Media headlines broadcast the end of free-market capitalism in the financial industry—the current situation is a failure of the free market, and we need to adopt strict government regulations to rein it in.
Only one problem. The current situation is a failure of government, not free markets.
The media has it right, that the current financial situation stems from the fact that lending institutions granted subprime mortgages—loans with low interest rates and low down payments—to people who couldn’t afford them. Home prices were rising, and homeowners thought they could always sell their homes if they got into trouble. Fannie and Freddie bundled these mortgages into securities they sold to financial institutions—which used them as reserves to make even more loans.
When home prices stopped rising and started to fall, many sub-prime mortgage holders couldn’t make their monthly payments, and the financial firms who had bought the securities were left without adequate reserves to sustain the losses. Since the new equilibrium prices have not yet been determined, some lending institutions are increasing their credit requirements, which is therefore denying loans to some applicants.
Why did Fannie and Freddie take these risks? First, they are not agents of unfettered capitalism. Fannie and Freddie are not called GSEs (Government Sponsored Enterprises) for nothing. Because the federal government stood behind them, they lacked the normal incentives of private firms to avoid risk. Second, some highly-placed Congressman “strongly encouraged” Fannie and Freddie to make home ownership possible for more of their constituents. Fannie and Freddie went along, and lowered credit requirements in response. And finally, although there were attempts to rein in the riskier lending practices in the mid- and late 1990s, these measures were defeated on strict party-line votes.
It is certainly true that there has been a movement toward lower regulation in the last couple of deades. But these regulations were not in the financial industry, and thus did not contribute to our current problems. The deregulations were in the airline, telephone and trucking industries—where we now enjoy lower prices.
Which brings us to the question of the real threat the current situation poses for our economy. The current financial tightness will pass in time. The real threat, however, is that legislators who believe that a free financial market was the cause will adopt restrictive and long-lasting regulations that will finally choke out whatever life remains of the free market, the institution that has created the amazing wealth that we Americans now enjoy.
And there is additional collateral damage. First, as George Will recently pointed out, nationalizing the financial sector will lower the productivity of capital as it passes into government control. Lower GDP and lower incomes will be the result.
Second, in addition to the negative effects of the regulation itself, even the current effort to draft it is counter-productive because everyone is waiting for regulations to be issued. Left to themselves, private institutions that have not engaged in risky lending would have produced a faster, natural solution by buying up assets at fire sale prices. (Count on the “greed” that is so despised at present.)
Finally, government control will be hard to change even if the drawbacks of nationalization become widely known. The new executive branch will form regulatory bureaucracies and commissions, the new Congress will form committees and hire staffers, and the financial industry will develop vested interests in the new style. Witness how long it took before Maggie Thatcher rescued Great Britain from the socialism that was choking the economy.
The new legislation and regulations will prove to be a cure that is worse than the disease.
Sunday, October 26, 2008
Financial Crisis: What is the Real Threat?
Media headlines broadcast the end of free-market capitalism in the financial industry—the current situation is a failure of the free market, and we need to adopt strict government regulations to rein it in.
Only one problem. The current situation is a failure of government, not free markets.
The media has it right, that the current financial situation stems from the fact that lending institutions granted subprime mortgages—loans with low interest rates and low down payments—to people who couldn’t afford them. Home prices were rising, and homeowners thought they could always sell their homes if they got into trouble. Fannie and Freddie bundled these mortgages into securities they sold to financial institutions—which used them as reserves to make even more loans.
When home prices stopped rising and started to fall, many sub-prime mortgage holders couldn’t make their monthly payments, and the financial firms who had bought the securities were left without adequate reserves to sustain the losses. Since the new equilibrium prices have not yet been determined, some lending institutions are increasing their credit requirements, which is therefore denying loans to some applicants.
