A friend recently showed me this excerpt from the book 13 Bankers by Johnathan Kwak and Simon Johnson, saying it pertained to libertarianism and the 2008 financial crisis. The authors argue the crisis was caused by a combination of greed and deregulation, made possible by free market ideology. Specifically, they posit that Wall Street power brokers used the mantra of economic freedom to pressure politicians into deregulating securities markets, thus removing or preventing safeguards which could have prevented the crash, so that traders and firms could make massive profits taking irresponsible gambles that eventually lost. The insinuation is that we must strengthen government regulation of the financial sector – and really capitalism in general – to prevent another crash in the future.
In other words, the book is an academic articulation of the predominant media narrative in the immediate aftermath of the crash. It also echoes the majority finding from the subsequent congressional inquiry into the cause of the crisis.
I find this explanation simplistic, exaggerated, politicized, and misleading. The truth is more complicated, but offers more nuance regarding which policies and ideologies are truly to blame for what went down.
The mainstream explanation is pervasive because it comports with widely held stereotypes about the sort of person who generally works on Wall Street. Indeed, the chapter of 13 Bankers my friend shared with me is titled “Greed is Good,” a clear reference to the Gordon Gecko caricature of a Wall Street investor that the left loves to imagine. Perhaps the best response to this instinct to blame “greed” came from Steve Horowitz, who wrote an open letter to the left in the wake of the 08 crash:
“[the] effects of the profit motive that you decry depend upon the incentives that institutions, regulations, and policies create…Greed is always a feature of human interaction. It always has been. Why, all of a sudden, has greed produced so much harm? And why only in one sector of the economy? After all, isn't there plenty of greed elsewhere? Firms are indeed profit seekers. And they will seek after profit where the institutional incentives are such that profit is available.”
Many of you have rightly criticized the ethanol mandate, which made it profitable for corn growers to switch from growing corn for food to corn for fuel, leading to higher food prices worldwide. What's interesting is that you rightly blamed the policy and did not blame greed and the profit motive! The current financial mess is precisely analogous.
No free market economist thinks "greed is always good." What we think is good are institutions that play to the self-interest of private actors by rewarding them for serving the public, not just themselves. We believe that's what genuinely free markets do. Market exchanges are mutually beneficial. When the law messes up by either poorly defining the rules of the game or trying to override them through regulation, self-interested behavior is no longer economically mutually beneficial. The private sector then profits by serving narrow political ends rather than serving the public. In such cases, greed leads to bad consequences. But it's bad not because it's greed/self-interest rather because the institutional context within which it operates channels self-interest in socially unproductive ways.”
Of course private firms, bankers and investors will pursue profit – they’ve never done otherwise. But how is it that gambling on the subprime mortgage market was so much more profitable than other investments these people could have put their money into? The simple answer is that the government made it so, with a series of well-intentioned but ill-advised policies designed to increase home ownership.
Here’s a list of ways the government intervened in the housing market to make subprime lending profitable and abundant, thereby shaping the institutional incentives Wall Street was operating within:
1. The creation of Fannie Mae and Freddie Mac. These “government sponsored enterprises” were chartered in the late 1960’s with the explicit purpose of making credit easier to obtain for would-be homeowners. They were never truly privatized, and in fact operated under fierce political pressure to lend liberally to the subprime market.
The very author of the post-crash Dodd-Frank regulations – Senator Barney Frank of Massachusetts – was one of the guiltiest nudges in that direction. As late as 2009, when nearly everyone else could see the writing on the wall, Frank was still writing letters demanding that Fannie and Freddie further reduce loan-qualifying standards for condo buyers.
Fannie and Freddie also operated on the implicit promise that they would be bailed out were they ever to fail (which of course they were), enabling them take risks no private firm could take without danger or personal loss. And in the early 1990s, Congress eased their lending requirements to 1/4th the capital required by regular commercial banks so as to increase their ability to lend to poor areas.
Their mission was very clearly to help the poor get homes, which skewed the risk/reward analysis of lending decisions in favor of more risk.
2. The Federal Home Loan Banks. These 11 banks were created way back under Herbert Hoover, but served the same purpose as Fannie and Freddie on a more local level. At the time of the crash in 2008, there were 28 million “Alt-A” mortgages (code for subprime, weak, or risky loans – the sort which caused the crisis) in the housing market. Of that 28 million, 20.4 million were held by government or quasi-government agencies like Fannie Mae, Freddie Mac, and the FHLBs. ¾ of the problem was directly caused by government.
3. The Community Reinvestment Act. Passed in 1977, this law requires banks to make a certain percentage of their loans within their local communities, especially when those communities are economically disadvantaged. Horowitz explains how created “enormous profit and political incentives for banks and Fannie and Freddie to lend more to riskier low-income borrowers.” In fact, the Clinton administration recognized this risk when the CRA was renewed in 1994, and did it anyway.
4. The Federal Deposit Insurance Corporation. This government created organization insures banks against failure, which incentivizes them to take more risk in general (not just in the housing industry.)
