Chief Justice John Marshall said it all in one sentence: "The power to tax is the power to destroy."
It is not the money that is taxed away that is destroyed. What is destroyed is the wealth that does not get produced in the first place, because high taxes make its production not worthwhile.
Friday, October 31, 2008
Thursday, October 30, 2008
Profit-seeking is not greed, but simply the means of directing resources to their most efficient uses in areas of greatest demand (and does so through voluntary exchange!!)
The wealth which is created through successful business ventures is not community property to be seized and "redistributed," but the reward properly earned through the efficient production of the goods and services most highly desired by others. (This too is accomplished without coercion.)
The wealth created beyond that which is used for personal consumption is the wealth which is invested in growth and progress. This excess wealth is required for taking risks on the new and untried. Only from this surplus are we able to improve the length and quality of our lives and environment.
To take from the rich is to impoverish ourselves.
To tax Big Oil, or any other Big Business, is to hinder their ability to invest in our future.
To take wealth by force, even when that force is laundered through the ballot box, is to attack a fundamental requirement of civil society: the right to property honestly earned.
Taxing the rich is like eating our farmers' seed corn.
Wednesday, October 29, 2008
“The Mortgage Market Mess” by Christopher Westley
In the United States today, there is approximately $10 trillion in outstanding mortgages, and of these, about one-quarter are subprime and Alt-A loans. (Subprime loans are made to borrowers with little or no credit, while Alt-A loans are made to borrowers with better credit but who are not considered prime.) Individuals who access such loans often pay a below-market interest rate, or an interest-only mortgage payment, for the first few years of the mortgage. But after that, mortgage payments are adjusted to reflect prevailing market rates. If 40 percent of the Alt-A market fails this year (as many estimate), financial markets will be looking at $1 trillion in defaults.
That's a lot of defaults, especially when you consider that the 1980s S&L crisis cost, by comparison, $150 billion (about $240 billion in today's dollars) and is partly blamed for the 1990-91 recession. Does today's mortgage market promise a similar result today, on the eve of the baby boomers' retirement? If so, the sound that defines 2007 may not be that of Beyonce or Bell but of air seeping from the housing bubble. Though unpleasant, it is a sound much to be preferred, since it reflects a housing market returning to fundamental levels, as well as one that will offer buying opportunities to many who currently cannot afford housing. But still, $1 trillion dollars makes for a lot of failed loans that were issued over the last few years. Surely, this is a clear example of market failure. Right?
Well, no, because when hyper-regulated markets fail, you can't blame market forces. In this case, rising real estate prices were forcing many low and middle class households out of the housing market well before the most recent recession. When that happened, home buyers had few options — either relocate to another part of the country and start over, or finance with a subprime or Alt-A loan and wait the bubble out. That's what many did, and it quelled genuine political revolts in bubble-plagued markets in the early 2000s, especially in California and the Northeast.
The situation reminds us that bad things happen when pols manipulate markets to achieve their ends. In this case, there was a recession that resulted from an inflationary boom that they created. What do you do when housing market malinvestments, spurred by Alan Greenspan's cheap-money policies of the 1990s, pushes housing prices out of reach to the middle class?
Option 1: Say mea culpa and cease policies that create bubbles in the first place (and pay a political price at the polls).
Option 2: Give those placed in such positions a short-term solution that allows them a way out, even if you are simply postponing the day of reckoning by a few years.
These two options reflect an important point made in Henry Hazlitt's classic book, Economics in One Lesson. Economic policy options often have either positive short-term effects and negative long-term effects, or negative short-term effects and positive long-term effects. It's obvious which option is favored in today's mass democracy, since politicians are extremely short-term oriented — indeed, their focus is about as long as the next election.
Presidential candidates this year will wax ad nauseam that home ownership is the American Dream and that this dream is now too expensive for average Americans. What they won't talk about is how government policies, and specifically monetary policies, help bring this situation about...Housing was the middle class's best hedge against a growing government intent on expanding its scope and power by inflating the money supply.
Friday, October 24, 2008
He used to be right, as when he wrote “Gold and Economic Freedom” in 1966.* What changed his mind since then remains a mystery.
Now he says:
“I made a mistake in presuming that the self-interests o f organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.” Referring to his free-market ideology, Mr. Greenspan added: “I have found a flaw. I don’t know how significant or permanent it is. But I have been very distressed by that fact.”But, as economist, Dr. George Resiman points out, it is not the free market that is to blame.
