Topic: Regulatory Studies

If Anyone Blames the Market, I Swear I’ll…

Right now, it’s very popular with politicians to blame the free market for our mortgage-driven economic woes. It’s also, as with most things popular among politicians, utter nonsense: Fannie and Freddie are Dr. Washington’s monsters, and DC has practically forced lenders to float loans to high-risk borrowers.

Of course, it’s not just in mortgages that the feds have been superheating the market, only to proclaim that they’re saving it every time they do something that will just make matters worse. They’ve been doing that in higher education for decades, delivering or guaranteeing loans targeted at high-risk borrowers, and the current credit “crisis” has done nothing to curb their enthusiasm. Heck, it’s emboldened them to do more.

You might recall something I wrote back in April about the Ensuring Continued Access to Student Loans Act, a fast-moving piece of legislation intended to shield any college student from the possibility that he or she might not be able to get a loan. Among other things, the act increased limits on several federal loans so that students could borrow even more, and loosened the eligibility guidelines for PLUS loans so that parents in significant mortgage arrears could still borrow college cash. It easily passed Congress, pushing significantly more money at ever-greater risks – and Congress has just extended it to 2010.

And people wonder why lenders make loans to obvious credit risks, and college costs keep on skyrocketing?

Unfortunately, some people in Washington never learn, or worse, know full well that pumping ever more money to big risks is a huge, dangerous distortion, and just don’t care. Case in point, this quote from Michael Dannenberg, senior fellow with the New America Foundation, lauding Senator Obama in a new AP article for proposing a new tax credit program—which includes a make-work “community service” payback piece—on top of all the other federal aid programs:

Michael Dannenberg, senior fellow with the New America Foundation and a former adviser to Sen. Edward Kennedy, D-Mass., says Obama’s proposals take the problem of college affordability more seriously than McCain’s. And he calls the tax credit a significant innovation.
“McCain’s message when it comes to increased tuition is, ‘You’re on your own,’” said Dannenberg, who has not worked for Obama’s campaign. “Obama’s message to families is, ‘We’ll give you more financial aid to help you with college costs, but your kids are going to have to help others.’”

Notice what taking a problem “seriously” means? Offering even more bankrupting government largesse! And who cares about the ultimate bill…until, that is, the reality of “no free lunch” ultimately forces it to come due.

In light of this, nobody, and I mean NOBODY, in Washington had better blame “market forces” for huge cost problems, inefficiencies, or just plain wasted money in higher education. Federal politicians, with their constant bribery of voters and special interests, have made our colossal financial messes, and they haven’t got a leg to stand on acting like they are the solution and freedom is the problem.

I’m from the Government and I’m Here to Stop Hurting You

The Washington Post discusses the great new options for street food in downtown Washington–not just hot dogs but “po’ boys, pulled pork, gumbo, shawarma” and more. Sure sounds like the much-criticized D.C. government is really helping this time: The jump headline says, “With City’s Help, Vendors Break the Mold.” Author Tim Carman writes, “Both [new food] vendors still needed public assistance.” And “the city [has] been working with vendors to give hungry Washingtonians a taste of what they want.” All praise the D.C. government, font of good food.

But of course the city hasn’t produced the food. It hasn’t subsidized the vendors. It hasn’t put vendors together with investors. All it has done is to lift, in one part of the city, “regulations that have choked the life out of D.C.’s street food for decades.” There are licensing rules (and a moratorium on issuing any new licenses), prohibitions on hiring employees, cart size rules, regulations on where you can park a cart at night, and so on. So the “public assistance” the vendors received was to be exempted from some of the regulations, inside a 32-block demonstration zone.

It reminds me of the wisdom of Henry David Thoreau: “This government never furthered any enterprise but by the alacrity with which it got out of the way.”

The Risk-Free Society Comes into View

Peter Bernstein draws a conclusion from the current problems in the financial markets:

The subprime mortgage mess, the huge leverage throughout the system, the insidious impact of new kinds of derivatives and other financial paper, and, at the roots, the vast underestimation of risk could not have happened in a planned economy.

