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Descent into fantasy for Free Market Fairy believers

What happens when you're a Free Market Fairy true believer like Tyler Cowen Alex Tabarrok and the current financial meltdown represents a total repudiation of everything you believe? You descend into conspiracy theories:

Finally, my own work (pdf) unearthed the real reasons for the separation in a titanic battle between the Morgans and Rockefellers.

Would you like a tin-foil hat with that pdf?

For a description of recent events that originates on the same planet that you and I live on, you can read this post on the Freakonomics blog.

Just to put this in a broader historical perspective, we had the great depression and following that laws were put in place to govern the operation of banks. Since then there have been two rounds of deregulation of the banking industry, the first led to the Savings and Loan Crisis in the late 70s and early 80s. ( That meltdown also included the Keating Five as a side show, starring one guy who is now running for president. ) The second was this last round that led to the current financial crisis.

How many times are we going to have to go through this before the lesson sinks in - markets are a means to an end, not an end unto themselves.

That post was written by Alex Tabarrok, not Tyler Cowen.

Posted by son1 on 2008-09-21

If you had read Diamond and Kashyap's analysis on Freakonomics more carefully, you might have noticed that the root of the problem is government intervention, not free markets:

[Fannie and Freddie] helped guarantee mortgages (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government. The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this hardly occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the “conforming” mortgage market.

Get it? The U.S. Government intervened in the housing market: it created government-sponsored enterprises that could help lower-income home-buyers but also out-compete the rest of the market, forcing the rest of the market into increasingly risky behavior to stay alive.

Further, this problem wasn't created by the Bush administration or even Republicans, it was created by politicians in general and supported by leaders and legislators in both parties over a long, long period of time. Going back to 1996, for example, Ron J. Feldman (Federal Reserve Bank of Minneapolis) wrote in Uncertainty in Federal Intervention:

The agencies—one with roots in the 1930s—have evolved into stockholder-owned and privately managed companies. But Fannie and Freddie, which purchase mortgages from lenders, are not completely privatized: Taxpayers, not investors, would likely bear the burden of Fannie and Freddie's debts if the two firms could not repay them, even though taxpayers are not legally liable. Together, the potential financial responsibility of taxpayers is substantial. Fannie and Freddie financed about 36 percent of all one- to four-family housing debt outstanding as of March 1996—more than the entire commercial banking system.

That's right, these government-sponsored behemoths out-competed the entire commercial banking system even when William J. Clinton was in the White House and the Democratic Party controlled both houses of Congress. Like I wrote, this isn't a Republican problem. It's a bad-government problem, and both parties were content to turn a blind eye to it.

So, what's the lesson that ought to sink in, again? If you examine the evidence more carefully, and if you consider the full history of the problem, you will see that the real lesson to be learned has little to do with free markets and everything to do with policymakers and government intervention.

Cheers,
Tom

Posted by Tom Moertel on 2008-09-21

son1,

Fixed, thanks!

Posted by Joe Gregorio on 2008-09-21

Tom,

Get it? The U.S. Government intervened in the housing market: it created government-sponsored enterprises that could help lower-income home-buyers but also out-compete the rest of the market, forcing the rest of the market into increasingly risky behavior to stay alive.

Ahh, and all those bad mortgages just appeared out of thin air? As opposed to, you know, because of the shredding of the rules mortgage originators had to follow?

That's right, these government-sponsored behemoths out-competed the entire commercial banking system even when William J. Clinton was in the White House and the Democratic Party controlled both houses of Congress. Like I wrote, this isn't a Republican problem. It's a bad-government problem, and both parties were content to turn a blind eye to it.

Sorry, at what point did I say this was a partisan problem? If you look at my last post you'll see that I mention Bill Clinton as signing the deregulation into law. Oh, and you might want to get your facts straight, the legislation I was referring to was passed in 1999, when both the House and Senate were controlled by the Republicans. Here are the links in case you want to edify yourself: Senate House.

...you will see that the real lesson to be learned has little to do with free markets...

Wow, another mis-read, if you actually went back and fully read my Free Market Fairy piece you'd know that I don't think free markets are the problem, I believe they are just one tool to be applied, along with laws, regulation, culture, etc. to make the world a better place. I only have a problem with true believers in the Free Market Fairy, those who believe that free markets are the only solution.

Posted by Joe Gregorio on 2008-09-21

Thanks for your response, Joe. My response to your response follows.

Ahh, and all those bad mortgages just appeared out of thin air? As opposed to, you know, because of the shredding of the rules mortgage originators had to follow?

