Misconceived intervention to blame for US sub prime failure

Two of the biggest lessons learned from the 20th century were that pure socialism, in all its forms, is an oppressive social system, as well as an economic system which fails to generate as much wealth as capitalism. In the 21st century, there is no question that capitalism is a superior economic system: the only disagreements between reasonable people concern how much government intervention is desirable.

But even on the issue of how much regulation, it is clear that those who have favoured less government participation have generally been more correct than those who have favoured more. This is why capitalist nations such as Australia and the United States have become more capitalist, with policies such as freer trade, privatisation and labour market flexibility all contributing to strong economic growth during the last 16 years.

Meanwhile, nations that have returned to heavy-handed government intervention, such as France and Germany, have suffered economically as a result. In countries such as Sweden, unemployment rates are approximately 25 per cent when you take into account all the young people completing mickey-mouse courses instead of working.

As a result, the evidence clearly shows that although regulation is necessary, it should carefully avoid destroying the wealth-creating power of the market. Unfortunately, however, there those today who are less interested in the evidence and more interested in pushing their anti-capitalist agendas.

These haters of capitalism tend to emerge during periods of economic bad news, or increasing alarmism over global warming with "I told you so", as though the system they despise is clearly the true culprit for the current problems. They are the modern day heirs of the numerous Western intellectuals who supported Stalinism and Communism in the 1950s and 60s: their hatred of markets blinds them to facts and reason. One example is Robert Manne, who during the recession of the early 1990s had the following prescient prediction:

The economic reform agenda in Australia has failed and will lead to permanent high unemployment, with real figures in the order of 15 to 20 per cent … (After the economic reforms of the 1980s and early ‘90s) the nation witnessed before its eyes the black cloud of economic rationalism casting its pall over the economy and its future ... The cost of economic rationalism, at the end of the day, is the 1990s permanent recession.

As Andrew Bolt stated many years later "Imagine where we'd be if Manne really was influential". But the same applies to his fellow travelers, who have emerged after nearly two decades of economic sunshine to arrogantly declare that the US sub prime collapse has demonstrated that capitalism has now been discredited, and that we should presumably go back to protectionist trade policies, highly centralised industrial relations systems and government control of major industries.

First, how the failure of US financial market exposes the flaws of free trade, the private sector as a whole and industrial relation systems is never explained. Logically, if one part of a system is flawed it doesn’t mean the rest of the system is flawed. If a tube on a pushbike has a puncture, does that mean that the entire bike should be thrown out? According to the reasoning of some, the answer is yes. Their “proof”' that capitalism as a whole has been defeated is based only on the alleged failure of one part of the system.

To find out exactly what went wrong in the United States, we should look at the facts.

It is already known and understood that the sub prime mortgage crisis was caused by excessive borrowing, as well as a decline in housing prices. Sub-prime loans are loans which are considered risky because they are made to individuals or organisations with low incomes or bad credit histories. In order to compensate for the increased risks, financial institutions charged higher interest rates. So while sub prime loans were risky, they were also often highly profitable.

As interest rates rose, mainly due to monetary policy, a high number of defaults occurred. Easy initial credit terms were followed by harder ones and this also contributed to defaults and foreclosures. In the third quarter of 2007, subprime variable mortgages were only 6.8 per cent of mortgages in the United States, but they also accounted for 43.0 per cent of foreclosures over the same period. There is hence no doubting the central role played by subprime loans.

In the housing market, an increase in foreclosures led to a drop in the price of housing and the bursting of the “housing bubble”, which in turn meant that foreclosures often led to financial institutions not recovering all or most of the amounts owed to them. This not only affected the profitability of institutions, but also their very survival. Hence the collapse of a number of institutions, including Lehman Brothers and Washington Mutual.

There is widespread agreement that relaxed credit standards were primarily responsible for the excessive lending. So the question is why credit standards were relaxed. Politicians have played the populist card by providing simplistic and misleading answers. Barack Obama in his first debate with John McCain alleged that a philosophy that says that regulation is a bad thing that needed to be removed was responsible. Similarly, our Prime Minister has blamed “extreme capitalism” for the crisis. Let's see if those claims are true.