Oh really? Another story from today’s New York Times reports:

The banking giant JPMorgan Chase, for instance, has 70 regulators from the Federal Reserve and the comptroller’s agency in its offices every day. Those regulators have open access to its books, trading floors and back-office operations. (That’s not to say stronger regulators would prevent losses. Citigroup, which on paper is highly regulated, suffered huge write-downs on risky mortgage securities bets.)

Goldman-Sachs, which was largely unregulated, mostly avoided losses related to the mortgage market through prudent hedging. Citigroup, which was highly regulated, suffered such losses. Expect state control without the promised payoff in a planned economy.

There’s a larger point here that Bernstein neglects completely. A prosperous society requires risk taking. Bernstein is correct: historically a planned economy has prevented such risk taking. Not surprisingly, such societies have not been prosperous, to put it mildly.

More important, they have not been free societies. Preventing the downside of risk requires control over people’s choices. Seventy bureaucrats reviewing your trades. More generally, the best and the brightest continually uttering imperative sentences. Stay away from that cake! Avoid that derivative! Think correct thoughts! The risk-free society will be a society filled with hectored serfs.

Right now, at this moment of hysteria, the political class suffers from availability bias. Like Bernstein, they see only the downside of risk and conclude the necessity of the planned economy. A more complex and nuanced view would see both sides of risk and the enduring value of liberty.

Fannie and Freddie

The IBD has an excellent front page summary of the 1990s roots to the Fannie Mae and Freddie Mac disaster.

One issue IBD touches on is the ineffectiveness of the regulating agency OFHEO. Here is OFHEO giving Fannie and Freddie a clean bill of health just last December.

One reason that having regulatory agencies is worse than having no suchagencies is the false sense of security provided to markets by such apparently off-base seals of approval.

Blame Urban Planning

The credit crisis has led to numerous calls for bigger government. Yet the truth is that big government not only let the crisis happen, it caused it.

This truth is obscured by most accounts of the crisis. “I have a four-step view of the financial crisis,” says Paul Krugman. “1. The bursting of the housing bubble.”

William Kristol agrees. His account of the crisis begins, “A huge speculative housing bubble has collapsed.” “The root of the problem lies in this housing correction,” said Secretary of the Treasury Henry Paulson.

So it all started with the bubble. But what caused the bubble? The answer is clear: excessive land-use regulation. Yet while many talk about re-regulating banks and other financial firms, hardly anyone is talking about deregulating land.

The housing bubble was not universal. It almost exclusively struck states and regions that were heavily regulating land and housing. In fast-growing places with no such regulation, such as Dallas, Houston, and Raleigh, housing prices did not bubble and they are not declining today.

The key to making a housing bubble is to give cities control over development of rural areas – a step that is often called “growth-management planning.” If they have such control, they will restrict such development in the name of stopping “urban sprawl” – an imaginary problem – while their real goal is to keep development and its associated tax revenues within their borders. Once they have limited rural development, they will impose all sorts of conditions and fees on developers, often prolonging the permitting process by several years. This makes it impossible for developers to respond to increased housing demand by stepping up production.

In contrast, when cities do not have control of rural areas, developers can step outside the cities and buy land, subdivide it, and develop it as slowly or rapidly as necessary to respond to demand. The cities themselves respond by competing for development – in other words, by keeping regulation and impact fees low. The Houston metro area, for example, has been growing at 130,000 people per year, yet it was readily able to absorb another 100,000 Katrina evacuees with virtually no increase in housing prices.

Before 1960, virtually all housing in the United States was “affordable,” meaning that the median home prices in communities across the country were all about two times median-family incomes. But in the early 1960s, Hawaii and California passed laws allowing cities to regulate rural development. Oregon and Vermont followed in the 1970s. These states all experienced housing bubbles in the 1970s, with median prices reaching four times median-family incomes. Because they represented a small share of total U.S. housing, these bubbles did not cause a worldwide financial meltdown.