Those bad mortgages appeared because dishonest borrowers and dishonest lenders were willing to lie. We know why the borrowers did it: to buy homes they couldn't otherwise obtain. But why did the lenders do it? Why would they risk fines, bankruptcy, and jail time to make a buck? Why would anybody? Answer: because there were no easier bucks to be had. Fannie and Freddie, quoting Diamond and Kashyap, had "squeeze[d] the private sector out of the 'conforming' mortgage market."

When policymakers intervene in markets, they generally do a bad job of it, even when they have the best of intentions. Fannie and Freddie are great examples. In this case, policymakers created a "market" that drove private lenders into the sub-prime lending business. If the private lenders could have made more money in the mainstream market, they would have had less incentive to go deeper into the fringes.

(I am *not* saying that honest lenders were made dishonest by the government. I *am* saying that people respond to incentives, and that government policymakers gave lenders more incentive to be dishonest when they allowed Fannie and Freddie to gobble up the "conforming" mortgage market, and that that incentive was large and shouldn't be discounted in any discussion of banking policy. Don't you agree?)

Sorry, at what point did I say this was a partisan problem?

At what point did I say it was a partisan problem? Didn't I write that "[the problem] was created by politicians in general and supported by leaders and legislators in both parties over a long, long period of time"? I only pointed to W. J. Clinton's first term to make clear that the problem was well established even in the early 1990s and that both Republicans *and* Democrats have turned a blind eye to it for a long time.

Oh, and you might want to get your facts straight, the legislation I was referring to was passed in 1999, when both the House and Senate were controlled by the Republicans.

My facts are straight, but what about your reading glasses? ;-) I wrote that "[Fannie and Freddie] out-competed the entire commercial banking system even when ... the Democratic Party controlled both houses of Congress." What does that claim have to do with 1999? Again, we're talking early 1990s.

Wow, another mis-read, if you actually went back and fully read my Free Market Fairy piece you'd know that I don't think free markets are the problem, I believe they are just one tool to be applied, along with laws, regulation, culture, etc. to make the world a better place. I only have a problem with true believers in the Free Market Fairy, those who believe that free markets are the only solution.

Sorry, but I didn't read your older piece. I was merely commenting on what you had written here.

I'm in agreement with you that free markets are not the only solution and that all the other things you mention play important parts in shaping a beneficial society. My disagreement is with your assertion that lack of government intervention is the root cause of our nation's recent banking crises:

Since [the Great Depression] there have been two rounds of deregulation of the banking industry, the first led to the Savings and Loan Crisis... The second was this last round that led to the current financial crisis.

My argument is that your argument largely ignores the influence of government intervention in these markets as a causative factor. (For example, do you think the current mortgage crises would be larger or smaller if the government hadn't created Fannie and Freddie and let them push private lenders into the fringes?)

Free markets aren't the only solution, but they are a better solution than government intervention in almost all cases where policymakers try to step in and "fix" things. (If you had to give the U.S. government a report card on its big, market-altering policies over the last 100 years, how would it fare? Was Social Security an "A" policy in your book? I trust not. How about Freddie and Fannie? Wouldn't there be a lot of failing grades on that card?)

Cheers,
Tom

Posted by Tom Moertel on 2008-09-21

John Robb:

As is often the case, the emerging victory of the market-based system created yet another problem/struggle. Specifically: is it better to trust that individuals empowered with growing salaries/wages will make the best investments for future economic success – or – is it better to grow corporate profits (at the expense of wages/salaries) and let capital markets invest the excess?

Between WW2 and 1974, while still engaged in a bitter struggle with Communism, the US hedged its bets on that question. Both individuals and the capital markets received an equal share of the benefits of productivity growth. Incomes rose mightily and we became broadly wealthy, mirrored by generous growth in the capital markets, relative to the start of the century. As a result of this shared decision-making system, smart investments in infrastructure, industry, education, and much more made America the economic powerhouse of the world. In short, we prospered.

However, the shared decision making system ended. From 1974 onwards, the rewards of productivity growth (economic expansion) went exclusively to the capital markets and not into income growth for individuals. […] As of this year, the final results of this American experiment in financial decision making are in. The allocation of this capacity exclusively to capital markets, rather than sharing that decision making with hundreds of millions of Americans, has produced a horrible result. Instead of investing the accumulated wealth of America in productive assets that yielded long term benefits, the money was invested in derivatives (illusory financial products) that yielded nothing of tangible value. In short, the narrow group of actors that operate within the capital markets made the decision to forgo the long and difficult process of growing investments in the tangible world in favor of the outsized returns available through investments in virtual products.

[…]

Given that most of the last 30 years of American economic investment is now vapor, it’s hard to imagine us avoiding economic catastrophe.

(And if one of his following posts turns out to be correct, the Obama vs McCain question may soon be irrelevant.)

Posted by Aristotle Pagaltzis on 2008-09-22

2008-09-21