Friday, October 03, 2008

History Lesson - Financial Crisis

RUSSELL ROBERTS tells the story of this financial crisis. Here is the moral of the story:
"Fannie and Freddie played a significant role in the explosion of subprime mortgages and subprime mortgage-backed securities. Without Fannie and Freddie's implicit guarantee of government support (which turned out to be all too real), would the mortgage-backed securities market and the subprime part of it have expanded the way they did?

Perhaps. But before we conclude that markets failed, we need a careful analysis of public policy's role in creating this mess. Greedy investors obviously played a part, but investors have always been greedy, and some inevitably overreach and destroy themselves. Why did they take so many down with them this time?

Part of the answer is a political class greedy to push home-ownership rates to historic highs -- from 64% in 1994 to 69% in 2004. This was mostly the result of loans to low-income, higher-risk borrowers. Both Bill Clinton and George W. Bush, abetted by Congress, trumpeted that rise as it occurred. The consequence? On top of putting the entire financial system at risk, the hidden cost has been hundreds of billions of dollars funneled into the housing market instead of more productive assets.

Beware of trying to do good with other people's money. Unfortunately, that strategy remains at the heart of the political process, and of proposed solutions to this crisis."
Today's financial crisis is not a story of market failure. It is a story of government failure. Some time ago Congress began intervening in real estate markets and changing incentives that affected both the supply and the demand for mortgages. The changes resulted in incentives to make a larger number of risky loans than would otherwise have been the case. In addition, Congress began requiring Fannie and Freddie to make larger and larger numbers of mortgage loans affordable, which of course also meant a larger and larger number of loans than would otherwise have been made. Congress encouraged and it even demanded many of the risky loans that are the bottom line of the present financial crisis.

Don't be fooled by the political yak-yak today that this crisis has it's beginning some time during the Bush presidency. The earliest date Professor Roberts writes about in his history is the year 1992, and many of the events he writes about happened before the election year of 2000. This crisis began to brew at least 16 years ago. And, it seems to me that the government's interventions with mortgage loan incentives began even earlier than this.

This crisis does not illustrate a failure of deregulation, and it does not illustrate the failure of capitalism. This crisis illustrates the failure of unconstrained government.

Indeed, beware of public policies that seek to do good with other people's money.

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