Mr. Waxman pressed the former Fed chair to clarify his words. “In other words, you found that your view of the world, your ideology, was not right, it was not working,” Mr. Waxman said.
“Absolutely, precisely,” Mr. Greenspan replied.
The actual responsibility for our financial crisis lies precisely with massive government intervention, above all the intervention of the Federal Reserve System in attempting to create capital out of thin air, in the belief that the mere creation of money and its being made available in the loan market is a substitute for capital created by producing and saving. This is a policy it has pursued since its founding, but with exceptional vigor since 2001, in its efforts to over come the collapse of the stock market bubble whose creation it had previously inspired...
In doing this, the Federal Reserve’s ultimate purpose was to stimulate both investment and consumer spending. It wanted the cost of obtaining capital to be minimal so that it would be invested on the greatest possible scale and for people to regard the holding of money as a losing proposition, which would stimulate them to spend it faster. More spending, ever more spending was its concern, in the belief that that is what is required to avoid large scale unemployment.
All this additional money is actually fictitious capital, leading people to believe they have more resources than they do. This causes investments and spending in areas which would not have occurred if the availability of money reflected the true state of wealth. Over-investment in a market sector not supported by real demand (which in economics is defined as the willingness and the ability to pay for something) is what creates a bubble. It’s called a bubble because it pops.
Many factors went into making the housing market the sector which experienced the bubble (Fannie, Freddie and their securitization schemes, the CRA, desire for a “real” investment following the dot-com crash, and more) but what made the bubble possible to the scale in which it occurred can be directly traced back to 2 major things (1) the infinite manipulability of fiat money, and (2) the failed central planning of the central bank system. Not until we return to the honest money system of the gold standard and the market discipline found in a free banking system will we be able to avoid the huge boom-bust swings of the past century, and the financial destruction they bring with them.
Greenspan is right to admit his system doesn't work, but it's ridiculously wrong to equate his system with a free market.
(*) In Capitalism: The Unknown Ideal by Ayn Rand
Thursday, October 23, 2008
"Historically, the United States has been a hard money country. Only [since 1913] has the United States operated on a fiat money system. During this period, paper money has depreciated over 87%. During the preceding 140 year period, the hard currency of the United States had actually maintained its value. Wholesale prices in 1913... were the same as in 1787."-- Kenneth Gerbino, former chairman of the American Economic Council
From "Gold and Liberty" by Richard Salsman, Economic Education Bulletin, vol XXXV no. 4:
Jastrum (1977) analyzed more than 4 centuries of gold and price data from Great Britain and the United States in order to measure gold's real purchasing power.... Remarkably, Jastrum found that gold's purchasing power was relatively constant through more than 4 centuries.Refers to Jastrum, Roy W., The Golden Constant: the English and american experience 1560-1976, New york: John Wiley 7 Sons, 1977
To see just how much money the government has created, here's a graph from St. Louis Federal Reserve. The ways in which government is able to create money from nothing are numerous, but the effect is the same: each dollar in circulation is worth less. (NB: Beginning in 1971, the US dollar was no longer on the gold standard.)
The cause of generally rising prices is an increase in the quantity of money. More specifically…the cause is an increase in the quantity of money at a rate more rapid than the increase in the supply of gold and silver... [S]ince government intervention into the monetary system is what has been responsible for the quantity of money being able to increase more rapidly than the increase in the supply of gold and silver...what is responsible for the problem of a persistent significant rise in prices is an increase in the quantity of money caused by the government.--George Resiman, Capitalism: A Treatise on Economics, pg 895
(If you are curious about how prices today compare to another time in the past, check out the inflation calculator. )
More on the value of a gold standard:
"For more than two thousand years gold's natural qualities made it man's universal medium of exchange. In contrast to political money, gold is honest money that survived the ages and will live on long after the political fiats of today have gone the way of all paper."
--Hans F. Sennholz
"The great merit of gold is precisely that it is scarce; that its quantity is limited by nature; that it is costly to discover, to mine, and to process; and that it cannot be created by political fiat or caprice."
"The gold standard makes the money's purchasing power independent of the changing, ambitions and doctrines of political parties and pressure groups. This is not a defect of the gold standard; it is its main excellence."
--Ludwig von Mises
In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. ... This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard."
-- Alan Greenspan, former Chairman, US Federal Reserve from Capitalism, the Unknown Ideal
Wednesday, October 22, 2008
Rescuing failing, or even struggling, institutions, undermines market discipline. The beauty of market discipline is that it rewards correct decisions and punishes wrong decisions, thus shifting resources to those who will invest them more wisely. Bailouts reverse the normal incentives. The failures are rewarded and the prudent are punished.
