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<title>an open letter to my friends on the left</title>

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<h2 align="center">an open letter to my friends on the
left</h2>
<h3 align="center" class=msonospacing>steven horwitz<br>
department of economics<br>
st. lawrence university<br>
sghorwitz@stlawu.edu</h3>
<p align="center">september 28, 2008 </p>
</p>
<p>my friends, </p>
</p>
<p>in the last week or two, i have
heard frequently from you that the current financial mess has been caused by
the failures of free markets and deregulation. i have heard from you that the
lust after profits, any profits, that is central
to free markets is at the core of our problems. and i have heard from you that
only significant government intervention
into financial markets can cure these problems, perhaps once and for all. i
ask of you for the next few minutes to, in
the words of oliver cromwell, consider that you may be mistaken. consider that
both the diagnosis and the cure might be equally mistaken. </p>
<p>consider instead that the
problems of this mess were caused by the very kinds of government regulation
that you now propose. consider instead
that effects of the profit motive that you decry depend upon the incentives
that institutions, regulations, and policies create, which in this case led
profit-seekers to do great damage. consider instead that the regulations that
may have been the cause were supported by, as they have often been throughout
us
history, the very firms being regulated, mostly because they worked to said
firms' benefit, even as they screwed the rest of us. consider all of this as
you ask for more of
the same in the name of fixing the problem. and finally, consider why you
would ever imagine that those with wealth
and power wouldn't rig a new regulatory process in their favor.</p>
<p>one of the biggest confusions in
the current mess is the claim that it is the result of greed. the problem with
that explanation is that greed is always a feature of human
interaction. it always has been. why, all of a sudden, has greed produced so
much harm? and why only in one sector of
the economy? after all, isn't there
plenty of greed elsewhere? firms are
indeed profit seekers. and they will
seek after profit where <i>the institutional
incentives are such that profit is available.</i> in a free market, firms
profit by providing
the goods that consumers want at prices they are willing to pay. (my friends,
don't stop reading there even if
you disagree - now you know how i feel when you claim this mess is a failure
of
free markets - at least finish this paragraph.) however, regulations and
policies and even the rhetoric of powerful
political actors can change the incentives to profit. regulations can make it
harder for firms to
minimize their risk by requiring that they make loans to marginal
borrowers. government institutions can
encourage banks to take on extra risk by offering an implicit government
guarantee if those risks fail. policies
can direct self-interest into activities that only serve corporate profits,
not
the public.</p>
<p>many of you have rightly criticized the ethanol mandate, which made it
profitable for corn growers to switch from growing corn for food to corn for fuel,
leading to higher food prices worldwide. what's interesting is that you rightly
blamed the policy and did not blame greed and the profit motive! the current
financial mess is precisely analogous. </p>
<p><i>no free market economist thinks "greed is always good."</i> what we think
is good are institutions that
play to the self-interest of private actors by rewarding them for serving the
public, not just themselves. we believe
that's what genuinely free markets do. market exchanges
are <i>mutually</i> beneficial. when the law
messes up by either poorly defining the rules of the game or trying to
override
them through regulation, self-interested behavior is no longer economically
mutually beneficial. the private sector
then profits by serving narrow political ends rather than serving the public.
