In Defense Of Liberty

October 21, 2008 • Commentary
This article appeared in Forbes on October 21, 2008.

The government has responded to the credit crisis with a massive expansion of its balance sheet and its role in the economy. Is there nothing for a good libertarian to do but head for the hills? No, you can stand and fight.

Libertarians and fans of small government, do not abandon all hope. There are lessons to be learned from the financial crisis, and battles to be fought. The first lesson to learn is that the Community Reinvestment Act of 1977 was a mistake. The law forces banks with branches in poor neighborhoods to lend money there–which is to say, to lend money to people with poor credit ratings. This price is exacted from any bank looking for permission to add a branch or buy another bank. The rule is enforced by private community organizations like Acorn.

There are two ways that banks cope with the law’s demands. One is simply by avoiding poor neighborhoods altogether, leaving the business of providing financial services there to pawnshops, check‐​cashing outlets and businesses making usurious payday loans. The other is by writing a lot of mortgages. That means issuing subprime mortgages with low down payments and low teaser rates. The monthly payments, that is, start out looking affordable. After a while the loan resets to a much higher rate.

The problems occasioned by the latter approach were compounded by a 1995 law permitting the securitization of subprime loans. Securitizing frees the mortgage originator from an obligation to hold weak loans in its own portfolio and thus makes that originator more indifferent to the risks. Beginning in the late 1990s the White House and Congress also put strong pressure on Fannie Mae and Freddie Mac to buy securities backed by these mortgages. Over the years 2005-07 about 40% of the mortgages that the two enterprises added to their portfolios of single‐​family loans were junk loans.

Now that Fannie and Freddie have been nationalized–adding $5 trillion of debt to the government balance sheet–what is the next step? At the moment the U.S. Treasury is trying to restore them to health so that it can send them back into the private sector. This is a mistake. The government should liquidate them.

The two megathrifts are based on a profoundly unsound business model in which their profits accrue to shareholders and executives and their losses accrue to taxpayers. That is a recipe for warped incentives. It’s why Fannie and Freddie stacked giant asset piles atop slim equity cushions. It’s why they went bust when house prices declined.

After auctioning off the assets of Fannie and Freddie, the government should stop playing any role in providing subsidized credit to the general housing market. How, then, will we help low‐​income families that want to own their homes? With a narrowly targeted mortgage subsidy. It would be keyed to people’s incomes, rather like food stamps, and it would be a far more efficient way to increase home ownership among poor people than the combination of the Community Reinvestment Act, Fannie and Freddie. The two mortgage giants are allowed to buy loans as big as $625,500. How can that possibly be the way to help poor people? One advantage of a mortgage subsidy is that it would be a line item in the budget rather than a cost imposed on private‐​sector banks or a hidden risk imposed on future taxpayers.

The second lesson from the crisis–a lesson that taxpayers will learn painfully over the next few years–is that it’s a bad idea to award immense new powers to the executive branch while ignoring the need to oversee the wielding of that power. Just as members were about to head home to campaign for reelection, Congress handed the Treasury Department a $700 billion credit card with which to bail out banks, brokers and issuers of commercial paper. The bill was a lot for the legislators to swallow. It went down more easily after the addition of $100 billion of expenditures and tax breaks for purposes wholly extraneous to the legislation’s main objective.

There are three precedents for blank‐​check authorizations on this scale, and none is reassuring. One is the Gulf of Tonkin Resolution that authorized the Vietnam War. The next allowed Richard Nixon to impose wage and price controls and a 10% surcharge on imports. The third authorized the Iraq War. Our political system cannot maintain a balance of power between the Administration and Congress on such important matters when the authorizing laws are so unbalanced.

My first piece of advice to Congress: Don’t be rushed. Very few decisions of any importance need to be made within days, even in an election year. In any election year two‐​thirds of incumbent senators are not running for reelection. They could provide a valuable forum for reviewing any important proposal from the Administration, while their colleagues and all the members of the House run to keep their jobs.

My second: Ask a bipartisan group of respected former government officials who have faced similar problems before to review the conditions that led to an Administration’s proposal, evaluate the proposal, and consider and evaluate feasible alternatives to it. For the recent financial crisis I would have recommended a panel that included Alan Greenspan, Paul Volcker, William Isaacs and Lawrence Summers.

And what do I tell fellow libertarians? Stand your ground. You do not win elections, but you influence them. Work across party lines if you want to have any effect. The number of voters who have generally libertarian political preferences is larger than the vote difference between the major parties. On important issues libertarians must be among the best informed and be willing to support the position of whichever major party is most consistent with their beliefs.

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