An Open Letter to my Friends on the Left
Steven Horwitz
Department of Economics
St. Lawrence University
sghorwitz@...
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
<http://www.ibdeditorials.com/IBDArticles.aspx?id=307241242284619> ) 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
<http://query.nytimes.com/gst/fullpage.html?res=9C0DE7DB153EF933A0575AC0
A96F958260&sec=&spon=&pagewanted=1> 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
<http://www.cato-at-liberty.org/2008/09/22/blame-urban-planning/> ,
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
<http://online.wsj.com/article/SB122204078161261183.html?mod=djemEditori
. 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 to 2006,
the percentage of loans in those riskier categories grew from 8% to 20%
of all US mortgage originations
<http://online.wsj.com/article/SB122212948811465427.html?mod=djemEditori
. 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
<http://www.cato-at-liberty.org/2008/09/22/blame-urban-planning/> "
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
Mike