in such cases, greed leads to bad consequences. but it's bad not because it's
greed/self-interest rather because the institutional context within which it
operates channels self-interest in socially unproductive ways.</p>
<p>this, my friends, is exactly what
has brought us to the mess we are now in.</p>
<p>to call the housing and credit
crisis a failure of the free market or the product of unregulated greed is to
overlook the myriad government regulations, policies, and political
pronouncements that have both reduced the "freedom" of this market and
channeled self-interest in ways that have produced disastrous consequences,
both intended and unintended. let me
briefly recap goverment's starring role in our little drama.</p>
<p>for starters, fannie mae and
freddie mac are "government sponsored enterprises". though technically
privately owned, they have
particular privileges granted by the government, they are overseen by
congress,
and, most importantly, they have operated with a clear promise that if they
failed, they would be bailed out. hardly
a "free market." all the players in the
mortgage market knew this from early on. in the early 1990s, congress eased
fannie and freddie's lending requirements (<a
href="http://www.ibdeditorials.com/ibdarticles.aspx?id=307241242284619">to
1/4<sup>th</sup> the capital required by regular commercial banks</a>) so as to
increase their
ability to lend to poor areas. congress
also created a regulatory agency to oversee them, but this agency also had to
reapply to congress for its budget each year (no other financial regulator
must
do so), assuring that it would tell congress exactly what it wanted to hear:
"things are fine." in 1995, fannie and
freddie were given permission to enter the subprime market and regulators
began
to crack down on banks who were not lending enough to distressed areas.
several attempts were made to rein in fannie
and freddie, but congress didn't have the votes to do so, especially with both
organizations making significant campaign contributions to members of both
parties. even the <i><a
href="http://query.nytimes.com/gst/fullpage.html?res=9c0de7db153ef933a0575ac0a96f9
58260&amp;sec=&amp;spon=&amp;pagewanted=1">new
york times<span style='font-style:normal'> as far back as 1999</span></a></i>
saw exactly what might happen thanks to this very unfree market, warning of a need
to bailout fannie and freddie if the housing market dropped.</p>
<p>complicating matters further was
the 1994 renewal/revision of the community reinvestment act of 1977. the cra
requires banks to to make a certain
percentage of their loans within their local communities, especially when
those
communities are economically disadvantaged. in addition, congress explicitly
directed fannie and freddie to expand
their lending to borrowers with marginal credit as a way of expanding
homeownership. what all of these did
together was to create an enormous profit and political incentives for banks
and fannie and
freddie to lend more to riskier low-income borrowers. however
well-intentioned the attempts were to extend homeownership to more americans,
forcing banks to do so and artificially lowering the costs of doing so are a
huge part of the problem we now find ourselves in.</p>
<p>at the same time, home prices
were rising making those who had taken on large mortgages with small down
payments feel as though they could handle them and inspiring a whole variety of
new mortagage instruments. what's interesting is that the rise in prices affected
most strongly
cities with <a
href="http://www.cato-at-liberty.org/2008/09/22/blame-urban-planning/">stricter
land-use regulations</a>, which also explains the fact that not every city was
affected to the same degree by the rising home values. these
regulations prevented certain kinds of land from being used for homes, pushing
the
rising demand for housing (fueled by the considerations above) into a slowly
responding supply of land. the result
was rapidly rising prices. in those areas with
less stringent land-use regulations, the housing price boom's effect was much
smaller. again, it was regulation, not
free markets, that drove the search for profits and was a key contributor to
the rising home prices that fueled the lending spree. </p>
<p>while all of this was happpening,
the federal reserve, nominally private but granted enormous monopoly
privileges
by government, was <a
href="http://online.wsj.com/article/sb122204078161261183.html?mod=djemeditorialpag
e">pumping
in the credit and driving interest rates lower and lower</a>. this influx of
credit further fueled the
borrowing binge. with plenty of funds
available, thanks to your friendly monopoly central bank (hardly the free
market at work), banks could afford to continue to lend riskier and
riskier.</p>
<p>the final chapter of the story is
that in 2004 and 2005, following the accounting scandals at freddie, both
freddie and fannie paid penance to congress by agreeing to expand their
lending
to low-income customers. both agreed to
acquire greater amounts of subprime and alt-a loans, sending the green light
to
banks to originate them. from 2004 to
