What Price Stability?

September 15, 2008 • Commentary
This article appeared in the South China Morning Post on September 15, 2008.

The US Treasury’s takeover of Fannie Mae and Freddie Mac, the nation’s largest mortgage financers, was predictable. The drive for profits while housing prices were rising, and the expectation that the federal government would not let these market‐​socialists fail, allowed Fannie and Freddie to accumulate a huge portfolio of mortgages and mortgage‐​backed securities. Now that the asset price bubble in housing is being deflated and Fannie and Freddie’s capital is shrinking, the Fed is compelled to come to the rescue in order to “stabilise” US and global financial markets.

The real issue is: “what next?” The two government‐​sponsored enterprises (GSEs) are going to be allowed to continue to expand their portfolios until the end of next year, but will then have to begin trimming back by about 10 per cent per year. In the past, Fannie and Freddie showered large sums on members of Congress to win votes and retain their privileged position. Although those payments are now illegal, Fannie and Freddie have many friends on Capitol Hill who believe the GSEs are essential to affordable housing; they will fight hard to maintain the status quo.

Fundamentally, the Fannie and Freddie debacle is about the role of government in a free society. If government is limited to protecting people and property, and individuals are allowed to keep the fruits of their labour and to bear the risks of loss, then capital will be efficiently allocated.

The secret to a harmonious financial system is to get institutions and incentives right. Experience has shown that market liberalism best directs resources to where they have the most value to society. The so‐​called voluntary principle, based on private property and the rule of law, allows information to be effectively processed by those individuals who have a stake in the results. Effective private property rights mean that rewards and losses are concentrated on decision‐​makers, not taxpayers. The hybrid nature of GSEs — whereby profits flow to shareholders and managers while losses are socialised — distorts institutions and incentives, and misdirects capital. Congress then calls for more regulation and delegates power to some regulatory agency to oversee the GSEs. However, when regulators have little to gain from efficiency, and losses due to lax regulation accrue to taxpayers, what incentive is there to be prudent?

Preserving the status quo by maintaining Fannie and Freddie’s crony capitalism would expand the size and scope of government, rather than make individuals responsible for their mistakes.

The problem is that once markets are polluted with privileged firms, private entrepreneurs will be crowded out. Instead of moving to a self‐​regulating market, the GSEs will be made to obey new regulations, which often have unintended consequences. The takeover of Fannie and Freddie could cost taxpayers US$200 billon to US$300 billion — and far more if housing prices fail to stabilise.

Once the door to government intervention is opened, more people and firms want favours. Keeping interest rates lower than market rates to benefit GSEs distorts capital markets. Contagion is often blamed on “market failure”. In fact, if true private markets exist and the locus of responsibility is on individuals rather than being socialised, errors of judgment would not accumulate as they do under market socialism or crony capitalism.

The next administration and Congress will have to decide whether to shut down Fannie and Freddie or continue on the path of market socialism. Choosing the latter would mean more regulation and state control, and less freedom. It would change the distribution of risk but not reduce risk.

When the US Treasury is raided to defend the government’s credibility to guarantee GSE debt, it may calm markets for a time. Yet, in the long run, the drifts towards socialism and increased government borrowing requirements discourage foreign investment, decrease private saving, increase interest rates and slow US growth. That is a high price to pay for “stability”.

About the Author
James A. Dorn

Vice President for Monetary Studies, Senior Fellow, and Editor of Cato Journal