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.

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.