In the October 2008 Freeman, Lawrence H. White wrote of the “unprecedented interventions” by the Federal Reserve that fueled the current financial turmoil. In this way he and many libertarians have effectively challenged the argument that “the free market” created the turmoil.
An opposing position traces our current problems not to interventionism but instead to deregulation in the financial industry. Economists who argue this way, notably former Federal Reserve chairman Alan Greenspan, may merely be presenting the corollary to the “blame-the-free-market” position. But there is a certain sense in which the banking deregulation of 1980 and 1999 may in fact be to blame. How can one maintain that the free market is not to blame but at the same time see the problem stemming from deregulation?
This paradox exists because of an ambiguity in the way some economists have interpreted the “dynamics of interventionism”—the core concept in the political economic scholarship of Ludwig von Mises, F. A. Hayek, and Israel M. Kirzner. That ambiguity, I believe, arises from a natural tendency to overemphasize the “expansionary phase” of the interventionist process, in which the size and scope of the state are growing, and to neglect the dynamics of the “contractionary phase” when the state is “disintervening.”
First, what exactly are the dynamics of interventionism in the expansionary phase? (For an extended treatment see Ludwig von Mises’s Interventionism: An Economic Analysis [FEE] and my Dynamics of the Mixed Economy [Routledge].)
The core ideas are that 1) government interventions into the market process tend systematically to generate unintended consequences; 2) many of these unintended consequences frustrate the announced goals of those who support the interventions; 3) the response to these frustrated intentions tends strongly in the direction of further intervention; 4) the economic system performs less effectively in coordinating the plans of buyers and sellers as it becomes burdened with the cumulative effects of an increasingly chaotic mix of interventions; and 5) the process comes to an end when these cumulative effects result in a major system-wide crisis and public choosers decide to reject interventionism in favor either of comprehensive planning or radically freer markets.
The stages outlined above can apply at the level of the macroeconomy, such as the U.S. or global economy, or at the industry or sectoral level.
Examples of the move from piecemeal to comprehensive intervention are found in the 1930s after the collapse of social democratic policies in Weimar Germany and in the United States after the failed interventions of the Hoover administration. Both events heralded even more radical (and tragic) interventions.
What we witnessed in 2008 in the housing and financial markets exemplifies in many ways the interventionist process, although it’s really just the latest stage (though not the last) of a long string of interventions begun decades ago.
Interventionist Origins of the Crisis
It’s easy to show that there has been no “free market” in housing or finance in the United States in recent memory and that the idea that “the free market” caused the housing bubble is untenable. (The main sources for this section are Murray Rothbard’s book America’s Great Depression, Stan Liebowitz’s “Anatomy of a Train Wreck”, and Roger Congleton’s “Notes on the Financial Crisis and Bail Out”.)
Perhaps the place to begin is 1913, when the U.S. Congress created the Federal Reserve system to serve as the country’s central bank and lender of last resort. In the 1920s the Fed discovered how to manipulate the interest rate—what we call today the federal funds rate—by buying and selling Treasury bonds from and to its member banks. It used this technique to create the artificial boom of the “Roaring Twenties.” The result was the Crash of 1929 followed by the Great Depression of the 1930s. It was in the midst of the Great Depression, in 1938, that Congress created Fannie Mae, the Federal National Mortgage Administration, whose mission was to promote private home ownership, with government support, by insuring and buying mortgages originated by local banks. As a result of this artificial boost, home ownership in the United States increased from 43 percent of all residences in 1949 to 62 percent in 1960.
In 1970 Congress then created Freddie Mac, the Federal Home Loan Mortgage Corporation, which together with a revamped Fannie Mae were mandated to insure or to buy and repackage (securitize) mortgages as part of a deliberate government policy to boost homeownership further and promote the American construction industry. By 2008 Fannie and Freddie had issued more than 60 percent of these mortgage-backed securities (MBSs), of which they themselves held $1 trillion, and insured about half of all MBSs.
Congress and various presidential administrations pressured Fannie and Freddie to take on a larger portion of MBSs while encouraging banks to loosen their traditional lending standards, to promote homeownership among lower-income minority residents, many of whom could not meet traditional lending criteria. Congress then passed the Community Reinvestment Act (CRA) in 1977, as well as other supporting legislation, to monitor its implementation. The CRA was strengthened in 1999. The unintended consequence of this policy and the pressure brought to bear on both lending institutions and Fannie and Freddie was to significantly undermine lending standards across all segments of the industry, not just for the poor and higher-risk borrowers. From these circumstances blossomed the so-called “subprime lending market,” which Congress and U.S. presidents encouraged Fannie and Freddie to make an increasing part of their own portfolios.
