Government regulation, not free-market greed, caused this crisis

When government distorts incentives, the invisible hand can become a fist.

Many observers, including most politicians, have blamed the ongoing financial crisis on the "free-market greed" supposedly unleashed by the "reckless deregulation" of the financial system. Such arguments are rhetorically powerful, but they don't stand up to scrutiny.

If they go unchallenged, however, they could hasten a "solution" that's worse than the problem. That's why it's so important to examine the record. What it shows is that government regulations and other interventions – not greed – are the major cause of our current problems.

Greed, or at least self-interest, is always present to some degree in the economy. Why has greed suddenly produced so much harm, and why only in one sector of the economy?

Firms are profit seekers, but they will seek it where the institutional incentives signal profit is available. In a free market, firms profit by satisfying their customers, investing wisely, and making prudent loans. Regulations, policies, and political rhetoric can change those incentives.

When the law either poorly defines the rules of the game or tries to override them through regulation, the invisible hand that makes self-interested behavior mutually beneficial may become more of a fist.

In such cases, "greed" can lead to problems, not caused by greed but by the institutional context channeling self-interest in socially unproductive ways.

To call the housing and credit crisis a failure of the free market or the product of unregulated greed is to overlook the myriad government regulations, policies, and political pronouncements that have both reduced the freedom of this market and led self-interested actors to produce disastrous consequences, often unintentionally.

The two biggest players in the mortgage market are Fannie Mae and Freddie Mac. Until they were nationalized recently, they were "government sponsored enterprises" (GSEs). That meant they enjoyed all the profit potential of a private business, but carried none of the risk. How would you run your business differently if you knew the government would bail you out or if Congress bullied you into adopting certain business strategies? Would you be acting greedily – or just rationally?

Throughout the 1990s, Washington encouraged these GSEs to expand home-ownership among lower-income, and thus more risky, borrowers. In 2004 and 2005, following the accounting scandals at Freddie, both GSEs paid penance to Congress by agreeing to expand their direct lending to low-income, higher-risk customers. Both acquired more subprime and Alt-A loans, making it profitable for banks to originate them, confident that the US taxpayers ultimately stood behind Freddie and Fannie. From 2003 to 2006, the percentage of loans the GSEs made in those riskier categories grew from8 percent to about 20 percent in 2006. This meddling helped drive up housing prices, leading other players to pile fancy new instruments on top of those mortgages, leading to a speculative bubble that was, at root, caused by the actions of two government-sponsored entities unleashed from the normal profit-and-loss checks of the free market.

Fueling this speculative fire was the Federal Reserve, also a government-sponsored organization. The Fed moved interest rates to extraordinarily low levels beginning in 2001. The additional credit it provided artificially lowered the cost of mortgages and dramatically accelerated the housing boom begun in the 1990s.

Did people suddenly get greedy in their pursuit of McMansions, second homes, and flipping homes for easy profit? Yes, but only because abnormally low interest rates made it foolish not to be. This was hardly a failure of free markets or greed. It was the predictable consequence of government distorting the interest rate.

The only relevant piece of deregulation of the past 15 years is the 1999 Gramm-Leach-Bliley Act, which repealed the Depression-era separation of investment and commercial banking. However, this has been a blessing rather than a curse, as it has enabled commercial banks to buy up failing investment banks and permitted other failing investment banks to save themselves by becoming commercial banks. Without that deregulation, today's crisis would have been even more devastating.

Good intentions are not enough in designing public policy. Regulations designed with the best of intentions are likely to lead to more crises if they distort incentives and thereby cause individual "greed" to undermine economic growth and harm millions. History is full of examples of politicians adopting short-run solutions without seeing the harmful long-run consequences.

Today, the calls to "do something" are loud. Yet amid the cacophony, there are a few voices urging not more, but less; not faster, but slower; not short term, but long term; not intent, but outcomes. Those are the voices we should heed, because if we had listened to them 15 or 20 years ago, we might not be where we are today.

Steven Horwitz is a professor of economics at St. Lawrence University.

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