Financial Crisis Talk
[From a talk given to a Memphis-area discussion group on Tuesday, October 14, 2008.]
Here we are in the midst of a Great Financial Crisis, with some likening it to the Great Depression and with many more claiming that something must be done. Specifically, people are clamoring for government to fix this latest, greatest crisis of capitalism. Fortunately, there is a steady stream of high-quality analysis coming forth on a daily basis, and synthesizing these contributions gives us a clearer picture of what is going on and how we can fix it. First, I want to look at several proposed explanations for the crisis. Then I will talk about how financial crises are examples of government failure. Third, I want to discuss some of the lessons we learned from the Great Depression. Finally, I will close with my best assessment of what should be done.
I. What caused it?
A. GREED. My friend and co-blogger at www.divisionoflabour.com Lawrence H. White said it well: blaming "greed" for financial crises is like blaming gravity for plane crashes. People are and always have been greedy, so the question is not "how do we get people to be less greedy?" but "how do institutions emerge that harness greed in such a way as to promote social stability?" In other words, how do societies get the institutions right? Further, there remains an unasked — and uncomfortable — question about greed which is likely to be unpopular but is nonetheless very relevant: is it greedy to want a house that's priced at four, five, or six times your annual income? Is it "greedy" to want to spend your home equity on current consumption? Is it "greedy" to want to own a house when the financially prudent thing to do is rent? Further, is it responsible to agree to finance a house you can't afford by signing a contract you don't understand? The crisis was fundamentally the result of incentives that encouraged irresponsible behavior, but if we are going to put some of the blame on "greed," we need to make sure that the blame is spread evenly.
B. DEREGULATION. Pundits like to blame "deregulation," but they are usually silent on the specific regulatory changes as well as how they created the crisis. As a blogger for Asymmetrical Information has put it, many complex and opaque financial instruments are the unintended consequences of regulations (hat tip: MarginalRevolution.com). If we're going to have regulations at all, they shouldn't define the instruments that can and cannot be traded because with millions (and even billions) of dollars on the line, intelligent people can find a way around it. The key is to try to ensure as much transparency and information disclosure as possible.
C. CAPITALISM. Massachusetts representative Barney Frank either hasn't been watching or is deliberately making things up, which is the impression one might get from Frank's statement that "(t)he private sector got us into this mess. The government has to get us out of it." That isn't true. There is plenty of blame to go around, but the real culprits are people like Frank who can criticize Government-Sponsored Enterprises for focusing on their own financial health rather than the housing needs of the poor one year and then blame the free market when the housing market collapses under pressure he helped create.
D. GOVERNMENT. It's easy to blame the state for everything, and people who blame government failure are unfortunately dismissed as reactionaries and ideologues. However, this is the case that is the most plausible. Government intervention distorts price and profitability signals and brings with it a host of unintended negative consequences. The government necessarily has to redistribute resources if they want people who didn't qualify for mortgages to own their own homes. When the Federal Reserve is issuing guidelines saying that a lack of credit history should not be a deciding factor in whether someone gets a loan or not, something in the regulatory institutions is clearly amiss.
II. What Happened? Financial Crises as Examples of Government Failure
The current financial crisis offers several conspicuous examples of government failure. The first failures occurred because government backing of Fannie Mae and Freddie Mac socialized the losses associated with risky mortgages. Second, when markets are allowed to work, everyone who wants a loan at the equilibrium interest rate can get one. When Fannie and Freddie agreed to buy dangerous mortgages, it gave originators, lenders, and brokers incentives to write dangerous mortgage contracts. Moreover, Fannie and Freddie's willingness to buy junk mortgages meant that originators and lenders didn't have much of an incentive to perform due diligence with respect to who could and who couldn't repay. All they had to do was make the bad loan, sell it to Fannie and Freddie, and enjoy the profits. Barney Frank (again) was unconcerned about the problems posed by pressure on Fannie and Freddie. According to Jacoby, when Fannie and Freddie's accounting problems were first brought to his attention (by Bush Administration officials, including Harvard economist N. Gregory Mankiw), Frank suggested that the administration and its economists were more concerned about the financial stability of FNMA and FRMC than about the supply of affordable housing.
And one can't say that we didn't see this coming. Several commentators have pointed to an eerily prescient 1999 article in the New York Times written by Steven A. Holmes pointing out how congressional pressure has created easier lending rules that work while rising home prices keep default rates low but that can create a disaster when home prices start to fall: "In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders … In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry of the 1980's."
Yet another potential villain is the Community Reinvestment Act, which basically directed banks to make bad loans in the areas where they do business. Jeff Jacoby of the Boston Globe has an excellent commentary on this, and it is worth quoting him:
" … mortgage lenders didn't wake up one fine day deciding to junk long-held standards of creditworthiness in order to make ill-advised loans to unqualified buyers." CRA allowed "regulators to punish banks that failed to 'meet the credit needs' of 'low-income, minority, and distressed neighborhoods.' … As long as housing prices kept rising, the illusion that all this was good public policy could be sustained. But it didn't take a financial whiz to recognize that a day of reckoning would come. "What does it mean when Boston banks start making many more loans to minorities?" I asked in this space in 1995. "Most likely, that they are knowingly approving risky loans in order to get the feds and the activists off their backs … When the coming wave of foreclosures rolls through the inner city, which of today's self-congratulating bankers, politicians, and regulators plans to take the credit?' … A manual issued by the Federal Reserve Bank of Boston advised mortgage lenders to disregard financial common sense. "Lack of credit history should not be seen as a negative factor," the Fed's guidelines instructed. Lenders were directed to accept welfare payments and unemployment benefits as "valid income sources" to qualify for a mortgage. Failure to comply could mean a lawsuit."