From the Washington Post:
Peter Fitzgerald, chairman of Chain Bridge Bank in McLean, said he was "much chagrined that we will be punished for behaving prudently by now having to face reckless competitors who all of a sudden are subsidized by the federal government."
At Evergreen Federal Bank in Grants Pass, Ore., chief executive Brady Adams said he has more than 2,000 loans outstanding and only three borrowers behind on payments. "We don't need a bailout, and if other banks had run their banks like we ran our bank, they wouldn't have needed a bailout, either," Adams said.
And from John Allison, President and CEO of BB&T in an open letter to members of Congress:
While all financial intermediaries are being impacted by liquidity issues, this is primarily a bailout of poorly run financial institutions. It is extremely important that the bailout not damage well run companies.
Corrections are not all bad. The market correction process eliminates irrational competitors. There were a number of poorly managed institutions and poorly made financial decisions during the real estate boom. It is important that any rules post “rescue” punish the poorly run institutions and not punish the well run companies.
If prudence and success are punished and imprudence and failure are rewarded, just how long can we maintain prosperity?
Tuesday, October 21, 2008
An interesting point of view on today’s situation can be found in a recent Wall Street Journal article by Brian Carney, "Bernanke is Fighting the Last War". The article is an interview of Ms. Anna Schwartz:
Most people now living have never seen a credit crunch like the one we are currently enduring. Ms. Schwartz, 92 years old, is one of the exceptions. She's not only old enough to remember the period from 1929 to 1933, she may know more about monetary history and banking than anyone alive. She co-authored, with Milton Friedman, "A Monetary History of the United States" (1963). It's the definitive account of how misguided monetary policy turned the stock-market crash of 1929 into the Great Depression.
Here is some of what she had to say:
This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. "The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible."
So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."
Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value…"
"Why are they 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them, you don't know what they're worth, your balance sheet is not credible and the whole market freezes up. We don't know whom to lend to because we don't know who is sound. So if you could get rid of them, that would be an improvement." The only way to "get rid of them" is to sell them…
How did we get into this mess in the first place? As in the 1920s, the current "disturbance" started with a "mania." But manias always have a cause. "If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset.
Those are just a few choice statements, but the entire article is worth reading. Check it out!
Friday, October 17, 2008
From Carpe Diem, Wed. Oct 15, 2008:
Biggest Economic Nonsense Since Great Depression
Graph update (in reponse to a comment):
An otherwise interesting Washington Post front-pager on “What Went Wrong” claims the current situation “has erupted into the biggest economic crisis since the Great Depression.” On the contrary, that honor surely goes to 1980-82, with 1973-75 as a close runner-up.This may indeed be the biggest postwar financial crisis, but that is a very different thing.The biggest postwar financial crisis so far was the S&L collapse of the late 1980s, when nearly 3000 financial institutions were closed (see chart above). But the impact of the S&L debacle on the real economy was minor at best (the economy grew by 2.9% a year during that “crisis”). The stock market crash of 1987 inspired many hysterical predictions but no recession at all.An economic crisis implies a deep and prolonged drop in real output and employment, not just another routine recession. To describe current conditions as a worse economic crisis than 1980-82 is fanciful nonsense.Cato Institute's Alan Reynolds
"Fascism should rightly be called Corporatism as it is a merge of state and corporate power."
-- attributed to Benito Mussolini(1883-1945),
For a discussion of the source:: http://www.publiceye.org/fascist/corporatism.html
The corporate State considers that private enterprise in the sphere of production is the most effective and usefu [sic] [typo-should be: useful] instrument in the interest of the nation. In view of the fact that private organisation of production is a function of national concern, the organiser of the enterprise is responsible to the State for the direction given to production.
State intervention in economic production arises only when private initiative is lacking or insufficient, or when the political interests of the State are involved. This intervention may take the form of control, assistance or direct management. (pp. 135-136)
--Benito Mussolini, 1935, Fascism: Doctrine and Institutions, Rome: 'Ardita' Publishers.
The above quotes help to provide the context for understanding that the following is not hyperbole.
The Road to Fascism
Washington, D.C.--The government has announced that it plans to use $250 billion to buy ownership stakes in various U.S. financial institutions. According to the New York Times, nine major U.S. banks have already been forced into the program. “The chief executives of the nine largest banks in the United States . . . were each handed a one-page document that said they agreed to sell shares to the government, then Treasury Secretary Henry M. Paulson Jr. said they must sign it before they left. . . . ‘It was a take it or take it offer,’ said one person who was briefed on the meeting, speaking on condition of anonymity because the discussions were private. ‘Everyone knew there was only one answer’”--even though at least one institution, the relatively healthy Wells Fargo, wanted to say no.
