Tuesday, September 30, 2008

The Financial Panic and the Only Proper Answer to It

One fact is absolutely clear: most of the blame for the current financial panic is utterly misdirected. Rather than hold accountable the irrational government policies that encouraged irresponsible lending and mountains of homeowner debt (and those who supported these policies), the moral foundation of the free market is itself being disparaged and attacked. We are told that the ruthless self-interest of Wall Street (rather than the "compassionate" gift-giving of the Congress) is the cause of the current crisis. Unfortunately, the truth is a little more complex. Perhaps we should examine this truth, that is, before we blithely allow our political leaders to add nearly a trillion dollars to the public debt and give new powers to those who helped bring the disaster along in the first place.

If you notice, our government has a policy of promoting borrowing over savings. For example, we permit our government to fully tax the savings that someone might make in order to pay for a home while allowing a person to deduct the interest costs of their home mortgage against their taxes; that is, through its tax policies, our government punishes savings and encourages home debt. Given this financial incentive to borrow (an incentive that happens to suit those who build and sell houses and lend mortgage money just fine) you would have to be a fool to save for a house rather than borrow for it. Most people tacitly recognize this fact and that is why they choose to take on debt in order to buy their homes.

Furthermore, if there is one thing that that government is, it is helpful to those who have political pull. For the last seventy years there has been no pull like that of those selling the American dream. To help encourage people to own their own homes, our government created two quazi-private monopolies: Fannie Mae in 1938 and Freddie Mac in 1970. These government-sponsored monopolies buy mortgage debt, pool it, and then resell the debt as mortgage-backed securities to investors on the open market. This secondary mortgage market increases the supply of money available for mortgage lending and new home purchases.

What happens when the government makes credit more available than credit would otherwise be in a free market? People will respond to the incentive and find ways to take advantage of the newly available cash. As long as home values were increasing because of the ever-increasing demand for homes, there wasn't really much to worry about; a person could do well even with risky financing arrangements like zero-down, interest only or negative amortization loans. And even if Fannie Mae and Freddie Mac didn't directly encourage those kinds of loans, they allowed themselves to be dangerously exposed to fallout from those who did.

But that is not the end of it; we didn't demand our government to limit its interference to just tax incentives and home loan monopolies however; we allowed it to offer us even more unearned gifts. Passed in 1977 and amended over the years, our government gave us the Community Reinvestment Act (CRA), a law that mandated that banks must extend credit to those who otherwise would not be credit-worthy. If the banks didn't make enough risky loans, being heavily regulated by the government, they would be denied the ability to open new branches, merge with other banks and enter new business endeavors, etcetera.

Again, as long as housing prices were always going up, real estate was a great racket to be in; in some areas, home prices saw double digit increase in valuations and there were even whole TV series dedicated to the phenomenon of house-flipping, the process where a real estate speculator would buy a distressed property, fix it up a little, and then cash in on the re-sell. Who would ever argue against the policies that helped make it all happen? How could one ever go wrong when the tide was always rising?

Yet the problem with tides is that they don't always rise. If you allow yourself to be heavily leveraged and the person who lends you money allows himself to be heavily leveraged and the insurer that insures his loan to you allows himself to be heavily leveraged, the fall of your one little domino can wreak a lot of havoc. Add tens of thousands of dominos all falling at the same time and you have the underpinnings of a financial panic.

Now in a free market, you might have your panic, but it would soon stop. Those people who made irrational choices with their money and assets would lose them. Those people who were rational and had chosen to protect themselves from calamity would not. If you look at the financial panics in the age before massive government intervention in our economy, these panics were smaller and when they did their damage, the spendthrifts received their just reward, and the rest of the people soon recovered and moved on with their lives.

Today, we are not fortunate enough to live under a free market. Most Americans seem to like their lives to be controlled by those who claim to act out of the public interest--and today there is no public interest like assuaging need through government controls. If you need to borrow money for a home even though you can't afford to pay back your loan, the government will see to it that you get your money. If you build your house in a flood plain and the flood comes, the government will tax others so you can rebuild it. If you make poor financial decisions that improperly account for economic risk and that cause your bank to go bankrupt, the government will pay to bail you out. Today we live under an economic and political system where need is a blank check and risk is nationalized.

So just who does our current system of national relief favor? Does it favor the independent, thrifty, hardworking and non-foolhardy? Hardly. Such a person is able to think and act for himself; what need does he have for our government? Instead, our system today favors the unwarranted risk-taker. It favors the person who presses for political favors. After all, there was a reason why the most corrupt (and now bankrupt) home lenders were giving sweetheart home loans to key members of Congress--and it wasn't to restore the free market in housing. It was to keep the incentives that Congress created to steer money into housing flowing because there was a ton of money to be had doing so.

