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The Usual Suspects

Mises Daily: Thursday, July 16, 2009 by

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The Usual Suspects

In 1977, the prolific economic writer Henry Hazlitt wrote,

[T]here has been a profound change in the economic reputation of Keynes' General Theory. It is no longer accepted as the new gospel. Professors of economics can openly declare themselves to be non-Keynesians and even anti-Keynesians and still be treated with respect.[1]

Keynesian economics provided the intellectual cover for more government regulation and confiscatory tax policies. However, in the time after Mr. Hazlitt wrote the words quoted above, the illusion of Keynesian economics began to vanish from the thinking process of learned policy makers. The stagflation of the 1970s provided clear evidence of the disastrous consequences of employing the tenets of the General Theory to the management of the economy.

A devastating blow was dealt to Keynesian principles in 1980, when Ronald Reagan was elected president and ushered in a rekindling of traditional economic thought, namely, that increased production creates jobs and prosperity. (Jean-Baptiste Say told us this 200 years ago, but he was ridiculed by the Keynesians in their so-called "refutation" of Say's Law.) Upon assuming the presidency, Mr. Reagan reduced marginal tax rates and began the deregulation of the American economy.

The result was decisive. It spurred the longest economic superexpansion in US history — an expansion that lasted into the sixth year of George W. Bush's presidency. During Mr. Reagan's administration, twenty million new jobs were created. The ranks of the middle class swelled, and Americans once again had a positive outlook on the future. Even the once-battered central cities were revitalized and began gaining population — a trend that continues to this day. To his credit, the left-leaning Bill Clinton was shrewd enough to discern the positive effects of Reaganomics and continued with policies of welfare reform, reducing the budget deficit, and free trade.

Then came George W. Bush and the real estate meltdown of 2006. Everyone was blamed for the crisis: Reagan for his deregulation, Bush for his tax cuts, and Wall Street for its greed. Even homeowners were blamed for buying more house than they could afford. Everyone was blamed except for the regulators and the politicians, along with their minions in local advocacy groups, who caused the distortions in the market that led to the debacle. The reasons for the distortions in the market are clear:

1. The ever-increasing push for homeownership, especially among minorities, as evidenced by the enforcement of the Community Reinvestment Act (CRA); and

2. The expansionary monetary policy pursued by the Federal Reserve.

The CRA became a capstone regulation in the mortgage arena. Although passed during the Carter administration, the CRA had its greatest impact in the 1990s, when there was a frenzy of bank mergers. There was a constant push from the left to make loans in questionable areas and to people of very questionable means. As a director in a municipal housing agency in the 1990s, I saw firsthand the pressure placed upon financial institutions to make loans in areas that the bureaucrats designated as "redlined." The Republicans in Congress, whether for a lack of a conservative philosophy or for a lack of understanding, acquiesced to this intrusion into the market.

The easy-money policy of the Federal Reserve distorted the production cycle and encouraged an oversupply of residential building. Even experienced developers openly asserted that they had miscalculated the demand for housing units. Billions of dollars in equity were dissipated in one tenth of the time it had taken to build it. Why were even talented and experienced developers deceived? Because of the distortions created by government regulation and intervention in the market place — most notably the Fed's expansionary monetary policy and the push for insupportable home ownership engendered by the CRA.

Having stated all of the above, who can we blame?

Can we blame the banks? If money is available, it must be put to work. This is exactly what the banking system did — and exactly what the politicians wanted it to do. All of this money found its way to where the greatest demand was: the housing construction industry. Financial engineering went full speed ahead in the mortgage industry, and all kinds of new mortgage products were developed. This is classic Austrian theory empirically proven by real events. When money is artificially created by monetary expansion, investors are deceived into thinking that there is real demand for their products — in this case, housing. At some point, however, the error is realized, the capital structure needed to continue is not there, and the deleveraging begins.

Can we blame the developers or the real estate investors? Developers are entrepreneurs. They are out to make a profit. While doing so, they provide a needed product. If they have easy access to money, as they did for the last ten years, then they will employ that money in the most leveraged way possible. This was especially true in the housing boom, when demand was high and an ever increasing number of people qualified for the housing units that developers were producing. Once again, the easy money policy of the Federal Reserve and the creative financial engineering undertaken by banks (fostered by such government interference as the CRA) distorted the level of actual demand and the durability of that demand. At the time, I was constantly amazed by how much I underestimated the actual sale price of my units.

Investors may not take the risks associated with building houses, but they do take the risk of losing the capital that they invest. In their role as investors, they also provide needed capital to the market. Without an equity investor, many of the projects that I designed would not have come to fruition. Developers and investors do not get into the market to lose equity or the money that they borrowed from the bank. Rather, they enter the market based on their positive assessment that they will be successful and provide a needed product that will make them money. But with the distortions created by regulation and other government interference, their positive assessments often turn out to be wrong.

So what did the politicians do to alleviate the crisis? They dusted off their copies of the General Theory and gave us a toxic dose of its main ingredients: regulation, interference, and stimulus. Instead of letting the market adjust, the politicians called on their financial "brain trust" (that is, the same people who got us into the mess) and began drawing plans to overhaul the financial system with more regulation. Additionally, they allocated billions of dollars to bail out the banks and other institutions.

