As always, whenever Krugman goes on a partisan political screed, truth is left behind, and his recent column is no exception. While I have no problem with his criticizing Republicans, nonetheless I actually would want for him to get his criticisms correct, especially his points that the Republican Party is dedicated to laissez-faire economics and actually cutting the size and scope of government.
Unfortunately, he decides to make essentially this set of claims:
- The financial meltdown was purely the fault of private enterprise except for one governmental error: it did not regulate enough;
- The GSEs, Freddie and Fannie, had absolutely nothing to do with the meltdown.
Start with the big question: How did we get into the mess we’re in?The only accusation he left out was that Republicans were responsible for keeping the space aliens away from us, thus nullifying our chances for economic recovery. But, let us take a look at the record, given that Krugman has made some very important claims.
The financial crisis of 2008 and its painful aftermath, which we’re still dealing with, were a huge slap in the face for free-market fundamentalists. Circa 2005, the usual suspects — conservative publications, analysts at right-wing think tanks like the American Enterprise Institute and the Cato Institute, and so on — insisted that deregulated financial markets were doing just fine, and dismissed warnings about a housing bubble as liberal whining. Then the nonexistent bubble burst, and the financial system proved dangerously fragile; only huge government bailouts prevented a total collapse.
Instead of learning from this experience, however, many on the right have chosen to rewrite history. Back then, they thought things were great, and their only complaint was that the government was getting in the way of even more mortgage lending; now they claim that government policies, somehow dictated by liberals even though the G.O.P. controlled both Congress and the White House, were promoting excessive borrowing and causing all the problems.
Every piece of this revisionist history has been refuted in detail. No, the government didn’t force banks to lend to Those People; no, Fannie Mae and Freddie Mac didn’t cause the housing bubble (they were doing relatively little lending during the peak bubble years); no, government-sponsored lenders weren’t responsible for the surge in risky mortgages (private mortgage issuers accounted for the vast majority of the riskiest loans).
But the zombie keeps shambling on — and here’s Mr. Rubio Tuesday night: “This idea — that our problems were caused by a government that was too small — it’s just not true. In fact, a major cause of our recent downturn was a housing crisis created by reckless government policies.” Yep, it’s the full zombie.
Understand that he is quietly making the larger claim: price signals mean nothing to entrepreneurs; only government regulators and agents can understand the economy and what actually is happening, and that only government, through spending, regulation, and outright ownership and control of the factors of production, can bring about prosperity.
So, let us talk about the government's role in this whole thing. First, he leaves out an important player, the Federal Reserve System, and the fact that neither Alan Greenspan nor Ben Bernanke would admit to the creation of the housing bubble and both continued with their policies of pushing down interest rates and directing funds into the housing market through their statements and actions.
Second, Krugman ignores the simple fact that government is the single largest player in the mortgage business through its policies of encouraging and funding home ownership. To claim that the only influence government had through the housing bubble was not regulating enough is yet another Krugman howler, and his claims that Freddie and Fannie were not lending during the "peak bubble years" and that government agencies did not encourage loans to "sub-prime" borrowers is the typical Krugman rewriting of history.
I'll get to Freddie and Fannie in a moment, but the notion that the banks simply came up with the idea of lending to sub-prime borrowers on their own really does defy history. Yes, it is true that the vast majority of sub-prime loans DID come from the banks, and that their attempts to securitize these loans in order to mitigate the risks were a disaster. I have no problem with this accusation against the Wall Street firms, but there is one thing that Krugman leaves out: the infamous Greenspan-Bernanke "Put."
When the financial deregulation occurred both during the Carter-Reagan years and at the end of the Clinton administration, the government did not get rid of the moral hazard that essentially guaranteed reckless behavior. Both Greenspan and Bernanke time and again promised to "create liquidity" if the banks got into trouble, and when the markets had the trillions of the Fed standing behind them, it is no wonder that they ran off the rails. Moral hazard has a way of encouraging the very actions that lenders and the entities supporting them should not be taking.
Free markets entail both profits and losses, and when the government essentially lets the banks keep their profits but then promises to socialize the losses, why are we shocked, SHOCKED when the banks do the things they did? What Krugman refuses to do is to acknowledge that the players in private enterprise really will respond to the prospect of losses when they engage in risky behavior. Instead, he simply ignores the fact that the banks knew the Fed and the taxpayers were covering their behinds and so they could be free to engage in behavior that anyone with half a brain knew could produce very bad outcomes.
I'll make another point about the crisis: the Austrians were on it long before the Keynesians and the rest of American economists jumped on the bubble bandwagon. Mark Thornton in 2004 wrote:
Signs of a "new era" in housing are everywhere. Housing construction is taking place at record rates. New records for real estate prices are being set across the country, especially on the east and west coasts. Booming home prices and record low interest rates are allowing homeowners to refinance their mortgages, "extract equity" to increase their spending, and lower their monthly payment! As one loan officer explained to me: "It's almost too good to be true."Furthermore, while the Austrians may be laissez-faire in their economic viewpoints, they hardly are fans of the banks and they certainly did not believe that the Fed and the housing bubble constituted a new era of prosperity. (For that matter, I warned the property tax appeals board in Allegany County, Maryland, in the spring of 2006 that the current housing situation was a bubble and that it would crash, and that government officials should not make future budget predictions off what we were presently seeing. They told me flat out that I was wrong.)
