Scapegoating Regulation

Many progressives now believe the age of Milton Friedman may be drawing to a close. Their hope is the current financial crisis has shown the costs and dangers of inadequate market regulation, thereby discrediting the anti- regulation philosophy of Milton Friedman and his Chicago School colleagues.

Evidence of the changing times is supposedly provided by Treasury Secretary Paulson’s and Federal Reserve Chairman Bernanke’s public admissions about the need for regulatory change.

Yet the reality is far more complex, and economic conservatives will not roll-over and surrender just because of a financial crisis. Instead, if history is a guide, they will blame regulation for the crisis. That was Milton Friedman’s modus operandi when he launched the modern era of deregulation and animus to government with his false claim that the Fed caused the Great Depression.

This tried and tested conservative tactic is already surfacing in the debate surrounding Fannie Mae and Freddie Mac, the giant mortgage financing companies. The conservative argument is government’s provision of an implicit guarantee to Fannie and Freddie distorted the market by giving them subsidized finance. The implication is that this enabled them to pump up the housing bubble, while simultaneously making them the dominant players in the securitized mortgage market.

This conservative tactic scapegoats Fannie and Freddie, making them the fall guys for the bubble’s financial excesses, when the true cause was inadequate regulation of mortgage lending and failed macroeconomic policy.

The insinuation that Fannie and Freddie were primary movers of the housing market excesses of 2004 – 2006 lacks even superficial merit. This is because since 2003 both Fannie and Freddie have had limited asset growth, and Fannie’s assets actually fell significantly after 2003.

Moreover, the roots of the crisis lie in the sub-prime market. That is where “no doc” and “zero down” mortgages proliferated, where loan originations exploded in volume, where losses started, and where the bulk of losses have been so far. Yet, Fannie and Freddie are prevented from financing such mortgage products by their charters.

These facts should make clear that Fannie and Freddie did not cause the crisis. Instead, it was driven by loose and negligent lending by banks and Wall Street. That behavior was due to lack of regulatory oversight, combined with a failed incentive system that rewards management and mortgage brokers for pushing loans rather than prudent lending.

Such loan pushing was even promoted by conservative animus to Fannie and Freddie, as Wall Street was encouraged to muscle in on the formers’ business. That is why the Bush administration sought regulatory limits on Fannie and Freddie’s asset holdings. However, unlike Fannie and Freddie, Wall Street has no legal restrictions on loan quality and opted for gorging on sub-prime.

The bubble’s origins lie in the combination of a flawed economic growth paradigm that prompted the Fed to push interest rates too low for too long, plus loose lending by banks and Wall Street. This combination inflicted a huge negative “pecuniary externality” on Fannie and Freddie, driving up house prices in the normally sound mortgage markets they serve. Consequently, they too have been battered by the bubble’s implosion.

The bottom line is Fannie and Freddie had little to do with the bubble. That said conservatives raise a legitimate question of how to organize the securitized mortgage market.

Fannie and Freddie’s implicit government guarantee has helped them lower the cost of mortgage finance, making home ownership more affordable to millions. In effect, the guarantee has made government’s lower borrowing cost available to the public, which is good. The downside is it has made Fannie and Freddie overwhelmingly dominant in the securitized mortgage market.

This suggests that in addition to tighter mortgage lending regulation, there is a case for nationalizing Fannie and Freddie on grounds that they are natural monopolies. That is the very opposite of conservative arguments opposing need for tighter regulation and proposing disbanding Fannie and Freddie. That would leave Wall Street unreformed, and make home ownership more expensive by removing the assist provided by access to government’s lower borrowing cost.

Copyright Thomas I. Palley

6 Responses to “Scapegoating Regulation”

  1. Tom Lindmark Says:

    Good article. I would quibble with the assertion that Fannie and Freddie lowered the cost of a mortgage by any appreciable amount. The evidence seems to indicate that the shareholders and management captured the benefit.

  2. Howard Richman Says:


    When you wrote that the housing bubble was caused by the Federal Reserve and loose regulation, you left out President Clinton’s elimination 1997 tax changes for homeowners. In fact we cite you pointing out that the housing bubble started at about the same time in our commentary today in today’s Enter Stage Right:

    And check out our graph which shows that corporate stock buybacks started increasing the same year that Bush lowered the capital gains tax rate from 20% to 15%. These capital gains tax cuts are killing our economy!

    I hope you agree that we have an original analysis of where the Flat Tax advocates are wrong on Capital Gains taxes. We wrote:

    “Flat Tax advocates are a curious combination of economic insight and economic blindness. They are insightful when they claim that the capital gains tax normally double-taxes income, but are blind to the fact that only taxation of reinvested capital does so. They correctly understand that accrued capital gains represent increased future income, but they are blind to the fact that the future income is being consumed if the capital and its gain are consumed. Instead of recommending, as we do, that capital gains be taxed at the same rate as other income when capital is consumed but go untaxed when the capital is reinvested, they recommend that capital gains be untaxed in every situation, a recommendation that encourages the consumption of capital.”

    And you also might like our point that President Truman got it right in 1951 when we wrote:

    “But it is also possible to incrementally improve the current income tax system. In 1951, President Truman improved the income tax for homeowners by giving them a tax deferment when they bought one home with the proceeds from selling another. Truman’s idea could easily be applied to income producing assets (e.g., stocks, bonds, and rental properties).”


  3. Cathy Says:

    The Milton Friedman style is disaster captalism. Make a lot of money,
    destroy then rebuild. To deregulate an industry that does nothing to
    regulate itself is sheer folly.
    Why not put the housing and the mortgage industry under strict
    government control. The government owns all housing which it sells
    to qualified buyers at low prices. Mortgage rates are low enough to
    keep people from defaulting and they pay off within a twenty-five
    year maximum. And the rates don’t change from city to city or state
    to state. Then people would not fear transfers or just the idea of
    moving for a better job. Oh yea, government isn’t supposed to control
    anything, forgot for a moment.

  4. Mark Novitsky Says:

    It would seem that the problem is not regulatory- It’s the enforcement of the rules already in place! (A selective “Temporary Ban” on short selling that is already illegal?) But can the SEC be trusted? I was liigally sued by my former employer…a substantial international Tech/TelComm Svs Holdings company…with a pattern of Get-Out-Of-Jail-Free Cards. The SEC seemed to protect this corporate criminal and was unwilling to detail how I received 2 very different responses to the very same FOIA request on the same day. After asking them how this happened a month later I received a completely different response w/o any explanation. Last week the company execs walked away unscathed from a back-dated options investigation that concluded 3,021 out of 4,886 had incorrect dates. The shareholders paid about $20M for the investigation and took over a $60M charge. Despite Sarbanes-Oxley…. SOX is a joke keeping only honest people honest offering only the illusion of regulatory oversight. Is that what we’ll get? SOX II? More Foxes guarding the henhouse??? - WHISTLEBLOWERS SAVE YOUR BREATH…nobody will help you.

  5. Says:

    Scapegoating Regulation…

    Economic conservatives will not roll-over and surrender just because of a financial crisis. Instead, if history is a guide, they will blame regulation for the crisis. That was Milton Friedman’s modus operandi when he launched the modern era of deregul…

  6. Where Do We Go From Here? « The Everyday Economist Says:

    [...] friend Thomas Palley posted an op-ed on his page about a month ago anticipating the “scapegoating” of regulation: [...]