2006, the percentage of loans in those riskier categories grew from <a
href="http://online.wsj.com/article/sb122212948811465427.html?mod=djemeditorialpag
e">8%
to 20% of all us mortgage originations</a>. and the quality of these loans
were dropping too: downpayments were getting progressively
smaller and more and more loans carried low starter interest rates that would
adjust upward later on. the banks were
taking on riskier borrowers, but knew they had a guaranteed buyer for those
loans
in fannie and freddie, back, of course, by us taxpayers. yes, banks were
"greedy" for new customers
and riskier loans, but <i>they were
responding to incentives created by well-intentioned but misguided government
interventions.</i> <i>it is these interventions that are ultimately
responsible for the risky
loans gone bad that are at the center of the current crisis, not the
&quot;free market.&quot;</i></p>
<p>the current mess is thus clearly
shot through and through with government meddling with free markets, from the
fed-provided fuel to the cra and land-use regulations to fannie and freddie
creating an artificial market for risky mortgages in order to meet congress's
demands for more home-ownership opportunities for low-income families. thanks
to that intervention, many of those
families have not only lost their homes, but also the savings they could have
held onto for a few more years and perhaps used to acquire a less risky
mortgage on a
cheaper house. all of these
interventions into the market created the incentive and the means for banks to
profit by originating loans that never would have taken place in a genuinely
free market. </p>
<p>it is worth noting that these
regulations, policies, and interventions were often gladly supported by the
private interests involved. fannie and
freddie made billions while home prices rose, and their ceos got paid
lavishly. the same was true of the various banks and
other mortgage market intermediaries who helped spread and price the risk that
was in play, including those who developed all kinds of fancy new financial
instruments all designed to deal with the heightened risk of default the
intervention brought with it. this was a
wonderful game they were playing and the financial markets were happy to have
fannie and freddie as voracious buyers of their risky loans, knowing that us
taxpayer dollars were always there if needed. the history of business
regulation in the us is the history of firms
using regulation for their own purposes, regardless of the public interest
patina over the top of them. this is precisely what happened in the housing
market. and it's also why calls for more regulation
and more intervention are so misguided: they have failed before and will fail
again because those with the
profits on the line are the ones who have the resources and access to power to
ensure that the game is rigged in their favor. </p>
<p>i know, my friends, that you are
concerned about corporate power. so am
i. so are many of my free-market
economist colleagues. we simply believe,
and we think history is on our side, that the best check against corporate
power is the competitve marketplace and the power of the consumer dollar
(framed, of course, by legal prohibitions on force and fraud). competition
plays mean, nasty corporations
off against each other in a contest to serve us. yes, they still have power,
but its negative
effects are lessened. <i>it is when corporations can use the state to
rig the rules in their favor that the negative effects of their power become
magnified, precisely because it has the force of the state behind
it. </i>the current mess shows this as
well as anything ever has, once you realize just what a large role the state
played. if you really want to reduce the
power of corporations, don't give them access to the state by expanding the
state's regulatory powers. <i>that's precisely what they want, as the current
battle over the $700 billion booty amply demonstrates</i>. </p>
<p>this is why so many of us
committed to free markets oppose the bailout. it is yet another example of the
long history of the private sector
attempting to enrich itself via the state. when it does so, there are no
benefits to the rest of us, unlike what
happens when firms try to get rich in a competitive market. moreover, these
same firms benefited
enormously from the regulatory interventions they supported and that harmed so
many of us. the eventual bursting of the
bubble and their subsequent losses are, to many of us, their just desserts for
rigging the game and eventually getting caught. to reward them again for their
rigging of the game is not just morally
unconscionable, it is very bad econonmic policy, given that it sends a message
to other would-be riggers that they too will get rewarded for wreaking havoc
on
the us economy. there will be short-term pain if we don't bailout these firms,
but that is the hangover price we pay for 15 years or more of binge lending. the
proposed bailout cannot prevent the pain of the hangover; it can only conceal it
by shifting and dispersing it among the taxpayers and an economy weakened by the
borrowing, taxing, and/or inflation needed to pay for that $700 billion. better we
