Last week the financial industry was exposed as much more vulnerable to what might have seemed like ephemeral economic developments than almost anybody — including most in the industry — imagined.
The supposedly wise people of Washington are huddling to come up with a plan to “stabilize” the markets that will undoubtedly cost taxpayers hundreds and hundreds of billions of dollars eventually — although there’s a chance that taxpayer exposure won’t be quite as bad as some fear.
We would have preferred it if the government had allowed businesses that got caught taking undue risks to feel the full consequences of their mistakes, even if that meant bankruptcy or being purchased at a deep discount. That’s how mistakes in a reasonably free marketplace are handled. When the government or some other entity steps in to shield people from the consequences of their mistakes, there is little incentive to learn from mistakes or to avoid undue risk in the future.
The key to a smoothly functioning economy is to get the incentives right. In a properly functioning free-market economy, one profits by fulfilling the needs and desires of customers, so there are strong incentives to be attentive to the needs of others and not to cheat them. As we work through this crisis, then it will be important to figure out what mistakes led to this debacle and put in place proper incentives to minimize the chances of such large-scale problems developing again — though given the fact that we are imperfect human beings, you can be sure the future will have its own problems.
It is also important to put the financial problems in perspective. The financial markets are connected to what might be called the “real economy,” and developments of the last few weeks will no doubt impact the general economy, especially insofar as the pendulum swings and even creditworthy individuals and small businesses have trouble getting access to credit.
As William Niskanen, chairman of the Cato Institute and formerly a member of the Council of Economic Advisers, said, however, GDP growth in the third quarter of this year came in about 3.3 percent and personal savings — the real basis for future capital — actually increased. Finance, housing, airlines, and the domestic auto industry have problems, but many sectors of the economy are doing better than the headlines would lead you to believe.
Still, the financial markets were revealed to have huge problems. How did they develop? The government made three key mistakes. The first was not to reform the obviously failed business model of Fannie Mae and Freddie Mac, government-sponsored enterprises run like private companies when they were profitable but able implicitly — and eventually explicitly — to socialize their losses to the taxpayers when things didn’t go well. The incentives were all wrong, encouraging management to take ever-greater risks and to double down on bad investments rather than getting out of them, hoping they would turn around but figuring Uncle Sam would come in if they didn’t. Those entities cannot be allowed to return with that model.
Second was to create the market for subprime mortgages, which the government did about 20 years ago with the Community Reinvestment Act.
The intentions — making home ownership more affordable for low-income people — were good, but you know which road is paved with good intentions. The act’s provisions prodded lenders to make loans to people who had little chance of repaying them, and some lenders learned to game that system. The mistake was compounded in 2005 when Fannie and Freddie were allowed to securitize — to package into new investment instruments — risky subprime mortgages.
The third huge mistake was made by the Federal Reserve, which kept interest rates artificially low from 2002 to 2005, after the brief 2001 recession. This created a general bubble in the economy that blew up and then popped with particular intensity (see above) in the housing market.
Private actors made big mistakes too. The credit rating bureaus, which are supposed to assess risk for savers and investors, failed utterly to evaluate the exotic investment instruments Fannie, Freddie and others were devising. Investment bankers and others thought the housing bubble would never burst, so they overestimated their capacity to assume risk and underestimated their need for working capital.
Wall Street operators will learn from their mistakes — at least for a while — and most will survive. But government actions and regulations create many of the incentives within which the market functions. Whatever structures come from this debacle must avoid undue encouragement of dangerous risk-taking and too-easy money.