In the 1980s and 1990s, however, several more states passed laws mandating growth-management planning: Arizona, Connecticut, Florida, Maryland, Rhode Island, and Washington. Massachusetts cities took advantage of that state’s weak form of county government to take control of the countryside. The Denver and Minneapolis-St. Paul metro areas adopted growth-management plans even without a state mandate. As a result, by 2000, prices of nearly half the housing in the nation were bubbling to four, six, and in some places ten times median-family incomes.

In the meantime, Congress gave the Department of Housing and Urban Development (HUD) oversight authority over Fannie Mae and Freddie Mac. While this was supposedly aimed at protecting taxpayers, Congress knew that HUD’s main mission is to increase homeownership rates, and Congress specifically pressured HUD to increase homeownership among low income families. So HUD responded to the housing bubble by directing Fannie and Freddie to buy increasingly high percentages of mortgages made to low income families, eventually setting a floor of 56 percent. This led Fannie and Freddie to significantly increase their purchases of subprime mortgages, which legitimized the secondary market for such mortgages.

Though everyone knows that the deflation of the housing bubble is what caused the financial meltdown, few have associated the bubble itself with land-use regulation. Back in 2005, Paul Krugman observed that the bubble was caused by excessive land-use regulation. Yet nowhere in his current writings does he suggest that we deregulate land to prevent such bubbles from happening again. Such suggestions have come only from the Cato Institute, Heritage Foundation, and a few other think tanks.

We know that if the regulation is left in place, housing will bubble again – California and Hawaii housing has bubbled and crashed three times since the 1970s. We also know, from research by Harvard economist Edward Glaeser, that each successive bubble makes housing more unaffordable than ever before – and thus leaves the economy more vulnerable to the inevitable deflation. This is because when prices decline, they only fall about a third of their increase, relative to “normal” housing, before bottoming out.

Thus, median California housing was twice median family incomes in 1960, four times in 1980, five times in 1990, and eight times in 2006. In the next bubble, it will probably be at least ten times. This means homeownership rates will decline (as it has declined in California since 1960), small business formation (which relies on the equity in the business owners’ homes for capital) will decline, and education will decline (children of families that own their homes do better in school than children of families who rent).

Worse, more states are passing growth management laws. Tennessee passed a law in 1998, too late to get into the recent housing bubble but enough to participate in the next one. Legislators in Georgia, North Carolina, and other fast-growing states are being pressured to also pass such laws. Naturally, the planners who promote such laws deny that their actions have anything to do with housing prices.

Even worse, the Environmental Protection Agency has proposed to “integrate climate and land use” – effectively using global warming fears to impose nationwide growth management. Supposedly – though there is no evidence for it – people in denser communities emit fewer greenhouse gases, and growth management can be used to impose densities on Americans who would rather live on quarter-acre lots. The California legislature recently passed a law requiring cities to impose even tighter growth restrictions in order to reduce greenhouse gases – and its implementation will be judged on the restrictions, not on whether those restrictions actually reduce emissions.

Instead of such laws, states that have regulated their land and housing should deregulate them. Congress should treat land-use regulations as restrictions on interstate mobility, and deny federal housing and transportation funds to states that impose such rules. Otherwise, hard as it may be to imagine, the consequences of the next housing bubble will be even worse than this one.

Big Victory for Economic Liberty

Amid a financial crisis that has pundits playing the game of who can come up with the most nationalization and re-regulation—and a presidential campaign where neither candidate seems to have much coherent to say about the economy—one bright ray of light shone through.

And it came from San Francisco, no less.