5. The Federal Reserve. The “Greenspan Put” was the policy from 1987-2000 of lowering interest rates to fuel money into securities markets. An artificially liquid money supply fuels inflation, which over the long term makes loans easier to pay off, which in turn makes banks more willing to give them out.
6. Tax deductions for home ownership and mortgage interest. These give people more incentive to buy houses (and therefore to take out loans they wouldn’t otherwise take out) and also drive up the price of houses (which makes lenders more likely to lend).
7. Local land use regulations. Not all government intervention happens at the national level, and studies show the housing bubble grew quicker in areas with stricter land use regulations. The reason why is sort of complicated, but it has to do with the myth that home prices could only ever keep rising, and the role that played in the housing market’s
The most direct cause of the crash was people being unable to pay back their loans. One of the most pervasive ideas which caused lenders and traders to not worry about the possibility that these people would be unable to repay their loans was the idea that housing prices would keep rising. The idea was that even if borrowers could not pay back their loans, and consequently had to foreclose on the house, the bank could just re-sell the house and recoup their losses, SO LONG as housing prices kept rising.
Why was it people believed housing prices would keep rising? Well, one of the things which inflated home prices and fueled the housing bubble was restricted supply of land. Horowitz explains:
“the rise in prices affected most strongly cities with stricter land-use regulations, which also explains the fact that not every city was affected to the same degree by the rising home values. These regulations prevented certain kinds of land from being used for homes, pushing the rising demand for housing (fueled by the considerations above) into a slowly responding supply of land. The result was rapidly rising prices. In those areas with less stringent land-use regulations, the housing price boom's effect was much smaller. Again, it was regulation, not free markets, that drove the search for profits and was a key contributor to the rising home prices that fueled the lending spree.”
To step back from this enormously tangled body of laws and government agencies and describe what you see as a “free market” belies a complete misunderstanding of what that term means. At best, the US has a mixed economy, wherein some sectors are more regulated than others. Silicon Valley is relatively unregulated, whereas healthcare and financial securities are among the most regulated.
The pro-regulation crowd that enacted these policies and created these organizations never foresaw the unintended consequences that caused the crash – but many libertarians did. Ron Paul famously predicted all of it in a 2003 speech to Congress. So did The Economist. So did Thomas Sowell, who had an “I hate to say I told you so” column when the crisis erupted in 2008:
“Our current economic meltdown results from the federal government, under both Democrats and Republicans, declaring home ownership to be a "good thing" and treating the percentage of families who own their own home as if it was some sort of magic number that had to be kept growing-- without regard to the repercussions on other things.
We are now living with those repercussions, which include the worst unemployment in decades. That is the price we are paying for increasing home ownership from 64 percent to 69 percent.
How did we get home ownership to 15 million unemployed Americans? By ignoring the fact that there was a reason why only 64 percent of families owned their own home. More people would have liked to be home owners but did not qualify under mortgage lending standards that had been in place for decades.
Politicians to the rescue: Federal regulatory agencies leaned on banks to lend to people they were not lending to before-- or else. The "or else" included not having their business decisions approved by the regulators, which could cost them more money than making risky loans.
Mortgage lending standards were lowered, in order to raise the magic number of home ownership. But, with lower lending standards, there were-- surprise!-- more mortgage payment delinquencies, defaults and foreclosures.”
Another libertarian who predicted the crash (and was famous for confronting Occupy Wall Street protestors in its aftermath) was Peter Schiff, who wrote a book in 2007 called “Crash Proof: How to Profit from the Coming Economic Collapse.” In the aftermath of his predictions proving correct, he made a good 2-3 minute summary of the misconception that the “free market” caused the crash:
“Unfortunately all the blame is on the free market. All the blame is on capitalism. It’s because there wasn’t enough regulation. There was too much greed. Right?…President Bush, in one of his speeches, said that Wall Street got drunk. And he was right, they were drunk….But what he doesn’t point out is, where’d they get the alcohol? Why were they drunk?...
We’ve always had greedy people. Everybody’s a bit greedy, not just Wall Street. But all of a sudden everybody was greedy all at the same time? Can’t they understand there’s a trigger for this, there’s a reason that everybody acted this way?
Normally, when people are greedy, they’re also fearful of loss, and people’s fear of loss overcomes their greed and checks their behavior. But what the government did, repeatedly, was try to remove the fear – they tried to make speculating as riskless as possible.
First, they provided us with almost costless money with which to speculate. And then they created the idea of the Greenspan Put. But whenever there’s a problem, don’t worry, the government is going to rescue you. The government’s not going to let the stock market go down. The government’s not going to let your bets go bad, so go ahead and keep placing them. That was the idea, that was the mentality. It was nothing that the free market did.”
What do Kwak and Johnson say about this? They seem to be aware of the connection between policy and subprime lending, but oddly attempt to reverse the cause and effect such that it fits in with their narrative that Wall Street was the origin of the trouble.