In fact, it is too good to be true. What the prophets of the new housing paradigm don't discuss is that real estate markets have experienced similar cycles in the past and that periods described as new paradigms are often followed by periods of distress in real estate markets, including foreclosure sales, bankruptcy and bank failures.
By leaving out the Fed's "Put" and the other quiet assurances from Congress and the Bush administration that the government had the backsides of the banks, Krugman ignores an important reason as to why the banks ignored price signals and engaged in reckless behavior. While I am sure that Krugman was taught early in in graduate school about moral hazard, his leaving out that important point more to his intellectual dishonesty than it does his lack of economic knowledge.
Freddie and Fannie
Were the GSEs actually non-players in this whole affair, as claimed by Krugman? First, if that were so, then neither entity would have gone bankrupt in 2007, since they did not have risky loans on their books. While it is true that neither GSE was responsible for the vast creation of the subprime loans and their subsequent securitization, but that did not mean they were minor players in the system at the time.
Veronique de Rugy writes:
Fannie and Freddie contributed to the housing crisis by making it easier for more people to take out loans for houses they could not afford. Beginning in 2000, Fannie and Freddie took on loans with low FICO scores, loans with low down payments, and loans with little or no documentation.In other words, the encouragement to create sub-prime housing loans came from federal policies, something that Krugman ignores. (Krugman apparently wants us to believe that the banks would suddenly create a bunch of bad loans on their own, and with the full knowledge that if they lost money, the government would not be there to force taxpayers to underwrite these bad loans.) Freddie and Fannie did play a role in creating these sub-prime securities, even if Krugman and the NYT want to ignore that fact.
The federal government’s role in the housing market goes back at least to 1938, but that role changed fundamentally in the 1990s when the government made a push to increase homeownership in the United States. At that time, the federal government pursued several policies that were meant to encourage banks to lend money to lower income earners and to give incentives to low income earners to buy houses. The result, as we now know, was a gigantic amount of subprime mortgages at a time when house prices were starting to go down.
It gets better. Far from being an almost non-existent player in the crisis, we find that the GSEs actually did have large housing portfolios during this time:
...Fannie Mae and Freddie Mac are considered government-sponsored enterprises (GSEs). Although both were, before the crisis, privately financed, the general sentiment was that in the event of a crisis in the mortgage market, the federal government would step in and back the GSEs. In other words, the government implicitly guaranteed Fannie and Freddie's securitized loans. This allowed them to borrow at interest rates below those of the financial markets and to hold much lower capital requirements than commercial and investment banks. The aggregate value of this subsidy has been estimated to range "somewhere between $119 billion and $164 billion, of which shareholders receive respectively between $50 and $97 billion. Astonishingly, the subsidy was almost equal to the market value of these two GSEs."Economist Russ Roberts also investigated and found that Freddie and Fannie were more like silent partners in the crisis, contra Krugman:
As a result, by the time the housing crisis began to unfold, Fannie and Freddie had become the dominating force in the secondary mortgage market, providing 75 percent of financing for new mortgages through securitization at the end of 2007. At the end of 2010, they still held about 50 percent of securitized, first-lien home loans.
Fannie and Freddie bought 25.2% of the record $272.81 billion in subprime MBS [mortgage-backed securities] sold in the first half of 2006, according to Inside Mortgage Finance Publications, a Bethesda, MD-based publisher that covers the home loan industry.We are not speaking of insignificant numbers. Furthermore, as de Rugy points out, Congress and the administration were not exactly non-players in setting the table for a housing crisis:
In 2005, Fannie and Freddie purchased 35.3% of all subprime MBS, the publication estimated. The year before, the two purchased almost 44% of all subprime MBS sold.
In addition, lawmakers in both parties enacted policies directed at increasing home ownership rates, resulting in lower mortgage underwriting standards for Fannie and Freddie. Roberts notes that from 2000 on, Fannie and Freddie bought loans with low FICO scores, loans with very low down payments, and loans with little or no documentation. Contrary to Paul Krugman’s assertions, Fannie and Freddie did not “fade away” or “pull back sharply” between 2004 and 2006.What Krugman would have us believe is that the government, along with its Frankenstein financial creatures, only wanted banks to make sound mortgages with the usual minimum of 20 percent down, good credit scores, and the like. That clearly is nonsense. As Thomas DiLorenzo notes, the only way that banks on their own would have made such risky loans was the fact that federal policies demanded they do so.
As the following chart from Roberts’ study shows, during that same time Government Sponsored Enterprises (GSEs) bought near-record numbers of mortgages, including an ever-growing number of mortgages with low down payments.
Moreover, as the chart below shows, while private players bought many more subprime loans than Freddie and Fannie, GSEs purchased hundreds of billions of dollars worth of subprime mortgage-backed securities (MBS) from private issuers, holding these securities as investments. (The charts are shown in the Roberts article.)
