That Die-Hard Myth about the Benefits of Market Regulation

Ever since the housing bubble burst we heard again and again that the event proves how unstable and dangerous a free market is and that all these economic woes could have been prevented by government regulation and oversight of the economic system. (The latter mostly meaning overseers and those overseen becoming best buddies.) This interpretation of the current crisis is exactly wrong. Regulation caused the housing market to collapse by partially dictating, partially luring financial institutions to make economically unsound decisions.

Phil Gramm has an excellent piece in the WSJ in which he points to two factors that together account for the economic downturn: the Fed’s low interest rates in response to the 2001 recession (unintentionally fueling the housing bubble) and political interests forcing irresponsible mortgage lending, in other words: putting people into houses they couldn’t and can’t afford. It is this undue politicisation of the housing market that is at the heart of what went wrong.

The root of the problem lays with the Community Reinvestment Act (CRA) which, taken by its original wording, is superfluous because it basically states that banks have to give loans when it’s economically reasonable. It might have had some meaning when it was enacted in 1977 because some geographical areas probably were pretty much ignored by banks because of the lack of information needed to assess the potential profitability of actively including those areas and the costly process of gathering such information. But as a basic rule, banks smell profits and when the risk is bearable, they go after them. If the risk isn’t bearable, though, no one gains from taking it on a systematic basis. This very economic turbulence is good proof for this.

But political interest groups – like Acorn, credit where it’s due – pushed exactly for such irresponsible lending to become mandatory for financial institutions, typically claiming that doing otherwise is racist and using such elegant methods as intimidation of bankers in their office buildings and even their private homes.

In 1992, rather than letting the notoriously greedy and evil market decide, government grew a housing law out of the CRA and set quotas for Fannie and Freddie by which to lend to specific income groups. Obviously, those quotas were not determined on efficiency considerations but on more friendly ones like fairness and inclusiveness. Of course, the bar that separates unfair, greedy and racist financial decisions from fair, altruistic and non-racist ones moved up over time and ever attentive lawmakers adjusted the quotas accordingly.

The result was as Gramm notes: “In 1994, 4.5% of the mortgage market was subprime and 31% of those subprime loans were securitized. By 2006, 20.1% of the entire mortgage market was subprime and 81% of those loans were securitized.” Surprisingly, too many of those mortgages proved to be bad risks, the housing market crashed, took the financial sector with it and the heretofore only implicit government-backing of Fannie, Freddie and too-big-to-fail banks has turned into an actual one.

What those who blame “the market” for this economic meltdown do not seem to understand is that “the market” is not an evil monster with the specific desire to make dishonest egoists rich and innocent Democrat voters poor. “The market” is composed of individuals who make economic decisions in a way that they perceive to best further their self-interests. That they can freely do so is a fundamental prerequisite for a free and prospering society. The market is neither “good” nor “evil”. It is a dynamic system in which each member can make the best of his situation and in so doing contributes to the prosperity of the entire society.

Because a free market system allows every participant to improve his own standing it is by nature self-correcting and “self-healing”. Well run businesses prosper, badly run businesses fail. After a failure a person normally doesn’t lay down to die but finds another way to sustain his living and economically climb up again. What the “blame the market” group seems to believe is that those who are successful always will be and those who are not never will, forgetting that business people weren’t allocated into their positions by drawing straws.

Ironically, market interventions have the effect of making the anti-market people’s fears come true. An interventionist government tends to protect big business, on the grounds that allowing them to fail would cause too many “small”  people to lose their jobs, and to reduce incentives for potential achievers to work for their own success by pampering them with social benefits, minimum wages etc. (Minimum wages, most of all, having so many unintended negative consequences that you could write a book about it.) Thus, those who mistrust the market are in favour of economic policies that create the type of market they seek to prevent.

Anti-market groups wanted mortgages to be available for people while they cannot afford them. (No sense in hoping that eventually they can afford them without subsidised deals because the poor stay poor forever.) They got what they wanted and caused a major economic crisis with the world financial system and the financial stability of everyone who did not live beyond his means as collateral damage. Just what they fear would happen when the market is left alone. This, of course, also explains why their reaction to the meltdown is calling for more regulation.