Something To Remember...

In the coming days you'll be bombarded with pundits and opinions on what caused the recession, largely with the story line of "deregulation" and the failures of the Bush Administration. That way the Obama Administration will have someone to blame.

But keep in mind the real reasons behind this world-wide crisis: politically motivated meddling in markets, creating the necessary conditions for what has happened.

Of course, you'll have lots of folks out there who will search for prime causes, someone or something to blame directly. The left is already doing this, blaming deregulation and capitalism for our woes.

But consider this: sometimes things happen not because of a direct, single and simple cause (as much as it stretches the intellectual ability of most on the left to consider this). Instead, they are the result of a chain of events, which may be a comedy of errors or may be rather more sinister than that. Indirect approaches to achieving goals can be subtle and may, in some cases, literally take decades to complete, and one ignores little steps that add up at one's peril.

Hence our troubles aren't based on any one single event, but rather a series of events, in many cases done with good will towards a good cause, but have led us to where we are now.

This editorial at the IBD gives good coverage of why the banks aren't to blame. But that's not the whole story.

The real story, for me, is that there is a real paucity of right and proper economic analysis out there. Sure, there are a lot of people out there writing analysis of what is happening, what has happened, what might happen: the problem is that relatively few of them are actually economists.

The problem is that the role that economists used to play has been largely usurped by non-economists. In the 1980s and well into the 1990s, most larger companies has a corporate economist who would write up analysis of what was going on in markets, what the Fed might do to interest rates, how markets might develop.

Starting in the mid-1990s, these folks slowly disappeared, more or less in conjunction with the increasing quant nature of economics training.

This is the failing of the economics profession, as far as I am concerned (and given that I have no academic aspirations, I also have no fears of upsetting anyone): the fatal conceit that to be a good economist, one must also be an excellent mathematician, mastering calculus and other advanced forms of math in order to build models. The problem with this is that the only ones who are really interested, then, in what you say are other quants or other technicians, rather than the businessmen who actually need your analysis to help them make decisions that make or break companies.

While I may be here, to a certain extent, guilty of perfect hindsight, I do remember, back when the Community Reinvestment Act was first introduced in 1977, being struck by the idea that high-risk loans be covered by higher costs for loans to those with lower risks. What struck me was that rather than subsidize the working poor so that they could buy a house (i.e. removing them from the high risk group that they belonged to), it had been decided to create something that was in and of itself inherently risky, and requiring banks to make such loans.

Now, I'm talking back in 1977 with the original CRA, rather than the later modifications under Clinton. The failure here was the creation of the risky loans, not how this risk was to be carried. Back then I was actually knew Acorn people and thought they were doing a good thing by fighting for those trapped in redlined districts to be able to buy a place to live, rather than be stuck paying rent to a landlord who may or may not have been exploiting the working poor.

And let us remember that these folks were the original target of aid: those who, while working and earning a living wage, were nonetheless severely disadvantaged as building up capital because their living costs failed to build up equity. They were denied loans not because they were a severe risk, but rather because of where they lived: their neighborhood was redlined. Redlining meant that on the local maps up at the local mortgage bank, the areas were marked off in red because the bank had decided that they wouldn't provide mortgages there at all: this might be because of empirical risks, or because the areas involved were slums and hence the banks wouldn't want to own buildings there in case of default, or because the banks had financed the slumlords who effectively had a monopoly on low-income housing in that area and hence a vested interest in keeping tenants in such housing. More often than not, the latter was the real reason for redlining a district after an investor had bought up a large majority of the buildings: this was a common business practice in the real estate business.

The goal was to get the working poor out of bad housing that was rented out at market rates, but with poor maintenance in order to save on costs. This is, after all, the only way to make money on renting to low-income tenants: you have to build cheap, and you have to cut all costs as strongly as possible in order to repay your loans as fast as possible in order to turn a profit on such rental units. Low maintenance meant that the places ran down fairly quickly and vandalism and destruction wasn't fixed in a timely manner (if at all). Increasing wages meant that people could afford to move away, but more often than not increasing wages would be accompanied by increasing rents.

So what was done to alleviate the problem? The Subprime Mortgage was invented, one that required the banks to make the loans to their community based on the makeup of the community, rather than based on the financials and economics of the situation.

And let me make it clear: the basic idea is good. Districts with lots of home owners are invariably cleaner, brighter places to live, in comparison to tenement slums and welfare islands.

But this is where the error was made. The banks kicked and screamed, quite rightly so, but also, when it became law, accepted the burden of the subprimes.

The error wasn't in trying to help the working poor, but rather how this help was achieved. The CRA distorted the market: loans were made to those who did not qualify for them in the traditional sense, but which were subsidized by increasing overall costs of lending monies for mortgages, i.e. the risks were carried by the traditional mortgage user.

This is where the mistake occurred: risky mortgages were created. This is the first sin, as it were, on the road to perdition.

Rather than having created the risky mortgage, other alternatives should have been considered, such as direct subsidies to first-time home buyers in distressed neighborhoods so that their mortgages were no longer risky; rezoning to eliminate tenement slums and encourage home ownership and rent subsidies to ensure that maintenance was properly done. These alternatives would have avoid the creation of risky mortgages, the creation of the subprimes, and would have effectively achieved the same result.

So keep in mind where the mistakes were made: they weren't made by deregulation (as if the banks weren't heavily regulated!), they weren't made by bankers selling off their mortgage portfolios, they weren't made by capitalists.

They were made by serious, ernest people trying to help out the working poor, but who chose to create something risky in order to right what they perceived as a wrong.

That was the failure, and hopefully the lesson to be learned: never chose the path of least resistance but of the greatest risk.


And also remember that decisions made today may first have their repercussions 30 years or more in the future, with changes and addendums done by those with the best of intentions but with no understanding of what they are really doing. The decision to create the subprimes was first and foremost a political decision, and these kinds of politics and economics do not mix.