Did the Free Market Cause the Current Crisis? - Part II

In an earlier post I began answering the question: “Did the Free Market Cause the Current Crisis?” My short answer is no, but not without qualifications. I argued that three factors led to the housing bubble – the but-for cause of the current recession. Two of the factors are government-related: the Fed and government-created homeownership incentives (I address the latter in this post). Only the third factor, banks’ excessive risk taking, is a direct result of the free market. I will address banks in Part III.

Factor #2: The Government - "Ownership Society"

In the late 1990s people began to believe that homes were always safe investments. One reason is that home prices had steadily risen during previous decades, and people simply believed that the increase would continue (behavioral economists call this "status quo" bias). Another reason is that income and population were rising in the 1990s, so more people could afford homes.

As people increasingly viewed homes as safe investments, demand and therefore prices rose. Soon many people were unable to afford 20 percent down payments. People began arguing that low income Americans, especially minorities, were unfairly denied the American dream. Beginning with the Clinton administration, the government began pushing Fannie Mae and Freddie Mac to offer loans to low-income Americans - under the implicit guarantee that the government wouldn't allow these institutions to fail. (This implicit guarantee explains why these institutions could borrow at low rates, despite the fact that they back so many risky loans). The government encouraged lenders to offer loans to people who would be unlikely to afford payments. Unfortunately, the Bush administration continued Clinton's inauspicious policies. President Bush hoped to achieve an “ownership society.” Furthermore, the federal government - and many state governments - began offering strong tax incentives to home buyers.

Still, it's possible to argue that it's a good idea for the government to encourage homeownership because of the positive externality effect: homeowners take better care of their properties than renters do, which increases neighborhood property values. Homeownership may also reduce crime - at least according to Giuliani's "broken window" theory. Nevertheless, as the recent crisis suggests, the government went way too far in its encouragement of homeownership.

The perpetuation of the idea that homes were safe investments and the government's encouragement of homeownership were not independent events. Each fueled the other. These events, along with the Fed's lowering of interest rates and banking deregulation, led to the huge spike in real home prices.

Before claiming that free markets caused the current crisis, however, it’s important to recognize that two of the three culpable events have nothing to do with free markets and everything to with government intervention.

Privatizing Social Security is a Good Idea - Still

In Richard Posner's book A Failure of Captilism (a great book I'll blog more about in the future), Judge Posner listed lessons this crisis has taught us. One thing he mentioned is that privatizing Social Security would have been a bad idea. He never explained his rationale (perhaps he thought it was self-evident?), and, for the reasons listed below, I don't agree with his claim.

First, it would initially seem that the people who would have been hurt the most by privatization are those (a) who had heavily invested their money in the stock market, and (b) who are close to retirement. But privatized accounts would likely work much like 401(k)'s. People could choose to invest in stocks, bonds, or some preset mix. As people approached retirement, most would shift their money to bonds, where funds have largely been sheltered. Most soon-to-be retirees wouldn't have been significantly affected by the crisis.

Secondly, it’s true that crisis would have harmed anyone who had invested in stocks. Still, I expect the return on stocks over the next decade or two to exceed the current return on Social Security contributions (which is close to two percent). Even those who would have been significantly hurt in the short-run would be better off by investing in stocks than by "investing" in Social Security - as long as they aren't looking to retire in the next couple of years.

Finally, privatizing social security would have encouraged higher savings rates, so people would have saved more in the early 2000s. Thus, when the crisis hit, people could have drawn on their savings, mitigating the sharp decline in consumption. Much of the savings, of course, would have gone to untouchable 401(k)-type accounts, but Congress could have simply passed a law allowing people to withdraw early without the standard penalty. Because the value of stocks will likely grow faster than two percent, people who withdrew early would still have money for retirement.

Did the Free Market Cause the Current Crisis? - Part I

I've decided to join the blogosphere (as if you couldn't tell...). I'm an environmental, behavioral economist who enjoys politics, legal issues, and, of course, economics. I think my position on various issues will become apparent as I go along.

I will begin by addressing a series of questions I often hear from my students: "is a carbon tax or a cap-and-trade system better" "what role should the Fed play in our economy?" "should we return to the gold standard?" "how can we lower healthcare costs?" "how accurate is economics when it is based on the provably false assumptions about rationality?" I would like to post daily, but time will tell whether I adhere to my goal.

The first question I attempt to answer is, "Did the free market cause the current crisis?" My short answer is "no," but the free market certainly played a part. Without government intervention, the recession would not be nearly as bad as it currently is. In this and future posts, I will try to lay out my view on this complex subject.

The current crisis is a direct result of the bubble in the housing market. Without the bubble, there would be no crisis, no recession, and no 9.4 percent unemployment. The bubble (and thus the recession) was caused by the confluence of three factors: the Fed dropping the interest too low for too long, the federal government's encouraging of an ownership society, and banks taking excessive risks. I’ll address the Fed in this post.

Factor #1: The Government - The Fed:

In the wake of 9/11, the Fed, under the direction of Greenspan, lowered the interest rate (technically, the target federal funds rate). The Fed typically lowers the interest rate when it is worried about a drop in production and consumption. Lower interest rates encourage businesses to borrow money to expand their operations (at least in the short run) because money is cheap. Low rate also encourage consumers to buy goods and homes on credit.

The economy was already struggling when terrorists attacked the Twin Towers; it was recovering from the bursting of the dot-com bubble. Because the economy was doing poorly and because many feared that the terrorist attack would further erode consumer confidence, the Fed acted wisely in lowering the interest rate. The Fed acted unwisely, however, in keeping rates so low for so long. The Fed didn't really begin raising the interest rate until 2005 - long after recessionary fears had passed

With extremely low interest rates in the early 2000s, banks offered home mortgages at low rates (especially on adjustable-rate mortgages, where borrowers often paid only one to two percent for the first two years). Home-buying became even more attractive than it already was. Plus, low interest rates made it easier for banks (including investment banks) to borrow money from the U.S. Treasury. It became profitable for banks to borrow tons of money from the Treasury, then lend most of that money to consumers through mortgages. These two factors together made money widely available.

Thus the first factor that caused the huge spike in demand for homes (and thus the bubble) was not the free market, but the government created central bank.

I'll address the other two factors in my next posts.