should take our short-term pain straight up and clean out the mistakes of our
binge and then get back to the business of free markets without creating an
unchecked executive branch monstrosity trying to &quot;save&quot; those who
profited most from the binge and harming innocent taxpayers in the process. </p>
<p>what i ask of you my
friends on the left is to not only continue to work with us to oppose this or
any
similar bailout, but to consider carefully whether you really want to entrust
the same entity who is the predominant cause of this crisis with the power to
attempt to cure it. new regulatory
powers may look like the solution, but that's what people said when the cra
was
passed, or when fannie and freddie were given new mandates. and the very firms
who are going to be
regulated will be first in line to determine how those regulations get written
and enforced. you can bet which way that
game is going to get rigged. </p>
<p>i know you are tempted to think
that the problems with these regulations are the fault of the individuals
doing
the regulating. if only, you think,
obama can win and we can clean out the corrupt republicans and put ethical,
well-meaning folks in place. think
again. for one thing, almost every
government intervention at the root of this crisis took place with a
democratic
president or a democratic-controlled congress in place. even when the
republicans controlled
congress, president clinton worked around it to change the rules to allow
fannie and freddie into the higher-risk loan market. my point here is not to
pin the blame for the
current crisis on the democrats. that
blame goes around equally. my point is
that hoping that having the "right people" in power will avoid these
problems is both naive and historically blind. as much as corporate interests
were relevant, they were aided and abetted, if unintentionally, by well-meaning
attempts by basically good people to do good things.the problem is that there
were a large number of undesirable unintended consequences, most of which were
predictable and predicted. it doesn't matter which party is captaining
the ship: regulations come with
unintended consequences and will always tend to be captured by the private
interests with the most at stake. and history is full of cases where those
with a moral or ideological agenda find themselves in political fellowship with
those whose material interests are on the line, even if the two groups are usually
on opposite sides. this is the famous &quot;<a href="http://www.cato-at-
liberty.org/2008/09/22/blame-urban-planning/">baptists and bootleggers</a>&quot;
phenomenon. </p>
<p>if you've made it this far, i am
most grateful. whether or not you accept
the whole argument i've laid out here, i do ask one thing of you: the story i
told at the start of the role of
government intervention in this mess is true, whatever your grander
conclusions
about the causes and cures are. even if
you don't buy my argument that more regulation isn't the cure, to blame this
mess on "the free market" should now strike you as an obvious falsehood and i
would hope, in the spirit of fair play, that you would stop making that claim
as you speak and write about the ongoing events of the last two weeks. we can
disagree in good faith about what to
do next, and we can disagree in good faith about the degree to which
government
intervention caused the problems, but blaming a non-existent free market for a
crisis that clearly was <i>to some extent</i> the result of government's
extensive interventions in that market is
unfair. so if i have persuaded you of
nothing else, i hope deeply that i have persuaded you of that.</p>
<p>in the end, all i can ask of you
is that you continue to think this through. explaining this crisis by greed
won't get you far as greed, like
gravity, is a constant in our world. explaining it as a failure of free
markets faces the obvious truth that
these markets were far from free of government. consider that you may be
mistaken. consider that perhaps government intervention, not free markets, caused
profit-seekers
to undertake activities that harmed the economy. consider that government
intervention might have led banks and other
organizations to take on risks that they never should have. consider that
government central banks are
the only organizations capable of fueling this fire with excess credit. and
consider that various regulations might
have forced banks into bad loans and artificially pushed up home prices.
lastly, consider that private sector actors
are quite happy to support such intervention and regulation because it is
profitable. </p>
<p>those of us who support free
markets are not your enemies right now. the real problem here is the marriage
of corporate and state power. that is the corporatism we both oppose. i ask of you
only that you consider whether
such corporatism isn't the real cause of this mess and that therefore you
reconsider whether free markets are the cause and whether increased regulation
is the solution.</p>

<p>thanks for reading. </p>

<p>steve </p>
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