Meanwhile, the Fed drove the federal funds rate down from 6 percent in January 2001 to 1 percent in January 2004. Since mortgage rates generally track that rate (although they are substantially higher owing to higher default risk and other factors), these also fell during this same time period, fueling further borrowing and, most important, reckless speculation.
What Are “Disinterventionist Dynamics”?
The core ideas of the “contractionary phase” of interventionist dynamics are in many ways simply the reverse of the dynamics of the expansionary phase, but with some key differences:
1) In a systemic crisis it becomes obvious that the current system is untenable, so that public choosers have to decide whether to jettison interventionism for more comprehensive planning or for significantly freer markets; 2) the latter entails large-scale rather than piecemeal disintervention because minor changes would do little to untangle interventionist gridlock; 3) if, however, disintervention leaves important areas of the system under effective state control, entrepreneurial energies will tend to shift into relatively less-regulated areas, causing bottlenecks in those areas; 4) these bottlenecks create negative unintended consequences (shortages, sharply rising prices, or perverse investments) that frustrate the intentions of the supporters of disintervention; 5) the response by public choosers to these consequences will depend a great deal on their ideological commitment to disintervention, and because the ideology of interventionism is typically still fresh in public choosers’ minds, recidivism—a return to state expansion—will usually occur.
Recall the experience with banking and finance in the 1970s. Among other interventions at that time, Regulation Q forbade banks to pay interest on checking accounts or branch out beyond the state in which they were chartered. Entrepreneurial pressure finally made matters untenable. For example, many banks resorted to offering their depositors toasters and other products in lieu of interest payments. By 1980 these market pressures compelled Congress to dramatically deregulate the banking industry, at the time one of the most regulated industries in the U.S. economy.
But it matters a great deal how and the extent to which disintervention occurs. The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 permitted branch banking, mergers among banks, payment of interest on demand deposits (removing Regulation Q), and checkable deposits at credit unions and savings and loans (S&L). An unintended consequence of this partial deregulation, however, was the placement of the S&Ls in the untenable position of having to pay rising short-term interest rates on their deposits—inflation was raging—while being burdened with fixed-interest payments on long-term mortgage loans. This was “remedied” by letting the S&Ls make other kinds of investments. However, federal deposit insurance remained in place and even strengthened, buffering depositors from the S&Ls’ reckless speculation. Hence the so-called S&L crisis of 1980s. Thus, bottlenecks occur with partial deregulation, which can generate negative unintended consequences that will encourage recidivism.
As noted, entrepreneurship flows to areas with less control and regulation. Critics of deregulation complain that trading in new financial derivatives, such as credit default swaps, occurred in an unregulated part of the market. Exactly. And if the current mood results in more intervention into the financial industry, “quicksilver capital” will find its way into other as yet unregulated areas. The inevitable consequence of this process of piecemeal re-intervention is the socialization of the entire financial industry, to a state perhaps even worse than prevailed before the partial deregulation of 1980.
That partial deregulation and the repeal in 1999 of the Glass-Steagall Act, which banned the same institution from engaging in both commercial and investment banking, went a long way to resolve the mounting contradictions within banking and finance that decades of regulation had produced. Unfortunately, these deregulatory steps left in place the government-sponsored enterprises Fannie Mae and Freddy Mac (as well as the Government National Mortgage Association or Ginnie Mae), and most important, the Federal Reserve itself, with its power to arbitrarily influence the structure of interest rates in the United States and indeed globally. These resulted in the pressures and policies discussed earlier.
People as different as Paul Krugman and Alan Greenspan blame deregulation for the mess Wall Street got itself into. Supporters of the free market respond, correctly, that the primary culprits are the incentives and pressures government created in the housing and finance industries that precipitated the housing bubble. But in the context of the theory of intervention outlined here, the grain of truth in what the market critics say is that partial deregulation, not deregulation per se, is to blame. The problem was not too much but too little deregulation.
We face a serious economic crisis, one that may have determined the 2008 presidential election and strengthened one-party government in Washington, D.C. As such, it looks to be a turning point in the interventionist process. Unfortunately, it appears that for the time being the direction of politico-economic change, supported by popular sentiment, is toward more government and more inflation. But this is no time to give up hope. The past 30 years demonstrate that, as FEE’s founder Leonard Read taught us, ideas matter. It’s in times like these that our own commitment to learn and spread economic literacy is more important than ever.