According to Yaron Brook, executive director of the Ayn Rand Center for Individual Rights, “In herding banking executives into a room and making them an offer they couldn’t refuse, the Paulson regime took its latest and most disturbing step yet on the path to state control of the economy.
“If fascism means coercive state control over nominally private property, then there is no more chilling sign of creeping fascism in America than government’s encroachment on the lifeblood of the U.S. economy--its financial institutions. While the government assures us it will be a ‘passive investor,’ merely funneling cash into the banking system rather than dictating how banks function, this is a lie. Not only does the money come with strings attached--such as restrictions on executive compensation, dividend payments, and the types of investments banks can make--but politicians are already promising a web of further controls. As John McCain recently noted, ‘We will not merely inject billions of dollars into companies and walk away hoping for the best. We will require that those companies be reformed and restructured until they are sound assets again, and can be sold at no loss--or perhaps even a profit--to the taxpayers of America.’
“The Paulson shakedown is the latest in a rapid-fire series of government bailouts and interventions over the last several months. Our leaders claim that this virtual takeover of markets is economically necessary. But it was government control of financial markets that spawned the financial meltdown in the first place: an inflationary boom brought on by the Fed’s easy-money policies, a campaign to promote home ownership that encouraged risky loans, regulations that pushed banks to become dangerously over-leveraged, etc., etc. The response to the crisis should be to restore freedom and to disentangle government from the economy. Instead, the same mentality and the same central planners that created the financial crisis are being given far wider reign to manipulate and distort markets. We must tell our government to reverse this fascist course--now.
Press Release Ayn Rand Center for Individual Rights , October 16, 2008
Fascism, communism, and socialism have in common the failure to view private property as a fundamental, inalienable right. They also fail to understand the role of private property in the creation of peace and prosperity. These failures are key to understanding why those systems are neither moral nor practical. Capitalism, properly understood as the economic system which consistently applies individual rights to the realm of economics, is both moral and practical. Until this country and its politicians understand this, government solutions will continue to hamper our prosperity, undercut our liberty and promote dissention instead of peace.
Tuesday, October 14, 2008
It is a blot upon our country that both candidates for president could use this instruction on capitalism from a Frenchman.
The financial crisis is not a crisis of capitalism. It is the crisis of a system that has distanced itself from the most fundamental values of capitalism, which has betrayed the spirit of capitalism.
Shelton presents a cogent argument that capitalism is not just a practical economic system, but is also a moral economic system. Morality requires honestly, hard work, individual responsibility, productivity. Where are we most likely to find these qualities of character? Entrepreneurs or politicians?
Politicians are crying "market failure" while ignoring how the actions of Congress and the Fed have undercut the integrity of our very money. Shelton reminds us that "Money represents a moral contract between government and ordinary citizens." When that contract is broken through manipulation of the money supply, it is not the market which has failed us, but government..
Monday, October 13, 2008
-- Alan Greenspan, former Chairman, US Federal Reserve
from Capitalism, the Unknown Ideal
Sunday, October 12, 2008
Friday, October 10, 2008
From Milton Friedman (1912-2006) Nobel Prize-winning economist, economic advisor to President Ronald Reagan
"Underlying most arguments against the free market is a lack of belief in freedom itself."
"I am myself persuaded, on the basis of extensive study of the historical evidence, that... the severity of each of the contractions - 1920-21, 1929-33, and 1937-38 - is directly attributable to acts of commission and omission by the Reserve authorities and would not have occurred under earlier monetary and banking arrangements.''
--from Capitalism and Freedom
"The power to determine the quantity of money...is too important, too pervasive, to be exercised by a few people, however public-spirited, if there is any feasible alternative. There is no need for such arbitrary power...Any system which gives so much power and so much discretion to a few men, [so] that mistakes - excusable or not - can have such far reaching effects, is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic - this is the key political argument against an independent central bank.''
(Hat tip to Liberty Quotes)
And from Yaron Brook in a press release from the Ayn Rand Center for Individual Rights:
The cycle starts with government intervening into the economy and imposing regulations and controls on business. This distorts the free market, leading to economic dislocations. When the problems caused by these distortions inevitably follow, everyone blames the free market and its greedy capitalists. The proposed solution? More government controls. Over the years, conservative critics of creeping government have repeatedly exposed this illogic but have always been helpless to explain why the cycle keeps repeating, decade after decade.
