Squaring the Culture

Karl Rove attempted to set the record straight regarding the causes of the credit meltdown in an editorial at the Wall Street Journal yesterday, explaining how President Bush attempted to rein in the principle culprits, FNMA and FHLMC, but was foiled by Democrats protecting their favorite lobbyists’ turf.

Observes Rove,

Mythmaking is in full swing as the Bush administration prepares to leave town. Among the more prominent is the assertion that the housing meltdown resulted from unbridled capitalism under a president opposed to all regulation.

Like most myths, this is entertaining but fictional. In reality, Fannie Mae and Freddie Mac were among the principal culprits of the housing crisis, and Mr. Bush wanted to rein them in before things got out of hand.

Rather than a failure of capitalism, the housing meltdown shows what’s likely to happen when government grants special privileges to favored private entities that facilitate bad actors and lousy practices.

The interesting twist on this defense is that it rests on a reversal of roles. In Rove’s account, the regulator was President Bush, and those opposed to regulation were the Democrats. This is historically accurate from what I know, but counter-intuitive. One would expect the President to be favoring deregulation (if one were laboring under the illusion that the President was actually conservative,) and the Democrats to be insisting on regulation.

The best explanation for the reversal comes from Newt Gingrich, who calls the Fannie/Freddie meltdown the result of “Crony Capitalism.” This particular piece of the economic failure was the result, not of errant Democratic policy, but of a too-cozy relationship between high-ranking Democrats in Congress and highly-placed officers of the Government Sponsored Entities (GSEs). And of course, in Rep. Barney Frank’s case (D, MA) “cozy” is literal, but we won’t peek behind that door. It seems that it’s not just Republican lawmakers who abandon their principles when they get used to the perks of office.

Let’s recount the major failures of the decades-long run-up to the current financial woes:

• The Community Reinvestment Act of 1978 forced bankers to make loans to debtors who were less than credit-worthy. Government policy in the 1990s increased the impact of this law 10-fold. This is a failure of liberal policy formulation.
• The Fed dropped the interest rate to near zero and created an economic bubble that overstimulated investment in real estate. This is a failure due to government intervention.
• Investors sank loads of money into investment vehicles that had questionable intrinsic value, on the recommendation of ratings agencies that were beholden to the sellers of those vehicles. This is a buyer error.
• A whole bunch of home buyers bought homes on margin that they could not really afford, assuming that housing values would continue to rise. This is a buyer error, lax banking, and in a lot of cases, fraud on the part of buyers.
• The government forced an accounting technique that required gross revaluing of assets in a manner that panicked investors. This is government over-regulation.
• The government did not require GSEs to meet the same reserve requirements or adhere to the same investment limits that other financial institutions must meet. This is a failure due to government micro-management (creating special governmental entities where normal, private ones would suffice) and to government influence-peddling.

So, what we have is government micro-management, government policy errors, corruption due to too much government power, and greedy buyers committing fraud and throwing caution to the winds.

There are those who attempt to argue that regulating derivitive trading would have prevented the disaster, but they’re just taking advantage of a crisis to tout their favorite theses. There’s no reason to believe regulators would have had the foresight to prevent the meltdown, especially given the fact that regulators with the power to interfere in derivative trading did, in fact, review the matter and decide not to intervene.

What we do not see in the picture is a failure of capitalism. We do see some greedy, fraud-committing investors losing their posteriors, but to call their losses a failure of capitalism is like calling it a failure of sports when drunken idiots go over a waterfall in a raft. It’s a worthwhile part of the system, indeed, a worthwhile characteristic of the universe, that idiots get what they deserve in response to their idiocy. It’s perhaps unfortunate that the weeding out of idiots affects others as well, but that cannot be avoided.

UPDATE: Here’s a hat tip to Protein Wisdom, who covered the same article today, with quotations from some older analyses. Here’s a clip — kinda long, sorry — from Kevin Hassett, director of Economic Policy Studies at the American Enterprise Institute:

Take away Fannie and Freddie, or regulate them more wisely, and it’s hard to imagine how these highly liquid markets would ever have emerged. This whole mess would never have happened.

It is easy to identify the historical turning point that marked the beginning of the end.

Back in 2005, Fannie and Freddie were, after years of dominating Washington, on the ropes. They were enmeshed in accounting scandals that led to turnover at the top. At one telling moment in late 2004, captured in an article by my American Enterprise Institute colleague Peter Wallison, the Securities and Exchange Comiission’s chief accountant told disgraced Fannie Mae chief Franklin Raines that Fannie’s position on the relevant accounting issue was not even “on the page” of allowable interpretations.

Then legislative momentum emerged for an attempt to create a “world-class regulator” that would oversee the pair more like banks, imposing strict requirements on their ability to take excessive risks. Politicians who previously had associated themselves proudly with the two accounting miscreants were less eager to be associated with them. The time was ripe.

Greenspan’s Warning

The clear gravity of the situation pushed the legislation forward. Some might say the current mess couldn’t be foreseen, yet in 2005 Alan Greenspan told Congress how urgent it was for it to act in the clearest possible terms: If Fannie and Freddie “continue to grow, continue to have the low capital that they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest rate risk aversion, they potentially create ever-growing potential systemic risk down the road,” he said. “We are placing the total financial system of the future at a substantial risk.”

What happened next was extraordinary. For the first time in history, a serious Fannie and Freddie reform bill was passed by the Senate Banking Committee. The bill gave a regulator power to crack down, and would have required the companies to eliminate their investments in risky assets.

Different World

If that bill had become law, then the world today would be different. In 2005, 2006 and 2007, a blizzard of terrible mortgage paper fluttered out of the Fannie and Freddie clouds, burying many of our oldest and most venerable institutions. Without their checkbooks keeping the market liquid and buying up excess supply, the market would likely have not existed.

But the bill didn’t become law, for a simple reason: Democrats opposed it on a party-line vote in the committee, signaling that this would be a partisan issue. Republicans, tied in knots by the tight Democratic opposition, couldn’t even get the Senate to vote on the matter.

That such a reckless political stand could have been taken by the Democrats was obscene even then. Wallison wrote at the time: “It is a classic case of socializing the risk while privatizing the profit. The Democrats and the few Republicans who oppose portfolio limitations could not possibly do so if their constituents understood what they were doing.”