19 December 2008

Why is everybody picking on poor, old Uncle Sammy?

Reader JK asks, regarding this posting, "Why is 'the government'...repeatedly blamed? From what I've read and what I've been told, it's the market players who merrily took part in a reality renaming game. The government is not innocent of course: It deregulated the market in the first place."

In brief, government gets repeatedly blamed because it is a major player in the market, and, for some of us, improperly so. The question is what specific role it played in the present mess. With specific reference to the housing bubble and its burst, I think there is some merit to claims The Community Reinvestment Act played a role in that it requires (or can be, and has been interpreted to require) lending instutitions to make loans to sometimes-risky borrowers with the idea of increasing home-ownership among the poor. I'm getting ahead of myself, however.

But even if that isn't the case, that doesn't take the government out of the picture. There is still the role played in the housing bubble by Fannie Mae.

Mortgages originate in institutions such as banks. Fannie Mae purchased mortgages from originators and then either held the mortgages or packaged them together as securities, called mortgage-backed securities (or agency debt) and sold those mortgage-backed securities on credit markets. A great number of these mortgage-backed securities were purchased by money market funds, and felt safe in doing so because the seller was, well, Fannie Mae.

In a real free-market economy with a sound monetary system (as opposed to our quasi-mercantilist economy, with its fiat money system ), all funds loaned to borrowers would have been saved by savers somewhere else in the economy. To save is to defer consumption from the present to the future. Since money loaned to borrowers is money saved by savers, when money is borrowed, savers require an interest payment for their sacrifice. Borrowers take on the obligation to pay interest because they value the opportunity to fund present consumption more highly. Interest is a sort of rental payment on the borrowed funds, if you will.

In these sorts of credit transactions, there is a risk that the borrower may not have sufficient income to fund his debt obligations. This risk of default must be borne by someone. Generally, it is borne by some combination of the two parties in the transaction, the saver (lender) and the borrowers. The borrower can put up collateral, or the lender can charge a higher interest rate to compensate for the risk. (The higher interest rate may induce the would-be borrower not to borrow, in which case the saver runs no risk. Or, he may take on the higher interest rate and exercise more due diligence than he might otherwise have done.) Private lenders that are risking their own capital have a natural caution about the level of risk that they are willing to assume.

But Fannie Mae isn't a private lender. Fannie is a financial intermediary: It borrows from some and lends to others; but it's regulatory status(there's your government involvement) gives it a number of special privileges which private firms operating in the credit markets do not have. In a free market, financial intermediation is a good. Intermediaries perform the valuable service of bridging potential buyers and sellers. (It's like a financial hook-up service, helping people find each other for a really good time.)

As a government-sponsored-enterprise, Fannie Mae is not a free-market intermediary. So, unlike private transactions, in which risk is shared by the parties to the transaction, Fannie Mae just transferred the default risk (beyond their capital reserves) to the taxpayer through an implied government (i.e., taxpayer!) guarantee.

But that’s not all, of course. On credit markets, agency debt is quite attractive, more attractive than debt issued by private corporations. (Private corporations don't have a government guarantee, implied or otherwise.) Because it transferred some of the default risk to third parties, Fannie was, demonstrably, less cautious in evaluating the default risk of borrowers than a private firm, risking its own capital, would have been. Furthermore, government-sponsored-enterprise securities are accorded preferential treatment in the calculation of bank reserves, so they can be purchased in many cases where private mortgage-backed securities, or other forms of debt, can not. And finally, the government-sponsored-enterprise are exempt from federal and state income taxes.

Now, when Fannie Mae purchased these risky mortgages, it sent (false!) signals to more and more lenders that there was a market for these sorts of loans, and, further down the line, to more and more builders, who, naturally, responded to this (false) demand by building houses. The markets did what markets do: they responded to a perceived demand. Home prices went up because that's what demand does to price. But this demand was created by Fannie Mae's purchasing, retaining, or guaranteeing more than 70 percent of the mortgage market. Fannie Mae's avowed goal, under Franklin Raines, was to increase home ownership. When you're in the business of purchasing, retaining, or guaranteeing mortgages, you have to have mortgages to purchase, retain, or guarantee. And that means you must somehow induce lenders to lend money they might not otherwise have done. In consequence, builders build houses they might not otherwise have done.

This is where legislation such as the Community Reinvestment Act comes into play. CRA required banks, among other things, to have a certain percentage of their loans to minorities, just like that, apart from assessment of risk. (The CRA required financial institutions to serve communities by extension of credit.) (See also and compare the Wikipedia article on CRA, accessed 17 December 2008.) Periodically, and especially in cases where one financial institution wanted to purchase another, the purchasing institution would have to demonstrate compliance with this provision of CRA. Additionally, such institutions have been opened to charges of racism by pillars of the national community like Jesse Jackson. In order to conduct business (as businesses rather than philanthropic organizations) some lending institutions have given what can justly be described as shake-down money to racial -- but certainly not special -- interests. For example, Chase Manhattan and J.P. Morgan donated hundred of thousands of dollars to ACORN at about the same time they were to apply for permission to merge and needed to comply with CRA regulations. (Michelle Minton, "The Community Reinvestment Act’s Harmful Legacy, How It Hampers Access to Credit," Competitive Enterprise Institute, No. 132, March 20, 2008, accessed 17 December 2008.)

