Monday, September 8, 2008

Don't say we didn't warn you...The Frannie Edition

Matt Ygelesias writes:

A broad ideological point while I continue to try to figure out what’s actually going on with the government’s re-acquisition of the GSEs — they say there are no atheists in foxholes, and by the same token there are no free marketeers in a financial crisis. Which reminds us that while we (mostly) use market mechanisms to set the prices of (most) stuff and do so for the very good reason that this encourages people to produce goods and services people want in appropriate quantities, that market activity doesn’t add up to anything like the “free market economy” of popular myth. Market transactions take place within a legal and institutional framework that involves many public choices at many points, choices that can (and are) made in different ways at different times and with different beneficiaries. We mostly don’t notice this stuff either because it operates silently in the background (copyright and patent law, say) or else because the changes tend to be small at any given point (Fed interest rate shifts) but when crisis strikes it leaps into the foreground.

And there’s nothing wrong with that, in principle. Faced with something like the Bear Stearns meltdown, it would be absurd for public officials to step aside and just “let things play out” irrespective of the damage done to the economy merely in order to bring practice into closer alignment with free market rhetoric. But by the same token, an obligation exists to make sure not just that the economy “works” instead of collapsing, or works just for the richest and best connected, but rather works for everyone who’s willing to work hard and contribute constructively to society insofar as he or she is able. At various points in the past, the economy has worked like that. In recent years it has not. We need to make it work like that again. Whether or not the current tendency of the rewards of economic growth to accrue almost exclusively to a small minority is the result of some kind of malfeasance is not, at the end of the day, really relevant. Insofar as it’s the result of shifting structural factors, the correct response is to use public policy to create counter-structures that will rebalance the situation...

Yglesias weak criticisms of advocates of capitalism notwithstanding(1), he boldy suggests that there are no free marketers in a financial crisis. Does the situation with Fannie Mae and Freddie Mac (collectively "Frannie") prove him correct? I would say that the answer to that question is a resounding "No".

Frannie are government sponsored entities that enjoyed competitive advantages that were brought about not through natural market mechanisms but from government: 1) the expectation that the GSE debt was guaranteed by the federal government meant that risk premiums were low and the entities had a lower cost of borrowing compared to other financial insitutions (and a $2.5 billion line of credit from the US Treasury doesn't hurt), and 2) the capital requirements were as a percentage of total assets is less than other financial institutions. Also, common with government programs, Frannie took on a life of their own, greatly deviating from their original purpose of trying to fill gaps in the mortgage markets, mainly with providing affordable loans. Frannie, from these origins, evolved into dominant players in mortgage finance market, holding nearly half of the mortgages in the U.S. Because of the turmoil in the mortgage markets, Frannie, entities that were the creation of the government, evolved into the entities they are today because of the government, enjoyed special anti-competitive privileges because of the government, are coming under the control of the government to prevent an economic catastrophy. In the words of The Cato Institute's Ed Crane, "this is a government failure, pure and simple."

In the face of this abject failure of government, Yglesias boldy makes a case for more government, suggesting that it is appropriate public policy to create counter-balances to mitigate perceived inequalities so that everyone benefits (read: engage in Kip's Law). Does he not realize that Frannie were intended as these sort of "counter-balances" he describes? Does his apparent enjoyment of dismissing supporters of capitalism for engaging in mythological fantasy blind him to the fact that Frannie makes for a great case study for capitalists and opponents of limited government like me to look to those who look to government to create a society in their own image and say "Don't say we didn't warn you..."? Sadly, Yglesias' entire ideological argument either 1) grossly misdiagnoses the problem, or, worse, 2) ignores it because, again, none of this has anything to do with a market failure.

While I am not a fan of government interventionism, I think the federal government's actions in this case were necessary in the short-term (the least worst alternative). I think allowing Frannie to fail (and I think they would have failed had the government not intervened) would have been disastrous (Tyler Cowen lists some reasons why and Paul Krugman's column on deleveraging is a helpful read in this context as well). I don't think I am necessarily violating my own free market principles if 1) I believe, in the big picture, the problem is not the bailout per se but the fact that we reached this point in the first place, and 2) to the extent that the takeover provides an opportunity to eliminate any and all special privileges and reduce the portfolio holdings in order to spread the risk out amongst various market participants and get the government out of this business as opposed to having quasi-public/private entities lingering around so that we get bit in the ass later, I'm all for it.

So, yes, I will gladly trumpet my support for free markets in the face of the Frannie (and frankly, the credit crisis in general) because Frannie was a government-caused abomination and markets had nothing to do with it. So-called "Progressives", it seems would rather continue to do battle with windmills and focus their ire towards the things that did not cause this problem while ignoring the things that actually did. None of this surprises me.


(1) Perhaps it's a personal bias, but I tend to debate liberals who associate "free market" with "unregulated market" absent, as Yglesias puts it, any sort of institutional or legal framework. With the exception of perhaps the libertarians of the more anarcho-capitalist variety, the libertarians I know do not share this view. We accept certain forms of regulations; therefore, the debate is not between something like "no regulations vs. regulations". Rather, the debate involves to what extent markets should be regulated. Here, libertarians (small l) and liberals hold widely divergent views.

I would love to know what free market of "popular myth" Yglesias speaks of, but he, not surprisingly, given his target audience, fails to define it. Also, I fail to see how my wanting to buy cereal at my local grocery store and the local grocery store wanting to sell it to me involves "public" choices and need to involve any beneficiaries outside of those involved in the transaction.

Anecdotally speaking, if Yglesias wants to think that regulations are the sorts of things we don't notice, I suggest he take a job at a Wall Street firm where he will get to know the people in the legal department and compliance very, very well, even if you never cause one bit of trouble for them. Just saying...