It seems clear that the economy is in a serious slowdown, if not a recession. The employment situation is shaky, real GDP fell slightly during the last quarter, and estimates of consumer confidence show it is declining. Much of this negative news flows from the problems in the housing, mortgage, and financial markets. Everyday commerce relies on well-functioning financial markets, so problems there can easily be transmitted elsewhere. Thus, a good resolution to these issues seems critical to revive the economy.
The key question is how do we best address these troubles. Some strongly suggest more government involvement, and indeed this has already happened. Through the Targeted Assets Relief Program (TARP), the federal government is purchasing poorly performing assets from financial institutions while the Capital Purchase Program (CPP) has enabled direct U.S. Treasury purchases of stock in these institutions. Furthermore, increased government regulation of capital markets and financial firms is increasingly called for, accompanied by the allegation that deregulation accounts for a sizable share of the present mess.
An alternative view is almost the opposite: that government meddling is an important cause of the current troubles and that a strong embrace of capitalism is needed to lead a recovery and promote future economic growth. This view holds that regulation is desired only if it can increase the amount of information available to borrowers and investors and improve transparency in transactions, making it easier for parties to come to mutually agreeable terms. Perhaps this point of view sounds like heresy, but to gain an understanding of it, it is worthwhile to review some important events leading up to the current situation.
The proximate cause, of course, is a high volume of bad mortgage loans. In the early 2000s, there was a strong upsurge in the amount of subprime and Alt-A mortgage contracts. Many were written for those who would not normally qualify: the borrower had a poor credit history, income was undocumented, there was little or no down payment, and payments were initially interest only but with a large, subsequent balloon payment.
A large share of these mortgages were sold and packaged into mortgage-backed securities and
resold to financial institutions throug-
hout the economy. The underlying mortgage loans relied on ever rising housing prices in order that they be repaid. Thus, they were high risk, though this risk was trivialized at the time. But when housing price increases did not materialize, defaults began occurring in large numbers and the roof caved in on many financial assets.
If that was the whole story, it would seem like a problem wholly in the private sector. But we need to look just a little further. Mortgage giants Fannie Mae and Freddie Mac were a major force behind the growth of subprime mortgages. These two institutions, which account for an over 50% market share in secondary mortgages, are "government-sponsored entities," enabling them to raise funds at favored rates and maintain their dominate market share. In exchange for their preferred status, it became clear that Congress expected Fannie and Freddie to help promote a political goal: aiding "affordable housing." Fannie and Freddie did so with alacrity. In the early-2000s, they devoted increasing funds to acquiring and insuring subprime mortgages, while lowering the standards of the type of mortgages they accepted. In addition, there was pressure on private-sector lenders to consider "flexible underwriting standards" that would enable many previously unqualified borrowers to obtain a mortgage. But flexible standards were, for the most part, a euphemism for lower standards. Though private institutions were already engaged in this type of lending, the aid and encouragement of the federal government induced private lenders to unwisely intensify subprime lending.
Thus, to serve a political goal, we have both public and private sector institutions engaging in high risk, imprudent lending activity by pushing mortgage loans where they really shouldn't have gone. This politicization of investment activity, which brought much of the current crisis on us, is endemic to heavy government influence in financial institutions and markets. And yet those who advocate more government involvement and regulation are essentially giving more power to those who played such a big hand in causing the present situation.
One can hope that TARP and CPP are short term enough that we don't go down this path, but some uncomfortable signs have emerged. Congress is already complaining that those receiving funds are not using them as the former would like1. The Office of the Comptroller of the Currency seems to be dictating firm merger activity, with the latest example being the funding of PNC contingent on its purchase of National City Corporation. It seems that the government is now picking which banks will succeed and which will fail, which in turn means the government officials are deciding which set of investors will make money and which will lose money. And there is talk of expanding government stock purchases into insurers, broker-dealers, and auto makers2.
In order for an economy to grow, its investments must be directed into value-creating activities. Politicization of investment distorts funding toward activities that look good politically but don't necessarily create goods and services of value. To facilitate a robust recovery of the economy, we simply can't go down this path. But I don't have much confidence that our present government will resist the temptation to do so. Based on recent approval ratings of Congress, I doubt the body politic does either.
That leaves us with the alternative of de-politicizing markets by relying on the private sector, with only regulation that improves information flows, promotes transparency, prevents fraud, and encourages honest evaluation of risk. This is not a bad alternative, by the way. This is the manner by which most of the wealth we have today was built. Let's let it work as it is intended to. At this juncture, this means firms dealing with bad debt on their books, either by re-negotiation, reorganization, or mergers, then moving onto to identifying and funding value-creating investments, and not being induced to undertake politically correct misadventures.
1. See, for example, "Lawmakers Want String Attached," Wall Street Journal, October 31, 2008, p. A4.
2. "U.S. Mulls Widening of Bailout to Insurers," Wall Street Journal, October 25, 2008, p. A1.
John Garen is Department Chair and Gatton Endowed Professor of Economics, University of Kentucky.