Scapegoating Regulation

Many progressives now believe the age of Milton Friedman may be drawing to a close. Their hope is the current financial crisis has shown the costs and dangers of inadequate market regulation, thereby discrediting the anti- regulation philosophy of Milton Friedman and his Chicago School colleagues.

Evidence of the changing times is supposedly provided by Treasury Secretary Paulson’s and Federal Reserve Chairman Bernanke’s public admissions about the need for regulatory change.

Yet the reality is far more complex, and economic conservatives will not roll-over and surrender just because of a financial crisis. Instead, if history is a guide, they will blame regulation for the crisis. That was Milton Friedman’s modus operandi when he launched the modern era of deregulation and animus to government with his false claim that the Fed caused the Great Depression.

This tried and tested conservative tactic is already surfacing in the debate surrounding Fannie Mae and Freddie Mac, the giant mortgage financing companies. The conservative argument is government’s provision of an implicit guarantee to Fannie and Freddie distorted the market by giving them subsidized finance. The implication is that this enabled them to pump up the housing bubble, while simultaneously making them the dominant players in the securitized mortgage market.

This conservative tactic scapegoats Fannie and Freddie, making them the fall guys for the bubble’s financial excesses, when the true cause was inadequate regulation of mortgage lending and failed macroeconomic policy.

The insinuation that Fannie and Freddie were primary movers of the housing market excesses of 2004 – 2006 lacks even superficial merit. This is because since 2003 both Fannie and Freddie have had limited asset growth, and Fannie’s assets actually fell significantly after 2003.

Moreover, the roots of the crisis lie in the sub-prime market. That is where “no doc” and “zero down” mortgages proliferated, where loan originations exploded in volume, where losses started, and where the bulk of losses have been so far. Yet, Fannie and Freddie are prevented from financing such mortgage products by their charters.

These facts should make clear that Fannie and Freddie did not cause the crisis. Instead, it was driven by loose and negligent lending by banks and Wall Street. That behavior was due to lack of regulatory oversight, combined with a failed incentive system that rewards management and mortgage brokers for pushing loans rather than prudent lending.

Such loan pushing was even promoted by conservative animus to Fannie and Freddie, as Wall Street was encouraged to muscle in on the formers’ business. That is why the Bush administration sought regulatory limits on Fannie and Freddie’s asset holdings. However, unlike Fannie and Freddie, Wall Street has no legal restrictions on loan quality and opted for gorging on sub-prime.

The bubble’s origins lie in the combination of a flawed economic growth paradigm that prompted the Fed to push interest rates too low for too long, plus loose lending by banks and Wall Street. This combination inflicted a huge negative “pecuniary externality” on Fannie and Freddie, driving up house prices in the normally sound mortgage markets they serve. Consequently, they too have been battered by the bubble’s implosion.

The bottom line is Fannie and Freddie had little to do with the bubble. That said conservatives raise a legitimate question of how to organize the securitized mortgage market.

Fannie and Freddie’s implicit government guarantee has helped them lower the cost of mortgage finance, making home ownership more affordable to millions. In effect, the guarantee has made government’s lower borrowing cost available to the public, which is good. The downside is it has made Fannie and Freddie overwhelmingly dominant in the securitized mortgage market.

This suggests that in addition to tighter mortgage lending regulation, there is a case for nationalizing Fannie and Freddie on grounds that they are natural monopolies. That is the very opposite of conservative arguments opposing need for tighter regulation and proposing disbanding Fannie and Freddie. That would leave Wall Street unreformed, and make home ownership more expensive by removing the assist provided by access to government’s lower borrowing cost.


Originally published at Thomas Palley and reproduced here with the author’s permission.

