Recently I was asked a series of questions by a journalist wishing to write an article about the nation’s current economic situation.  What follows in this article and others following over the next week is one of those questions and my answer to it.

What are the kinds of questions policymakers should be asking as they evaluate economic stimulus proposals?

The main question that should be asked is “are we doing more good than harm.”

There is only one thing policymakers should do – attempt to create individual confidence in the economy and the banking system and stay out of individuals’ economic decisions.  If government would reduce taxes and regulations and enable the private sector to flourish, the economy would return to health much more rapidly than if government increases regulations, increases taxes, increases spending and thereby increases debt.

Government stimulus typically refers to increased government spending.   Where does government get the money it spends? From taxes.   When government takes money out of the hands of the private sector and chooses where this money should be spent, policymakers are saying they know better what to spend money on than do the people who labored and created the money. If government chooses not to increase current taxes, then its increased spending has to come from debt.  The government borrows which means that either taxes must be raised in the future to pay back creditors or the debt is “monetized” .  This  means the Federal Reserve buys the debt with dollars it prints from thin air which leads to inflation. Monetization is simply a hidden tax – inflation.

The second question that should be asked is “are we inducing uncertainty about the security of private property”.  When Paulson and Bernanke panicked, going from one policy approach to another and when they turned from buying toxic assets to bank equity, the private sector had no idea what was going on.  It, therefore, panicked as well.  People have to believe their property is secure, that the regime of security over that property is not changing, and  that property will not be confiscated. Much like the early 1930s, people today are not confident that their property is secure and that what they earn with their labor they will be able to keep. A poll in May of 1939 asked:
“Which of the following comes closest to being your prediction of the kind of economic structure with which this country will emerge after the war?”

1. A system of free enterprise restored very much along the prewar lines, with modifications to take care of conditions then current. [7.2 percent]
2. An economic system in which government will take over many public services formerly under private management but still leave many opportunities for private enterprise. [52.4 percent]
3. A semi-socialized society in which there will be very little room for the profit system to operate. [36.7 percent]
4. A complete economic dictatorship along fascist or communist lines.  [3.7 percent]

Source: (Robert Higgs, 2007, Depression, War, and Cold War: Studies in Political Economy Oxford University Press, USA (June 22, 2006) ISBN-10: 0195182928

90 percent of the respondents thought that the future was one of socialism or worse.  No one wanted to  invest in such an environment and this is what current policymakers should focus on avoiding.

It is now taken for granted that markets and capitalism are flawed and must be regulated and controlled, if not destroyed.    The message from the current economic crisis is clear. “It is the end of capitalism.”  Barney Frank tells us that “The private market got us into this mess; the government will have to get us out.”

Bashing markets is convenient and  politically popular. But to make the argument requires a willful disregard of facts.  The role of bankers and other market players in causing the current crisis is undeniable, but none of them would have undertaken their actions had it not been for the massive role played by government. The trigger for the financial meltdown was the U. S. sub-prime housing fiasco – a pure example of government failure and regulatory policy run amok.

Barney Frank in the House and Chris Dodd in the Senate pushed for loosened mortgage lending restrictions so first-time home buyers could qualify for loans they could never get before.  Reacting to these and other more significant policy changes, lenders such as Countrywide Financial in California set up units to service these so-called borrowers. On the brink of bankruptcy, Countrywide had $170-billion in mortgage assets, most of them subprime. (Interestingly, Chris Dodd  and members of Fannie Mae and Freddie Mac executive corps, received  below-market special mortgage loans from Countrywide.)

The Government Sponsored Agencies (GSEs) Fannie Mae and Freddie Mac, were forced by the democrats to increase the percentage of “affordable loans” they made. The Housing and Urban Department gave the GSEs a target of 42% of assets in the mid 1990s. The target increased to 50% in 2000 and 52% in 2005. In addition, for 1996 HUD required that 12% of all mortgages purchased by GSEs be special affordable loans — income less than 60% of the median in the area – then 20% in 2000, 22% in 2005 and 28% in 2008.

Politicians in Congress fueled the explosion. The incestuous relationship between Congress and the GSEs has not been made clear.  For years, Fannie Mae and Freddie Mac– right up to their seizure by the U. S. government earlier this year – were everywhere.  They funded politicians’ interests, kept mortgage interest rates low and became government-backed agencies for trillions of dollars in risky mortgage lending.  Look at who received the greatest campaign contributions from the GSEs and you will see who was unwilling to rein them in.

Between 1995 and 2007, the combined balance sheet of Fannie Mae and Freddie Mac, including Mortgage Backed Securities (MBS), rose from $1.4-trillion to $4.9-trillion, an annual increase of almost 15%. About $1-trillion dollars of Fannie/Freddie activity involved exposure to subprime and lower-grade mortgages. The loosened standards meant that investors could purchase several homes with out having any “skin in the game”. Housing prices shot up. This gave rise to even greater use of credit, as speculators and buyers piled onto a credit and ownership machine that seemed to offer no risk and guaranteed gains. Not all funding came via government and regulatory overreach. Hundreds of billions were raised through new mortgage based securities and other risk-distribution vehicles by private players, as these mortgages, issued under no lending standards, were packaged and then sold as AAA-rated securities. AAA rating? Who gave them this sterling rating?   Essentially the government did.

There are only three rating organizations approved by the SEC:  S&P, Moody’s and Fitch and these three earn money by favorable ratings. Lack of genuine market competition in the ratings business, meant that the ratings firms, became part of the social program. The view that subprime mortgages issued under lax standards to low income Americans were no more risky than prime mortgages, especially when they were packaged into large agglomerations became widely accepted. Ratings inflation ensued, with AAA and other high ratings accorded to all manner of high-risk mortgage products.

Crucial to the story is the role of the Federal Reserve under Alan Greenspan. Mr. Greenspan’s low-interest rate policy -which brought the Fed funds rate to 1% through much of 2003– helped push home values up even higher. As values rose, the lax lending standards started to look even better.

The mortgage and financial crisis now sweeping the world is the product of a colossal build-up of unintended consequences brought on by government policy and regulation. What we are witnessing today, as governments pile on massive new rounds of intervention, is a growing pyramid of government failures. It is not a failure of free markets; it is a failure to have free markets.  Solving the problem by enlarging government’s role in the economy is the road to socialism, not the road to salvation.