Conveniently, the market, which has had terms dictated to it, is now blamed for a mess which it would hardly, operating on it own, have gotten itself into by some of its players making bad loans. When one is instructed to ignore risk, the risk doesn't just go away. Your notion, that "the market players...merrily took part in a reality renaming game," is incorrect (emphasis added). There was no merriment to it. The market did exactly what the market does when it is forced to make decisions which fly in the face of risk: it found ways to mitigate risks it was forced (by our benevolent government) to take on. Reality, to any extent to which is was renamed, was renamed by the government. The market simply responded to its perception of this reality.

On top of that, we should, as Robert Murphy argues, consider the role that the Fed played in creating the housing boom. (See also this, clarifying, post.) Briefly, Murphy argues that the Fed, created the necessary and sufficient causes of the housing boom by virtue of Greenspan allowing "the monetary base to grow quite rapidly precisely when the housing boom shifted into high gear, and precisely when interest rates collapsed."

As an Austrian (in economics) I just happen to think that the credit expansion period (or "boom" period, if you will) produced an unsustainable misallocation of resources based on an incorrect interest rate, in this case a misallocation of all those resources associated with the housing market. The "bust" is nothing more than the (rather catastrophic) end to an artificially created bubble (a government-activity created bubble ). The market didn't self-organize to expand the credit availability. It could not have done.

Clearly, that does not absolve private players of any wrong-doing. But the private players, if you listen to some, are limited to unscrupulous lenders, who, we must believe, tied people up and made them sign loans they wouldn't have done but for this coercion. There were, ostensibly, no unscrupulous borrowers, no people who lied about or inflated incomes, resulting in inaccurate risk-assessment by lenders (to the extent that they were able to take risk into account and who, as lenders, don't have as much to gain by mis-assessing risk as borrowers do in giving false reports of financial strength).

Finally, regarding JK's assertion that government "deregulated" the market -- he must surely be joking. Granted, Glass-Steagal was repealed, but one should be able to list much more in the way of "deregulation". "Regulation" involves, at some point, legislative acts of Congress. So when I hear someone assert "deregulation" I want to hear all of the legislative acts which amount to this "deregulation". I also look for a physical decrease in the number of pages in the Federal Register.

The only "deregulatory" acts I can of are: The Depository Deregulation and Monetary Control Act of 1980 (which forced all banks to abide by the Fed's rules; allowed banks to merge; removed the power of the Federal Reserve Board of Governors under the Glass-Steagall Act and Regulation Q to set the interest rates of savings accounts; raised the deposit insurance of US banks and credit unions from $40,000 to $100,000; allowed credit unions and savings and loans to offer checkable deposits; allowed institutions to charge any interest rates they chose -- yeah, a lot of deregulation there); Reigle-Neal Interstate Banking and Branching Efficiency Act of 1994 (which, repealing the Bank Holding Company Act, allows interstate mergers between adequately capitalized and managed banks, subject to concentration limits, state laws and Community Reinvestment Act (CRA) evaluations, other restrictions which prohibited bank holding companies from owning non-financial institutions having been repealed in 1999 by Gramm-Leach-Bliley Act but still prohibiting financial holding companies in the United States from owning non-financial corporations in contrast to Japan and continental Europe where this arrangement is common -- oh, yeah, big time deregulation); and Gramm-Leach-Bliley Act of 1999 (which allows banks to engage in previously prohibited activities such as lending, depositing, issuing insurance, and financial advising -- just awful). Oh, my goodness gracious! Will these heinous acts of deregulation never cease? I can see how it could be argued that these acts made the crisis possible: they allowed too much freedom of contract. Perhaps -- but these are not necessary and sufficient causes, only contributing factors which, but for the actions of the Fed under Greenspan (as Murphy argues in the above-linked article), would have had negligible effects.

Let me pause to take note of the fact that these horrendous acts of gross deregulation took place before Bush started running the economy, uh, I mean, country -- before he started running the country.

But even with all this putative deregulation, as of 2007, the last full year for which data are available, the Federal Register contained seventy-three thousand pages (that's 73,000 pages) of detailed government regulations. This is an increase of more than ten thousand pages since 1978, the very years during which our system, was supposedly "tilted in favor of business deregulation and against new rules" (according to the New York Times). Go figure. If that's degulation, then I suppose a man who gets his hair trimmed can justly be called bald.

One might argue that surely the market shares some of the blame, even if deregulation is a net good. In point of fact I don't think the market is to blame in the same sense in which the government is to blame. The market isn't because the market didn't do anything wrong; certain players in the market may have done (e.g., unscrupulous lenders, lying borrowers, or ignorant borrowers, who can't tell whether they can afford a loan, weak borrowers, who can't say no to an unscrupulous lender), but not the market. The entire government is to blame because the entire government makes, executes, and adjudicates the laws which forces the market to operate politically, rather than economically.

The government is repeatedly blamed because it repeatedly did -- and does -- things for which it is blame-worthy. (Then it conveniently points the finger at the market, which many people are all too ready to accuse in the first place.) The government is like that kid we all knew in high school, you know the one. He could start a food fight in the cafeteria then quietly, and cleanly, walk out, and on his way out the door look at a teacher, point to a random student and say, "He started it." I was once a victim of that student, on the last day of school, my senior year, no less. There are times when I still think he needs his butt kicked -- better late than never.

Some of us feel the same way about the un-federal government. It's time for it to receive its come-uppance and be forced to get the heck out of the market. The government is not comprised of dis-interested bystanders and has no business, therefore, regulating the market. There is no reason, now, for supposing that anyone in government can make the market work better than those whose daily task it is, and don't perform the task to curry favor with dis-informed, mal-educated, prehensile voters.


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James Frank Solís
Former soldier (USA). Graduate-level educated. Married 26 years. Texas ex-patriate. Ruling elder in the Presbyterian Church in America.
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