Why did Fannie and Freddie take these risks? First, they are not agents of unfettered capitalism. Fannie and Freddie are not called GSEs (Government Sponsored Enterprises) for nothing. Because the federal government stood behind them, they lacked the normal incentives of private firms to avoid risk. Second, some highly-placed Congressman “strongly encouraged” Fannie and Freddie to make home ownership possible for more of their constituents. Fannie and Freddie went along, and lowered credit requirements in response. And finally, although there were attempts to rein in the riskier lending practices in the mid- and late 1990s, these measures were defeated on strict party-line votes. (The push for lower regulation that some quote as a contributing cause for the current situation was in the airline, telephone and trucking industries—where we now enjoy lower prices.)
Which brings us to the question of the threat the current situation poses for our economy. The current financial tightness will pass in time. The real threat, however, is that legislators who believe that a supposedly free financial market was the cause will adopt restrictive and long-lasting regulations that will finally choke whatever lifeblood remains out of the free market, the institution that has created the amazing wealth that we Americans now enjoy.
And there is additional collateral damage. First, as George Will recently pointed out, nationalizing the financial sector will lower the productivity of capital as it passes into government control. Lower GDP and lower incomes will be the result.
Second, in addition to the negative effects of the regulation itself, even the current effort to draft it is counter-productive. Left to themselves, private institutions that have not engaged in risky lending would have produced a faster, natural solution by buying up assets at fire sale prices. (Count on the “greed” that is so despised at present.) This solution is now foreclosed because everyone is waiting for government action.
Finally, government control will be hard to change even if the drawbacks of nationalization become widely known. The new executive branch will form regulatory bureaucracies and commissions, the new Congress will form committees and hire staffers, and the financial industry will develop vested interests in the new style. Witness how long it took before Maggie Thatcher rescued Great Britain from the socialism that was choking the economy.
The new legislation and regulations will prove to be a cure that is worse than the disease.
Only one problem. The current situation is a failure of government, not free markets.
The media has it right, that the current financial situation stems from the fact that lending institutions granted subprime mortgages—loans with low interest rates and low down payments—to people who couldn’t afford them. Home prices were rising, and homeowners thought they could always sell their homes if they got into trouble. Fannie and Freddie bundled these mortgages into securities they sold to financial institutions—which used them as reserves to make even more loans.
When home prices stopped rising and started to fall, many sub-prime mortgage holders couldn’t make their monthly payments, and the financial firms who had bought the securities were left without adequate reserves to sustain the losses. Since the new equilibrium prices have not yet been determined, some lending institutions are increasing their credit requirements, which is therefore denying loans to some applicants.
Why did Fannie and Freddie take these risks? First, they are not agents of unfettered capitalism. Fannie and Freddie are not called GSEs (Government Sponsored Enterprises) for nothing. Because the federal government stood behind them, they lacked the normal incentives of private firms to avoid risk. Second, some highly-placed Congressman “strongly encouraged” Fannie and Freddie to make home ownership possible for more of their constituents. Fannie and Freddie went along, and lowered credit requirements in response. And finally, although there were attempts to rein in the riskier lending practices in the mid- and late 1990s, these measures were defeated on strict party-line votes. (The push for lower regulation that some quote as a contributing cause for the current situation was in the airline, telephone and trucking industries—where we now enjoy lower prices.)
Which brings us to the question of the threat the current situation poses for our economy. The current financial tightness will pass in time. The real threat, however, is that legislators who believe that a supposedly free financial market was the cause will adopt restrictive and long-lasting regulations that will finally choke whatever lifeblood remains out of the free market, the institution that has created the amazing wealth that we Americans now enjoy.
And there is additional collateral damage. First, as George Will recently pointed out, nationalizing the financial sector will lower the productivity of capital as it passes into government control. Lower GDP and lower incomes will be the result.
Second, in addition to the negative effects of the regulation itself, even the current effort to draft it is counter-productive. Left to themselves, private institutions that have not engaged in risky lending would have produced a faster, natural solution by buying up assets at fire sale prices. (Count on the “greed” that is so despised at present.) This solution is now foreclosed because everyone is waiting for government action.
