Misconceived intervention to blame for US sub prime failure

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.