Archived: Government Failure Has Made a Mess

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To hear the media pundits and presidential candidates tell it, you’d think Adam Smith has been president for the last eight years and, with a Congress full of free-market advocates, had enacted an agenda of full-blown laissez-faire.

Had that been the case, we would not be in the mess we are in economically. Alas, it has not been the case.

Politicians have an obvious interest in portraying the financial meltdown as the result of a government hands-off policy. They can’t very well advocate government controls if government controls are responsible for the debacle we’re now living through. The pundits just don’t understand economics.

But believe it or not, the problems in the financial and housing industries are not a market failure. They are a government failure.

The U.S. government has heavily regulated the financial sector since the 1930s. Yes, some regulations have been tweaked over the years. In 1999 — under Bill Clinton — the New Deal’s Glass-Steagall Act, which had separated investment and commercial banking, was repealed. But it is important to realize that these regulatory changes were in response to specific problems caused the regulations themselves. Separating commercial and investment banking was an arbitrary and artificial decision by government officials, and this action prevented banks from having the flexibility to better serve their customers in a competitive global economy. They were not part of any laissez-faire program, unless President Clinton was really a secret free-market advocate.

There was no general deregulation. Why do the pundits think differently? Because they are blinded by words.

The Bush administration and Republicans talk about the costs of business regulation. But that is not the same as repealing regulations. As economist Tyler Cowen writes in the New York Times, there has been “continuing heavy regulation, with a growing loss of accountability and effectiveness…. When it comes to financial regulation, for example, until the crisis of the last few months, the administration did little to alter a regulatory structure that was built over many decades. Banks continue to be governed by a hodgepodge of rules and agencies including the Office of the Comptroller of the Currency, the international Basel accords on capital standards, state authorities, the Federal Reserve and the Federal Deposit Insurance Corporation. Publicly traded banks, like other corporations, are subject to the Sarbanes-Oxley Act.”

Moreover, as Cowen points out, it has been long-standing government policy to make it easier for non-creditworthy people to get mortgages: “legislation that has been on the books for years — like the Home Mortgage Disclosure Act and the Community Reinvestment Act — helped to encourage the proliferation of high-risk mortgage loans.” In fact, banks could be penalized for appearing to avoid lending money to people with poor prospects for repayment. The passionate advocates of this social-welfare policy now call such bank conduct “predatory lending.”

Even if the Bush administration had ended all oversight of the banking industry, the government would still not be off the hook for the current difficulties. That is because for many years it has intervened in the mortgage and financial markets not by regulating in the traditional sense, but rather by implicitly promising to protect lending and underwriting institutions from their own folly. Most egregious of all has been the understanding that Fannie Mae and Freddie Mac — two government-sponsored enterprises — would not be permitted to go bankrupt. These organizations, both created and subsidized by government, gave us the subprime mess by buying mortgages from banks, bundling them into securities, and then selling the securities to investors — with an explicit guarantee that the income would keep flowing even if the homeowners stopped paying their mortgages. That system nearly assured that banks would lend promiscuously. What did they have to lose? Ultimately, the taxpayers would bail them out.

The result is what we today call the “subprime mortgage crisis.”

Make no mistake: the government, not the free market, created this fiasco. The solution, therefore, is not more government, but the end of all regulations and business privileges.

Sheldon Richman is senior fellow at The Future of Freedom Foundation, author of Tethered Citizens: Time to Repeal the Welfare State, and editor of The Freeman /www.fee.org/publications/the-freeman/  magazine.

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