Wednesday, October 8, 2008
Here's a few key excerpts to encourage you to listen to or read the whole speech:
"Our own Government appears to be leading our country into the pit of socialism."
"The problem was not created by our free enterprise system. It was created by us, the Congress and the Federal government. With good intentions, we made a mess of things."
"I believe this Congress should admit its guilt, prove we have learned from our mistakes, and correct the bad policies immediately that have caused these problems. We should insist the Federal Reserve end the easy money policy. We should repeal the laws that require our banks to make risky loans, and fix the accounting requirements that force banks to undervalue their assets. We should develop a plan to break up Fannie Mae and Freddie Mac and sell them to private investors who will run them as private companies.
We should reduce corporate and capital gains taxes to encourage capital formation and boost asset values. We should also repeal the section of Sarbanes-Oxley that has driven billions of dollars of capital overseas...
We should immediately pass a law that expedites the development of our oil and natural gas reserves to help relieve the burden of high prices and gas shortages for our families. We should immediately adopt a freeze on nonsecurity discretionary spending and pass a moratorium on earmarks until we fix this wasteful and corrupting system. We should sacrifice our political pork as we ask taxpayers to sacrifice for our mistakes. "
"[W]e are trying to use this crisis to expand our power to control and manage the free enterprise system."
"We are telling people not to worry because we are going to rescue them with their own money."
Refreshing, isn't it.
Tuesday, October 7, 2008
The missing ingredient.
Our greatest loss in this current financial down turn has been the successful attack on one of the most crucial elements in our productive capacity, an element whose destruction will have ramifications far beyond our immediate loss in wealth. That essential element is our economic freedom. The lack of understanding of the true source of economic stability has led people to cry out for and our lawmakers to enact a “solution" which merely extends the very factors which created the problem in the first place: government intervention into the market place. In an economic system consisting of a mixture of freedom and control, freedom is taking the bum wrap for the true villain, the government-backed controls which violate our individual rights. Fear and economic ignorance drive the clamor for the government to save us. Government grows and our liberty withers.
Economic freedom is simply individual rights applied to the realm of trade. It is the protection of the rights to private property and to free association (contracts, employment arrangements etc.,) all of which must be guaranteed under a system of the rule of law. The recently passed Emergency Economic Stabilization Act of 2008 undermines those rights, and the rule of law, in numerous ways. Instead of protecting property rights, new and expanded wealth distribution mechanisms have been established. Instead of the rule of law, arbitrary power has been delegated to Harry Paulson and the Treasury Department.
Freedom is the engine of prosperity. As long as men are free to act in their own self-interest and refrain from initiating force to interfere with the same freedom of others, then innovation, production and exchange will flourish. The available literature is rich with the economic and political theories explaining why this is so.* A new and expanding body of works is now available which proves that it is so. For elaboration on this point, I strongly recommend a recently posted article by Eric Daniels. This piece, excerpted from the first chapter of the U.S. Economic Freedom Index: 2008 Report, provides an excellent introduction to the concept of economic freedom and to the existing body of literature which demonstrates a clear connection between freedom and prosperity.
As Jean-Baptiste Say states in his Treatise on Political Economy:
[O]f all the means by which a government can stimulate production, there is none so powerful as the perfect security of person and property, especially from the aggressions of arbitrary power. This security is of itself a source of public prosperity that more than counteracts all the restrictions hitherto invented for checking its progress. Restrictions compress the elasticity of production; but want of security destroys it altogether.Economic freedom is an indispensable element of wealth creation; it is also indivisible from political freedom. We can not preserve one without preserving both. Just as wealth is the solution to poverty, so freedom is the solution to wealth, and wealth and freedom are the means to life.
*I refer here to the works of Adam Smith, John Lock, Jean-Baptiste Say, Carl Menger, Ludwig von Mises, Friedrich Hayek, Milton Friedman, George Reisman, among others.
Saturday, October 4, 2008
So how did we get here? What policies not only allowed but encouraged the poor financial decisions for which we are now paying the price? Here is my attempt to understand it all. Comments and corrections are welcome.
A full understanding has to go back to debunking the myths which permeate explanations of the 1929 stock market crash and the Great depression. The standard interpretation is that both were caused by the free market and ended by government intervention. Lest this article become unwieldy, I refer you here and here for arguments which address those myths, and effectively demonstrate how government meddling both caused the crash and delayed the recovery. (For a brief summary, check here.)