On September 16, the U.S. Court of Appeals for the Ninth Circuit delivered a blow against unfair economic regulation in the case of Merrifield v. Lockyer. Pacific Legal Foundation lawyer and Cato adjunct scholar Tim Sandefur argued on behalf of Alan Merrifield, a businessman prevented from building structures to keep out pests by a bizarre licensing regulation. The California law in question required people who do not use pesticides to undergo years of training and take an examination testing their knowledge of chemicals and insects before they can use pest control techniques that involve neither chemicals nor insects.The law only applies to pigeons, rats, and mice, however, so putting spikes on a building to keep seagulls off it does not require a license. But the same activity aimed at deterring pigeons does. Moreover, the record showed that the rule was designed for the sole purpose of protecting people who have licenses from having to compete in the marketplace against upstart businesses like the one operated by Merrifield.

Circuit Judge Diarmuid O’Scannlain, writing for the panel majority, succinctly explained the problem with California’s rationale:

The possibility that non-pesticide-using pest controllers might interact with pesticides or will need the skill to suggest pesticide use when it would be more effective is the very rationale that government’s counsel proffered, and we relied upon, in upholding the requirement that Merrifield obtain a license under due process grounds. We cannot simultaneously uphold the licensing requirement under due process based on one rationale and then uphold Merrifield’s exclusion from the exemption based on a completely contradictory rationale. Needless to say, while a government need not provide a perfectly logically solution to regulatory problems, it cannot hope to survive rational basis review by resorting to irrationality.” (Emphasis in original)

That is, “economic protectionism for its own sake, regardless of its relation to the common good, cannot be said to be in the furtherance of a legitimate governmental interest.”

This decision is thus a tremendous blow against the various licensing advantages granted by legislatures to the few at the expense of the many. As Sandefur put it in PLF’s press release, “This is a victory for free enterprise and for the Constitution’s safeguards for entrepreneurship.”

The battle for economic rights remains an uphill struggle, however, because the invalidation of California’s pernicious legislation rested not on the basic right to earn an honest living but on the state’s “irrational singling out of three types of vertebrate pests” to the economic benefit of some exterminators as against others.The case necessarily turned on an “equal protection” violation, instead of constitutional protection of any substantive rights. Without that arbitrary listing of pigeons, rats, and mice, the pesticide/insect requirements would have withstood Merrifield’s challenge. Judge O’Scannlain implicitly recognized that reaching the correct result in this manner was intellectually unsatisfying, but that his hands were tied by the Supreme Court’s 1873 Slaughterhouse Cases (which eviscerated the Fourteenth Amendment’s Privileges or Immunities Clause). So long as the Supreme Court shies from revisiting the twisted logic of that precedent, the Constitution will offer precious little defense against legislation that restricts the ability of individuals to freely exchange goods and services.

Nevertheless, in establishing the legal principle that mere protectionism is not a legitimate state interest, the Merrifield case is a major victory for economic liberty—and the first time the Ninth Circuit has taken up this issue.

Congratulations to Tim and to Pacific Legal!

The United States of Permanent Receivership

Next year marks the 30th anniversary of the appearance of the second edition of Theodore J. Lowi’s The End of Liberalism, subtitled The Second Republic of the United States. The preface to the second edition ends, “I want to express a very belated thanks to Friedrich A. Hayek. His work had much more of an influence on me than I realized during the writing of the First Edition. I neither began nor ended as a Hayekist but instead found myself confirming, by process of elimination and discovery, many of his fears about the modern liberal state.”

Lowi argues that the Second Republic is marked by “the state of permanent receivership,” which is defined as “a state whose government maintains a steadfast position that any institution large enough to be a significant factor in the community may have its stability underwritten. It is a system of policies that sets a general floor under risk, either by attempting to eliminate risk or to reduce or share the costs of failure.” This state includes anticipatory receivership, which includes “businesses that are not actually on the brink of bankruptcy but are in a sector of the economy where bankruptcies or reorganizations are likely unless there is some kind of a preventive measure.”

Thirty years out, Ted Lowi looks pretty good this morning. Not much else looks good, but the second edition of The End of Liberalism shows that this dour morning has been coming for some time.

Read the book.