It is instructive to quote a passage that Murray Rothbard wrote in 1991 with great foresight: "Since given the mindset of the American politician and their evident philosophy of 'too big to fail,' it would be certain that they would be forced to embrace the second alternative — massive, hyperinflationary printing of enough cash to pay off all of the banks liabilities. The redeposit of such cash in the banking system would bring about an immediate runaway inflation and a massive flight from the dollar."[2]

How "on the money" is this statement! The first part of Rothbard's prediction has already been fulfilled with the TARP program and the enormous "stimulus" funding approved by Congress. The second part is in process. My advice to the current administration: pick up a copy of The Failure of the New Economics, and read it!

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Nevertheless, the regulatory web thickens. Freddie Mac and Fannie Mae are de facto government agencies that have a substantial regulatory role in the real estate market. In fact, Nobel Prize–winning economist Vernon L. Smith, referring to Freddie Mac and Fannie Mae, has stated, "Both were exempt from state and local taxes, as well as SEC oversight, and implicitly believed by all to be ultimately protected by the US Treasury."[3]

And they were! Freddie Mac and Fannie Mae buy mortgages in the secondary market and repackage them as mortgage-backed securities. Wall Street investment banks and other institutions bought these securities. Should they be criticized for their actions? This is exactly what the housing bureaucrats and the politicians wanted them to do to keep the stream of mortgage money ever flowing. If not for the implicit government backing of these institutions, many of the Wall Street concerns that bought these securities would have acted more cautiously.

What is most incredible about this debacle is that the role played by regulation and government interference has been overlooked. In fact, a presumed lack of regulation has been cited as the culprit. Even the so-called "conservatives" and supposed proponents of the free market in Congress failed to make this distinction. Government regulation gives people, as it did the investment bankers, a false sense of security. As a result, a dangerous philosophy develops: if it is backed by the government, it must be okay. Yet government backing is no guarantee. I can't tell you the number of times that I have had costly problems due to the actions of a government-licensed lawyer, architect, or engineer!

With the current administration, we are seeing a deepening of the problem. In fact, we are seeing a return to the illusionary tenets of Keynesian economics: more regulation, confiscatory tax policies, and huge budget deficits. All of this will lead to a fulfillment of Rothbard's second prediction stated above: another bout of inflation.

It is interesting to note that the current administration devised a "housing rescue" plan based on refinancing. However, to be eligible you must have a mortgage "backed by government controlled mortgage companies Freddie Mac and Fannie Mae." Not surprisingly, the program does not appear to be working. The Mortgage Bankers' Association has reported that refinancing is at its lowest level since November 2008, because mortgage rates have risen from 4.84% to 5.49%.

It is simple economic fact that mortgage rates will rise when investors begin to detect inflation. The inflation premium on bonds will rise in proportion to this sentiment. Once again, we see that regulation intended to cure a problem only makes matters worse. According to a study by Professor Stan Liebowitz, negative equity — not monthly mortgage payments — is the greatest factor in home foreclosures. He states: "A simple statistic can make the point: although only 12% of homes had negative equity, they comprised 47% of all foreclosures."[4] Clearly, had the government allowed the market to operate, home prices would have found the bottom more quickly, and the housing crisis would have ended sooner. Regulation and intervention only distort!

The Road Ahead

It is clear that regulation is expanding daily in the United States and will continue to do so — with disastrous consequences. The current administration and congressional leaders are all committed to big government as a tool of economic and social change — as long as that social change is what they and their constituents desire.

This then is the essence of government regulation: to effect an outcome desirable to a favored constituency for both votes and ideological consistency. Hence, the reemergence of Keynesian economics. For, as described above, Keynes provides the intellectual cover for government intrusion in the market and, as a result, intrusion in our everyday lives.

The only problem, of course, is that the Obama Administration and their cohorts in Congress will not be able to create the wealth necessary to "spread around." Most politicians fail to understand a basic fact of economic life: entrepreneurs create wealth through risk taking and through the channeling of resources to a desired goal. Bureaucrats and politicians and even consumers do not create wealth.

The requirements for wealth creation are simple: a favorable business climate free from overbearing regulation and a belief that the earnings from hard work and risk taking will not be confiscated by a government bent on the redistribution of income.

As a developer, I will not engage in the difficult and risky business of providing housing if I believe that regulation will so hamper me that my profits will blow out the window along with my elaborately-constructed pro formas. For economic expansion to resume, confidence must be restored. This can only be done through the adherence to the principles of free market economics. Only then will small business, the basic engine of job creation, begin to expand and drive the economy upwards. This will not happen as long as businessmen are viewed as villains and expropriators — especially when the only thing being expropriated is their money!

This essay on the current economic climate has been laced with political reference. The reason for this is simple: economics is intertwined with politics. Economists can only analyze, explain, and recommend. To effect change, policy must be enacted. This can only be done by politicians through the political process. Will there be another Ronald Reagan to lead the US back in the direction of sound economic policy? I don't see one on the horizon. What I do see is another bout of inflation and weak economic performance — another replay of the Keynesian-induced stagflation of the 1970s.

Notes

[1] Henry Hazlitt, Critics of Keynesian Economics, preface to the second edition, p. 5.

[2] Murray Rothbard, The Case for a 100 Percent Gold Standard, preface.

[3] Vernon Smith, "Bubbles: Surviving Until Next Time," Economic Science Institute, Chapman University, 10/21/2008.

[4] Stan Liebowitz, "New Evidence on Foreclosure Crisis," Wall Street Journal, July 3-5, 2009, p. A13.