One does not need to hold the banks to be innocent bystanders to recognize the role of government policy in the financial crisis. Furthermore, while I have no problem with financial deregulation, I DO have a problem with financial deregulation that is backed by moral hazard. Deregulation was supposed to free financial entities to diversify their loan portfolios and to be able to provide liquid capital to entrepreneurs and businesses that had promising and new ventures.
Furthermore, financial deregulation did make possible the revolution in computers and telecommunications, and had we kept the regulatory system Krugman endorses in place, there would be no Apple Computers, cellphone networks, improved transportation, and IBM would still be the industry leader in the dominant mainframe computer business. Since Keynesians know nothing about entrepreneurship and even less about finance, Krugman probably is incapable of understanding how economies grow, still being stuck in the "aggregate demand" intellectual ghetto.
But financial deregulation only could have worked in the long run had the government made banks and financial houses responsible for their losses. By increasing the various government-led financial backstops as deregulation occurred, Congress almost guaranteed more reckless behavior, and no one should be surprised at what happened.
Unfortunately, these tidbits of truth are left out in Paul Krugman's own zombie version of economic history. That this rewriting of history comes on the editorial pages of the New York Times should shock no one. After all, the "Newspaper of Record" has been fabricating the "record" for a long time.
Fantastic article. So clear and to the point. Thanks for putting it out.
Excellent post as usual William.
I have yet to meet a single Austrian Economist who was surprised by the bursting of the housing bubble.
I have heard many people blame Countrywide for the housing collapse, but at the height of the bubble Fannie and Freddie held more sub prime securities than Countrywide.
That neither Krugman nor any other Keynesian has ever or will ever present a fair, honest and true account of Austrian concepts and analysis just SCREAMS the obvious fact that our analysis is quite irrefutable and must be distorted in every instance by the Keynesians. There is a reason why the basic Misean analysis from 1912 was completely omitted from "The General Theory" in 1936. Nothing has changed and nothing will change. It's all over. We've won.
Why are you acting so arrogant, Bob and why is it that in the world of people like you, the only school of economics that matters to you is Keynesianism, and you don't even bother to note the many variants of it?
Why do I pick on the Keynesians? For one thing, they have civilization by the throat.
Heck, I read the heck out of the MMTers. I'm quite open minded concerning the various sects of the Keynesian Hoax.
Just the other day, I was mocking the Post Keynesian Minsky-ites for their purposeful obliviousness.
Well couldn't you say that about the bastardized, botched neoliberalism caused much of the problems in the past 30 years? Scott Sumner loves to defend it.
Major_Freedom used to calmly and thoroughly critique Sumner daily. This provoked Sumner to give a typical anti-Austrian analysis:
Much to the dismay of many frequent visitors to that blog. It has to suck being ostracized like that.
"BTW, I’ve done at least 100 pages of text in reply to MF comments. So you are wrong about that as well. I find that dogmatic ideologues like you and MF are wrong about just about everything. Which is why no one cares what you think." -
BTW, I’ve done at least 100 pages of text in reply to MF comments.
I note you provided no link. Where are those comments? My recollection was that Sumner meticulously and purposefully ignored MF while responding to almost every other commenter.
Did Sumner leave short replies like this?
The moral hazard has one of its root causes in the FDIC (the other of course having a printing press at your disposal). Like all Federal insurance programs, it forces the government's hand, as it is cheaper to bail out a bank than to let it fail and pick up the tab for depositor losses. When they deregulated the banks (Glass Steagall etc.), they should have also eliminated the FDIC. I wonder how many depositors BofA would have if there was no FDIC...
Any historic mention of Fannie Mae and Freddie Mac in relation to economic crisis should rightly also discuss Ginnie Mae (GNMA) because this is necessary to complete the picture.
Ginnie Mae systematically manipulated the pricing of risk, and in doing so transferred the danger of mortgage default away from the banks and onto the shoulders of the taxpayer. Worse, Ginnie Mae created a centralised assessment of risk, which replaced the diverse individual assessment that would normally operate in a free economy.
I believe this is one of the reasons why the government was obliged to bail out the banks, and also why the Fed is pumping up MBS prices by buying with printed money. If the banks were to feel under real pressure they would do the logical thing and pull in massive claims against their Ginnie Mae insurance policies.
The moral hazard has one of its root causes in the FDIC.
Yes, and go one step further because government has no real ability to backstop any sort of insurance at all. The only thing government can do is transfer the burden from the failed entity onto other non-failed entities. Any time you see government pretending to act as backstop on some sort on insurance scheme, it is a fake, and sooner or later the bluff will be called.
Thanks for the article. I have been looking for someone to help reconcile the findings from the analysis done by Avery & Brevoort (link below), where they conclude that CRA or the GSE goals played a significant role in the subprime crisis. From the logical chain of events (and having looked at many other unintended consequences of "affordable" anything policeis), I am struggling with their research. Can you please comment on their findings? Thanks!
Sorry, a typo -- their conclusion was that CRA or GSE goals "did not" play a significant role in the crisis.
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