Wednesday, October 8, 2008

How we got here, and who’s to blame

With increased pressure on the world financial system, governments all over the world are nationalizing banking and credit, and calling for more regulation and government interference. World leaders are blaming the free market for the economic crisis, with French President Nicolas Sarkozy saying,

"The present crisis must incite us to refound capitalism on the basis of ethics and work … Self- regulation as a way of solving all problems is finished. Laissez-faire is finished. The all- powerful market that always knows best is finished," (full story -

and British Prime Minister Gordon Brown blaming, “conventional thinking or outdated dogma,” and calling for, “the fresh and innovative [federal] intervention that gets to the heart of the problem.” (clarification added, full story -,2933,434284,00.html)

Of course, none of this gets to the heart of the problem. Blaming free-market capitalism fails to recognize that much of the current financial crisis is the direct result of government intervention in the lending industry. The lending giants Fannie Mae and Freddie Mac, both created by the federal government, (Fannie Mae as part of Delano Roosevelt's 'New Deal,' and Freddie Mac by congress in 1968 as a Government Sponsored Enterprise), are at the heart of the current lending crisis. These agencies were created for the express purposes of fixing what the government saw as a current crisis in the mortgage industry at the time. Fannie Mae was to provide liquidity in the mortgage industry by buying mortgages from banks and then converting them to guaranteed mortgage backed securities and reselling them. That means that whoever buys the mortgage on the secondary market has a guarantee from these firms that if the original borrower fails to repay, Fannie or Freddie will cover the loss.

Sound familiar? Economic crisis, need for liquidity, government interference in credit industry, loans backed by government sponsored enterprises? Any of this sound topical today? Doesn't this sound a lot like what the government is doing right now to “rescue” us from the current crisis?

One of the problems with these companies which has brought us to this collapse, is that they were buying bad loans. That was the entire reason for their creation. The reason they were needed to “inject liquidity” into the markets is because banks were holding a lot of unpaid debt because the economy was struggling and people were failing to repay their loans. By buying this debt off of these banks, they freed up capital within the banking system which could then be used to give more loans. Then, in 1995 the federal government began encouraging them to buy up sub-prime, (read riskiest possible type of secured debt), buy giving them financial incentives. Then in 1999 the Clinton administration encouraged them to increase lending to people of low income or poor credit. For a brief period of time, new regulations discouraged these kinds of loans, but the federal government again encouraged them by changing the regulations back in 2004 in order to increase credit to high risk borrowers, (full story -

Think about it. High risk borrowers. There's a reason they are high risk. There's a reason it's harder for them to get credit. Sarkozy wants to blame the “laissez-faire market” and Brown wants to blame “outdated dogma,” but in reality, the market wouldn't lend money to these people. It was the federal government which encouraged high risk lending. It was the federal government which created the lending giants, during another economic crisis, which are responsible in part for the mess we're in now.

When confronted with tough economic times, companies, like individuals, need to be more careful where they allocate their financial resources, not less. Yet each time, the government steps in and discourages conservative business decisions by removing the bad assets, funneling public funding to these companies, and transferring the burden of these bad decisions from the original actor to the public debt. In each case, this frees up money in the banking system which the government then encourages them to spend on high risk ventures in order to 'jump start' a sluggish economy.

If they simply allowed these businesses to fail, many would suffer. But in the long run, smarter lending practices would lead to more judicious and productive allocation of capital in the market place. Businesses would only get loans if they offered a product or service that could prove financially viable. Home owners would have to work to build savings in order to purchase homes they could invest in. Fewer banks would have fewer unpaid and unsecured debt listed as assets on their books, and there wouldn't be a credit crisis. Instead we are again faced with a huge government bailout. These are occurring closer and closer together, and the cost is increasingly exponentially each time. It is the intervention of governments which is at the heart of the problem, and as history shows us, it is hardly innovative or fresh.

Laissez-faire indeed. If only they would “allow to do.”

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