large role the state played. If you really want to reduce the power of corporations, don't give them access to the state by expanding the state's regulatory powers. That's precisely what they want, as the current battle over the $700 billion booty amply demonstrates.
This is why so many of us committed to free markets oppose the bailout. It is yet another example of the long history of the private sector attempting to enrich itself via the state. When it does so, there are no benefits to the rest of us, unlike what happens when firms try to get rich in a competitive market. Moreover, these same firms benefited enormously from the regulatory interventions they supported and that harmed so many of us. The eventual bursting of the bubble and their subsequent losses are, to many of us, their just desserts for rigging the game and eventually getting caught. To reward them again for their rigging of the game is not just morally unconscionable, it is very bad econonmic policy, given that it sends a message to other would-be riggers that they too will get rewarded for wreaking havoc on the US economy. There will be short-term pain if we don't bailout these firms, but that is the hangover price we pay for 15 years or more of binge lending. The proposed bailout cannot prevent the pain of the hangover; it can only conceal it by shifting and dispersing it among the taxpayers and an economy weakened by the borrowing, taxing, and/or inflation needed to pay for that $700 billion. Better we should take our short-term pain straight up and clean out the mistakes of our binge and then get back to the business of free markets without creating an unchecked Executive branch monstrosity trying to "save" those who profited most from the binge and harming innocent taxpayers in the process.
What I ask of you my friends on the left is to not only continue to work with us to oppose this or any similar bailout, but to consider carefully whether you really want to entrust the same entity who is the predominant cause of this crisis with the power to attempt to cure it. New regulatory powers may look like the solution, but that's what people said when the CRA was passed, or when Fannie and Freddie were given new mandates. And the very firms who are going to be regulated will be first in line to determine how those regulations get written and enforced. You can bet which way that game is going to get rigged.
I know you are tempted to think that the problems with these regulations are the fault of the individuals doing the regulating. If only, you think, Obama can win and we can clean out the corrupt Republicans and put ethical, well-meaning folks in place. Think again. For one thing, almost every government intervention at the root of this crisis took place with a Democratic president or a Democratic-controlled Congress in place. Even when the Republicans controlled Congress, President Clinton worked around it to change the rules to allow Fannie and Freddie into the higher-risk loan market. My point here is not to pin the blame for the current crisis on the Democrats. That blame goes around equally. My point is that hoping that having the "right people" in power will avoid these problems is both naive and historically blind. As much as corporate interests were relevant, they were aided and abetted, if unintentionally, by well-meaning attempts by basically good people to do good things.The problem is that there were a large number of undesirable unintended consequences, most of which were predictable and predicted. It doesn't matter which party is captaining the ship: regulations come with unintended consequences and will always tend to be captured by the private interests with the most at stake. And history is full of cases where those with a moral or ideological agenda find themselves in political fellowship with those whose material interests are on the line, even if the two groups are usually on opposite sides. This is the famous "Baptists and Bootleggers" phenomenon.
If you've made it this far, I am most grateful. Whether or not you accept the whole argument I've laid out here, I do ask one thing of you: the story I told at the start of the role of government intervention in this mess is true, whatever your grander conclusions about the causes and cures are. Even if you don't buy my argument that more regulation isn't the cure, to blame this mess on "the free market" should now strike you as an obvious falsehood and I would hope, in the spirit of fair play, that you would stop making that claim as you speak and write about the ongoing events of the last two weeks. We can disagree in good faith about what to do next, and we can disagree in good faith about the degree to which government intervention caused the problems, but blaming a non-existent free market for a crisis that clearly was to some extent the result of government's extensive interventions in that market is unfair. So if I have persuaded you of nothing else, I hope deeply that I have persuaded you of that.
In the end, all I can ask of you is that you continue to think this through. Explaining this crisis by greed won't get you far as greed, like gravity, is a constant in our world. Explaining it as a failure of free markets faces the obvious truth that these markets were far from free of government. Consider that you may be mistaken. Consider that perhaps government intervention, not free markets, caused profit-seekers to undertake activities that harmed the economy. Consider that government intervention might have led banks and other organizations to take on risks that they never should have. Consider that government central banks are the only organizations capable of fueling this fire with excess credit. And consider that various regulations might have forced banks into bad loans and artificially pushed up home prices. Lastly, consider that private sector actors are quite happy to support such intervention and regulation because it is profitable.
Those of us who support free markets are not your enemies right now. The real problem here is the marriage of corporate and state power. That is the corporatism we both oppose. I ask of you only that you consider whether such corporatism isn't the real cause of this mess and that therefore you reconsider whether free markets are the cause and whether increased regulation is the solution.
Thanks for reading.
Steve