4 Responses to "Scapegoating Regulation"

  1. MIchael LittleBig   August 13, 2008 at 12:50 pm

    Alan Greenspan recommends a new type of regulatorMr. Greenspan has a point that is well taken, probably 80 years too late but better late than never. The average American takes comfort and security in the BIG LIE. The Big Lie is that the banks and financial institutions are well regulated, supervised and enforcement is quick and efficient when needed.Congress, the Regulators, Treasury and the bureaucrats watched this crisis unfold day by day.Even economist Roubini who in 2002 predicated is exactly what was to take place was ignored.No one should have been surprised. In fact the Congress, regulators and Treasury were over whelmed. It was like a bank robbery gone bad.That American image of a security blanket really became a noose around the neck of the economy. Our government, the bankers, the financial institutions are all intertwined in a spider web of power and money. They all feed and protect each other at the expense of their fellow citizens. We are beginning to understand that at this time the projected credit loss is 2 trillion dollars. The average equity loss to the average home owner is stated today as a 62% loss in value. Those among who have the lest to gain and the most to loose are victims of the federal regulatory system.My experience and research is based on the Office of Thrift Supervision who by law regulates, supervises and enforces those regulations of Federally Chartered Savings Banks (FCSB’s). At best this is a myth. The OTS does not have the knowledge, the manpower, the time, the expertise or the credibility to supervise the FCSBs. Most FCSB’s are self regulated. The President appoints the Director of the OTS who only answers to Congress. Let me you a very limited idea of the OTS and its supervision of the FCSBs. There are very few federal regulations that deal with mortgage lending. There are no Federal Consumers Banking Regulations. It is designed this way by the powerful Congress. The wealthy and powerful banks will not permit any regulation to interrupt their multi billion dollar cash flow. The 2005 Bankruptcy act revised to reduce credit card loses is an example of the Banks power over Congress.From the Bankers standpoint, the less regulations you have, the more control you have. These FCSB’s conduct their lending operations with absolute impunity. The have no fear of consumer reprisal since there are no laws that permit that. The consumer cannot contest, object or question any thing including foreclosure within the federal regulatory system which is the same system that the FCSB lend their mortgage money. The Congress is well aware of this. The FCSBs really answer to no one. The mortgage banker makes his own rules, his own paper work and his own consumer enforcement. The FCSB operates on the Lynch Mob theory. Foreclosure the Mortgage and hang the Borrower. The borrower has no rights. The borrower cannot afford an attorney for the Legal Dance. This is where the borrower’s attorneys and the banks attorney dance to the Courts band until the borrower’s runs out of money.The Banks blamed the homeowners and the Congress agreed. We know that because the 700 page housing bill just passed protected everyone but the homeowner. The analogy here is that the financial rape victim was blamed for the rape by the rapist.. We need federal consumer banking regulations to level the playing field so the borrower can defend himself against an unethical bank. The consumer is like a smoke detector in a house. Smell smoke and the detector goes off. The consumer sensing something unethical can contest what his bank done through the federal regulatory system. By tracking those consumer complaints we may be able to stop the next crisis. Now the bank just hangs the consumer. Yes Alan Greenspan we need a powerful regulator that is not tied to Congress, the Financial community or the Treasury DeptMichael LittleBig

  2. Anonymous   August 15, 2008 at 12:56 pm

    Breaking News!Milton Friedman is still dead.

  3. aaron   August 20, 2008 at 10:03 am

    I think the true cause here is the fed. It still holds true that inflation is every where and always a monetary phenomon. Why that extra money ended up in housing is another question. Was it due to regulatatory changes or some psycological phenomena (fear of other equities and lack of appeal for bonds etc.)? Probably both. Was regulation the cause? No. But it is certainly not the solution. Transparancy and auditing are the solution, not stricter requirements.

  4. Guest   August 23, 2008 at 9:56 pm

    I think the housing bubble was caused in part by tax policy, as housing is increasingly the only tax shelter available for the two thirds of Americans who own homes. The tax loopholes apply not only to mortgage interest and the capital gain upon sale, but also to MEW, effectively granting homeowners a privileged tax status which renters do (did) not enjoy. The government incentives for the housing bubble were obvious. What is not obvious is how they will unwind.