Writing in the Wall Street Journal on October 3, my former supervisor Russ Roberts pointed to the problems created by Federal pressure on lenders. Congressional pressure started in 1992, with an explicit target set for 1996 by HUD, in Roberts's words, "42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005." In 1996, 12% of Fannie/Freddie mortgage purchases had to be "special affordable," meaning mortgages to people with 60% or less of median income in their area. The target for 2000: 20%. for 2005: 22%. and finally for 2008, the goal was 28%. Roberts describes the mortgage mess as "a political free lunch," at least in the short run, because it allowed Congress to subsidize housing off-budget. In a similar fashion, unusually low default rates meant that securitizing CRA mortgages (which Bear Stearns started doing in 1997) paid off profitably as long as "rising housing prices kept default rates unusually low."
In the Wall Street Journal on September 23, Charles W. Calomiris and Peter J. Wallison argue that the crisis has its roots in political pressure on Fannie Mae to finance more "affordable housing." Backed by the federal government, Fannie and Freddie were taking tens if not hundreds of billions of dollars worth of bad risks. As Calomiris and Wallison point out, the key problem with Fannie and Freddie is that they were government-sponsored and therefore had virtually unlimited access to credit with which they could buy mortgaged-backed securities. Their ability to socialize the risks they took on made them profitable and allowed them to buy political support from Congress by focusing on affordable housing.
The government's pursuit of its political goals created the mess. The government was able to expand the supply of affordable housing and do so off the books by weaking underwriting standards rather than by subsidizing home purchases. In an excellent discussion of the causes of the housing market collapse, Stan J. Liebowitz argues that the mortgage crisis had its roots in systematic government efforts to undermine underwriting standards that begain in the early 1990s. Aggressive credit expansion and changes in the tax treatment of real estate reduced default rates and fueled a run-up in housing prices, which ended in 2006. According to Liebowitz, foreclosures began increasing for both prime and subprime loans, which reduced the value of mortgage-backed assets. Fannie Mae, Freddie Mac, and several large banks were caught off guard. Liebowitz argues that political pressure also likely helped encourage the overly-optimistic ratings of mortgage-backed securities: SEC regulations hung over the rating agencies like the sword of Damocles, and the raters didn't want to attract undue regulatory attention by opposing a politically popular initiative.
The crisis is largely the result of government intervention rather than the government's failure restrain unmitigated greed. This has not stopped many from invoking the Great Depression in their clamor for increased government involvement. Research by Robert Higgs can teach us several lessons from the Great Depression that can help us better understand what caused the crisis, what further intervention will likely accomplish, and what should be done to help people weather the storm.
III. Learning our Lessons
Robert Higgs's 1987 book Crisis and Leviathan offers a brilliant theoretical and empirical examination of the evolution of government intervention during and after the World Wars and the Great Depression. State discretion expanded, and while it receded somewhat after the crises, the state had more discretion over economic activity as a result of the crises. This "ratchet effect" for government intervention explains in part the rise of bigger government during the twentieth century.
Recently, Higgs pointed out another important legacy of the New Deal after the Fed intervened on behalf of AIG. The ratchet explains short-run increases in state discretion, but government reactions to crises also leave long-run institutional and ideological legacies. In the case of the AIG intervention, the federal government used emergency powers that had been granted to it during the Great Depression.
Another relevant institutional and ideological legacy of the Great Depression is the popular view that some combination of the New Deal and World War II ended the Depression. As Higgs has argued in his 2006 book Depression, War, and Cold War, however, the uncertainty created by anti-business policies during the New Deal in fact exacerbated the crisis. Further, World War II led to net capital consumption as men and materiel were used to prosecute the War instead of being used to produce goods and services at home. An old maxim says that if you repeat something often enough, it become a fact regardless of whether it is true or not. Repeated comparisons of current conditions to the Depression and repeated exhortations to follow New Deal-esque policies will lead us down a policy road we should not wish to travel.
In his excellent essay "An Open Letter to my Friends on the Left," Steven Horwitz explains how government intervention rather than free-market capitalism has created the present unpleasantness and argues that deregulation, rather than an increased scope for government, is the appropriate way to deal with the crisis. In an earlier essay on inequality, Horwitz argues that before asking the "oughts" of ethics, we have to consider the "cans" of economics. The present crisis is humbling: it illustrates the unfortunate consequences of what F.A. Hayek called "The Pretence of Knowledge." A mixture of political incentives, hubris, and a desire to "help those in need" combined to create a financial disaster in which "those in need" are finding themselves worse off than they were before their anointed benefactors decided to lend them a helping hand.
The most important thing we can do is learn from the present crisis. Just because we think something is morally desirable — "affordable housing," for example — does not mean that it is economically feasible. Government intervention changes incentives and leads to calls for further government intervention, and while we can conceal the distortions with credit expansion in the short run, this is not a viable strategy in the long run. Precipitous drops in asset values and increases in home foreclosures bear testimony to this fact.