In 1999, the Clinton administration pressured Fannie Mae, an intermediary in the secondary mortgage market, into increasing its risky borrowing to lower and middle income people. Later, in 2004, Fannie Mae and Freddie Mac asked for more government support for its sub prime lending after they were involved in accounting scandals. Now, of course, Fannie Mae and Freddy Mac were privately-owned corporations. But their close relationship to the US Congress compromised their abilities to act prudently and in accordance with sound commercial principles. As Thomas Sowell has pointed out, it is a matter of record that Senator Christopher Dodd and Congressman Barney Frank, both Democrats, consistently denied that either institution was taking excessive risks. In fact, they led calls by many Democratic politicians in the US for Fannie Mae and Freddy Mac to go even further with their risky lending practices.

It is ironic that support in the US Presidential race when the crisis reached a peak swung in favour of Obama, given how implicated in the crisis his party was.

Why did the US Congress push to relax lending standards? Sadly, good intentions and progressive theories are the cause. Proponents of sub prime lending believed that such practices were justified because many poor people, particularly those from ethnic minorities, would otherwise be unable to obtain credit and achieve home ownership.

The best way to help the poor is to have a strong economy which provides them with opportunities. Letting them borrow money when they don't have the means to repay is no path out of poverty. It’s a pity that it had to take a financial crisis to demonstrate this.

Another way in which government regulation helped bring about the crisis is through laws which favoured borrowers. In particular, the laws that allowed mortgagors to simply walk away from their mortgage debts, This prevented financial institutions from recovering monies owed to them when the housing bubble burst. This resulted in banks suffering massive losses during the sub prime crisis.

It is also well-known that speculation in real estate was also a contributor to the financial turmoil today. But again, one of the major causes of this was government intervention, which has made real estate a more attractive to investors. For instance, the United States Tax Code makes interest paid on mortgages 100 per cent tax deductible and also extends tax deductibility to part of the principle. In Australia and the United States, negative gearing is largely responsible for making real estate speculation more attractive than other investment options. Again, the "free market" is not to blame here. Muddle-headed government inference is. If the Australian government abolished negative gearing in Australia, house prices would quickly drop, to the benefit of first home buyers.

Inaccurate credit ratings, poor securitisation practices and excessive borrowing by the financial institutions also contributed to the collapse of the credit house of cards.

Clearly, new regulations do need to be introduced in order to ensure there is high transparency, superior oversight and more prudent lending. But it is a huge mistake to assume that "right wing policies" and "free market capitalism" are to blame for the financial crisis. Government intervention deserves an equal if not even larger share of the blame.

The reasons for setting the record correctly on this point are extremely important. If we mis-diagnose the problem, we are likely to end up with a solution which is worse than the problem itself, as the US government's contribution to this problem itself has demonstrated. Indeed, this entire chapter is a sublime demonstration of Friedrich von Hayek's law of unintended consequences, where government intervention intended to address perceived problems often results the creation of other problems.

Indeed, Rudd's misdiagnosis of "extreme capitalism" perhaps contributed to his own decision to issue an unlimited bank guarantee, which resulted in a disastrous flight from non-bank institutions. As much as the Rudd Government tried to spin the guarantee as being a sound policy which required “fine-tuning”, it was in reality an almost unmitigated disaster, and a reminder of how clumsy government meddling in markets can indeed be.

As a result, more regulation and government intervention is clearly not the solution. In the words of Janet Albrechtsen, "Wrong regulation, rather than deregulation, is the problem.". The last thing we need is more regulation, which will not only maintain the legislation which forces financial institutions to lend money on non-commercial grounds, but also destroy the ability of markets to create wealth and opportunities throughout the economy. What is instead required is superior regulation, which results in effective oversight and sound rules which must be followed. Borrowing is an essential part of modern business which must be allowed to continue for commercial reasons.

More conservative lending practices can help reduce occurrences of loan defaults, repossessions, foreclosures and bankruptcies. We all have to accept the fact that not everyone can realise the dream of owning their own home. Policies aimed at helping the poor should concentrate on increasing their net incomes, rather than letting them borrow too much.

In summary, the facts show that the US sub prime fiasco has above all been an indictment on ineffective and irresponsible government interference, not capitalism. The economic turmoil which followed irresponsible lending practices has above all been a painful lesson in the Hayekian rule of intended consequences when it comes to interventionism.

The lesson is that financial institutions should be allowed to make sensible commercial decisions, and regulation should ensure that lending practices are transparent and responsible. The previous financial regime in the US ensured that borrowing would often not be responsible, and this is what precipitated the financial situation today.