However, several legacies of the New Deal are playing key roles in our present situation. One of those is the Federal National Mortgage Association. More affectionately know as Fannie Mae, this government agency was initially established in 1938 with the express purpose of increasing home ownership by stimulating the mortgage market. This was accomplished through government enhancement of the secondary market for mortgages.
A secondary market is not in and of itself a problem. The trouble is caused when government interference distorts free market signals so that lenders and borrowers invest and take risks in ways not justified by the true state of the economy. Free market prices connect us to reality. Government manipulations in the market place distort those price signals, disconnecting everyone from economic reality.
But what actually is a secondary market? A secondary market is simply the resale of an item. Here it involves “repackaging” mortgages into bundles based on risk, and then selling and buying small portions of the loan packages as securities. (That's the infamous "securitization" we keep hearing about.) This makes sense because lenders make loans to make money. Mortgage-backed securities are a way for investors to make money on the loan business, just like investors buy stock in Wal-Mart or Microsoft with the hope of participating in the financial successes of those businesses.
Fannie Mae purchases loans from banks, pools them by risk level, and subsequently offers them for sale as securities. In this manner, shares can be purchased in large or small amounts, in varying degree of risk, depending on the resources available to the investor. The idea is for risk to be spread out among multiple investors (a.k.a. risk-takers) lowering the amount of risk assumed by any one investor. Lower risk makes it possible to charge less interest. (In a free market, risk and interest are directly related. That’s why you’re getting less than 1% on your federally-insured bank savings account, and you have potentially much higher return –or loss- on stocks.) Lower interest rates on the mortgages means more people can afford the loans. Again, not necessarily a bad thing, unless the lower interest rates are not based on the presence of real value.
Fannie Mae was created to buy mortgages from primary lenders. By selling to Fannie Mae, initial lenders are able to use the money received to make even more loans. For 30 years, Fannie Mae had a virtual monopoly on the secondary mortgage market. Why? Because of its association with the government, at first directly, as an actual government agency, and after 1968 implicitly, as a GSE (Government-Sponsored Entity.) Perceived as more financially secure due to government backing, Fannie was able to borrow funds at lower rates and sell at higher rates compared to companies without that government association. The savings Fannie experienced could be passed down the line to home buyers via lower interest rates, making houses relatively “more affordable.” It also let them out-compete their private competitors in the secondary mortgage market.
Freddie Mac (Federal Housing Finance Agency), another GSE, was created in 1970 to expand the secondary market even further, and purportedly to provide “competition” for Fannie. This increased secondary-market for mortgages directed even more investment into housing. Securitization –the way Fannie and Freddie offered the pooled mortgages for sale-- in and of itself is not a cause but rather simply the means by which the expansion occurred.
(There is much more complexity to the Fannie/Freddie story, including dubious ties to politicians along with questionable accounting schemes and business practices. More information can be found here and here. )
In 1977, Congress instituted the Community Reinvestment Act. The CRA was enacted for the express purpose of increasing access to mortgages under the guise of fair and affordable housing. Justified by the erroneous perception of racial discrimination in lending practices*, the CRA holds the banking industry hostage through its regulatory power to deny permission for expansion, new branches, and mergers. The ransom? Banks must provide a certain amount of mortgage money to borrowers who without government pressure would not otherwise qualify for loans. Why wouldn’t they qualify? Poor credit history, insufficient income and even lack of employment, lack of down payment. In other words, people who are at high risk for default.
The regulatory powers of the CRA were strengthened and the push to lend to subprime borrowers was significantly increased in 1995 under the Clinton administration. Advocacy groups like ACORN and NACA gained influence and leverage, further politicized the mortgage business, and placed even more pressure on banks to make unsound loans. An excellent analysis of the effects of the CRA came be found in Howard Hussock’s City Journal article, “The Trillion-Dollar Shakedown That Bodes Ill for Cities.” More information can be found here, here, and here.
To summarize the set-up: In response to the bankruptcies and loss of homes which occurred following the 1929 stock market crash and subsequent Great Depression, FDR created Fannie Mae to make borrowing to buy a home easier. The key question to ask is this: easier than what? Easier than what was supported by actual economic circumstances. Freddie Mac expanded this assistance, further increasing the artificial stimulus to home purchases. Freddie and Fannie made it easier for everyone to obtain mortgages, but the CRA, required banks to lend to the marginally-solvent, precisely because they were not creditworthy, all under the admirable-sounding euphemism of “affordable housing.”
