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Friday, March 21, 2008

The State Is Morally Hazardous to Your Health

It’s never been more important for advocates of individual liberty to emphasize that what is failing today is not the free market but the state. To claim otherwise, as so many people do, is to ignore generations of pervasive and deep-seated government interference with the marketplace. A brief article can’t possibly catalogue all the ways that politicians and regulators have gummed up the works, created massive distortions, and brought us to our current ominous condition. But it’s worthwhile to hit some highlights.

Intentions are irrelevant. The laws of economics proceed whether those who interfere have good motives or bad. But we should not be oblivious to the fact that most interference is not public-spirited. Rather, it’s self-serving, as power-wielding politicians hunt for votes and reward corporate allies. The interventions provide privileges that the special interests are happy to collect.

Many of the privileges have been in the form of guarantees to institutions that lend money to homebuyers. The subprime-mortgage mess is being portrayed as the result of recklessness and predation by the lenders in an unregulated marketplace. But ask yourself this: Would they have lent large amounts of money to people with weak credit histories and no assets if they knew that they and their stockholders would have to bear the losses in full?

The question answers itself. Why would they engage in such lending? The option of foreclosure is not a good answer, since it’s not a preferred solution. Lenders don’t like being stuck with houses that will bring too little money at auction. No, such a pattern of lending can only be explained by the presence of an explicit or implicit guarantee against loss. And only the government–the Federal Reserve (the government’s legal counterfeiter) in particular–is in a position to offer such a guarantee by overtly or covertly promising to come to the rescue through low interest rates or an injection of liquidity. (See Gerald O’Driscoll’s Freeman article here.)

Moral Hazard

The result is called moral hazard, a well-known phenomenon in which a guarantee against risk increases the likelihood of risky activity. Put another way, people respond to incentives. When someone else bears the losses, people act differently from how they act if they expect to bear the losses themselves. The self-regulating market points all the incentives in the direction of prudence. Government intervention does the opposite. Read the history of the Samp;L collapse for details.

This is the key to the subprime calamity that has spread throughout the credit markets and brought the economy to a crawl. Lenders had money to lend and a government safety net under them. So they found borrowers even if those borrowers were less than credit-worthy.

Another part of the story is the government’s efforts to drastically lower the cost of buying a home. A combination of government agencies and government-sponsored enterprises (FHA, VA, Fannie Mae, Freddie Mac) made it possible for people to buy houses with little or no down payment and insured mortgages. On top of that, the federal government threatened sanctions against lenders that were reluctant to take on low-income borrowers with poor credit (redlining). So credit standards were relaxed.

The result was a volume of mortgages that would be viable only as long as home values continued to increase. But, despite government-fueled expectations and ill-advised policies (pdf), there was no guarantee of that, as we’ve seen. When values went south and monthly payments went up, a slew of homeowners were left with adjustable-rate loans that were larger than the market value of their homes. Refinancing was ruled out, and the absence of equity made default an attractive option.

The government-boosted secondary market for mortgages and the emergence of mortgage-backed securities, pioneered by government-sponsored enterprises like Freddie Mac, put the volume of bad mortgages in a position to rattle hedge funds and investment banks. Now lenders are reluctant to part with their money, putting the economy in the doldrums. The Fed has bailout on its mind.

Stratospheric Costs?

The consequences of government’s short-circuiting the credit markets are now clear for all to see. No one knows how bad the damage will be when it all plays out. The costs to the American people, either as taxpayers or as inflation-ravaged consumers, are potentially stratospheric if the government tries to shore up shaky institutions or engineer rescues, such as the Fed’s Bear Stearns move, which (if the deal goes through) will bail out the investment bank’s creditors while helping JPMorganChase acquire Bear’s solid assets for a song. (The Fed graciously agreed to swap MorganChase Treasury securities for Bear’s bad subprime mortgages securities–to the tune of $30 billion.)

Here’s the bottom line: this colossal mess is the exclusive product of a tangled web of government policies. The free market cannot justly be blamed because for ages there has been no free, undistorted market in housing or most anything else. The privileges granted under political capitalism, or the corporate state, have seen to that. Yet the only solutions people can imagine consist of more of the same and worse, including ex post changes in mortgage contracts, interest-rate freezes, expanded authority for Freddie and Fannie, and wider scope for Fed bailouts of investors through loans based on bad collateral.

The table is set for the next crisis–which will of course be attributed to the unregulated marketplace. Then the power-mongers can declare laissez faire dead. The fix is in.

  • Sheldon Richman is the former editor of The Freeman and a contributor to The Concise Encyclopedia of Economics. He is the author of Separating School and State: How to Liberate America's Families and thousands of articles.