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