Then, along came the dot-com boom and crash. Euphoria in the success of new markets via the Internet fueled investment beyond actual value. We know it now as the Dot-Com Bubble. Eventually, enough of the companies with poor management or inadequately marketable ideas – failed. Stock prices adjusted to more accurately reflect real existing value. First the euphoria and then market confidence in general dissipated. Add in a contraction of the money supply by the Fed in 1999 and early 2000, and voila! The crash.
With the dot-coms no longer a “sure bet,” savings and investment money needed a new outlet. Burned by the ephemeral ether of the Internet, people looked for something tangible, solid and real in which to invest. (They don’t call it real estate for nothing!)
Compound this new flow of money into housing, facilitated by the expanded mortgage market through Fannie and Freddie, with an intentional “easy money” policy by the Federal Reserve (which hoped to lift the economy out of first the dot-com, and then the 9/11 market down-turns,) all accompanied by the effects of the CRA –and you have the recipe for the Housing Boom, Bubble and Bust.
I’ve explained Fannie, Freddie and the CRA, but what is “easy money” and how does that contribute? Easy money means it’s easier to get (borrow) money. Through a series of financial transactions, the Fed increases the supply of money available to banks. This increased supply leads to a fall in interest rates. (Interest is the price of money and when supply goes up, price comes down.) The rising and falling of interest rates is not the problem though---it's that fact that the cost of our money is being intentionally manipulated. Artificially-created lower interest rates makes borrowing more affordable than it otherwise would be. Debt is encouraged. In this case, the debt was heavily in the form of mortgages. The secondary-mortgage market greased the spending/lending further. Increased housing debt means increased demand for houses which leads to increased housing prices. Rising prices encourage building, investment and speculation. A new bubble begins to form.
As long as housing prices were going up, then marginally-solvent borrowers could refinance when they got into trouble. But, the building spree resulted in increased supply of houses, and…prices fell. Unable to sell or refinance when adjustable rates increased, more and more people defaulted. The magnitude of the problem was enhanced by highly leveraged speculation, both in houses and in the mortgaged-backed securities of the secondary market, so sweetly enlarged by Fannie and Freddie. Lower housing prices and defaulting loans brought into question the value of the complex financial instruments which were based on them, so the credit market froze. Trapped between illiquid assets of uncertain value and a built-in system requiring short term cash flow, banks began to fail.
Eventually reality caught up. The inflated housing prices were not real and there for not sustainable. The end result is the crash (a.k.a. a correction) we are experiencing now. Unless the manipulation of the money supply, lending regulations which violate free trade and property rights, and the use of economic policy for political purposes are recognized as significant causes of dangerous distortions in the market,all those destructive policies will continue. Solutions which include those flawed policies will be ineffective, and any benefits will be temporary.
*Day, Theodore and Liebowitz, "Mortgage Lending to Minorities: Where's the Bias?" Economic Inquiry 36:1:1998 referenced here.
Husock, Howard “The Trillion-Dollar Shakedown That Bodes Ill for Cities” City Journal Winter 2000 http://www.city-journal.org/html/10_1_the_trillion_dollar.html as of 10-03-08
An 8 page in-depth review of the history the CRA, ACORN and NACA and their effects on lending practices.
DiLorenzo, Thomas “Government-Created Subprime Mortgage Meltdown” http://www.lewrockwell.com/dilorenzo/dilorenzo125.html as of 10-03-08
Liebowicz, Stan “The Real Scandal: How the Feds Invited the Mortgage Mess” New York Post 02-05-08 http://tinyurl.com/RealScandal
Charen, Mona, “ACORN, Obama and the Mortgage Mess” RealClearPolitics 9-30-08 http://tinyurl.com/CharenMona
Pethokoukis, James, "Why McCain Goes Easy on Fannie and the CRA" US News 10-30-08 http://tinyurl.com/3lf8xa
Fannie and Freddie
Hassett, Kevin, “How the Democrats Created the Financial Crisis” Bloomberg.com News 09-22-08 http://tinyurl.com/HassettKevin
Burnham, Bill “Fannie Mae’s Golden Goose: A Lesson in Moral Hazard”on Burnham's Beat 07-11-08 http://billburnham.blogs.com/burnhamsbeat/2008/07/fannie-maes-gol.html
If you only have time for one article on this topic, start here.