At the top of page 110, they write “[The idea that homeownership is intrinsically good] may have its roots in various government programs.” Later on, they specify:
“The Clinton administration had made an expansion of homeownership a central part of its economic strategy; in 1995, Clinton set a goal of a 67.5 percent homeownership rate at a time when the actual rate was 65 percent (it would peak the next decade at 69 percent). In order to help meet this goal, the Department of Housing and Urban Development mandated that Fannie Mae and Freddie Mac—the giant government-sponsored enterprises that provided funding for the mortgage market—had to devote 42 percent of their money to loans to low- and moderate-income households. That target was increased to 50 percent in 2000 and then to 56 percent in 2004…George W. Bush not only continued his predecessor's support for increased homeownership but even made the "ownership society" a centerpiece of his political message.”
After pointing this out, the authors concede that “Subprime lending had been around for decades, but only recently became a major source of money to buy houses, as opposed to refinancing them.” But why did that recently become? If they are to be believed, it was just because Wall Street suddenly figured they could make a bunch of money on it. It wasn’t that government made it uniquely profitable to do it, with all the policies they themselves described, but that “Wall Street co-opted this ideology to justify the central place of modern finance in the economic and political system.” I mean, sure – people will gobble up anything that validates their importance. But who was feeding it to them? Where did this ideology come from?
On page 111 the authors describe how Wall Street was able to “ensure the political success” of mortgage backed securities by linking it in with increases in home ownership. They lament how “the story stuck,”- as if it all started with some insidious scheme to bamboozle oblivious politicians into lining their pocket books!
It was the other way around. The urge to increase home ownership did not naturally sprout from the minds of Wall Street traders or banking executives. It was an inherently political incentive, because it tied in with the American Dream and sounded nice on a campaign platform. It wasn’t that politicians who had never previously cared about home ownership were hoodwinked by lobbyists promoting its benefits for selfish ulterior motives. It was that politicians had dedicated entire platforms and speeches and ideologies towards promoting home ownership as early as the 1950’s, and then made dozens of policies pressuring private actors to behave in a way which promoted home ownership. Wall Street just responded to these pressures, singing the song their overseers wanted to hear.
The extent to which Wall Street “justified” subprime lending using this narrative is merely the extent to which they were forced to navigate and bargain with a complex web of government regulators and power-brokers, which is itself proof of just how un-free the market was!
They write “The idea that complex securities could help low- and middle-income families own homes was especially attractive to Democratic congressmen and officials who might ordinarily be distrustful of mortgage lenders and investment bankers, and helped seal off Wall Street's new money machine from criticism.” This is exactly backwards. The fact that government had engineered a money-machine for Wall Street was what helped seal off the idea that complex securities could help low- and middle-income families own homes from criticism.
They go on: “Not only did the federal government make no attempt to regulate subprime lending, but it even became a cheerleader for the subprime boom.” But the subprime boom itself was just a reaction to the very thing which the federal government had been a cheerleader for all along: increased home ownership, for all the social and economic and political benefits it was supposed to create.
Corruption requires two complicit parties. Libertarians are the first to agree that politicians are too cozy with Wall Street or corporate leaders, but that is a consequence of regulation! Wall Street is just adjusting to the rules of the game.
The Wall Street “takeover” that forms the running focal point of the book is nothing more than regulatory capture: the well-documented process by which the largest and most powerful firms in a regulated industry wind up influencing the regulations to their benefit, often enlarging their profits and strengthening their already-dominant market share to the detriment of both consumers and their competition. This is a recurring, foreseeable and inherent problem with regulation, not some kind of inherent market failure!
In fact, the existence of any such body for Wall Street to “take over” in the first place reveals the lie in the notion that the “free market’ was to blame for anything, because in a free market, firms wouldn’t need to navigate this complex web of agencies and authorities at all. In a free market, firms compete with one another by lowering their prices or bettering their product. This is healthy greed, because it better serves others. But regulation allows firms to compete in another way: by convincing politicians to write the rules which favor them, punish opponents, make their business artificially lucrative, or bail out their mess-ups. In other words, it diverts that healthy, cooperative greed into unhealthy rent-seeking.
In summary, 13 Bankers is correct to point out that Greenspan and crew were hostile to government regulation of the financial sector, but incorrect that the resulting deregulation and lack of oversight is what caused the crash. The authors themselves concede that Greenspan only thought markets were efficient so long as the participants had all the information necessary (page 103). In a healthy market, prices are the vehicles which transport that information, and the “price” in the home loan market is the interest rate (the price of borrowing money). But for decades prior to the 2008 crash, government interference in the loan market distorted those prices, along with the signals and information they are supposed to convey, by pressuring banks to give out ever more and ever riskier loans. The crash occurred when too many of these loans were not repaid. There was never any free market involved.
PS – I don’t dispute anything the authors said about derivatives, complexity, or financial innovation – they are mostly right that innovation isn’t inherently good. But I think the ever-more-creative ways to distribute all the risk the housing markets were taking on was a symptom of the bubble, not the cause. Splitting up risk isn’t a bad idea, generally; there just shouldn’t have been that much risk to distribute in the first place, because Fannie and Freddie and the FHLBs shouldn’t have been giving out the loans they were giving.