Freitag, Juli 03, 2009

Market Failure?

I've written before here on the Left's seriously mistaken call on what drove us into recession, back in March.

Again, it's not market failure.

Here is someone else who gets it. Of course, he (John H. Makin) does it better than I do:

Subsidies for home ownership—in the form of full deductibility of mortgage interest, lower mortgage borrowing rates derived from government guarantees for mortgage lenders like Fannie Mae and Freddie Mac, and deductibility of local real-estate taxes—have long benefited those who own homes at the expense of those who do not. The size and severity of the burst bubble makes a mockery of the argument that the disproportionate gains to homeowners also improved the welfare of renters. By erasing, in just a few years, nearly one-third of the wealth on the national balance sheet, the collapse has created a substantial loss in national welfare, including for renters.

Bingo: subsidies must improve the pareto optimum for them to be legitimate. This is what will be the textbook example of how a government subsidy - housing - was clearly and without a doubt not pareto optimum: we've had a massive loss in national welfare, not an improvement.

The goal of expanding home ownership led to the creation of new mortgage subsidies across the board. The loosening of standards became the policy of Fannie Mae and Freddie Mac, the pseudo-private "government-sponsored enterprises" that bought mortgages from originating lenders. A particular change in the tax law in 1997 encouraged many households to make buying and improving a home the primary vehicle by which they enhanced net worth. By eliminating any capital-gains tax on the first $500,000 of profits from the sale of an owner-occupied residence once every two years, Washington encouraged enterprising American families to purchase homes, fix them up, re-sell them, and then repeat the process. Flipping became a financial pastime for millions because this special advantage created a new incentive—which didn't exactly fit the model of encouraging people to remain in a stable home for many years and thereby help to stabilize the neighborhood around them.

Bingo: the behavior of the flippers, which was not intended by those who made the laws, was created by those very laws. As the good Doctor says: Flipping became a financial pastime for millions because it was encouraged by the way the laws were written.

It took the addition of a new market in derivatives to drive bankers, lenders, and credit agencies to create the conditions for an implosion by expanding mortgage financing to borrowers who could not possibly afford the homes they were purchasing.

Bingo: If the ability of banks and issuers to securitize mortgages hadn't been expanded, the bubble would have turned out to be significantly smaller and less destructive. End of story.

The hunger for more mortgages that could serve as backing for more new securities led to the acceleration of undocumented, no-down-payment, negative-amortization mortgage loans to individuals with virtually no prospect of servicing them. The designers of derivative securities effectively collaborated with the rating agencies, such as Standard & Poor's and Moody's, that were relied upon (often through government mandate) by pension funds and other gigantic repositories of wealth with identifying the securities safe enough to invest in.

A situation in which creators of derivatives provide the monetary compensation for the very agencies that are tasked with determining the riskiness of their securities hardly constitutes a competitive market. Indeed, it constitutes dangerous collusive behavior. But that collusion, again, was made possible by the distorting actions of government agencies, which effectively provided a subsidy for risk-taking that was, by definition, unsustainable.

Bingo: the fraud began with the collusion of the rating agencies with the issuers of derivative securities, aided by the failure of the Bush Administration to effectively garner in the behavior of Fannie Mae and Freddie Mac, which was, of course, thwarted by the Democrats in Congress, who were using these institutions to enrich the party faithful (this is where folks like Rahm Emmanuel made their seed monies).

The salvation of Long Term Capital Management suggested a new reality for the marketplace: Aggressive risk-taking in pursuit of huge profits was manageable even if bubbles were created, just so long as the Fed was around to raise the "systemic risk flag" in the event of serious trouble. There would always be a rescue; the trick was to get out before everything began to collapse.

Bingo: The Fed is also culpable for being asleep at the wheel, but they were asleep for their own reasons...

The housing bubble was thus a fully rational response to a set of distortions in the free market—distortions created primarily by the public sector. The heads of large financial institutions...recognized the risk-taking subsidy inherent in public policy, but felt they had no choice but to play along or fall behind the other institutions that were also responding rationally to the incentives created by government intervention.

Bingo: Markets worked, market players behaved rationally according to the rules that they must work within. 

It's the government who screwed up. The Fed screwed up because Greenspan didn't want to create a recession; the government screwed up because laws were made and signed that distorted markets; banks screwed up because the risk agencies didn't do their jobs; the risk agencies screwed up because they were allowed to collude (and who oversaw them?); consumers screwed up because the government made it very profitable to behave in a manner that would have otherwise been irrational; finally, house builders screwed up because they met demand.

The housing collapse and its painful aftermath, including that $15 trillion wealth loss for U.S. households (so far), do not, therefore, represent a market failure. Rather, they represent the dangerous confluence of three policy errors: government policy aimed at providing access to home ownership for American households irrespective of their ability to afford it; the Fed's claim that it could not identify bubbles as they were inflating but could fix the problem afterward; and a policy of granting monopoly power to rating agencies like Standard & Poor's, Moody's, and Fitch's to determine the eligibility of derivative securities for what are supposed to be low-risk portfolios, such as pension funds.

That's one heck of a learning cost that we're all going to be paying for.

Solutions? They're there, but is anyone listening (of course, there are lots of players running around with fingers in their ears at this point, screaming "la la la I can't hear you")?

Alas, the federal government's response to the collapse of the housing bubble has been deeply problematic. It has chosen to provide additional subsidies to homeowners while nationalizing the government-sponsored enterprises, Fannie Mae and Freddie Mac, that helped to subsidize lower mortgage-interest rates While the extreme distress visited on American households by the collapse of the housing bubble certainly needs some alleviation, over the longer run we must have a serious national debate on the question of the degree to which we still want to consider home ownership a public good.

Bingo: this is a clear case where government is indeed a deep and fundamental part of the problem, and that government at times is simply incapable of ceasing to dig when it is in a hole. Of course, it doesn't help when the guys running the place are convinced that there is no hole and that digging is in and of itself the best thing to be doing.

The long-term solution is for government to stop playing favorites, as it has for decades with housing. Home ownership should neither be penalized nor favored under government policy. We have seen how that distortion led inexorably to a degree of wealth destruction we have not seen in our lifetimes. The distortion of the market introduced by government intervention can and must be brought to an end. The market that would take its place after this dramatic and admittedly difficult change would allow Americans to allocate their resources more effectively. It would no longer create an unjust advantage for the wealthy home buyer. And it would, finally, make it possible for Americans to see their homes as they should be seen—not as investment vehicles, but rather, as the places they live in, the hearthstones of their families.

I don't own a house. I rent. It didn't make sense to do anything else, given the extremely high cost of housing where I live. Owning a house is something that's nice, but not at the costs I was facing. We have a nice place in a great neighborhood, and while it'd be nice to have a larger place than we have, it isn't necessary and it's not something I'm willing to pay for.

Of course, that's pretty much a post-materialist attitude...

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