Finally, government control will be hard to change even if the drawbacks of nationalization become widely known. The new executive branch will form regulatory bureaucracies and commissions, the new Congress will form committees and hire staffers, and the financial industry will develop vested interests in the new style. Witness how long it took before Maggie Thatcher rescued Great Britain from the socialism that was choking the economy.
The new legislation and regulations will prove to be a cure that is worse than the disease.
Tuesday, October 14, 2008
No Representation Without Taxation!
“No Taxation without Representation” is one of the oldest slogans in U.S. history. It was a principal justification for the American Revolution, and predated it by more than 25 years. The slogan is still powerful because taxation without representation contradicts the underlying idea of a democratic society, which derives its power from the will of the people, not from a monopoly on force as is the case in dictatorships. And the slogan still retains its appeal today: it is written on the license plates of cars in the District of Columbia as a call to action for D.C. residents who lack voting representation in Congress.
But the slogan also has a more subtle implication, that taxation should reflect the desires of those being taxed. This principle is currently being ignored, however, by a major thrust of the Democratic candidate's platform. The proposal to raise the taxes of the top 5 percent of earners implies that it is the desires of the majority that are to be considered, rather than the desires of those being taxed. Surely it is akin to tyranny for the majority to pick out a small, and in this case, unpopular minority and take its property. Yet that is what our democratic society has come to.
There is a considerable imbalance between these two groups. In 2004, approximately 58 million individuals, or 44% of the total working population of 133 million paid no taxes at all: Approximately 15 million people had earnings but filed no returns, and 43 million filed returns but incurred no tax liability. (These figures exclude those individuals without any earnings at all.) Assuming that these figures reflect the voting population as well, 44%, or less than half of all voters are paying no taxes but are nevertheless contributing to decisions about how much the remaining 56% of the population should pay. But even this greatly understates the degree to which the tax burden is shifted toward the top: the top 1% of taxpayers contributes almost 40% of total taxes.
I propose we remove this imbalance between who decides and who pays by adopting a reverse of the old revolutionary slogan: “No Representation without Taxation.” Much federal spending is income redistribution, and there is much to be said for living in a generous society where those who are less well-off are helped by the more affluent. And the degree of after-tax voluntary philanthropy indicates that the wealthier members of our society are, indeed, quite generous. But it is contrary to the spirit of democratic principles to use the power of the federal government to create the current separation between the two groups—those who decide tax policy, and those who pay the taxes. Making voting dependent on whether or not one pays taxes would go a long way toward making politics more responsible.
But the slogan also has a more subtle implication, that taxation should reflect the desires of those being taxed. This principle is currently being ignored, however, by a major thrust of the Democratic candidate's platform. The proposal to raise the taxes of the top 5 percent of earners implies that it is the desires of the majority that are to be considered, rather than the desires of those being taxed. Surely it is akin to tyranny for the majority to pick out a small, and in this case, unpopular minority and take its property. Yet that is what our democratic society has come to.
There is a considerable imbalance between these two groups. In 2004, approximately 58 million individuals, or 44% of the total working population of 133 million paid no taxes at all: Approximately 15 million people had earnings but filed no returns, and 43 million filed returns but incurred no tax liability. (These figures exclude those individuals without any earnings at all.) Assuming that these figures reflect the voting population as well, 44%, or less than half of all voters are paying no taxes but are nevertheless contributing to decisions about how much the remaining 56% of the population should pay. But even this greatly understates the degree to which the tax burden is shifted toward the top: the top 1% of taxpayers contributes almost 40% of total taxes.
I propose we remove this imbalance between who decides and who pays by adopting a reverse of the old revolutionary slogan: “No Representation without Taxation.” Much federal spending is income redistribution, and there is much to be said for living in a generous society where those who are less well-off are helped by the more affluent. And the degree of after-tax voluntary philanthropy indicates that the wealthier members of our society are, indeed, quite generous. But it is contrary to the spirit of democratic principles to use the power of the federal government to create the current separation between the two groups—those who decide tax policy, and those who pay the taxes. Making voting dependent on whether or not one pays taxes would go a long way toward making politics more responsible.
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