An Open Letter to my Friends on the Left
http://myslu.stlawu.edu/~shorwitz/open_letter.htm
Steven Horwitz
Department of Economics
St. Lawrence University
sghorwitz@stlawu.edu
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 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
http://myslu.stlawu.edu/~shorwitz/open_letter.htm
