Howdy Ya'll. Sorry have been so quite. Still very busy. But I wrote this for something at school and thought it might be interesting to share here...
A completely free market would experience downturns and corrections. The idea at issue today is the proper role of policy and regulation in these cycles. There are two primary questions: 1) whether government regulation causes and/or deepens bubbles and corrections; and 2) whether government intervention will hasten or delay recovery. If the ‘free market’ instigated the current crisis then perhaps the solution is government intervention. If policy was the cause, more intervention may not help the situation.
Market Forces as a Cause
Owner occupied real estate is the principal investment for most Americans. Home prices historically tend to rise. Even if they fell, investors believed, the illiquidity of the housing market protects it from the type of volatility seen in the stock market. This ignores that most homeowners are highly leveraged, and continue to be so as they trade more desirable real estate.
In the past several decades, this may have led banks to offer loans to potential buyers with less and less money down. While the standard loan had been based on a 20% down payment, this number dwindled to zero over the past decade. With decreasing equity, it became more likely that buyers would be subject to foreclosure if home prices fell or even flattened. Why did bankers and buyers assume this great risk?
There are two major strains of answers to this question that laid the blame on a ‘free market.’ First, economists such as Robert Shiller proffer the idea that it was irrational exuberance. There is some power to this idea. The banks’ increased willingness to give out loans created more scarcity, which began an inflation that resulted in a bubble. Market participants were irrational (or there an inefficient market), and homebuyers were willing to pay significantly more than the real value of the assets. Some may have been hoping that they could exit before they would become a bag holder, but others truly believed home prices would never go down.
The second idea is related more to the bankers, namely that securitization of loans allowed banks to pass on this irrational risk to unwitting investors. When mortgage lenders take a risky loan, they package it with other loans that have a better credit rating and sell them as a securitized bundle to 3d party investors. It was the government’s failure to regulate such securitized loans and the credit rating agencies, they reason, that allowed this behavior. Once the bill became due, the bubble was bound to burst. Indeed, there were 18 million vacant units in the U.S. in Q4 2008, out of 130 million total households.
The Government as the Cause
While there certainly are inefficiencies, the idea that there is a free housing market is ludicrous. There are not just a few policies involved, but rather a bouillabaisse that stewed for decades. There were two major government policies (among many) that had a hand in the crisis: 1) encouragement of risky lending, and 2) restrictive land use policies.
First, the U.S. government believes that people who are unqualified to own homes should do so. While large economies like France and Germany have lower than 50% home ownership, the U.S. is generally around 65-70%. In the 1970s, Carter decided this was not high enough. His Community Reinvestment Act (CRA), encouraged banks to lend to unqualified buyers. Clinton deepened the meaning and enforcement of the CRA. This was placed on top of the existing structure of Freddie Mac and Fannie Mae that have generally speaking, since the 1930s, had the goal of lowering the risk of lending.
The second major factor is geographic. Metro areas with restrictive land use policies create false scarcity, which contributed to skyrocketing prices. DC, LA and Miami, which all have relatively illiberal land use policies, saw some of the greatest increases on the Case-Shiller index during the past decade. Conversely, markets with more liberal land use policies, did not suffer from the same degree of boom and bust. (See Appendix: Case Shiller Home Price Index for Several Major Metro Markets, Jan 1987–Jan 2009).
Government as the Solution
Since policy has contributed to, or even caused this crisis, are the proffered solutions the best response? We would do well to remember Henry Hazlitt’s Economics in One Lesson: Always consider the unintended consequences of a policy in the near and long terms.
AIG and other bank bailouts: While bank bailouts will insure that capital does not dry up, they create a dangerous moral hazard. When risks are socialized and rewards are privatized, the incentive structure leads to increasingly bad decisions.
The Auto bailout: In the near term some jobs may be saved. However, those jobs will be for an industry that has proven itself to be uncompetitive on the global market. If the U.S. still has any comparative advantage in auto manufacturing, it would be better realized if failing businesses were allowed to fail. Businesses that create marketable products and that are willing to operate in right-to-work states, thus lowering costs, would take their place.
Increasing the money supply: The goal is to ‘unfreeze’ the credit market so that investors can have cash to spend on growth. However, as Milton Friedman taught us, MV=PQ. Increases in the money supply will lead to inflation. With the massive spending program underway, we run the risk of hyperinflation the moment that we begin recovery.
Government Stimulus: The key Keynesian premise is that available cash will kick start demand. This is flawed for a couple of reasons (among many). 1) The Obama administration assumes a multiplier for government spending of about 1.57. His own adviser, Christina Romer, has said that: a) the multiplier is lower than that; and b) the tax cut multiplier is as large as 3.[1] 2) Make-work employment adds nothing to the GDP. This is the fallacy that that George Mason economist Bryan Caplan refers to as Sisyphusism, or the belief that an unemployed man is better off rolling a rock up a hill only to have it roll back down, ad infinitum. The market has already decided that much of what the stimulus package proposes to do is not important enough to fund. Therefore it is unlikely that these projects will lead to real growth.
TARP: This program carriers many similar dangers. The moral hazard created will incentivize poor investment. If bad assets were allowed to fail, there would be pain in the near term, however, as the market absorbs this failure, future investment will be more efficient.
Conclusion
As Hayek warned us more than 60 years ago, the fundamental premise of Keynesianism is that planners know better than the market. This ignores the wisdom of crowds. Millions of individual actors will happen upon better solutions faster than the smartest policy makers with unlimited resources. When a large portion of the GDP is socialized we will all suffer from unlikely negative events. When the economy is more decentralized on the other hand, there are winners and losers, but capital soon flows away from bad ideas and toward good ones.
[1] The Macroeconomic effects of tax changes: Estimates based on a new measure of fiscal shocks, Christina Romer, David Romer (March, 2007).
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