Wallison, Peter and Calomiris, Charles “Blame Fannie and Congress for the Credit Mess” Wall Street Journal 9-23-08 http://www.aei.org/publications/filter.all,pubID.28664/pub_detail.asp
Duhigg, Charles, “At Freddie Mac, Chief Discard Warning Signs” New York Times 08-05-08 http://tinyurl.com/DuhiggCharles
Lott, John “Financial Markets Are In A Mess” FoxNews.com 03-17-08 http://www.foxnews.com/story/0,2933,338629,00.html
Editor, Wall Street Journal “A Mortgage Fable” WSJ 09-22-08 http://online.wsj.com/article/SB122204078161261183.html
Provides a nice summary of the contributions the Fed, Fannie/Freddie, CRA, bank regulations and credit-rating to the curent crisis. It's no surpirze that politian's are blaming Wall Street and fail to see how thier policies and laws created the set-up in the first place.
Coats, Warren “The ABC’s of the Housing “Crisis” Warren Coats’ Facebook, Sunday, April 6, 2008 http://tinyurl.com/CoatsABCs
If my article is an introduction or summary, Coat's articles provides Crisis 101. This article is linked to in the "DEF" article below. I had to join Facebook to access it. If you want a copy and can't access it here, email me and I will send you one.
Coats Warren, “The D E Fs of the Financial Markets Crisis” Cato.org 09-26-08 http://www.cato.org/pub_display.php?pub_id=9667
Coats, Warren, “The US Mortgage Market – The Good, the bad and the Ugly” delivered to the Association of Banks in Jordan, June 22, 2008 http://tinyurl.com/goodbaduglu
Leonhardt, David, “Can’t Grasp the Credit Crisis? Join the club" New York Times 3-13-08 http://tinyurl.com/LeonhardtDavid
Studies on Lending Discrimination
Zuckoff, Mitchell, “Mortgage Gap Still Exists for Minorities” Globe.com 09-27-1992 http://tinyurl.com/mortgagegap
Closing the Gap: A Guide to Equal Opportunity Lending http://www.bos.frb.org/commdev/commaff/closingt.pdf
Day, Theodore and Stan Liebowitz, “Mortgage Lending to Minorities: Where's the Bias?” Economic Inquiry, 1998, vol. 36, issue 1, pages 3-28
Malanga, Steven “The Long Road to Slack Lending Standards” RealClearMarkets 10-01-08 http://tinyurl.com/SlackStandards
Federal Reserve/Monetary Policy
Calhoun, Joseph, "In Times of Crisis, Trust Capitalism" RealClearMarkets 9-29-08
This article discusses how the Fed has contributed to the credit crunch and describes how a free market would handle the problem better.
O’Driscoll, Gerald “Asset Bubbles and Their Consequences” Cato Institute Briefing Paper No. 103 May 20, 2008 http://www.cato.org/pubs/bp/bp103.pdf
Shelton, Judy “Loose Money and the Roots of the Crisis” Wall Street Journal 9-30-08 http://online.wsj.com/article/SB122273029076687929.html
Powell, Jim, FDR's Folly: How Roosevelt and His New Deal Prolonged the Great Depression
Read a review here: http://www.amazon.com/review/R54S4FGIWH20O/ref=cm_cr_rdp_perm
PALIN: Darn right it was the predator lenders…There was deception there, and there was greed and there is corruption on Wall Street … pushing for even harder and tougher regulations. Look at the tobacco industry. Look at campaign finance reform.… And those huge tax breaks aren't coming to the big multinational corporations anymore …I had to take on those oil companies and tell them, "No," … the greed there that has been kind of instrumental … put government back on the side of the American people, stop the greed and corruption on Wall Street… made aware now to Americans about the corruption and the greed on Wall Street …
The error? A lack of understanding of the role of the entrepreneur and the capitalist in wealth creation. The middle class and the workforce are crucial elements of a health economy, but so are the risk-takers, the investors, the capitalists, in other words, the current favorite villains of our presidential and vice-presidential candidates: Wall Street and Big Oil. Without “windfall” profits, innovation, progress and wealth creation are severely hampered. Funny how no one seems concerned over “windfall” losses.
The omission? While everyone is busy blaming the greed of Wall Street, little is being said about the role of government policies in creating the current economic down-turn. The wisest statement of the debate may have been Biden’s when he said, “If you don't understand what the cause is, it's virtually impossible to come up with a solution.” Without addressing the major role of government policies in causing the current melt-down-- the easy money policy of the Fed, the forcing of banks by the CRA into making high-risk loans, the role of Fannie and Freddie in creating a housing bubble—the “solutions” will continue those mistakes, setting us up for further crises in the future.
For criminals, ignorance of the law is no excuse. For our politicians, ignorance of economics can not be an excuse either.