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Articles

Petr Mach: American Financial Crisis – Failure of State Regulation

Euro, 08.10.2008

published: 29.10.2008, read: 8364×

 

by Petr Mach, executive director, Center for Economics and Politics, Prague, Czech Republic

Published originally in the Czech language in the Czech weekly Euro, 6 October 2008

 

The United States have experienced a shock on its financial markets. First, the government imposed conservatorship on Fannie Mae and Freddie Mac on September 7. Later, on September 16, AIG started having solvency problems, and the Fed granted it a rescue loan of $85 billion, and the government took over 80 % of its shares. Now the Bush administration is trying to push through the Congress a plan for taking over the assets of other banks worth $700 billion. The media, both Czech and international, featured comments mocking free capitalism, which allegedly failed. But what is the reality?

State Interventions Everywhere

The American financial markets were far from laissez faire capitalism. Fannie Mae and Freddie Mac were established by the government. The former in 1938 under President F. D. Roosevelt – during the New Deal, the latter in 1970. It was a typical leftist idea to "help the housing market" and "improve affordability of homes". The banks then obviously granted mortgage loans more willingly. They bore virtually no risk, when the mortgage loans from these banks were soon bought by these government-established institutions. Furthermore, Fannie Mae and Freddie Mac enjoyed a number of other advantages: For example, they were exempted from state and local taxes, and their bonds held by other financial companies were preferred in terms of the rules of capital adequacy.

Fannie Mae was privatized in 1968 and Freddie Mac in 1970, right after having been established. Nevertheless, it was exactly the fake kind of neoconservative privatization, the purpose of which is to win quick money for the state budget but which also assigned the company a "public" role and grants it a government guarantee. The government came up with a new legal norm, a "government-sponsored enterprise", GSE – not a state company, not a public corporation, but rather a hybrid. Under their status, the companies must 1) "provide stability in the secondary market for residential mortgages", 2) respond appropriately to the private capital market, 3) support mortgages on housing for low- and moderate-income families and subsidize these mortgage loans from their other revenues.

Freddie Mac and Fannie Mae had seemingly risk-free and profitable business. Their assets included mortgage loans (i.e., bonds covered by real-estates, which are traditionally considered little risky), and as a source they had low-interest, state guarantee-supported bonds. From banks they were buying – as it has turned out – not only subprime mortgage loans but also speculative mortgage loans motivated by the currently growing property prices. All of a sudden, Freddie and Fannie were possessing mortgage loans, which their recipients did not repay. There is no such thing as a free lunch, and so also the idea of fulfilling a political goal for private money did not last forever.

Ill-Fated Role of the Central Bank

Another state institution involved in the "risk-free" revenue game was the Federal Reserve System (Fed) established in 1913. One of the key prices in the economy, the interest, was controlled by the Fed bureaucrats instead of being subject to market-created demand and supply. Fed acted as the chief central planner in deciding about the interest rate. The central bank, instead of providing just undistorting, mild and smooth growth of the money supply (since there is already the state monopoly for money printing) as suggested by the monetarist theory promoted by Milton Friedman, an economics Nobel prize winner and a great advocate of the free market, Fed was playing with the interest rate, increasing and decreasing it by massive financial operations.

On a free market – in a situation where the demand for mortgage loans grows – the interest rate would have already tended to grow. But at that time, Fed decided to decrease the interest rates by means of massive purchases of government bonds. The central planner’s hand therefore significantly contributed to the problems of Freddie Mac and Fannie Mae.

On September 16, AIG announced its inability to comply with its obligations. It happens. The very essence of capitalism is that it allows the unsuccessful to go and new ones to come. Fed, however, quickly announced takeover of the insurer, reasoning that it was too big to fail, especially a few days before the elections. Fed therefore released a loan for AIG in the amount of $85 billion (central banks, who print money, are able to act as the "lender of last resort" – i.e., to lend money to the banks, to which no one else is willing to lend). The Bush administration also took over 79.9% of AIG shares, and thus nationalized the largest insurer. The assets will probably be transferred to a government-run agency, which will later sell these assets. The Bush administration wants to push a $700 billion bailout plan through the Congress, which is intended to buy assets of additional banks.

The government is therefore creating a typical moral hazard. With its guarantees it sends a message to major investors: in the good years, when your investments are profitable, you are entitled to the yield. When there is a risk of getting no money for the securities you have bought the government will come with the taxpayers’ money and relieve you from the risk. Politicians dispose of billions of taxpayers’ dollars; the taxpayers, unlike the major investors, are scattered and cannot defend themselves.

Conclusion

It was not free market that failed in the American financial crisis. It was again the presumptuous hand of state planners.

The American and West-European legal systems have always been given us - in the Czech Republic - as examples. Some even suggested in 1989 that we adopt a legal and institutional system as a whole. Nonsense. And the increasingly state-controlled American mortgage market should certainly be the last example for us.

There are the following recommendations resulting from the American crisis: Let us not imitate schemes such as mortgage support through a "government-sponsored agency", which will provide cheap mortgage loans for low and medium income families. We should also give a second thought to the Euro-American model of monetary policy, which controls the interest rate centrally, and often apparently against the healthy direction of a free market.

Petr Mach

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