So unlike the claims of some, the current crisis is not so much a battle between Wall Street and Main Street. The problem we face today rests in every street; it rests in our nation's unchallenged enshrinement of need as a virtue and its willingness to use government power to assuage that need. Instead of leaving people free to work toward improving their lives though their own efforts, we have created a system of perverse incentives; a system that has now collapsed as a system so-designed must.

What then is the answer to this panic? I hold that we simply ought to let the businesses that failed fail, expedite the liquidation of their assets at their current market value under streamlined bankruptcy laws, and once and for all remove our government from the business of creating perverse economic incentives.

Notice however that such a plan is not a serious proposal being debated within the halls of Congress. Instead we are told that we require more regulation of banking through "Financial Stability Oversight Boards," smaller CEO salaries, stricter business accounting rules, massive taxpayer-funded bailouts of banking, subsidies to borrowers, and perhaps most rich, we are told that we should expect our government to make money from it all as it essentially nationalizes the commercial banking sector. I'm sure the folks at Amtrak think that they are going to make money one day too, but institutions that respond to political wishes rather than the reality of the marketplace do not make money; they lose it and in our age they lose it to the tune of billions upon billions of dollars.

So for the market to be restored, we must first demand an ethical revolution, one that says that people have a right to their life, liberty and the freedom to pursue their own happiness, but not a right to claim the unearned or a right to have our government provide it for them. Our nation needs to learn a new mantra: Give us liberty, and death to government controls.


Brad Williams said...

You are confusing the government's coercion and distortion of the market for supposedly irrational investing. Buyers and sellers -- including "flippers" -- should not be blamed for *acting reasonably in the context of a heavily distorted marketplace*. There are actually very few to blame here, almost everyone is a victim of the government's manipulation. There was not the bad faith of "unwarranted risks" by buyers and sellers going on as you imply, except by two parties: those who have actually defaulted on their loans, and the government which made those extra-risky loans attractive to investors. Most homeowners are not defaulting, but are victims of the boom, in which they paid too much, and the bust, in which they will lose too much. A "racket" in which everyone is a victim of central planning is not much of a racket, Nicholas. The real racket here was the one in which the politicians traded market distortion for votes.

Anonymous said...

I agree with this and think Nick wrote an excellent summary of the crisis. But I do feel for some people who acted responsibly and were hit hard by the real estate meltdown. Here is an example: say you put 100k down on a 500k house taking a 400k mortgage with an ARM. Now, real estate prices in your area are plummeting and your once 500k house is worth 300k. You have a 400k mortgage on a 300k house. You can't go through bankruptcy because you still have assets and can afford to pay your loan.

Now, I believe you should still honor your mortgage but this kind of person was genuinely screwed by the current financial house of cards. I can see such a person thinking that the "fat cats" screwed him. I have read of many such cases.

Michael Smith said...

Great article, Nick.

I can't decide which is more disgusing: watching those alleged defenders of capitalism -- the conservatives -- agitate for the bailout bill, or listening to the left gloat that the "rabidly laissez faire" Bush adminstration admits the free market has failed.

madmax said...

"...listening to the left gloat that the "rabidly laissez faire" Bush adminstration..."

This is a common tactic of the Left. To them anything less than full socialism represents "laissez faire" or "unrestrained capitalism". They have redefined capitalism as the mixed economy so as to eliminate even the possibility of a genuine free market. They started this tactic over 120 years ago with the Progressive Era. It turns my stomach too.

z said...

Egalitarianism and Inflation by Ayn Rand

Mike said...

anonymous: I'm sort of in that situation too, as I bought a $257k house that was $420k at the height of the boom (here in high-impact Phoenix) and will probably drop to somewhere around $200k before it recovers, based on comps and the rate of resale on a neighborhood-by-neighborhood basis. However, the $60k of equity I will lose this year will come back. 5 years from now the house will be worth $300k fair and square. 15 years from now it will crack half a million and I can probably sell out at a fair profit and put money down on an upgrade or something. This works for me, and it will work for most normal homebuyers, because we bought our homes to LIVE in them, not to flip them. The flippers are getting massacred, and that's the risk they take when they sign on the dotted line. I'm not too keen on the gub'mint letting them off the hook at my expense.

Nicholas Provenzo said...

In my haste to get out the door for a date with a very special four-year-old, I missed a couple of typos; thanks to those who pointed them out for me :)